Importance of Efficiency Market Hypothesis

Today mainstream academic views hold position that capital markets operate with high degree of efficiency what is expressed in Efficient Market Hypothesis (EMH). The hypothesis was introduced by Louis Bachelier`s The Theory of Speculation (1900) but the work was ignored for a long period. The efficient market hypothesis emerged as a prominent theoretic position in the mid 1960s. Works of Paul Samuelson and Eugene Fama who published further evidence supporting the hypothesis and became their well known proponents.

Standard those investors should be build portfolio with instability matching to became normally accepted of expected return. There are variance views on standards of portfolio stricture. Investment strategy mainly significantly connected with Efficiency Market Hypothesis is indexing. Efficiency Market Hypothesis means that period does not issue. Because it is create time killing to expose for lower price assets. Assets are valued effectively. Mathematical methods of testing market efficiency include Dickey Fuller test, runs test. Dickey-Fuller test version for a unit root can be written as:

Yi=βyi-1+Vi,

where yi is the variable of interest, i is the time index, β is a coefficient, and Vi is the error term.

So inactive subsequent of a certain index must generate better profits. There is especially well-built empirical data following rightness of the approach. Transaction costs are increased and it is generally recognized to lower performance of aggressively trading funds. Some time it shows deviation dynamic operating would generate higher results. It is not important in actual situation in the world; if not added transaction cost. This is not unexpected buy & hole (index) strategy also draws significant disapproval. In the view is examined of stock value change linked with index enclose/ omission. Market stock value tend to increase while a share is enclose and decrease if omission. So it is shows that share value change does not relay to company basics but it could be good clarified by the detailed that portfolio managers changing inactively control portfolio. As per example 17% Royal Dutch share value decreased for omission in S&P in a week. There is also empirical date of following return in values of shares omission from share index. Buy & Hold and Index have difference, it should be observed. If transaction costs are minimizing, Buy & Hold strategy are more constant and index combination would be change. Buy& Hold strategy is a one kind of Indexing by Wilkens et al (2006). Buy & Hold and Indexing are said to be reliable with Efficient Market Hypothesis.

Mutual Funds

Mutual funds (MFs) present rapidly growing sector and most affordable option for general public how to participate on equity markets. There have been many debates about mutual fund performance – especially about the persistence of excess returns. The debate can be divided into two parts: on one hand, those like Carhart (1997) point out that mutual funds excess performance does not persist, except in the very short term; and, on the other hand, those like Gruber (1996), who argue that excess performance does persist and that past performance can be a predictor of future performance. Market liberalization, sociological and technology factors have fuelled rapid growth in last decades in developed countries and recently also in emerging markets. Mutual funds in developed countries are subject of state regulation which put some limits on portfolios construction such as inclusion of derivates or leverage. However, these instruments are utilized by hedge funds which finds way how to evade the regulation in order to provide higher although risky returns. The basic MFs divide with respect to portfolio construction is on active and passive portfolio management. Active portfolio managers seek stocks which they believe have potential of over average returns. In general mean variance weighted framework is theoretical background for creation of active portfolios. However, as documented by academic research these principles are often not applied in MFs management. Passive investing may be identified with index funds. There are three portfolio construction strategies typically used to manage an index fund: linear optimization/stratified sampling, quadratic optimization, and full replication. Ultimate goals are low tracking error and low turnover to deliver the index return at the lowest possible cost.

Full replication, where every stock in the portfolio is held at its exact weight in the index, is not a feasible strategy for managing a portfolio of institutional size. Low liquidity for the smaller capitalization stocks in the index make them very expansive if not impossible to own. Further, it is not necessary to invest in the lower tiers of capitalization to successfully deliver the index return, as long as the portfolio has the correct exposure to the characteristics of the index that drive performance. Quadratic optimization is a tool most often used by active managers for portfolio construction. Stratified Sampling has been developed by Wilshire Associates. The sampling approach divides the index into cells which usually represent industry sectors and market capitalization rankings. The number of cells necessary to define an index is directly proportional to the number of stocks that comprise that index.

