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Market Efficiency by Sean Cleary, PhD, CFA, Howard J. Atkinson, CIMA, ICD.D, CFA, and Pamela Peterson Drake, PhD, CFA Sean Cleary, PhD, CFA, is at Queen’s University (Canada). Howard J. Atkinson, CIMA, ICD.D, CFA, is at Horizons ETF Management (Canada) Inc. (Canada). Pamela Peterson Drake, PhD, CFA, is at James Madison University (USA). LEARNING OUTCOMES Mastery The candidate should be able to: a. describe market efficiency and related concepts, including their importance to investment practitioners; b. distinguish between market value and intrinsic value; c. explain factors that affect a market’s efficiency; d. contrast weak-form, semi-strong-form, and strong-form market efficiency; e. explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management; f. describe market anomalies; g. describe behavioral finance and its potential relevance to understanding market anomalies. INTRODUCTION Market efficiency concerns the extent to which market prices incorporate available information. If market prices do not fully incorporate information, then opportunities may exist to make a profit from the gathering and processing of information. The subject of market efficiency is, therefore, of great interest to investment managers, as illustrated in Example 1. 1 Equity Investments R E F R E S H E R R E A D I N G 2 0 2 0 C FA P R O G R A M • L E V E L I • R E A D I N G 3 8 C F A I N S T I T U T E M E M B E R U S E O N LY © 2019 CFA Institute. All rights reserved.
Refresher Reading Market Efficiency 2 C F A I N S T I T U T E M E M B E R U S E O N LY EXAMPLE 1 Market Efficiency and Active Manager Selection The chief investment officer (CIO) of a major university endowment fund has listed eight steps in the active manager selection process that can be applied both to traditional investments (e.g., common equity and fixed- income securities) and to alternative investments (e.g., private equity, hedge funds, and real assets). The first step specified is the evaluation of market opportunity: What is the opportunity and why is it there? To answer this ques- tion, we start by studying capital markets and the types of managers operating within those markets. We identify market inefficiencies and try to understand their causes, such as regulatory structures or behavioral biases. We can rule out many broad groups of managers and strategies by simply determining that the degree of market inef- ficiency necessary to support a strategy is implausible. Importantly, we consider the past history of active returns meaningless unless we understand why markets will allow those active returns to continue into the future. 1 The CIO’s description underscores the importance of not assuming that past active returns that might be found in a historical dataset will repeat themselves in the future. Active returns refer to returns earned by strategies that do not assume that all information is fully reflected in market prices.

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