Prices incorporate the information in a specified information set, so persistent abnormal risk-adjusted returns from that information are hard to earn.
Fama's 1970 framing distinguishes weak, semi-strong and strong forms by the information set they assume. The strong form concerns private information and has been tested; strict strong-form efficiency is not generally supported. The practically useful finding is that most active managers underperform index funds after fees.
In practice
- A fund manager who beats the index for three years attracts inflows and reverts, and the fees are the only reliable part.
- A commentator who correctly called one crash is invited back for the next decade, having called nine others that did not happen.
- Possible explanations
- The explanation is competition: if information implies a profit, traders act on it until the price moves, so the information stops being profitable.
- In its favour
- Prices do respond to news within minutes, and the long record of active managers underperforming index funds after costs is what the hypothesis predicts.
- Against it
- Documented anomalies such as momentum and value persist, bubbles and crashes are hard to reconcile with it, and the joint hypothesis problem means any test is a test of the hypothesis and a pricing model together.
- Standing
- Weak, semi-strong and strong forms differ by information set; strict strong-form efficiency is not generally supported.
- Further reading
- Wikipedia
- Subject
- Economics & Incentives
- Essay
- The theories behind every argument about money