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.

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

In a weak-form efficient market, historical price analysis can’t reliably produce consistent abnormal returns. This is because any anomalies tend to be quickly corrected. So, technical analysts may struggle to earn extra profits in such a market.

However, there are other strategies, like fundamental analysis and insider trading, which might create opportunities for abnormal returns. The key here is that public and non-public information may not be entirely reflected in market prices, giving room for potential gains.

In the same way, active management using fundamental analysis might be able to achieve abnormal returns. This indicates that, even before accounting for fees, active management could potentially outperform passive management in a weak-form efficient market when considering risk.

Moreover, assume the abnormal returns generated through active fundamental analysis surpass the extra fees linked with active management. In such an instance, active management might still lead to abnormal returns even after accounting for those 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 for investors to manage certain risks and achieve financial goals. In strong-form efficient markets, even insider trading cannot earn abnormal profits. However, 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?

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 strongly efficient market, rational investors wouldn’t choose an actively managed fund. This is because such funds charge higher fees and incur more transaction costs, all without the ability to earn abnormal returns.

C is incorrect. Fundamental and technical analyses cannot earn abnormal returns in a semi-strong efficient market.