American Finance Association

Efficient Capital Markets: A Review of Theory and Empirical Work Author(s): Eugene F. Fama Source: The Journal of Finance, Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969 (May, 1970), pp. 383-417 Published by: Blackwell Publishing for the American Finance Association Stable URL: http://www.jstor.org/stable/2325486 . Accessed: 28/01/2011 08:13
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SESSION TOPIC: STOCK MARKET PRICE BEHAVIOR

SESSION CHAIRMAN: BURTON G. MALKIEL

EFFICIENT CAPITAL MARKETS: A REVIEW OF THEORY AND EMPIRICAL WORK*

EUGENE

F. FAMA**

I.

INTRODUCTION

ROLE of the capital market is allocation of ownership of the THE PRIMARY

prices in which terms, theideal is a market economy's capitalstock.In general provideaccuratesignalsforresourceallocation: that is, a marketin which decisions,and investorscan choose firms can make production-investment underthe of firms' activities ownership that represent amongthe securities all available inpricesat any time "fullyreflect" assumption that security A market in whichpricesalways"fullyreflect" availableinformaformation. tionis called"efficient." This paper reviews on the efficient literature the theoretical and empirical work concerned model.Aftera discussion of the theory, empirical markets of security subsets information pricesto threerelevant withthe adjustment set is just is considered. First,weak formtests,in whichthe information tests, in whichtheconThen semi-strong form are discussed. historical prices, thatis obviously cernis whether adjust to otherinformation pricesefficiently stocksplits,etc.) of annual earnings, publicly available (e.g., announcements giveninwithwhether formtestsconcerned Finally,strong are considered. relevantfor access to any information vestorsor groupshave monopolistic are reviewed.'We shall concludethat,with but a few exprice formation markets modelstandsup well. ceptions, theefficient work,to keep the proper Though we proceed fromtheoryto empirical workin we shouldnoteto a largeextent the empirical historical perspective first of thetheory. The theory is presented thisarea preceded thedevelopment resultsare most here in orderto moreeasily judge whichof the empirical of thetheory. The empirical workitself, from theviewpoint however, relevant in moreor less historical willthenbe reviewed sequence. readerwill surelyrecognize in thispaper instances Finally,the perceptive not such studies are In cases whererelevant my apolspecifically discussed. The area is so bountiful that some such ogies shouldbe taken forgranted. goal here will have been acinjusticesare unavoidable.But the primary of main the if a coherent lines of the work on efficient picture complished an is presented, state of along with accuratepictureof the current markets thearts.
* Research was supported theNationalScienceFoundation. I on thisproject by a grantfrom RobertAliber,Ray Ball, MichaelJensen, to Arthur am indebted Laffer, JamesLorie, Merton and Ross Wattsfortheir Richard comments. Charles helpful Taylor, Nelson, Roll,William Miller, ** University Society. Sessionwiththe Econometric of Chicago-Joint weak and strong form testswas first between 1. The distinction suggested by HarryRoberts.

383

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II.

The Journal of Finance

THE THEORY OF EFFICIENT MARKETS

A. ExpectedReturnor "Fair Game" Models market prices"fullyreflect" thatin an efficient The definitional statement testableimplicathatit has no empirically is so general availableinformation mustbe tions.To make the modeltestable,the processof price formation more exactly in moredetail. In essencewe mustdefinesomewhat specified whatis meantby the term"fullyreflect." prices (or expectedrewouldbe to posit that equilibrium One possibility Sharpe [40]as in the "two parameter" are generated turns) on securities modelsand esthe theoretical however, Lintner[24, 25] world.In general, have not been this tests of capital marketefficiency peciallythe empirical thatthe Most of the availableworkis based onlyon the assumption specific. can (somehow)be statedin termsof exconditions of marketequilibrium modelsuch theories like the two parameter In generalterms, pectedreturns. information set,the equilibrium on somerelevant wouldpositthatconditional theories of its "risk."And different is a function on a security return expected in how "risk"is defined. primarily woulddiffer can, however, theories" of the class of such "expectedreturn All members be described as follows: notationally
E(gj,t+,I|@t) =[I + E(r-,t+1|0t) ]pjtl 1

j at timet; E is theexpected value operator;pit is thepriceof security where cash income of any intermediate pj,t+iis its priceat t + 1 (withreinvestment return(pi,t+l- pjt)/ percentage from the security); ri,t+iis the one-period is assumedto be set of information pjt; (Dtis a generalsymbolforwhatever are random variablesat t. on the return expected The value of theequilibrium E(rj,t+llijt) projected expected theparticular from wouldbe determined basis of theinformation iJt of (1) is meant notation expectation at hand. The conditional theory return modelis assumedto apply, return expected thatwhatever to imply, however, expected equilibrium the information in 1t is fullyutilizedin determining in theformation And thisis the sensein which1t is "fullyreflected" returns.
"fully reflected"in the price at t; and the tildes indicate that pj,t+i and r,t+i

of the price pjt.

of measuresof a distribution value is just one of manypossible summary thatprices"fully notion per se (i.e., thegeneral efficiency and market returns, does notimbueit withany specialimportance. reflect" availableinformation) on dependto some extent of testsbased on thisassumption Thus, theresults But somesuch assumpof themarket. as wellas on theefficiency its validity tion is the unavoidableprice one mustpay to give the theoryof efficient markets content. empirical can be stated of marketequilibrium that the conditions The assumptions

The expected necessarily implied by the general notion of market efficiency.

that the offthat,simpleas it is, the assumption But we shouldnoteright can be statedin termsof expectedreturns equilibrium conditions of market conceptof expectedvalue to a status not elevatesthe purelymathematical

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385

in terms of expected returns and thatequilibrium expected returns are formed on thebasis of (and thus"fully the information set (Dthave a major reflect") of trading empirical rule out the possibility implication-they based systems in (Dtthathave expectedprofits or returns onlyon information in excess of or returns. Thus let equilibrium expected profits (2) Xj,t+l Pj,t+l- E(pj,t+1I4Dt). Then E (:j',t+lJ4t) =?0 (3) which, by definition, says thatthesequence{xjt} is a "fairgame"withrespect to theinformation let sequence{@t}. Or, equivalently, then
zjt+l =rj,t+l
-

E(rj t+lt),

(4)

sequence {41}. In economic terms,xJ,t+i is the excess market value of security j at time

(5) E(Zjt+i141t) y, so thatthesequence{zjt} is also a "fairgame"withrespect to theinformation

t + 1: it is the difference between the observed priceand the expectedvalue of the pricethatwas projected at t on the basis of the information (Dt.And similarly, at t + 1 in excess of the equilibrium expected zj,t+l is the return return projectedat t. Let
a(1(t) [al(QDt), a2(2Dt),
. . .,

a1((Dt)]

be any trading system based on 1?t whichtellstheinvestor theamounts aj ((It) of funds availableat t thatare to be invested in each of then availablesecurities. The totalexcessmarket value at t + 1 thatwillbe generated by such a is system
n
Vt+ j=1

Ejja((Dt)

[rj,t+l-E(rj,t+llt)],

from which, the "fairgame"property of (5) has expectation, E (Vt+lIDt)

j=l

Z
n

cj((<Dt)E(!j,t+1[(Dt)

0.

The expectedreturnor "fair game" efficient marketsmodel2has other important testableimplications, but theseare bettersaved forthe later discussionof theempirical work.Now we turnto twospecialcases of themodel, thesubmartingale and the random walk,that (as we shall see later) play an rolein the empirical literature. important
2. Though we shall sometimesreferto the model summarizedby (1) as the "fair game" model, keep in mind that the "fair game" properties of the model are implications of the assumptions that (i) the conditionsof marketequilibriumcan be stated in termsof expected returns, and (ii) the information equilibriumexpected returnsand thus (Pt is fullyutilized by the market in forming currentprices. The role of "fair game" models in the theory of efficient markets was first recognized and studied rigorously by Mandelbrot r27] and Samuelson [38]. Their work will be discussedin more detail later.

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Model B. Tke Submartingale Supposewe assumein (1) thatforall t and (Dt (6) E(i,t+1iDt) > 0. E("',t+1Ilt) > Pit, orequivalently, a subj follows thatthepricesequence{pit} forsecurity This is a statement whichis to say sequence Ol?t}, with respectto the information martingale value of nextperiod'sprice,as projected morethanthattheexpected nothing price. thanthecurrent (Dt, is equal to or greater on thebasis oftheinformation are changes and price If (6) holds as an equality(so thatexpectedreturns a martingale. zero), thenthepricesequencefollows Consider implication. empirical in priceshas one important A submartingale we mean rulesby which trading and cash" mechanical theset of "one security theconditions and thatdefine securities on individual thatconcentrate systems or simply sell it short, wouldhold a givensecurity, underwhichthe investor of (6) that expectedreturns hold cash at any timet. Then the assumption directly impliesthat such tradingrules conditional on (Dt are non-negative than profits expected in Ct cannothave greater based onlyon theinformation periodin the future during the security a policyof alwaysbuylng-and-holding part of the empirical question.Tests of such rules will be an important model.8 markets on theefficient evidence C. The Random Walk Model that model,the statement markets of the efficient In the earlytreatments was available information price of a security"fully reflects" the current pricechanges (or moreusually,successive assumedto implythatsuccessive it was usuallyassumedthat In addition, are independent. one-period returns) Togetherthe two distributed. changes(or returns)are identically successive themodelsays walk model.Formally, the random constitute hypotheses
= f(rj,t+?), (7) f(rj,t+?ItDt) and marginal that the conditional probability whichis the usual statement variable are identical.In addition, randomn of an independent distributions function f mustbe thesame forall t.4 thedensity buyvis-'a-vis and cash" trading systems of "one security profitability 3. Note thattheexpected markets or "fairgame"efficient model. return expected is not ruledout by the general and-hold but returns, in excessof equilibrium expected withexpected profits rulesout systems The latter cash (whichalways returns to be negative, holding expected it allowsequilibriunm sincein principle some return than holding expected return) may have higher hag zero actual and thusexpected security. returns forsomesecurities For example, are quite possible. expected equilibriumn And negative extension of the portfolio [24, 25] model(whichis in turna natural in theSharpe[40]-Lintner on a security depends return expected [30] and Tobin [43]) theequilibrium models of Markowitz in thesecurity's return ig related to dispersion distribution to whichthe dispersion on theextent on averagemove opposite whosereturns A security on all other securities. to the in the returns returns, and so its of portfolio dispersion valuable in reducing marketis particularly general return maywellbe negative. expected equilibrium is loose.Priceswill onlyfollowa random are indewalk if pricechanges 4. The terminology since and even thenwe shouldsay "random walk with drift" distributed; pendent, identically If one-period dis. identically can be non-zero. returns are independent, pricechanges expected will depend of pricechanges a random willnot follow walk sincethe distribution prices tributed,

