Market Efficiency for Fundamental Analysis

The table below shows if abnormal returns can be earned through various strategies and active management assuming different types of market efficiency.

$$
\begin{array}{l|cccc}
\textbf{} & \textbf{Technical Analysis} & \textbf{Fundamental Analysis} & \textbf{Insider Trading} & \textbf{Active Management} \\
\hline
\textbf{Weak} & \text{No} & \text{Yes} & \text{Yes} & \text{Yes} \\
\textbf{Semi-strong} & \text{No} & \text{No} & \text{Yes} & \text{No} \\
\textbf{Strong} & \text{No} & \text{No} & \text{No} & \text{No} \\
\end{array}
$$

• Weak Form Efficiency:
  • Technical Analysis: No abnormal returns can be earned because past price information is already reflected in stock prices.
  • Fundamental Analysis: Can potentially earn abnormal returns as past price information is not sufficient; public information may not yet be fully reflected.
  • Insider Trading: Can earn abnormal returns as private information is not reflected in the stock price.
  • Active Management: Can earn abnormal returns if it involves strategies that are not fully captured by past price data.
• Semi-Strong Form Efficiency:
  • Technical Analysis: No abnormal returns because all publicly available information is already reflected in stock prices.
  • Fundamental Analysis: No abnormal returns because all publicly available information is incorporated into stock prices.
  • Insider Trading: Can still earn abnormal returns as private information is not yet reflected in the stock prices.
  • Active Management: No abnormal returns based on public information as it’s already incorporated into the stock prices.
• Strong Form Efficiency:
  • Technical Analysis: No abnormal returns as all information (public and private) is reflected in stock prices.
  • Fundamental Analysis: No abnormal returns for the same reason.
  • Insider Trading: No abnormal returns as even private information is reflected in the stock prices.
  • Active Management: No abnormal returns, as all information is reflected in stock prices.

Question

Which of the following statements is most likely true?

1. In a strong form efficient market, a rational investor would invest in an actively managed fund.
2. In a weak-form efficient market, active management can outperform passive management net of fees.
3. In a semi-strong form efficient market, fundamental analysis can earn abnormal returns, but technical analysis cannot.

Solution

The correct answer is B.

Active management should be able to outperform passive management gross of fees in a weak-form efficient market. However, its ability to outperform net of fees depends on how high abnormal returns are relative to additional management fees.

A is incorrect. In a strong form efficient market, no rational investor would invest in an actively managed fund since the fund would charge more fees, and pay more transactions costs, without being able to earn abnormal returns.

C is incorrect. Both fundamental analysis and technical analysis cannot earn abnormal returns in a semi-strong efficient market.