Effective market hypothesis12 / May / 2020
The idea of financial market efficiency was at the peak of its popularity in discussions of theorists in 60-70s. This hypothesis says that any information related to the price of an asset is instantly displayed on the value therefore, it makes no sense to trade based on such information. The value changes only under the influence of what can happen next but the news for that and the news that it is impossible to guess about them in advance. The value of shares is "at random". It is no coincidence that a book called "A Random Walk on Wall Street" turned out to be a bestseller. Such an idea flooded the index funds, which only buy all reference shares from the S&P 500 list. Since the 70s, index funds have been gaining momentum, increasing their share in the market. At the moment, they have approximately 20% of all assets under their management.
However, the efficient market hypothesis has been repeatedly challenged. Once in October 1987, the U.S. stock market instantly collapsed by 23%, and it was quite unclear why investors changed their own opinion about the fair price of assets so rapidly and dramatically. Robert Schiller of Yale University won the Nobel Prize in Economics for his work on the fact that the stock market is more volatile than it actually is if traders make adequate predictions about the cash flow that goes into traders' pockets.
Another example of the discrepancy between theory and reality is the currency market. After Sushil Wadhwani left the hedge fund in 1999 and joined the Bank of England Financial Policy Committee, he was very surprised by the bank's approach to forecasting currency movements. The largest bank was based on the theory of "uncovered interest parity," which suggests that expected exchange rate movements are proportional to the difference in interest rates between the two countries. This suggests that the best way to predict changes in exchange rates on the market was to base the exchange rate on the forward rate.
Vadhwani could not understand: he knew many people who practice carrie trades borrowing finance in a low yielding currency with further investment in a more acceptable currency. But when the truth is on the side of the bank, such trading can't be profitable. As a result of long negotiations, the Bank of England agreed to the traditional British compromise: it started only partially forecasting the currency movement based on the forward rate.
Many people in the financial industry still believe that they can outperform the market. In fact, at the heart of the theory of an effective market is a possible flaw. In order for the data to be reflected in prices, it is necessary to conduct the trading process. But why do traders need to enter into transactions when their efforts fail anyway?
Anti Ilmanen, once a market researcher and today an AQR asset manager, expressed his opinion on the "effective inefficiency" of the industry. Simply put, a retail investor is unable to outperform the market. And if you agree to contribute a significant amount and master powerful software, you have a chance of success.
This significantly explains the increase in the number of quantitative investors. They try to speculate on anomalies that cannot be clarified by the efficient market hypothesis. An example is the Momentum effect: shares, whose values have recently been higher than market values, do not lose their positions. Another example is the effect of weak volatility: stocks that are more stable than the market is changing all the time bring more risk-adjusted profits than theory has shown.
To benefit from these anomalies, new types of funds have opened up, called "smart beta", in the exchange language. In a certain sense, such funds simply try to systematically imitate the traditional approaches of stock managers, interrogate management companies and understand the balance sheets, trying not to miss profitable shares.
The prosperity of such funds depends on factors of profitability of the anomalies in the past. There are three potential options.
First: the anomalies are quirks of statistics: if you look at the data for a long time, it may turn out that stocks are moving forward, for example, on rainy Mondays in April. However, this does not mean that this will continue.
The second option is that the increased profitability is a compensation for the existing risk. The income of small businesses may be negative, but their shares will become less liquid in this case, and therefore it will be difficult to sell them if necessary they may go bankrupt. Eugene Phama and Kenneth French, said that most of the anomalies are due to three factors: the company's size, its estimated price relative to its assets and their volatility.