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387

Expression(7) of coursesays muchmorethanthegeneralexpected return if we restrict modelsummarized by (1). For example, that (1) by assuming theexpected on security thenwe have return j is constant overtime, = E(rj,t+?). (8) E(,j,t+1|f't) This says thatthe meanof the distribution of rj,t+lis independent of theinformation available at t, t, whereasthe random walk modelof (7) in additionsays thatthe entire of CF.5 distribution is independent We argue later that it is best to regardthe randomwalk model as an extension of the generalexpectedreturnor "fair game" efficient markets modelin the sense of making a moredetailedstatement about the economic environment. The "fairgame" modeljust says thatthe conditions of market can be statedin terms equilibrium of expected and thus returns, it says little about thedetailsof thestochastic processgenerating A returns. random walk arises withinthe context of such a modelwhen the environment is (fortuitously)such thattheevolution of investor tastesand the processgenerating new information combine to produceequilibriain whichreturn distributions repeatthemselves through time. thatempirical testsof the "randomwalk" model Thus it is not surprising are morestrongly in support thatare in facttestsof "fairgame" properties theviewpoint of themodelthantestsof theadditional(and, from of expected return market efficiency, superfluous) pure independence assumption. (But it is perhapsequally surprising that,as we shall soon see, the evidenceagainst of returns theindependence overtimeis as weak as it is.) D. MarketConditions Consistent withEfficiency Before turning to the empiricalwork,however, a few words about the market conditions thatmight efficient of pricesto help or hinder adjustment are in order.First,it is easy to determine information for conditions sufficient capitalmarket For example, efficiency. consider a market in which (i) there costsin trading are no transactions is securities, (ii) all availableinformation available to all market costlessly and (iii) all agree on the imparticipants, information for the current plicationsof current price and distributions of future In sucha market, pricesof each security. thecurrent priceof a security all availableinformation. obviously "fullyreflects" marketin whichall information But a frictionless is freely available and notdescriptive investors of markets agreeon its implications met is, of course, in practice.Fortunately, theseconditions are sufficient formarketefficiency, For example,as long as transactors but not necessary. take account of all
is usuallydesirable, on the pricelevel.But though our loose use of terms rigorous terminology shouldnot cause confusion; and our usage follows that of the efficient markets literature. walk literature, Note also thatin the random theinformation set (t in (7) is usuallyassumed 5. The randomwalk modeldoes not say, however, that past information is of no value in distributions of future returns. assessing Indeed since return distributions are assumedto be are the bestsourceof suchinformation. stationary through time, past returns The random walk thatthesequence modeldoessay,however, (or theorder)of thepast returns is of no consequence of future distributions returns. in assessing
to include only the past returnhistory, rj,t,rj t-1
. . .

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The Journal of Finance

available information, even large transactions costs that inhibitthe flowof transactions do notin themselves implythatwhentransactions do take place, priceswillnot "fullyreflect" available information. Similarly (and speaking, as above, somewhat loosely),the market if "sufficient may be efficient numbers" of investors have readyaccess to available information. And disagreementamonginvestors abouttheimplications of giveninformation does notin itself imply market inefficiency unlessthere are investors who can consistently make betterevaluations of available information thanare implicit in market
prices.

But though transactions costs,information thatis not freely availableto all investors, and disagreement amonginvestors about the implications of given information are notnecessarily sourcesof market inefficiency, theyare potenAnd all three in real worldmarkets. tial sources. existto someextent Measuring their effects on theprocessof priceformation is, of course, themajorgoal of empirical workin thisarea. III. THE EVIDENCE All the empirical on the theory of efficient research markets has been concerned with whether prices "fully reflect" particularsubsets of available information. Historically, the empirical workevolvedmoreor less as follows. The initial studies wereconcerned withwhatwe call weak form testsin which theinformation subsetof interest is just past price (or return) histories. Most of theresults herecomefrom therandom walkliterature. Whenextensive tests the efficiency at thislevel,attention seemedto support was turned hypothesis testsin which theconcern is thespeed of priceadjustment to semi-strong form of to otherobviouslypubliclyavailable information (e.g., announcements new security stock splits,annual reports, issues,etc.). Finally,strong form or groups (e.g., manageis whether testsin whichthe concern any investor access to any information of mutualfunds)have monopolistic ments relevant of priceshave recently forthe formation appeared.We reviewthe empirical in moreor less thishistorical research sequence. First, however,we should note that what we have called the efficient of earliersectionsis the hypothesis marketsmodel in the discussions that all available information. security pricesat any pointin time"fullyreflect" Thoughwe shall arguethatthemodelstandsup rather well to the data, it is an extreme null hypothesis. obviously null hyAnd, like any otherextreme true.The categorization we do not expectit to be literally of the posthesis, and strong form will servetheusefulpurposeof testsintoweak,semi-strong, thelevelofinformation at whichthehypothesis us to pinpoint breaks allowing thatthereis no important evidenceagainstthe down.And we shall contend form in the weak and semi-strong tests (i.e., prices seem to effihypothesis to available and onlylimited ciently adjust obviously publicly information), in the strongformtests (i.e., monopolistic evidenceagainst the hypothesis aboutpricesdoes notseemto be a prevalent access to information phenomenon in the investment community).

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389

MarketsModel A. Weak Form Tests of theEfficient 1. RandomWalks and Fair Games: A Little HistoricalBackground markets can be conworkon efficient As notedearlier, all of the empirical sideredwithinthe contextof the generalexpectedreturnor "fair game" on the special submartingale model,and muchof the evidencebears directly discussions of expectedreturn modelof (6). Indeed,in the early literature, of the even more special the efficient markets modelwerephrasedin terms were we shallarguethatmostof theearlyauthors random walkmodel, though "fair game" model. in factconcerned more general versions of the with is understandable. Someof theconfusion in theearlyrandom walkwritings of a theory Researchon security pricesdid not beginwiththe development tests.Rather,the of price formation whichwas thensubjectedto empirical the accumulation of evforthe development of a theory came from impetus idencein the middle 1950's and early 1960's that the behaviorof common stockand otherspeculative by a random pricescould be well approximated feltcompelled to offer some ratioeconomists walk. Faced withthe evidence, was a theory of efficient markets statedin terms of nalization. What resulted somemoregeneral "fairgame" model. random walks,but usuallyimplying It was notuntiltheworkof Samuelson[38] and Mandelbrot[27] in 1965 modelsin the theory and 1966 thatthe role of "fair game" expectedreturn markets between thesemodelsand thetheory of efficient and the relationships And thesepapers came somewhat studied.6 of random walks wererigorously workon random walks. In the earlierwork,"theoafterthemajorempirical werealwayslacking though usuallyintuitively appealing, retical"discussions, in rigorand ofteneithervague or ad hoc. In short,until the Mandelbrotresults Samuelsonmodelsappeared,thereexisteda large body of empirical in searchof a rigorous theory. statewereignored forsixtyyears,the first his contributions Thus, though walk modelwas thatof Bachelier[3] in 1900. mentand testof the random forthe behaviorof priceswas thatspeculaBut his "fundamental principle" to thespecuthe expected tionshouldbe a "fairgame"; in particular, profits of the moderntheoryof stochastic lator should be zero. With the benefit we knownowthattheprocessimplied principle by thisfundamental processes, is a martingale. priceslaggeduntilthe on thebehavior of security After Bachelier, research
6. Basing theiranalyses on futurescontractsin commoditymarkets,Mandelbrot and Samuelson show that if the price of such a contractat time t is the expected value at t (given information t) of the spot price at the terminationof the contract,then the futuresprice will follow a sequence {jt); that is, the expected price change from martingalewith respectto the information period to period will be zero, and the price changes will be a "fair game." If the equilibriumexpected returnis not assumed to be zero, our more general "fair game" model, summarizedby (1), is obtained. But though the Mandelbrot-Samuelsonapproach certainly illuminates the process of price in commoditymarkets,we have seen that "fair game" expected returnmodels can be formation of the assumptionsthat derived in much simplerfashion.In particular,(1) is just a formalization the conditions of market equilibriumcan be stated in terms of expected returns and that the marketprices at t. informationt is used in forming

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In 1953 Kendall [21] examinedthe behaviorof comingof the computer. share pricesand in indicesof Britishindustrial weeklychangesin nineteen spot prices for cotton (New York) and wheat (Chicago). Afterextensive in quite graphicterms: he suggests, analysisof serial correlations, ofChance theDemon almost as ifoncea week one, looks likea wandering Theseries andaddedit dispersion of fixed population from a symetrical number drew a random price[21,p. 13]. week's thenext price to determine to thecurrent earlierby Working[47], had in fact been suggested Kendall's conclusion results. by Kendall'sempirical provided lackedtheforce his suggestion though financial research and forstockmarket of theconclusion And theimplications by Roberts[36]. analysiswere laterunderlined and Robertsthatseriesof speculaby Kendall,Working, But thesuggestion walkswas based on observation. by random tivepricesmaybe well described forthe rationale to providemucheconomic None of theseauthorsattempted rejectit. wouldgenerally Kendall feltthateconomists and,indeed, hypothesis, similar to those assumed by Osborne [33] suggestedmarketconditions, walk. But in his model,independence thatwouldlead to a random Bachelier, of thatthe decisions the assumption of successive pricechangesderivesfrom to from transaction investorsin an individualsecurityare independent is littlein theway of an economic model. transaction-which and Samuelson) triedto proeconomists Whenever (priorto Mandelbrot for the randomwalk, their arguments usually vide economicjustification Alexander[8, p. 200] states: a "fairgame." For example, implied is that or commodity speculation to start outwith theassumption a stock If onewere withan of gainor loss or, more accurately, a "fairgame"withequal expectation of thebehavior onewould be wellon thewayto picturing of zerogain, expectation as a random walk. prices speculative is not sufficient herethatthe "fairgame" assumption There is an awareness to lead to a randomwalk, but Alexandernever expands on the comment. Cootner[8, p. 232] states: Similarly, would of buyers buying weretoo low,their If anysubstantial thought prices group due for be true for Except appreciation sellers. The reverse would force up theprices. of tomorrow's given today's theconditional price, to earnings expectation retention, price. price, is today's from arethose that result that would occur a world, theonly In such changes price to be non-ranis no reason to expect thatinformation Sincethere newinformation. be random of a stock theperiod-to-period should pricechanges domin appearance, of one another. statistically independent movements, seemsto of thefirst thelast sentence paragraph imprecise, Thoughsomewhat walk.' In thislight,the pointto a "fairgame" modelratherthana random conenvironmental can be viewedas an attempt to describe secondparagraph walk. But the specificathatwouldreducea "fairgame" to a random ditions forthispuron theinformation tionimposed processis insufficient generating about investor pose; one would, for example,also have to say something
of historical would be "Giventhe sequence statement prices." conditioning 7. The appropriate

CapitalMarkets Efficient

391

otherstoo severelyfor amtastes. Finally,lest I be accused of criticizing biguity, lack of rigorand incorrect conclusions,
for By contrast, the stock markettraderhas a much more practicalcriterion in successive judgingwhat constitutes important dependence price changes.For his of the past behavior purposesthe randomwalk modelis valid as long as knowledge of theseriesof pricechangescannotbe used to increaseexpected gains.More specifof realityas long as ically,the independence assumption is an adequate description in theseriesof pricechanges to allow is not sufficient theactual degree of dependence in a way whichmakes the past history of the seriesto be used to predict the future expectedprofits greaterthan they would be under a naive buy-andhold model [10, p 35].

