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.

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

Since abnormal returns from the analysis of historical prices would be quickly arbitraged away in a weak-form efficient market, no technical analyst would be able to earn consistent abnormal returns. However, fundamental analysis and insider trading can still earn abnormal returns in a weak-form efficient market because public information and non-public information would not necessarily be fully reflected in market prices. Similarly, active management that utilizes fundamental analysis could also be capable of earning abnormal returns. Therefore, active management could consistently outperform passive management on a risk-adjusted basis – gross of fees – in a weak-form efficient market. If abnormal returns earned by active fundamental analysis exceed additional active management fees, active management could also earn abnormal returns net of fees.

Fundamental analysis and active management lose their abilities to earn abnormal returns in a semi-strong efficient market due to prices fully reflecting public information. Despite active management’s inability to outperform passive management at the same risk level, active management may still be a rational investment option as a way for investors to manage certain risks and achieve financial goals. In strong-form efficient markets, even insider trading cannot earn abnormal profits. Most markets are not strong-form efficient due to regulations against trading on non-public information.

Question

Which of the following statements is most likely true?

A. In a weak-form efficient market, active management can outperform passive management net of fees

B. In a semi-strong form efficient market, fundamental analysis can earn abnormal returns, but technical analysis cannot

C. In a strong form efficient market, a rational investor would invest in an actively managed fund

Solution

The correct answer is A.

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.

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

Option C 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.

Reading 38 LOS 38e:

Explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management



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