Burton G. Malkiel

The Efficient Market Hypothesis and Its Critics

Ageneration ago, the efe cient market hypothesis was widely accepted by academic e nancial economists; for example, see Eugene Fama’ s (1970) ine uential survey article, “ Efe cient Capital Markets.” It was generally believed that securities markets were extremely efe cient in ree ecting information about individual stocks and about the stock market as a whole. The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay. Thus, neither technical analysis, which is the study of past stock prices in an attempt to predict future prices, nor even fundamental analysis, which is the analysis of e nancial information such as company earnings and asset values to help investors select “ undervalued” stocks, would enable an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks, at least not with comparable risk. The efe cient market hypothesis is associated with the idea of a “ random walk,” which is a term loosely used in the e nance literature to characterize a price series where all subsequent price changes represent random departures from previous prices. The logic of the random walk idea is that if the e ow of information is unimpeded and information is immediately ree ected in stock prices, then tomorrow’ s price change will ree ect only tomorrow’ s news and will be independent of the price changes today. But news is by dee nition unpredictable, and, thus, resulting price changes must be unpredictable and random. As a result, prices fully ree ect all known information, and even uninformed investors buying a diversie ed portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts.

Hedge Funds: Risk and Return

From a database that is relatively free of bias, this article provides measures of the returns of hedge funds and of the distinctly nonnormal characteristics of the data. The results include risk-adjusted measures of performance and tests of the degree to which hedge funds live up to their claim of market neutrality. The substantial attrition of hedge funds is examined, the determinants of hedge fund demise are analyzed, and results of tests of return persistence are presented. The conclusion is that hedge funds are riskier and provide lower returns than is commonly supposed. Hedge funds have become an increasingly popular asset class since the early 1990s. The amount invested globally in hedge funds rose from approximately

Efficient Market Hypothesis

50 billion in 1990 to approximately

Risk and Return Revisited

1 trillion at the end of 2004. And because these funds characteristically use substantial leverage, they play a far more important role in the global security markets than the size of their net assets indicates. Market makers on the floor of the NYSE have estimated that during 2004, trades by hedge funds often accounted for more than half of the total daily number of shares changing hands. Moreover, investments in hedge funds have become an important part of the asset mix of institutions and even wealthy individual investors. Hedge funds are marketed as an “asset class” that provides generous returns during all stock market environments and thus serves as excellent diversification for an all-equity portfolio. This article reports our study of a reasonably comprehensive database of hedge fund returns. We examine the magnitude of two substantial biases that can influence measures of hedge fund performance in the data series—backfill bias and survivorship bias. We conclude that these biases may be far greater than has been estimated in previous studies. We examine not only the returns of hedge funds but also the distinctly nonnormal characteristics of the returns. We also investigate the substantial attrition of hedge funds, analyze the determinants of hedge fund demise, and provide the results of tests of return persistence. We show that the practice of voluntary reporting and the backfilling of only favorable past results can cause returns calculated from hedge fund databases to be biased upward. Moreover, the considerable attrition that characterizes the hedge fund industry results in substantial survivorship bias in the returns of indices composed of only currently existing funds. Correcting for such biases, we found that hedge funds have lower returns than is commonly supposed. Moreover, although the funds tend to exhibit low correlations with general equity indices and, therefore, are excellent diversifiers—hedge funds are extremely risky along another dimension: The cross-sectional variation and the range of individual hedge fund returns are far greater than they are for traditional asset classes. Thus, investors in hedge funds take on a substantial risk of selecting a dismally performing fund or, worse, a failing one.

Bank Portfolio Allocation, Deposit Variability, and the Availability Doctrine

A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. Formally, the market is said to be efficient with respect to some information set, o, if security prices would be unaffected by revealing that information to all participants. Moreover, efficiency with respect to an information set, o, implies that it is impossible to make economic profits by trading on the basis of o.

Racetrack betting and informed behavior

0 ne time-honored rule in the field of finance is that risk and return are related. Often called the “no free lunch” principle, it asserts that over the long run it is not possible to achieve exceptional returns without accepting substantial risk. Any standard equilibrium model of asset pricing justifies ths relationship. Data from Ibbotson Associates confirm that since 1926, U.S. common stocks have provided a total return of 10.7% per year, about seven percentage points greater than the return from riskless Treasury bds.

Passive Investment Strategies and Efficient Markets

I. Portfolio theory and the availability doctrine, 113. — II. Portfolio optimization under deposit variability, 120. — III. Some extensions of the argument, 125. — IV. Conclusions, 128. — Appendix, 130.

Expectations, Bond Prices, and the Term Structure of Interest Rates

Abstract Horse racing data permit interesting tests of attitudes toward risk. The present paper studies a new sample of racetrack results from Atlantic City, New Jersey. The questions examined are: (1) Are the market odds the best data for predicting the order of finish? (2) Do horses go off at odds that reflect their true probability of winning? (3) Is there any evidence that late bettors have better information than early bettors? It is found that market odds predict the order of finish well, but that ‘favorites’ are good bets and ‘long shots’ are poor ones. The data suggest that there does exist an ‘informed’ class of bettors and that bettors are on the whole neither risk neutral nor risk averse.

The Growth of Index Funds and the Pricing of Equity Securities

This paper presents the case for and the evidence in favour of passive investment strategies and examines the major criticisms of the technique. I conclude that the evidence strongly supports passive investment management in all markets—small–capitalisation stocks as well as large–capitalisation equities, US markets as well as international markets, and bonds as well as stocks. Recent attacks on the efficient market hypothesis do not weaken the case for indexing.

Term Structure of Interest Rates

Introduction, 197. — The mathematics of bond prices, 199. — Expectations and the term structure of rates, 206. — Altering some of the assumptions, 214. Concluding remarks, 218.