We knownow, of course,that this last condition hardlyrequiresa random walk. It willin factbe metby thesubmartingale modelof (6). But one shouldnot be too hard on the theoretical efforts of the earlyempiricalrandom walk literature. The arguments wereusuallyappealing;where in the theory of stochastic theyfellshortwas in awarenessof developments processes.Moreover, we shall now see thatmostof the empirical evidencein the random walk literature can easilybe interpreted as testsof moregeneral return or "fairgame" models.8 expected 2. Tests of MarketEfficiency in theRandomWalk Literature As discussed earlier,"fair game" models imply the "impossibility" of varioussortsof trading systems. Someof therandom walk literature has been concerned withtesting theprofitability of suchsystems. More of theliterature has, however, been concerned withtestsof serial covariances of returns. We shall now show that,like a randomwalk, the serial covariancesof a "fair game" are zero, so thatthesetestsare also relevant forthe expectedreturn models. If Xt is a "fair game,"its unconditional expectation is zero and its serial covariance can be written in generalform as:
E (it+r iit)
xt

xtE (it+rIxt) f(xt)dxt,

wheref indicates a density function. But if Xt is a "fairgame,"

E (5Et+ lxt) = 0. 8. Our briefhistoricalreviewis meant only to provide perspective, and it is, of course,somewhat incomplete.For example, we have ignored the importantcontributions to the early random walk literaturein studies of warrants and other options by Sprenkle, Kruizenga, Boness, and others. Much of this early work on options is summarizedin [8]. 9. More generally, if the sequence {xj is a fair game with respectto the information sequence {(Dt}, (i.e., E(Xt+1?It) = 0 for aH Pt); then xt is a fair game with respect to any Vt that is a subset of (t (i.e., E(xt+? I t) = 0 for all 't). To show this,let (P = (Vt, V"t). Then, using Stieltjes integralsand the symbol F to denote cumulative distinctionfunctions,the conditional expectation

E(xt+ll,t)

% ] f xt+dF(xt+i t1e, = f[f xt+dF(xt+1I4t)

,
(Pt Xt.+1

dF(O)-

bt Xtt+

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From this it follows that forall lags, the serial covariances betweenlagged valuesofa "fairgame"variableare zero.Thus, observations of a "fairgame" variableare linearly independent.10 But the "fair game" model does not necessarilyimply that the serial returns are zero. In the weak formtests of this covariancesof one-period modelthe "fairgame" variableis
zj,t -rj,trj,t-2, E(r-j,tIrj,t_j,
. . .).

(Cf. fn.9)

(9)

forexample, But thecovariance between, ritand rj,t+iis ) E( rFj,t+j-E(r'j,t+j) ] [r-jt-E(r'jt)]

rjt

[rjt-E(rjt)]

[E(rj,t+lIrjt)-E(rj,t?i)]f(rjt)drjt,

and (9) does not implythat E(rj,t+?irjt) E(ij,t+1): In the "fair game" of the return fort + 1 from markets its condiefficient model,the deviation is a "fair game" variable,but the conditional tionalexpectation expectation observed fort.1' can dependon thereturn itself this problem is not recognized, In the randomwalk literature, since it is of assumed that the expected return(and indeed the entiredistribution time.In practice, returns) is stationary through thisimpliesestimating serial of deviations of observedreturns from covariances by takingcross products It is somewhat thatthisprotheoverallsamplemeanreturn. fortuitous, then, a rather from whichrepresents the viewpoint of cedure, grossapproximation markets efficient the generalexpectedreturn model,does not seemto greatly of the covariance theresults stocks.'2 affect tests,at least forcommon
But the integralin bracketsis just E(xt?iI |t) which by the "fair game" assumptionis 0, so that

E(xt?+l 't) = 0 forall Vt C t.

with a "fair game," they do not implysuch 10. But thoughzero serial covariancesare consistent a process. A "fair game" also rules out many types of non linear dependence. Lhus using argumentssimilarto those above, it can be shown that if x is a "fair game," E(xtxt+l . . . xt+r) = 0 for all -r,which is not implied by E(Xtxt+T) = 0 for all T. For example, considera three-period case where x must be either? 1. Suppose the process is xt+2 = sign (xtxt+?), i.e.,
xt Xt+l i Xt+2

?
-

+
?

If probabilitiesare uniformly distributedacross events, E(xt?21xt+l) = E(xt+2Ixt) .= E(xt+llxt) = E(xt+2) = E(xt+?) = E(xt) = 0, so that all pairwise serial covariances are zero. But 'the process is not a "fair game," since E(Xt?2lXt+?, xt) & 0, and knowledgeof (xt+i, Xt) can be used as the basis of a simple "system" with positive expected profit. 11. For example,suppose the level of one-periodreturnsfollows a martingaleso that
E(fijt+1?rjt, rj,t_1
... ) = rjt.

Then covariances between successive returnswill be nonzero (though in this special case first differences of returnswill be uncorrelated). 12. The reason is probably that for stocks, changes in equilibrium expected returns for the

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TABLE 1 (from [10]) forOne-, Four-, Nine-,and Sixteen-Day First-order Serial Correlation Coefficients Changesin Loge Price Stock One Differencing Interval (Days) Four Nine -.091 -.112 Sixteen -.118 -.044

.029 Allied Chemical .017 .118* .095 Alcoa -.124* AmericanCan -.087* -.010 -.039 A. T. & T. .111* -.175* American Tobacco .067* -.068 Anaconda .013 -.122 Bethlehem Steel .012 .060 Chrysler .013 .069 Du Pont .025 -o.006 Eastman Kodak .020 .011 GeneralElectric .061* -.005 GeneralFoods -.004 -.128* General Motors -.123* .001 Goodyear -.017 -.068 International Harvester .038 International Nickel .096* .046 .060 International Paper .006 -.068 JohnsManville -.021 -.006 Owens Illinois -.006 Procter& Gamble .099* -.070 .097* Sears .025 -.143* StandardOil (Calif.) .008 StandardOil (N.J.) -.109 -.004 -.072 Swift& Co. -.o53 Texaco .094* .107* Union Carbide .049 .014 United Aircraft -.190* .040 -.006 U.S. Steel -.02 7 -.097 Westinghouse .028 -.033 Woolworth * Coefficient its computed standard is twice error.

-.009 .033 -.148 -.043

-.053 -.004 -.140 -.037 -.026 -.125

-.060

-.003 .007 .112 .040 -.055

-.023 .202

.031

.000
.033

.009

-.098

-.028

-.004 -.002 .003

-.244* .124

.098 -.113
-.046 -.082

-.010 .002 -.022

.116 .041

.076 .041
.040

.118 -.047
-.101 -.192* -.056

-.121 -.197 -.178 .124

-.137 -.112

-.040 .236*

.067 .040

beFor example, Table 1 (taken from[10]) showsthe serialcorrelations tweensuccessivechangesin the naturallog of price for each of the thirty stocksof theDow JonesIndustrial Average, fortimeperiodsthatvaryslightly from stockto stock,but usuallyrunfrom about theend of 1957 to September 26, 1962.The serialcorrelations of successive changesin loge priceare shown fordifferencing intervals of one,four, nine,and sixteen days.13
commondifferencing intervalsof a day, a week, or a month,are trivial relativeto other sources of variation in returns. Later, when we consider Roll's work [37], we shall see that this is not true for one week returnson U.S. Government Treasury Bills. 13. The use of changesin loge price as the measure of returnis common in the random walk It can be justifiedin several ways. But for currentpurposes,it is sufficient literature. to note that for price changesless than fifteen per cent,the changein loge price is approximately the percentage price change or one-periodreturn.And for differencing intervalsshorterthan one month,returns in excess of fifteen per cent are unusual. Thus [10] reportsthat for the data of Table 1, tests carried out on percentage or one-period returnsyielded results essentiallyidentical to the tests based on changesin loge price.

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The results in Table 1 are typical of thosereported by others fortestsbased on serial covariances.(Cf. Kendall [21], Moore [31], Alexander[1], and the resultsof Grangerand Morgenstern [17] and Godfrey, Grangerand Morgenstern [16] obtained by meansof spectral analysis.) Specifically, there is no evidenceof substantial between lineardependence laggedprice changes or returns. In absoluteterms themeasured serialcorrelations are alwaysclose to zero. Lookinghard,though, one can probablyfindevidenceof statistically "significant" lineardependence in Table 1 (and again thisis trueof resultsreportedby others).For the daily returns elevenof the serial correlations are morethantwicetheir computed standard and twenty-two out of thirty errors, of thecoefficients are positive. On theother and twenty-four hand,twenty-one forthefourand nineday differences are negative. But withsamplesof thesize underlying Table 1 (N- 1200-1700observations per stockon a dailybasis) from statistically "significant" deviations zero covarianceare not necessarily a basis forrejecting the efficient markets model.For the resultsin Table 1, the standarderrorsof the serial correlations were approximated as (1/ (N-i) )'/2,whichforthe daily data impliesthat a correlation as small as .06 is morethantwiceits standard error. But a coefficient thissize impliesthata linearrelationship withthe laggedpricechangecan be used to explainabout price change,whichis probablyinsig.36% of the variationin the current nificant from an economic viewpoint. In particular, it is unlikely thatthesmall absolutelevels of serialcorrelation thatare alwaysobservedcan be used as thebasis of substantially profitable trading systems.'4 It is, of course,difficult to judge what degreeof serial correlation would of trading implythe existence rules withsubstantial expectedprofits. (And indeedwe shall soonhave to be a littlemorepreciseaboutwhatis implied by "substantial" profits.) Moreover, are consistent zero serialcovariances witha "fairgame" model, but as notedearlier(fn. 10), thereare typesof nonlinear dependence thatimply the existence of profitable and yet do trading systems, not implynonzeroserial covariances. Thus, formanyreasonsit is desirable testtheprofitability of varioustrading to directly rules. The first on trading majorevidence ruleswas Alexander's [1, 2]. He testsa but the most thoroughly examinedcan be decribedas varietyof systems, follows:If the price of a security movesup at least y%7,buy and hold the untilits price movesdownat least y%' froma subsequent security high,at sell and go short.The shortposition whichtimesimultaneously is maintained untilthe price rises at least y%oabove a subsequent low, at whichtimeone coverstheshort and buys.Moves less thany% in either direction position are
14. Giventhe evidence of Kendall [21], Mandelbrot [28], Fama [10] and others that large pricechanges occurmuchmorefrequently thanwouldbe expected if the generating process were the expression Gaussian, (1/(N-1))'/2 understates the sampling of the serialcorrelation dispersion coefficient, and thusleads to an overstatement of significance levels.In addition, the fact that sampleserialcorrelations are predominantly of one signor the otheris not in itself evidence of lineardependence. If, as theworkof King [23] and Blume[7] indicates, there is a market factor whosebehavior affects the returns on all securities, the samplebehaviorof this market factor maylead to a predominance of signs of one typein theserialcorrelations forindividual securities, even thoughthe population serial correlations forboth the market factorand the returns on individual securities are zero.For a moreextensive of theseissues analysis see [10].

