This statement gets bandied about from time-to-time, but what does it actually mean? Why is it important in the world of investment?  And more importantly, why should you care? 

What does it actually mean?

‘Investment markets work’ is in fact a statement about how capable markets are in assigning prices to assets.  The Efficient Markets Hypothesis¹ (EMH) asserts that at any given moment in time, the price of an asset accurately reflects all the news and information available about that particular asset.  Furthermore, any additional news or information is instantaneously reflected in the price of that asset.  Therefore, spending significant amounts of time and money to analyse news and information, in the hope of discovering some price advantage over all other investors in the market is prone to add costs and detract return from your portfolio over the long-term.

However, it is important to make the distinction between markets working and markets being perfect at pricing assets.  There certainly are times when investors’ emotions take over and prices of an asset or a group of assets are irrationally bid up or down to unsustainable levels.  The tech bubble of the late 1990s is
a great example of irrational exuberance at its best (or worst, depending on your context), as investors paid increasingly higher prices for tech shares that had no substance behind them.  We need look no further than our own share market collapse in September / October last year, when investors oversold based on
the bad news at the time – not realising that the bad news was already incorporated into the downward spiralling prices they were willing to accept for their shares as more and more investors reacted to the bad news.

Why is it important?

EMH has a profound impact on anyone involved with or impacted by investment decision making, as it directly influences how investment portfolios are constructed. 

Most people know that when they go to the supermarket to buy their groceries, the price they pay from week to week will depend on a range of factors, but supply and demand will be the primary drivers.  If demand for an item is high, or conversely, if an item is in short supply, the price goes up.  The same could be said about most markets for goods and services around the world.

Supporters of EMH accept that the current price of an asset, as determined by supply and demand, and incorporating all available information and expectations, is its fair price.  Therefore, an investor will buy the asset if they want to include it in their portfolio, or sell it if they do not.  These investors recognise that unexpected news and events affect prices.  Importantly, they also recognise that as it is nearly impossible to predict news and events, it is therefore nearly impossible to predict future prices with any long-term consistency.

On the other side of the spectrum there are active fund managers, stockbrokers and day-traders who believe that markets are not efficient and that their analytical skills are superior and will give them an edge over all other investors in the market. They do this by systematically analysing all the news and information affecting the price of an investment, in the hope it gives them some special insight into its price, over and above everyone else analysing the same news and information.  Their analysis generates a ‘fair’ price to pay, and if the fair price they have calculated is above the current market price
(ie the investment is currently ‘cheap’), then they will buy the investment.  However, to make a profit, the current market price must rise to their calculated fair price, allowing the investor to sell at this higher price.  

Why should you care?

To answer the question of why an investor should care about market efficiency, below we look at some data recently released on managed funds.  If markets are inefficient, then active fund managers should be able to use their superior analytical skills to consistently outperform the general market, after accounting for their fees and costs.  However, if markets are efficient then over the longer term they are unlikely to outperform others, as their analytical skills won’t be able identify the inefficiencies there to exploit.

In a report released on 30 July 2009, Standard & Poor’s Index Versus Active Funds Scorecard (SPIVA) found that for the five years ending 30 June 2009, the S&P/ASX 200 outperformed 66.07 per cent of all active funds in the Australian market for which they had data.  This evidence flies in the face of inefficient markets and the notion that active fund managers should be able to show persistent outperformance.  Now, opponents of EMH will argue that if only 66.07 per cent were outperformed by the index, this still leaves a very healthy 33.93 per cent that actually beat the index. While this is accurate and in a perfect world we would all invest with these managers, but how do you pick which of the between 224 – 256 funds² are a part of the 33.93 per cent successes? 

Interestingly this pattern was also repeated with other asset classes, as shown in the table below.


The one year numbers are a little friendlier to active managers, however, you would still have to try and pick the good from the bad, a task made increasingly difficult as the number of funds in the market changes from time to time.

Alternatively, you could accept that as markets are extremely well-organized in pricing assets, you are happy to receive the capital market rate of return that is there for the taking.  Not only will you pay less for the privilege, you will eliminate the stress and hassle of trying to predict which shares or active funds are going to next deliver on their promise.  After-all that is what you are paying them for; to deliver on a promise that they can beat the general market, without taking any more risk than the market itself.  Unfortunately, such an investment just does not exist, if you want to outperform the general market, you have
to take more risk. 

The recent ructions in both the Australian and International share markets, have focused attention on the returns generated by fund managers. Almost every Australian either directly, or indirectly through their superannuation fund, will have been exposed in some form to the financial downturn which will have reduced their balance. As annual statements arrive, perhaps it will cause some to ponder the way in which their money is invested and how the managers
they, or their super funds, have employed have managed their monies over the past 12 months, and more importantly, over the longer-term.

 1    Documented in 1966 by Eugene F. Fama of the University of Chicago
 2    32 funds closed or merged and the results have been adjusted to account for this