In this extended essay I will address a number of key issues in relation to market efficiency. I will define market efficiency and describe the three different forms of market efficiency which consist of; weak-form efficiency, semi-strong form and strong-form efficiency. I will also outline the characteristics of market efficiency. I will then define what a mutual fund is and compare and contrast an open-ended mutual and a closed-ended mutual fund. I will also then give my opinion on why I don’t think that mutual funds consistently out-perform the market.
Market efficiency was developed in 1970 by economist Eugene Fama. He came up with the theory efficient market hypothesis which states that it is not possible for an investor to outperform the market because all available information is already built into all stock prices. Market efficiency is basically the degree to which stock prices reflect all the available and relevant information. A perfectly efficient market means that the prices reflect all information knowable and relevant. A perfectly efficient market means that there are no undervalued or overvalued securities.
It doesn’t matter what the pricing structure of the market is, the market is priced perfectly in terms of that structure. An efficient market is defined by available and accurate information about the securities and their prices. The efficient market hypothesis is based on the idea that every investor has all of the information about the securities available, the price demand as well as all of the other information which can be regarded as relevant. This relevant information may include past market behaviour or the performance of the particular company who are issuing the stock.
The idea of an efficient market is that the more efficient it is then the more informed the decisions are of the investors. A market can be described as a place for investors to trade securities. An efficient market is one where prices change rapidly in response to the changes in demand and supply; therefore prices are fair at any given time. Fama defined an efficient market as “one in which prices always fully reflect available information”. The efficient-market hypothesis theory states that in any given time, the prices of the market already reflect all known information and also change fast to reflect new information.
Therefore, nobody could outperform the market by using the same information that is already available, except through pot luck. Fama came up with three different levels of market efficiency: Weak-form efficiency: Prices of the securities instantly and fully reflect all information of the past prices. This basically means that future price cannot be predicted by using past prices. Past data on stock prices are of no use in predicting future stock prices. Everything happens randomly. A “buy-and-hold” strategy is best used in this case.
All historical information is reflected in the stock price. Semi-strong form efficiency: Prices fully reflect all of the available information to the public. This includes information in the firms accounting reports, the reports of competing firms, any information relating to the economy and any other information available to the public in terms of the valuation of the firm. This basically means that only somebody with additional inside information could have an advantage in this market. Any price abnormalities are quickly found out and the market adjusts.
All public available information is reflected in the stock price. Strong-form efficiency: Prices fully reflect all of the public and inside information available. This basically means that nobody could have an advantage in the market in terms of predicting prices because there is no data that would provide any additional value to the investors in the markets. All information; public and private are reflected in the stock price. The main difference between the three forms of efficiency is basically the levels of information incorporated into the stock price.
The Characteristics of an efficient market are as follows: Prices should respond quickly and accurately to any new information that is relevant to the valuation. Changes in expected returns are driven by changes in the level of risk free rate and changes in the level of risk premium in terms of that particular security. Changes in stock prices that are driven by other events should be completely random. By separating investors who are knowledgeable from investors who aren’t, we will find out that there isn’t a significant difference between the average investment performances of the two.
A mutual fund is a type of professionally managed collective investment scheme that pools money from many investors to purchase securities such as stocks, bonds and similar assets. They are managed by money managers, who invest the funds capital in an attempt to produce income for the investors. A mutual fund is structured and organised. A mutual fund gives small time investors the opportunity to invest in professionally managed, diversified portfolios of equities, bonds and other securities which would be hard to create with a small amount of capital.
Mutual funds are diversified which means they are made up of a lot of different investments. By diversifying it lowers the risk. There are two types of mutual funds; open-ended mutual funds and closed-ended mutual funds. An open-ended mutual fund is a type of mutual fund that has no restrictions on the amount of shares they issue. Even if demand is high the fund will keep on issuing shares no matter how many investors there are in the fund. Also in an open-ended mutual fund they buy back shares when investors want to sell.
In comparison a closed-ended mutual fund is basically a publically traded investment company that raise a fixed amount of capital through an initial public offering. The fund is then listed and traded like a stock on the stock exchange. Mutual funds fall into three different categories: Equity funds- These are made up of investments of only stock. These can be riskier than other types of mutual funds. They may be riskier but they also provide you with a higher return. Fixed income funds- These are made up of government and corporate securities. Fixed income funds provide a fixed return and are usually low risk.
Balanced Funds- These are made up of a combination of both stocks and bonds. They offer a moderate to low risk however this is also combined with lower rates of return. Less risk usually equals less return. No I don’t think mutual funds are consistently outperforming the market. In 2012, 66% of all equity funds underperformed when they were matched up against the S+P 1500. Basically over time, because of their costs, approximately 80% of mutual funds will underperform the stock markets returns. So the question is why are some funds outperforming the market?
Well there not, there just coming across that they do. Mutual fund companies always have a few funds on in their portfolios that have brilliant results in the last 5 years. Mutual fund companies say it’s because they have the best fund managers that money can buy. If one particular fund doesn’t do well and loses money for investors, then the unprofitable and unpopular fund is closed up and usually rolled into another fund. Seeing as the worst funds in the portfolio don’t exist after a few years therefore it makes the existing funds in the portfolio look good.
Personally I think that it’s down to pot luck; there have been numerous studies done that show that the average fund performs worse than the market average. Also mutual fund companies have no rules in respect to marketing their pot-luck as if it is all down to the fund manager’s skill. Mutual funds aren’t consistently outperforming the market; personally I think its down to luck. To conclude, I defined what market efficiency is and described the three different types of market efficiency and the main characteristics an efficient market possess. I also described what mutual funds are.
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