Capital Markets Efficient

395

ignored. Such a system is calleda y% filter. It is obviously a "one security and cash" trading rule,so that the resultsit producesare relevantforthe submartingale expected return modelof (6). After extensive testsusingdaily data on price indicesfrom1897 to 1959 and filters fromone to fifty per cent, and aftercorrecting some incorrect presumptions in theinitialresults of [1] (see fn.25), in his final paperon the subject, Alexander concludes: In fact, at thispoint I should adviseanyreader whois interested onlyin practical results, and whois nota floor trader and so must paycommissions, to turn to other sources onhowtobeatbuyandhold. The rest ofthis article is devoted to principally a theoretical consideration of whether the observed results are consistent witha random walkhypothesis [8], p. 351). Later in the paper Alexanderconcludesthat thereis some evidencein his resultsagainstthe independence assumption of the randomwalk model.But market efficiency does not requirea random walk,and from the viewpoint of thesubmartingale modelof (6), theconclusion thatthefilters cannot beat buyand-hold is supportforthe efficient markets hypothesis. Further supportis provided by Fama and Blume [13] who comparetheprofitability of various filters to buy-and-hold forthe individual stocksof the Dow-Jones Industrial Average.(The data are thoseunderlying Table 1.) But again, lookinghard one can findevidencein the filter tests of both Alexander and Fama-Blumethat is inconsistent withthe submartingale efficient markets model,if thatmodelis interpreted in a strict sense.In particular,the resultsforverysmallfilters (1 per centin Alexander's testsand .5, 1.0, and 1.5 per centin the testsof Fama-Blume)indicatethatit is possible to devisetrading schemes based on veryshort-term (preferably intra-day but at most daily) price swingsthat will on average outperform buy-and-hold. on individual The averageprofits fromsuch schemesare ministransactions cule, but theygeneratetransactions so frequently that over longerperiods and ignoring commissions they outperform buy-and-hold by a substantial These resultsare evidenceof persistence margin. or positivedependence in veryshort-term price movements. this is consistent And, interestingly, with the evidencefor slightpositivelinear dependence in successivedaily price changes produced by theserialcorrelations.15
15. Though strictlyspeaking, such tests of pure independence are not directly relevant for expected returnmodels, it is interesting that the conclusionthat very short-term swings in prices persistslightlylonger than would be expected under the martingalehypothesisis also supported by the resultsof non-parametric runs testsapplied to the daily data of Table 1. (See [10], Tables 12-15.) For the daily price changes,the actual numberof runs of price changes of the same sign is less than the expectednumberfor 26 out of 30 stocks.Moreover,of the eightstocksfor which the actual numberof runs is more than two standarderrorsless than the expectednumber,five of the same stocks have positive daily, firstorder serial correlationsin Table 1 that are more than twice theirstandard errors.But in both cases the statistical"significance" of the resultsis largely of the large sample sizes. Just as the serial correlationsare small in absolute terms a reflection (the average is .026), the differences between the expected and actual number of runs on average are only three per cent of the total expected number. On the other hand, it is also interesting that the runs tests do not support the suggestionof slight negative dependencein four and nine day changes that appeared in the serial correlations. In the runs tests such negative dependencewould appear as a tendencyfor the actual number of runs to exceed the expectednumber.In fact, for the four and nine day price changes,for 17 and

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coststhatwould But whenone takesaccountof even theminimum trading theiradvantageover buy-and-hold be generated by small filters, disappears. For example, evena floor trader(i.e., a personwho ownsa seat) on theNew feeson his tradesthatamount York StockExchangemustpay clearinghouse transaction to about .1 per cent per turnaround (i.e., sales plus purchase). Fama-Blumeshow that because small filters producesuch frequent trades, are costs sufficient to theseminimum trading wipe out theiradvantageover buy-and-hold. like theserialcorrelations, Thus thefilter noticetests, produceempirically from of the efficient able departures the strictimplications marketsmodel. an economic But,in spiteof any statistical significance theymight have,from are so small that it seems hardlyjustified the departures viewpoint to use themto declarethe marketinefficient. in the Random Walk Literature 3. OtherTests of Independence It is probablybest to regardthe random walk modelas a special case of themoregeneral return modelin thesenseof making expected a moredetailed of theeconomic specification environment. That is, thebasic modelof market equilibrium is the "fair game" expectedreturn model,with a randomwalk environmental conditions arisingwhenadditional are such that distributions of one-period returns repeat themselves through time.From this viewpoint violations of thepureindependence walk modelare assumption of therandom to be expected. But whenjudged relativeto the benchmark provided by the random walk model,theseviolations can provideinsights into the natureof the marketenvironment. For example, one departure from thepure independence assumption of the random walk modelhas been notedby Osborne[34], Fama ([10], Table 17 and Figure8), and others. In particular, largedailypricechangestendto be followed by large daily changes.The signsof the successorchangesare apwhichindicatesthat the phenomenon parently random, however, represents a denialoftherandom walkmodelbut notof themarket efficiency hypothesis. it is interesting Nevertheless, to speculatewhythe phenomenon might arise. It may be that whenimportant new information comes into the marketit cannot always be immediately evaluated precisely.Thus, sometimesthe to the information, initialpricewill overadjust and othertimesit will underindicates thatthepricechangeson days followadjust.But sincetheevidence in sign,theinitiallargechangeat least ingtheinitial largechangeare random represents an unbiasedadjustment to theultimate priceeffects of theinformais sufficient forthe expected tion,and tlhis return efficient markets model. and Osborne [32] document Niederhoffer two departures fromcomplete in common randomness stockprice changesfromtransaction to transaction. First,theirdata indicatethat reversals(pairs of consecutive price changes of opposite sign) are from twoto threetimesas likelyas continuations (pairs of consecutive price changesof the same sign). Second, a continuation is
18 of the 30 stocksin Table 1 the actual numberof runs is less than the expected number.Indeed, runs testsin generalshow no consistent evidence of dependencefor alnydifferencing intervallonger than a day, whichseems especiallypertinent in light of the comments in footnote14.

Capital Markets Efficient

397

Niederhoffer and Osborneoffer forthesephenomena explanations based on the market of theNew York Stock Exchange (N.Y.S.E.). In parstructure there ticular, are three majortypesof ordersthatan investor might place in stock: (a) buy limit (buy at a specified a given price or lower), (b) sell limit (sell at a specified priceor higher), and (c) buy or sell at market(at lowest the sellingor highest buyingprice of anotherinvestor).A book of unexecuted in thatstock limitorders in a givenstockis keptby thespecialist onthefloor of the exchange. Unexecuted sell limitordersare, of course,at higher prices than unexecuted buy limit orders.On both exchanges,the smallest non-zero pricechangeallowedis Y8 point. Suppose nowthatthere is morethanone unexecuted sell limitorderat the lowest priceof any such order.A transaction at thisprice (initiatedby an order to buy at market'7) can onlybe followed either by a transaction at the same price(if thenextmarket orderis to buy) or by a transaction at a lower price (if the nextmarket orderis to sell). Consecutive price increasescan usually only occurwhenconsecutive marketordersto buy exhaustthe sell limit ordersat a givenprice.'8In short,the excessivetendency towardreforconsecutive versal non-zero pricechangescould resultfrom bunching of unexecuted buy and sell limitorders. -) to occurslightly The tendency fortheevents(+ ++) and (more frequently than(+?+-) and (-I-+) requires a moreinvolved explanation we shall not attempt which in fullhere.In brief, to reproduce Niederhoffer and Osbornecontendthat the higherfrequency of (+|++) relativeto a tendency forlimitorders"to be concentrated at in(+I+-) arises from order of preference."'9 The frequency of the event (+I++), whichusually at at least twoconsecutively be exhausted requires thatsell limit orders higher at an odd eighth), more frequently prices(the last of whichis relatively thanthe more the absenceof sell limitordersat odd eighths heavilyreflects event thatsell limitordersat onlyone price usuallyimplies (+?+-), which of havebeen exhaustedand so moreor less reflects the averagebunching limit orders at all eighths. But though and Osbornepresent of staNiederhoffer evidence convincing
16.On a transaction to transaction basis,positive and negative pricechanges are aboutequally are random, likely. Thus,underthe assumption thatpricechanges any pair of non-zero changes fortriplets of consecutive non-zero should be as likely as any other, and likewise changes. 17.A buy limitorder fora priceequal to or greater thanthe lowestavailable sell limitprice an order and is treated as suchby thebroker. iseffectively to buyat market, 18.The exception is whenthere is a gap of morethan IX between the highest unexecuted buy and the lowestunexecuted sell limitorder, limit so that market orders(and new limitorders) canbe crossed at intermediate prices. for this claim is a few samplesof specialists' 19.Theirempirical documentation books for selected days,plusthe observation prices, at leastforvolatile highpriced [34] thatactualtrading at integers, seemto be concentrated halves, quarters and odd eighths in descending order. stocks,

areslightly more frequent than(+1+-)

morefrequent slightly aftera preceding continuation than aftera reversal. That is,let (+I++) indicate theoccurrence of a positive pricechange, given two Then the events(+?++) and (-I---) preceding positive changes.

or ( _|+).1B

tegers (26, 43), halves (26X2, 43'2),

quarters and odd eighthsin descending

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fromindependence tistically significant in price changes from departures transaction to transaction, and though theiranalysisof their findings presents interesting intotheprocessof market insights on themajorexchanges, making the types of dependence uncovereddo not implymarketinefficiency. The best documented sourceof dependence, the tendency towardexcessivereversals in pairs of non-zero price changes,seems to be a directresultof the abilityof investors to place limitordersas well as ordersat market, and this negative in itself dependence does notimply theexistence of profitable trading rules. Similarly, the apparenttendency for observedtransactions (and, by limitorders)to be concentrated implication, at integers, halves,even eighths and odd eighthsin descending order is an interesting fact about investor but in itselfis not a basis on whichto concludethatthe market behavior, is
inefficient.20

The Niederhoffer-Osborne analysisof market makingdoes, however, point clearlyto theexistence of market but withrespect inefficiency, to strong form testsof the efficient markets model.In particular, the list of unexecuted buy and sell limitordersin the specialist'sbook is important information about the likelyfuture behavior of prices,and thisinformation is onlyavailable to the specialist.When the specialistis asked fora quote, he gives the prices and can give the quantitiesof the highestbuy limit and lowest sell limit orderson his book,but he is prevented by law from divulging thebook's full contents. The interested readercan easilyimagine situations wherethe structureof limitordersin the book could be used as the basis of a profitable rule.2'But therecord trading seemsto speak foritself: It should notbe assumed that these transactions undertaken by thespecialist, andin he is involved which as buyer or seller in 24 per centof all market volume, are necessarily a burden to him. Typically, thespecialist sellsabovehislastpurchase on 83 per centof all his sales,and buysbelowhis last sale on 81 per centof all his purchases ( [32], p. 908). Thus it seemsthatthespecialist has monopoly poweroveran important block of information, uses his monopoly and, not unexpectedly, to turna profit. ofcourse, is evidence Andthis, of market in thestrong form inefficiency sense. economicquestion, The important of course,is whether the marketmaking
and Osborne 20. Niederhoffer offer little to refute thisconclusion. For example ([32], p. 914): thespecific in thisstudyhave a significance Although properties reported from a statistical point of view,the readermay well ask whether or not theyare helpful in a practical sense.Certain trading rulesemerge as a result of ouranalysis. One is thatlimit and stop orders shouldbe placed at odd eights, at Y8 forsell orders and at /8 forbuy orders. preferably Another is to buywhena stockadvances a barrier and to sell whenit sinksthrough through a barrier. The first rule"tellstheinvestor to resist his innate "trading inclination to place orders at integers, to placesell orders but rather below an integer and buy orders I/8 I/8above.Successful execution of the orders is thenmorelikely, sincethe congestion of orders thatoccurat integers is avoided. is apparent. But the costof thissuccess The second"trading rule"seemsno morepromising, if indeedit can evenbe translated intoa concrete foraction. prescription 21. See, forexample, ([32], p. 908). But it is unlikely thatanyone but thespecialist couldearn from substantial of the structure profits of unexecuted knowledge limitorders on the book. The specialist makestrading in manytransactions, profits by engaging each of whichhas a small average but forany other profit; thosewithseatson theexchange, trader, including theseprofits to thespecialist. wouldbe eatenup by commissions