The literature on mutual fund performance is consistent with the contention that on average the portfolio management skills provided by mutual fund managers are of little value to investors.

Evidence that the average mutual fund underperforms a passive benchmark portfolio suggests that investors who believe fund managers have superior stock selection ability are naive. Day et al., (2001) performed analyses where they investigated causes of underperformance of mutual funds portfolios.

Value and Growth Investment Strategies

There is also another broadly defined framework for investment strategies which is known as value and growth investment strategies. These strategies are roughly opposing in view of assessing future cash flows. While value investment prefers current and certain income, growth investors are prepared to wait for future growth in exchange for higher returns. While this framework is not much used in current professional nor academic portfolio research not connected to other modern portfolio theory concepts its importance lies in fact that average investors and mutual funds themselves position their investment products in this ways as this concept is well established and easy to understand.

Value investing is a broad concept that has evolved over time. There are more definitions of this investment approach. Investopedia.com (2008) states that value investing is the strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company’s long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated. Typically, value investors select stocks with lower-than-average price-to-book or price-toearnings ratios and/or high dividend yields.

In general substance of value investing is that investment should follow intrinsic investment value and the intrinsic value proxies should be base for fundamental analysis. Therefore value investors stress importance of some of such a proxies like Price/Earnings, Price/Book ratios. Some other such as PEG (Projected Growth in Earnings) has been applied specifically in value investing. The PEG is calculated by dividing the P/E ratio by the projected growth in earnings for the coming year.

Technology change of 1990s brought much easier access to financial data and trading statistics and is assumed to erode advantage of screeners using fundamental analysis. Presumably in this context Berkshire Hathaway changed its strategy in favor of approach termed by Damodaran (2008) as Activist Value Investor. That is search for poorly managed and poorly run companies take shareholder stake there and than try to change the way companies are run. As substantial capital is required for the “activist” approach accumulated wealth may provide Berksihre Hahaway last competitive advantage. faced with current equity markets efficiency. However, long term performance of the company which had easily outperformed all benchmark indeces is often pointed out as example of investor beating the market.

On base of P/E ratio many investment and timing strategies shave been proposed. They include switching to safer investment instruments such as T-bill on base of a particular P/E value and vice versa. Another option is to extend trading rules by dividend yield as this is also parameter used in value investing. Workability of these strategies was tested among others by Fisher and Statman (2005) while they find that it is in general difficult to overcome buy&hold strategy. However, they find that possible when transaction costs are not considered under some circumstances and on some world markets.

Conversely the strategy seen as opposite to the value is growth investing. Investopedia.com (2008) states that growth investing is a strategy whereby an investor seeks out stocks with what they deem good growth potential. In most cases a growth stock is defined as a company whose earnings are expected to grow at an above-average rate compared to its industry or the overall market. Damodaran (2008) generic definition is that growth investor is one who buys growth companies where the value of growth potential is being underestimated. In other words, both value and growth investors want to buy undervalued stocks. The difference lies mostly in where they think they can find these bargains and what they view as their strengths. However, there is disagreement whether growth investing profits are excess or justified by higher risk associated with small companies. Growth stocks are characterized by high P/Es but naturally this can not criterion in growth portfolio selection. Income growth indicators, company and industry prospects are judged but substantial facts that it is hard to estimate future returns and overall more problematic to research small companies should be recognized.

It is not surprising that some approaches tries to balance both above mentioned strategies in order to utilize their advantages. One of them is GARP (Growth at A Reasonable Price) but other principles were formulated as well. GARP investors look for companies that are showing consistent earnings growth above broad market levels (a tenet of growth investing ) while excluding companies that have very high valuations (value investing). The overarching goal is to avoid the extremes of either growth or value investing; this typically leads GARP investors to growth-oriented stocks with relatively low price/earnings (P/E) multiples in normal market conditions.

In fact value-growth dimension presents rather broad descriptive framework for investors and mutual