Efficient Capital Markets

399

moreeconomically by some nonfunction of the specialistcould be fulfilled mechanism.22 monopolistic 4. Distributional Evidence evidenceis such that economists of the empirical At this date the weight existsin seriesof historical dependence agree thatwhatever wouldgenerally Indeed, of the future. predictions returns cannotbe used to make profitable in the evidence thereis little forreturns thatcoverperiodsof a day or longer, random walk model,at least as a of the stronger thatwould cause rejection goodfirst approximation. has centered issue of the randomwalk literature Rather,the last burning of price changes (which,we should note on the natureof the distribution since markets hypothesis is an important issue forthe efficient immediately, toolsrelevant affects boththetypesof statistical thenature of thedistribution of any resultsobtained).A fortesting and the interpretation the hypothesis distributed price changes was firstproposedby normally model implying to transacBachelier[3], who assumedthatprice changesfromtransaction randomvariables with finite tion are independent, distributed identically spread across time,and if the variances. If transactions are fairly uniformly is verylarge,thentheCentral per day,week,or month number of transactions LimitTheoremleads us to expectthat theseprice changeswill have normal or Gaussian distributions. theirempirical Osborne [33], Moore [31], and Kendall [21] all thought high tails (i.e., but all observed hypothesis, thenormality evidence supported in theirdata distributions vis-a-vis of largeobservations) higher proportions on were normal.Drawing these whatwouldbe expected if the distributions [28] thensuggested own, Mandelbrot workofhis findings and someempirical thatthese departures normality could be explainedby a moregeneral from form if one does not assume that disof the Bacheliermodel.In particular, have necessarily to transaction of price changesfromtransaction tributions forprice changesover longer distributions thenthe limiting finite variances, of thestable class, whichincludes couldbe any member intervals differencing have higher stable distributions the normalas a special case. Non-normal feature observed and so can accountforthisempirically tailsthanthenormal, the data of price changes.Afterextensive of distributions testing(involving stable fromthe stocksin Table 1), Fama [10] concludesthat non-normal on comof dailyreturns distributions are a better of distributions description mon stocksthan the normal.This conclusion is also supported by the emto stocks,and it has been extended piricalworkof Blume [7] on common U.S. Government TreasuryBills by Roll [37]. primarto accepttheseresults,2" been reluctant have,however, Economists
22. With moderncomputers, it is hard to believethat a more competitive and economical to replacethe entire system would not be feasible. It does not seemtechnologically impossible floor of theN.Y.S.E. witha computer, fedby manyremote consoles, thatkeptall thebooksnow keptby thespecialists, thatcouldeasilymaketheentire book on any stockavailableto anybody (so that interested individuals could then compete to "make a market" in a stock) and that out transactions carried automatically. 23. Somehave suggested thatthelong-tailed empirical distributions might result from processes

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available for dealingwith ily because of the wealthof statistical techniques normal variablesand the relative paucityof such techniques fornon-normal stable variables.But perhapsthe biggestcontribution of Mandelbrot's work has been to stimulateresearchon stable distributions and estimation proceduresto be appliedto stablevariables.(See, forexample, Wise [46], Fama and Roll [15], and Blattberg and Sargent[6], amongothers.)The advance of statistical sophistication (and the importance of examining distributional assumptions in testing the efficient markets model) is well illustrated in Roll [37], as compared, forexample, withtheearlyempirical workof Mandelbrot [28] and Fama [10]. 5. "Fair Game" Models in the TreasuryBill Market Roll's workis novel in otherrespectsas well. Comingafterthe efficient markets modelsof Mandelbrot [27] and Samuelson[38], it is the first weak form empirical workthat is consciously in the "fair game" ratherthan the random walk tradition. Moreimportant, as we saw earlier, the"fairgame"properties of thegeneral expected return modelsapplyto
zjt= rjt- E(fjtjDt_j).

(10)

For data on common stocks,testsof "fair game" (and randomwalk) propertiesseem to go well whenthe conditional expectedreturn is estimated as forthesampleof data at hand.Apparently theaveragereturn thevariation in about theirexpectedvalues is so large relative common stockreturns to any values thatthe lattercan safelybe ignored. changesin the expected But, as Roll demonstrates, thisresultdoes not hold forTreasuryBills. Thus, to test the "fair game" model on TreasuryBills requiresexpliciteconomictheory fortheevolution of expected returns time. through Roll uses three of theterm structure theories existing (thepureexpectations of Lutz [26] and two marketsegmentation one of hypothesis hypotheses, of Hicks-[18] and whichis the familiar"liquidity preference" hypothesis In his modelsrnt is therateobserved Kessel [22]) forthispurpose.24 from the termstructure at periodt forone week loans to commence at t + j - 1, and can be thought of as a "futures" rate. Thus rj+i,t-i is likewisethe rate on
thatare mixtures of normal distributions withdifferent variances. Press[35], forexample, suggests a Poissonmixture of normals in whichtheresulting of pricechanges distributions have longtails but finite variances. On the other hand,Mandelbrot and Taylor[29] showthatother mixtures of normals can stilllead to non-normal stabledistributions of pricechangesforfinite differencing intervals. of pricechanges are long-tailed If, as Press'modelwouldimply, distributions but have finite thendistributions of pricechanges over longer and longer variances, should intervals differencing be progressively to normality was observed in [101 closerto the normal. No such convergence used weresomewhat the techniques (thoughadmittedly rough). Rather,exceptfor originand for longerdifferencing intervals seem to have the same "high-tailed" scale, the distributions forshorter as distributins which is as wouldbe expected characteristics differencing intervals, if the are non-normal stable. distributions all availabletestsof market 24. As notedearlyin our discussions, are implicitly efficiency also return models of market tests of expected But Roll formulates equilibrium. the economic explicitly his estimates of expected and emphasizes modelsunderlying that he is simultaneously returns, structure models of the term as well as market testing economic efficiency.

Capital Markets Efficient

401

in thiscase at t - 1. at t + j -1, but observed one week loans to commence premium" in rjt;thatis Similarly, Litis theso-called"liquidity
rjt E((ro,t+j_iIIt) + Ljt.

from the rateforperiodt + j - 1 observed In words, "futures" the one-week at t of the "spot" ratefort + j -1 plus term at t is theexpectation structure be positiveor negative). a "liquidity (whichcould,however, premium" In all threetheories of the termstructure considered by Roll, the conditionalexpectation required in (10) is of the form
E(r"j,tPt_1) - rj+?,tl + .. E(LjtJI~t-L)- Lj+L,t-

differ only in the values assignedto the "liquiditypreThe threetheories must hypothesis, investors preference" in the"liquidity miums." For example, so rate uncertainty, forbearinginterest alwaysbe paid a positivepremium hyin the "pure expectations" thatthe Lit are alwayspositive.By contrast, are assumedto be zero,so that premiums pothesis, all liquidity
-:tL)i( tJOt

rj+L,t -L.

segmentation (i) thatthetwomarket testing, Roll concludes After extensive with hypothesis, hypotheses fitthe data betterthan the pure expectations and (ii) hypothesis, preference" advantageforthe "liquidity perhapsa slight themarket forTreasuryBills is effcient. thatas faras his testsare concerned, model is termstructure that when the best fitting Indeed, it is interesting "futures" ratein (10), the resulting used to estimate theconditional expected thatif he It is also interesting variablezjt seemsto be seriallyindependent! would Roll's results assumedthathis data distributions were normal, simply model.In thiscase taking markets in support of theefficient notbe so strongly afsubstantially accountof the observedhightails of the data distributions of the results.25 fectedthe interpretation 6. Tests of a MultipleSecurity Expected ReturnModel markets Though the weak formtests supportthe "fair game" efficient model,all of the evidenceexaminedso far consistsof what we mightcall of individual "single securitytests." That is, the price or returnhistories be used as the forevidence of dependence thatmight securities are examined We have not discussedtestsof basis of a trading systemforthat security. one another. whether are "appropriately priced"vis-a-vis securities differences between are "appropriate" averagereturns But to judgewhether is required. At the moof equilibrium an economictheory expectedreturns is thatof Sharpe [40] and Lintner[24, theonlyfully theory developed ment,
assumptionsis also illustratedin Alexander'swork on trad25. The importanceof distributional systems[1], Alexanderassumed that purchases could always ing rules. In his initial tests of filter be executed exactly (rather than at least) y% above lows and sales exactly y% below highs. Mandelbrot [281 pointed out, however, that though this assumptionwould do little harm with price changes (since price series are then essentiallycontinuous), with nonnormallydistributed it would introducesubstantialpositive bias into the filterprofits(since normal stable distributions with such distributionsprice series will show many discontinuities). In his later tests [2], (i.e., the presence of large Alexanderdoes indeed find that taking account of the discontinuities of the filters. lowers the profitability price changes) in his data substantially

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25] referred to earlier.In this model (which is a directoutgrowth of the mean-standard deviationportfolio models of investorequilibrium of Markowitz[30] and Tobin [43]), theexpected return on security j from timet to t+ 1 is
E(f,t+1j1t)
= rf,t+l

rf,t+l E(Fm,t+lfDt) -

co] C(j,to,y

) rm,t+4lDt (11)

whererf,t+1 from is thereturn t to t + 1 on an asset thatis riskless in money terms; rm,t+1 is the return on the "marketportfolio" m (a portfolio of all investment assetswitheach weighted in proportion to the totalmarket value of all its outstanding units); 02(rm,t+110t) is thevarianceof the return on m;
cov

In words,(11) says thattheexpected return on a security is the one-period rateof interest riskless one-period plus a "riskpremium" thatis proporrf,t+1 tional to cov(rij,t+i, model rm,t+ilDt)/6(rm t+11100.In the Sharpe-Lintner holds some combination of the risklessasset and the market each investor so that,givena mean-standard deviation portfolio, the riskof an framework, individual asset can be measured to the standard deviation by its contribution of the returnon the marketportfolio. This contribution is in fact cov *26 The factor (rj,t+i, rm,t+l r(t)/I(imst+it)
- rf,t+1]/0(rm,t+1j@I t), [E(r-m,t+,ifDt)

infinite variances.

the appearanceof lIt indicatesthat the various expectedreturns, variance and covariance, could in principle dependon 'Dt. ThoughSharpeand Lintner derive(11) as a one-period model,the resultis givena multiperiod justification and interpretation in [11]. The modelhas also been extended in (12) to thecase wherethe one-period returns could have stable distributions with

(rij,t+i,

rm,t+:Lit)is the covariance between the returnson j and m; and

whichis the same forall securities, is thenregarded as the marketprice of risk. Publishedempirical testsof theSharpe-Lintner modelare notyetavailable, There is some publishedwork,however, thoughmuchworkis in progress. not directed at the Sharpe-Lintner which, though model,is at least consistent withsomeof its implications. The statedgoal of thisworkhas been to determinethe extentto whichthe returns on a givensecurity are relatedto the on othersecurities. returns It started (again) with Kendall's [21] finding common stockpricechangesdo notseemto be serially thatthough correlated, thereis a high degreeof cross-correlation betweenthe simultaneous returns of different securities. This line of attackwas continued by King [23] who (usingfactor analysisof a sampleof monthly returns on sixty N.Y.S.E. stocks fortheperiod1926-60) foundthaton averageabout 50% of thevarianceof an individualstock's returns could be accountedfor by a "marketfactor" thereturns whichaffects on all stocks, with"industry for factors" accounting at mostan additional10%'o of the variance.
26. That is, coy (rjt+i

= rm Crm ,t+ilt)/o ,t+iI1,t) (Yrm,t+iI,Dd.

CapitalMarkets Efficient

403

Thus theobserved properties of the"market model"are consistent withthe expected return efficient markets model,and, in addition, the "market model" tellsus something about theprocessgenerating expected returns from security to security. In particular,
E(r- t+c) = aj + PjE(riM,t+1). (13)

rM,t+1.

For our purposes,however, the workof Fama, Fisher,Jensen, and Roll [14] (henceforth FFJR) and the more extensive work of Blume [7] on monthly return data is morerelevant. Theytestthefollowing "market model," originally suggested by Markowitz[30]: r,t+i = aj + ijrM,t+1+ ij,t+ (12) wherera,t+1 is the rateof return on security j formonth t, rm,t+i is the corresponding return on a marketindexM, aj and ij are parameters that can vary from security to security, and uj,t+l is a randomdisturbance. The tests of FFJR and subsequently thoseof Blumeindicate that (12) is well specified as a linearregression model in that (i) the estimated parameters aj and ij remainfairly constant over longperiodsof time (e.g., the entire post-World War II periodin thecase of Blume), (ii) rM,t+1and theestimated ufj,t+,, are close to seriallyindependent, and (iii) the uj,t+i seem to be independent of

The questionnow is to what extent(13) is consistent with the SharpeLintnerexpectedreturnmodel summarized by (11). Rearranging (11) we obtain E(r-j,t+1J|t) aj((Dt)+ (3j((Dt)E(rim,t+i1|Dt), (14) where, noting thatthe riskless rate rf,t+1 is itselfpart of the information set we have t, and
aj(@Dt) rf,t+l[ P-j (Dt)], (15)

t+11(Dt) Pj( D) =cov (r'jja,~rm

( 16)

Withsome simplifying assumptions, (14) can be reducedto (13). In particular, if the covarianceand variancethat determine Wj(Ct) in (16) are the same forall t and Dt,thenPjf(Dt)in (16) corresponds to Pj in (12) and (13), and the least squares estimate of Pj in (12) is in fact just the ratio of the and variancein (16). If we also assumethat samplevalues of the covariance is thesame forall t, and thatthebehavior of thereturns on themarket rf,t+1 m are closelyapproximated on some representative portfolio by the returns indexM, we willhave comea longway towardequating(13) and (11). Inlinkis whether in the estimated of (12) deed,theonlymissing parameters S) ajrf (I (17) Neither FFJR nor Blume attack this question directly, thoughsome of Blume's evidenceis at least promising. of the In particular, the magnitudes

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consistent with (17) in the sense thatthe estimates estimated `j are roughly are alwaysclose to zero (as theyshouldbe withmonthly return data).27 in establishing the apparentempirical In a sense, though, validityof the "market model"of (12), both too muchand too littlehave been shownvisreturn a-vis theSharpe-Lintner expected modelof (11). We knowthatduring rateson riskless thepost-World interest assets (e.g., War II periodone-month have not been constant. to maturity) government bills withone month Thus, if expectedsecurityreturns were generatedby a versionof the "market model"thatis fully consistent withthe Sharpe-Lintner model,we would,according to (15), expectto observesome non-stationarity in the estimates of basis, however, variation through timein one-period riskless aj. On a monthly relative to variation trivial in otherfactors interest ratesis probably affecting commonstock returns, monthly so that more powerful statistical methods wouldbe necessary of changesin theriskless to studythe effects rate. In any case, since the workof FFJR and Blume on the "marketmodel" thismodelto the Sharpe-Lintner was not concerned withrelating model,we forthe former are somewhat can onlysay thattheresults consistent withthe of the latter.But the resultsforthe "marketmodel" are, after implications of thereturn and theyare all, just a statistical description generating process, probablysomewhatconsistent with other models of equilibrium expected returns. Thus theonlyway to generate strong empirical conclusions about the Sharpe-Lintner modelis to testit directly. On theotherhand,any alternative modelof equilibrium mustbe somewhat expectedreturns consistent withthe model,' giventhe evidence in its support. "market B. Tests of MartingaleModels of the Semi-strong Form In general, form semi-strong testsof efficient markets modelsare concerned with whether current all obviously prices "fullyreflect" publiclyavailable Each individual information. is concerned withthe adjustment test,however, of security prices to one kind of information generating event (e.g., stock of financial splits, announcements reports by firms, new security issues,etc.). Thus each testonlybringssupporting evidenceforthe model,withthe idea thatby accumulating such evidencethe validity of the modelwillbe "established." the availableevidence In fact,however, is in support of theefficient though to a few major typesof information markets model,it is limited generating The initial thestudyof stocksplitsby Fama, events. majorworkis apparently
27. With least squares applied to monthlyreturndata, the estimateof (X in (12) is
aj = rj,t jrm,t,

where the bars indicate sample mean returns. But, in fact, Blume applies the marketmodel to the wealth relativesRjt = 1 + rjt and RMt = 1 + rmt.This yields preciselythe same estimateof ,1 as least squares applied to (12), but the interceptis now a'J=Rjt3jRMt = 1 + rJt-3j(1 + rMt) = 1- pj + aj 1, which implies that

Thus what Blume in fact finds is that for almost all securities, j'j + 3j ctj is close to 0.

Capital Markets Efficient

405

Fisher,Jensen, and Roll (FFJR) [14], and all the subsequent studiessummarizedhere are adaptations and extensions of the techniques developedin FFJR. Thus, thispaper will first be reviewed in some detail,and thenthe otherstudieswill be considered. 1. Splits and the Adjustment of Stock Prices to New Information Since theonlyapparent resultof a stocksplitis to multiply thenumber of shares per shareholder without increasing claimsto real assets,splitsin themselves are not necessarily sourcesof new information. The presumption of FFJR is that splitsmay oftenbe associatedwith the appearanceof more fundamentally important information. The idea is to examine security returns aroundsplitdates to see first if thereis any "unusual"behavior, and, if so, to what extent it can be accountedforby relationships betweensplitsand other morefundamental variables. The approach of FFJR to theproblem reliesheavily on the"market model" of (12). In thismodelif a stocksplitis associatedwithabnormal behavior, thiswouldbe reflected in the estimated regression residualsforthe months 0 as themonth surrounding thesplit.For a givensplit,define month in which theeffective 1 as themonth date of a splitoccurs, month followimmediately -1 as the month ingthe splitmonth, month etc. Now define the preceding, residual overall splitsecurities average formonth m (whereforeach security mis measured relative to thesplitmonth)as
N
u

N'1

where fUjmis thesampleregression residual forsecurity j in month m and N is thenumber of splits.Next,define thecumulative averageresidualUm as
m
Um
i k=-29
Uk.

as the average deviation(in The averageresidualum can be interpreted m relativeto splitmonths)of the returns of split stocksfromtheir month withthemarket. normal relationships Similarly, Um can be interpreted as the deviation month -29 cumulative month to define (from m). Finally, u+, u;, U+ and Um as the averageand cumulative averageresidualsforsplitsfollowed by"increased"(+) and "decreased"(-) dividends. An "increase"is a case where the percentage on the splitsharein theyearafter changein dividends thesplitis greater thanthe percentage changeforthe N.Y.S.E. as a whole, while a "decrease"is a case ofrelative dividend decline. The essenceof theresults of FFJR are thensummarized in Figure1, which shows the cumulative average residualsUr U+ and U- for -29 ` m 30. The sampleincludesall 940 stocksplitson the N.Y.S.E. from1927-59, where the exchange was at least fivenew sharesforfourold, and wherethe was listedforat least twelvemonths security beforeand afterthe split. For all threedividend categories the cumulative averageresidualsrise in

406

The Journalof Finance

the29 months priorto thesplit, and in factthe averageresiduals(not shown here) are uniformly This cannot positive. be attributed to thesplitting process, sincein onlyabouttenper centof thecases is thetimebetween theannouncement and effective dates of a splitgreater than fourmonths. it seems Rather, thatfirms tendto splittheir sharesduring "abnormally" good times-thatis, during periods whenthepricesof their shareshave increased morethanwould o.44
U m

, , , , ,

' ' ' ' '

0.33 -

0.22

0.11

o
-29 25-20_15-10 _50
la

5 10 15 20 25 30

Monthrelative to split--m Cumulative average residuals-all splits.

u

FIGURE

u-

o.~~~~~~~~~ 44
0.33

10. 44

,T

33 ~0.

0.22

0.22

0.11

0.11 _.

o:i
0 -29 25-2 15-10 _50 5 10 15 20 25 30

~-29 --20
-25

-loO0 -15 5

1 0 3 1015 20523

Monthrelative to split--m
FIGURE lb Cumulative average residuals for dividend "increases."

Monthrelative to Split--m

Cumulativeaverage residualsfor dividend "decreases."

FiGuRE lc

CapitalMarkets Efficient

407

be impliedby theirnormalrelationships with generalmarketprices,which itselfprobablyreflects a sharp improvement, relativeto the market, in the earnings of thesefirms prospects sometime theyearsimmediately during precedinga split.28 After thesplitmonth there is almost no further movement in Un, thecumulativeaverageresidualforall splits.This is striking, since 71.5 per cent (672 out of 940) of all splitsexperienced greater percentage in dividend increases theyear afterthe splitthanthe averageforall securities on the N.Y.S.E. In lightof this,FFJR suggest thatwhena splitis announced the market interprets this (and correctly so) as a signal thatthe company'sdirectors are probably confident thatfuture earnings willbe sufficient to maintain dividend payments at a higher level. Thus the largepriceincreasesin the months immediately preceding a splitmay be due to an alteration in expectations concerning the future earning potential of thefirm, ratherthan to any intrinsic effects of thesplititself. If thishypothesis is correct, return behavior subsequent to splitsshouldbe substantially different forthe cases wherethe dividendincreasematerializes thanforthe cases whereit does not. FFJR arguethatin factthe differences are in the directions that would be predicted. The fact that the cumulative averageresidualsforthe "increased"dividends(Figure lb) drift upwardbut onlyslightly in the year afterthesplitis consistent withthe hypothesis that whenthesplitis declared, there is a priceadjustment in anticipation of future dividend increases. But thebehavior of theresiduals forstocksplitsassociated with "decreased" dividendsoffers even stronger evidencefor the splithypothesis. The cumulative averageresiduals forthesestocks(Figure lc) risein the fewmonths beforethe split, but thenfall dramatically in the fewmonths afterthe split when the anticipated dividendincrease is not forthcoming. When a year has passed afterthe split,the cumulative averageresidualhas fallento aboutwhereit was fivemonths priorto thesplit,whichis about the earliesttimereliableinformation about a splitis likelyto reachthe market. Thus by the timeit becomesclear that the anticipated dividendincreaseis not forthcoming, the apparenteffects of the split seem to have been wiped have reverted away,and the stock'sreturns normalrelationship to their with market returns. Finally, and mostimportant, although thebehavior of post-split returns will be verydifferent on whether or notdividend "increases" depending occur,and in spite of the fact that a large majorityof split securities do experience dividend"increases,"when all splits are examinedtogether(Figure la), to thesplitthere is no netmovement subsequent up or downin thecumulative
28. It is importantto note, however,that as FFJR indicate,the persistent upward driftof the cumulativeaverage residualsin the monthsprecedingthe split is not a phenomenonthat could be used to increaseexpectedtradingprofits. The reason is that the behavior of the average residuals is not representative of the behavior of the residuals for individual securities.In months prior to the split, successivesample residualsfor individual securities seem to be independent.But in most cases, there are a few months in which the residuals are abnormally large and positive. The monthsof large residualsdiffer fromsecurityto security,however,and these differences in timing explain why the signs of the average residualsare uniformly positive for many months preceding the split.

408

The Journal of Finance

of makesunbiasedforecasts the market Thus, apparently averageresiduals. are fully and theseforecasts dividends, of a split forfuture the implications conAfter by theend of thesplitmonth. in thepricesof thesecurity reflected here,FFJR conclude moredata analysisthancan be summarized siderably thatthestock supportto the conclusion lend considerable thattheirresults to its abiliyto adjust to theinformaat leastwithrespect is efficient, market in a split. tionimplicit 2. OtherStudiesof PublicAnnouncements of residualanalysisdevelopedin [14] have been Variantsof the method kindsof publicannouncements, of different theeffects to study used by others hypothesis. markets the efficient and all of thesealso support Ball and Brown fortheperiod1946-66, Thus usingdata on 261 majorfirms announcements. earnings annual of effects the study to [4] applythemethod of of theannualearnings a timeseriesregression from They use theresiduals earnings firm's the classify to firms all their of a firm on theaverageearnings to themarket. or "decreased"relative fora givenyearas having"increased" of an index on returns stock common of monthly Residualsfrom regressions cumulative compute used to are then (12)) of model market (i.e., the returns and residualsseparatelyfor the earningsthat "increased," average return throughrise residuals return average cumulative The thosethat"decreased." "increased" for the earnings out the year in advance of the announcement Ball and Brown "decreased"category.29 and fall forthe earnings category, of percent thatin factno morethanabout tento fifteen [4, p. 175] conclude has notbeenanticipated announcement in theannualearnings theinformation of the announcement. by themonth to of residual analysis On themacrolevel,Waud [45] has used themethod rate changesby Federal of discount of announcements examinethe effects just the deviations ReserveBanks. In thiscase the residualsare essentially the average and Poor's 500 Index from of the dailyreturns on the Standard "announcement significant He findsevidenceof a statistically daily return. an announcement, day following forthe first trading on stockreturns effect" .5%. More is small,neverexceeding of the adjustment but the magnitude is his conmarkets hypothesis of the efficient from the viewpoint interesting the announcements (or inthe marketanticipates clusionthat,if anything, is based on the leaked in advance). This conclusion formation is somehow residualson the days of the signs of average return patterns non-random the announcement. preceding immediately is promarkets of the efficient hypothesis evidencein support Further of common offerings vided in the workof Scholes [39] on large secondary common stocksby individuals sales of existing stock (ie., largeunderwritten thaton averageseconand on newissuesof stock.He finds and institutions) one and twoper centin daryissuesare associatedwitha declineof between stocks. common forthecorresponding thecumulative averageresidualreturns is unrelated to the size ofthe of the price adjustment Since the magnitude
here. 28 is againrelevant of footnote 29. But thecomment

CapitalMarkets Efficient

409

is not due to "sellingpressure" thatthe adjustment issue,Scholesconcludes from information rather results imis but (as commonly believed), negative block firm's sell a of a in is to stock. plicit thefactthatsomebody trying large in a seconMoreover, he presents evidence thatthe value of the information as would be on the vendor;somewhat darydependsto someextent expected, by far the largestnegativecumulativeaverage residualsoccur where the vendoris the corporation withinvestment comitselfor one of its officers, is notgenerally of the vendor paniesa distant second.But theidentity known and corporate insidersneed only reporttheir at the timeof the secondary, six days aftera transactions stockto theS.E.C. within in their owncompany's sale. By thistimethemarket on averagehas fully adjustedto theinformation in the secondary, as indicated by the fact thatthe averageresidualsbehave randomly thereafter. thatthough thisis evidencethatpricesadjust efficiently to Note, however, public information, it is also evidencethatcorporate insidersat least sometimeshave important information about theirfirm that is not yet publicly known.Thus Scholes' evidenceforsecondary distributions providessupport forthe efficient modelin the semi-strong markets formsense,but also some strong-form evidenceagainstthe model. Thoughhis resultshere are onlypreliminary, Scholes also reports on an of residualanalysisto a sampleof 696 new issues of the method application of common stockduring theperiod1926-66.As in the FFJR studyof splits, thecumulative risein themonths averageresiduals preceding thenewsecurity offering (suggesting that new issues tend to come after favorablerecent events)30 but behaverandomly in the months following the offering (indicatingthatwhatever is contained in thenewissueis on averagefully information reflected in thepriceof themonth of the offering). In short,the available semi-strong formevidenceon the effect of various sortsof publicannouncements on common stockreturns is all consistent with model.The strong markets of the efficient the is point evidence, however, its ratherthan its quantity;in fact, few different consistency typesof public have been examined, information thoughthose treatedare among the obas we shall now see, the amountof semiviouslymostimportant. Moreover, form is evidence voluminous strong comparedto the strongformtests that are available. Form Tests of the Efficient C. Strong MarketsModels The strongformtests of the efficient marketsmodel are concerned with whether all available information is fullyreflected in pricesin the sense that has higher no individual expectedtrading profits thanothersbecause he has access to someinformation. monopolistic We wouldnot,of course,expectthis modelto be an exact description of reality, and indeed,thepreceding discussions have alreadyindicatedthe existence of contradictory evidence.In parNiederhoffer and Osborne [32] have pointedout thatspecialistson ticular, theN.Y.S.E. apparently use their access to information concernmonopolistic
30. Footnote 28 is again relevanthere.

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The Journal of Finance

and Scholes' evidence limitordersto generate ing unfilled monopoly profits, thatofficers of corporations sometimes have monopolistic access [39] indicates firms. abouttheir to information Sincewe alreadyhave enoughevidenceto determine thatthe modelis not how strictly valid,we can nowturnto otherinteresting questions. Specifically, the investment do deviationsfromthe model far down through community permeate? Does it pay forthe averageinvestor(or the averageeconomist) out littleknowninformation? Are such acto expendresourcessearching forvariousgroups of market evengenerally tivities profitable "professionals"? More generally, who are the people in the investment community that have access to "special information"? Thoughthis is a fascinating problem, only one grouphas been studiedin of open end mutualfunds.Severalstudiesare any depth-the managements available (e.g., Sharpe [41, 42] and Treynor[44]), but the most thorough willbe limited to his work.We shall are Jensen's [19, 20], and our comments modelunderlying his tests,and thengo on to his first present the theoretical results. empirical 1. Theoretical Framework theperformance of mutualfundsthe majorgoals are to deterIn studying in generalfundmanagers mine (a) whether seem to have access to special and information whichallowsthemto generate "abnormal"expected returns, such special information some fundsare betterat uncovering (b) whether be the abilityof fundsto produce Since thecriterion will simply thanothers. than some normwith no attemptto determine what is rehigherreturns the "special information" that leads to high sponsibleforthe high returns, could be eitherkeenerinsight into the implications of publicly performance in market thanis implicit available information access pricesor monopolistic of themutualfund information. Thus the testsof theperformance to specific form testsof the efficient are not strictly markets model. industry strong The major theoretical (and practical) problemin usingthe mutualfund markets model is developing to test the efficient industry a "norm"against can be judged.The normmustrepresent whichperformance the results of an investment thatpricesfullyreflect all availpolicybased on the assumption And if one believesthatinvestors are generally able information. riskaverse forany risksundertaken, and so on averagemustbe compensated thenone of finding definitions of riskand evaluating has theproblem each appropriate withits chosenlevelof risk. to a norm fundrelative exJensenuses the Sharpe [40]-Lintner[24, 25] model of equilibrium discussedabove to derivea normconsistent pectedreturns withthesegoals. From (14)-(16), in thismodeltheexpectedreturn j on an asset or portfolio from t to t + 1 is
E(r'j,t?l 10t) rf,t+l [1
-

(Dt))] + E (rm,t+1ikt)Pj(3t),

(18)

are as defined in SectionIII. A. 6. But (18) is an wherethevarioussymbols and to evaluateperformance an ex post normis needed. ex ante relationship,

Efficient CapitalMarkets

411

on the the realizedreturn One way the lattercan be obtainedis to substitute return forthe expected in (18) withthe result3' market portfolio
E(rij,t+,(Dt, rm,t+,)

rf,t+l [1 -

3j((Dt)] + rm,t+,(j(QDt).

(9)

(19) says that withinthe contextof the Sharpe-Lintner Geometrically, on on j (giveninformation (Dtand thereturn theexpected return model, rm,t?l of its risk is a linearfunction themarket portfolio) known, thatthevalue of (3j(Dt) is somehow as indicated in Figure2. Assuming if j is a mutualfund,its ex post performance or can be reliablyestimated, of realized its combination nowbe evaluatedby plotting from t to t + 1 might falls and riskin Figure2. If (as forthepointa) thecombination return rj,t+l called,the "market line (or, as it is morecommonly return above theexpected thanwouldbe expected givenits level of risk,while line"), it has donebetter if (as forthepointb) it fallsbelowtheline it has doneworse.
r E(ib,t?1lit,rn ,t+1)------------------------------------

p(34Q>) - COV (irj,t+1,

rm

b,t+- - -------------m,t+IL

a,tR %+1 t rm,t+1-

o- ?
Paia( t)

.
PM(1t FIGURE 2

PO t)

04t)

Performance EvaluationGraph

the marketline shows the combinations of return and risk Alternatively, that are simplemixtures of the risklessasset and the provided by portfolios m. The returns and risksforsuch portfolios (call themc) market portfolio are
(z1)) cv r =,t+l (" ,t+1, rm, "m,t+1! (rcst t arf,t+l + t)

(D)=coy (3~QD~)

co l|a cov

t+ 11t) O2(irm,

(1 -0rM,t+1 ( ?( )mtat Pt+l| )t (1a ) r'm, + l, rm, mt+1IlI

-adrm,t+ij(Dt)1-

to hereis thatthe return according r; t--l is generated 31. The assumption and
rj,t+l = ri,t+,[l - j(Dt)] + rm,t+j0j((Dt) + Uj,t+ls

t+IIrm,t+,)= 0 forall rm,t+. E(UJ,

412

The Journalof Finance

of portfolio fundsinvestedin the risklessasset. wherea is the proportion of return and riskalongthe Thus,when1 > a > 0 we obtainthecombinations line fromrf,t+? to m in Figure 2, whilewhena < 0 (and underthe market can borrowat the same rate that theylend) we assumption that investors of return and risk along the extension of the line obtainthe combinations m. In the market line this the through interpretation, represents resultsof a naive investment whichthe investor strategy, who thinks pricesreflect all availableinformation follow. The performance of a mutualfundis then might measured relative to thisnaive strategy. 2. EmpiricalResults framework uses thisrisk-return to evaluatetheperformance Jensen of 115 mutual fundsover the ten year period 1955-64. He argues at lengthfor as the nominalten year rate withcontinuous measuring return compounding (i.e., the naturallog of the ratioof terminal wealthafterten yearsto initial data on nominalone-yearrates with conwealth) and for using historical tinuouscompounding to estimate risk.The Standardand Poor Index of 500 majorcommon stocksis used as theproxyforthemarket portfolio. The generalquestion to be answered is whether mutualfundmanagements have any special insights or information whichallows themto earn returns above thenorm.But Jensen attacksthequestionon severallevels.First,can the fundsin generaldo well enough to compensate investorsfor loading charges, management fees,and othercosts thatmight be avoided by simply the combination of the risklessasset f and the marketportfolio choosing m withrisklevel comparable to thatof the fund'sactual portfolio? The answer seemsto be an emphatic no. As faras net returns to investors are concerned, in 89 out of 115 cases, the fund'srisk-return combination for the ten year periodis belowthemarket line fortheperiod,and theaverageoverall funds of the deviations of tenyear returns from themarket timeis -14.6%o. That is, on averagethe consumer's wealthafterten yearsof holding mutualfunds is aboutfifteen per centless thanifhe held thecorresponding portfolios along the market line. But theloadingcharge thatan investor pays in buying intoa fund is usually a pure salesman'scommission thatthe funditselfnevergets to invest.Thus one mightask whether, ignoring loading charges (i.e., assumingno such chargeswere paid by the investor), in generalfundmanagements can earn returns above the normto coverall otherexpensesthatare presufficiently related to the management sumablymore directly of the fund portfolios. Again,the answerseemsto be no. Even whenloadingchargesare ignored in the risk-return computing returns, combinations for 72 out of 115 fundsare belowthemarket line,and theaveragedeviation of tenyear returns from the market line is -8.9%. Finally,as a somewhat stronger test of the efficient markets model,one would like to knowif, ignoring all expenses,fundmanagements in general showedany abilityto pick securities that outperformed the norm.Unfortunately,this questioncannotbe answered withprecision forindividual funds data on curiously, brokerage commissions are not publishedregularly. since,

Efficient Capital Markets

413

the available evidenceindicatesthat the answerto the But Jensen suggests Specifically, addingback all otherpubquestionis again probablynegative. for58 combinations the risk-return of fundsto theirreturns, lishedexpenses of ten line,and the averagedeviation werebelowthemarket out of 115 funds from the line was -2.5%o. But part of thisresultis due to the year return these comEstimating for brokeragecommissions. absence of a correction rates forall fundsfor the period turnover missionsfromaverageportfolio forall fundsincreasesthe average 1953-58, and addingthemback to returns whichstill is not infromthe market line from-2.5%o to .09%o, deviation dicativeof the existence of specialinformation amongmutualfundmanagers. in general do notseemto have access to mutualfundmanagers But though in prices,perhapsthereare individual information not alreadyfully reflected and so provideat least some do better thanthenorm, fundsthatconsistently model.If thereare such markets strongformevidenceagainstthe efficient funds,however,they escape Jensen'ssearch. For example,for individual do not seem to be associated above thenormin one subperiod funds, returns And regardless of how above thenormin othersubperiods. withperformance expenses), chargesand other (i.e., netor grossofloading returns are measured from themarket deviations of returns thenumber withlargepositive of funds thatwould be expectedby chance line of Figure 2 is less than the number have no special with115 funds thatfundmanagements undertheassumption talentsin predicting returtis.32 of the Jensenargues that thoughhis resultsapply to only one segment in favorof the striking evidence theyare nevertheless investment community, model: efficient markets form ofthemartingale thatthestrong certainly do notimply Although these results in strong evidence they provide and forall time, hypothesis holdsforall investors of thathypothesis. are extremely well realize thatthese analysts One must support in thesecurities markets every dayandhavewideMoreover, they operate endowed. communities. in boththe business and financial and associations ranging contacts returns areapparently to forecast thatthey unable enough accurately Thus,thefact in favor andtransactions costs is a striking to recover their research pieceofevidence form of themartingale leastas faras the extensive of the strong hypothesis-at is concerned available to these subset ofinformation analysts [20, p. 170].
IV. SUMMARY AND CONCLUSIONS

In as follows. The preceding analysiscan be summarized (ratherlengthy) thetheory of efficient is concerned markets withwhether prices general terms, The theory availableinformation. onlyhas at anypointin time"fullyreflect" model of withinthe contextof a more specific content, however, empirical
32. On the other hand, thereis some suggestionin Scholes' [39] work on secondaryissues that Aftercorporateinsiders,the mutual fundsmay occassionallyhave access to "special information." next largest negative price changes occur when the secondary seller is an investmentcompany (includingmutual funds), though on average the price changes are much smaller (i.e., closer to 0) than when the seller is a corporateinsider. Moreover, Jensen'sevidence itself,though not indicative of the existenceof special information never precise to conclude that such information among mutual fund managers,is not sufficiently exists. This strongerconclusion would require exact data on unavoidable expenses (including brokeragecommissions) of portfoliomanagementincurredby funds.

414

of Ftnance The Journal

that is, a model that specifiesthe nature of market marketequilibrium, We have seen available information. whenprices "fullyreflect" equilibrium based on or explicitly is implicitly literature thatall of theavailableempirical can be stated in of marketequilibrium that the conditions the assumption return is thebasis of theexpected This assumption returns. of expected terms models. markets or "fairgame" efficient depending work itselfcan be dividedinto threecategories The empirical testsare conStrong-form subsetof interest. of theinformation on thenature access or groupshave monopolistic investors individual cernedwithwhether One would not expectsuch forprice formation. relevant to any information of the world,and it is probably modelto be an exact description an extreme from of deviations againstwhichthe importance best viewedas a benchmark tests semi-strong-form can be judged.In the less restrictive efficiency market includesall obviouslypubliclyavailable subset of interest the information subset is just while in the weak formtests the information information, sequences. priceor return historical marketmodel are the most voluminous, Weak formtestsof the efficient in support.Though and it seems fair to say that the resultsare strongly in successiveprice changes evidencefor dependence significant statistically withthe "fair game" some of this is consistent has been found, or returns into declarethe market modeland the restdoes not appear to be sufficient a day or longer, or returns covering efficient. Indeed,at leastforpricechanges offthere isn'tmuchevidenceagainstthe"fairgame" model'smoreambitious walk. the random spring, in day-to-day evidenceof positive dependence Thus, thereis consistent is of a on commonstocks,and the dependence price changesand returns In rules. the basis of trading be used as profitable marginally form can that that are shows up as serial correlations Fama's data [10] the dependence closeto zero,and as a slight tendency butalso consistently consistently positive and negative of runsofpositive pricechangesto be less forobserved numbers from a purelyrandom process.More thatwouldbe expected thanthenumbers of Alexander in filter tests also showsup the thedependence important, [1, 2] to forvery small filters and thoseof Fama and Blume [13] as a tendency But any systems(like the filters) in excessof buy-and-hold. produceprofits of necessity into trading to turnshort-term profits dependence that attempt thattheirexpectedprofits would be absorbed so manytransactions generate traders commissions fees) thatfloor handling (security by even theminimum intermustpay. Thus, usinga less thancompletely strict on majorexchanges this positive dependencedoes not seem of of marketefficiency, pretation of the efficient model. markets to warrant rejection sufficient importance of the "fair game" efficient marketsmodel for Evidence in contradiction covering periodslongerthan a single day is more price changesor returns negative Cootner[9], and Moore [31] report preponderantly to find. difficult common in weekly stockreturns, and this (but againsmall) serialcorrelations analyzedby Fama [10]. But it resultappears also in the fourday returns if anything, thereis some slight does notappear in runstestsof [10], where, but actually not much evidenceof any indicationof positivedependence,

Capital Markets Efficient

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dependence at all. In any case, there is no indication thatwhatever dependence returns can be used as thebasis of profitable existsin weekly trading rules. evidenceof dependence in returns Otherexisting inprovidesinteresting sightsinto the processof price formation in the stockmarket, but it is not relevantfor testingthe efficient marketsmodel. For example,Fama [10] showsthatlargedailypricechanges tendto be folowed by largechanges, but of unpredictable sign. This suggeststhat important information cannotbe evaluatedimmediately, completely but that the initialfirst day's adjustment of pricesto theinformation is unbiased, whichis sufficient forthe martingale model.More interesting and important, however, is the Niederhoffer-Osborne [32] finding of a tendency towardexcessivereversals in common stockprice changesfrom transaction to transaction. They explainthisas a logical result of the mechanism whereby ordersto buy and sell at marketare matched limitorderson the books of the specialist.Given the way against existing this tendency towardexcessivereversalsarises,however, thereseems to be no way it can be used as thebasis of a profitable trading rule.As theyrightly claim,theirresults are a strong refutation of the theory of random walks,at least as appliedto pricechangesfrom transaction to transaction, but theydo not constitute refutation of the economically morerelevant "fair game" efficientmarkets model. formtests,in whichprices are assumed to fullyreflect all Semi-strong obviouslypubliclyavailable information, have also supportedthe efficient markets hypothesis. Thus Fama, Fisher,Jensen, and Roll [14] findthatthe information in stocksplitsconcerning the firm's future dividend payments is on averagefully in thepriceof a splitshareat the timeof the split. reflected Ball and Brown[4] and Scholes[39] cometo similar conclusions withrespect in (i) annual earning to the information contained announcements by firms and (ii) newissuesand largeblocksecondary issuesof common stock.Though onlya few different typesof information generating eventsare represented here,theyare amongthe moreimportant, and the resultsare probablyindicativeof whatcan be expected in future studies. thestrong-form in whichpricesare efficient markets As noted earlier, model, all availableinformation, is probablybest viewedas assumedto fullyreflect from market in a benchmark againstwhichdeviations efficiency (interpreted have in factbeen obits strictest sense) can be judged.Two such deviations and Osborne [32] point out that specialistson served.First,Niederhoffer have monopolistic on unexaccess to information major security exchanges to generate ecutedlimitordersand theyuse thisinformation trading profits. the "marketmaking"function of the This raises the questionof whether economicfunction)could not as specialist (if indeed this is a meaningful -mechanism be carriedout by some other that did not implymoneffectively opolisticaccess to information. Second, Scholes [39] findsthat,not unexinsidersoftenhave monopolistic access to information pectedly, corporate firms. about their At themoment, however, corporate insiders and specialists are theonlytwo whose to information been access has documented. groups monopolistic There fromthe strong formof the efficient is no evidencethatdeviations markets

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modelpermeate downany further theinvestment For the through community. purposes of mostinvestors theefficient markets modelseemsa good first (and second) approximation to reality. In short, theevidence in support of theefficient markets modelis extensive, and (somewhatuniquely in economics) contradictory evidence is sparse. we certainly do notwantto leave the impression thatall issues Nevertheless, are closed.The old saw, "muchremains to be done,"is relevant hereas elsewhere.Indeed,as is oftenthe case in successful now that scientific research, we knowwe'vebeenin thepast,we are able to pose and (hopefully) to answer an evenmoreinteresting set of questions forthe future. In thiscase themost pressing fieldof future endeavor is the development and testing of modelsof marketequilibrium underuncertainty. When the processgenerating equilibriumexpected returns is better understood (and assuming thatsomeexpected return modelturns out to be relevant), we willhave a moresubstantial frameworkformoresophisticated intersecurity testsof market efficiency.
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