Active Vs. Passive Fund Management

FINS 2624 ASSIGNMENT 2

EXECUTIVE SUMMARY

To sum up, based on the discussion above, it seems that for the US market, it appeared to be working under a weak-form of inefficient market considering market anomalies of momentum effects and pricing-earning ratio and intrinsic measure anomalies. However, for Australia market, due to the characteristics difference of Australia market, the portfolio of Australian shares are consistent with the weak-form of market efficiency, however, it does not apply to the individual stocks. Besides, no intrinsic measure anomalies were found for the long horizon. Overall, Australia market is more efficiency compared to US market in terms of weak-from of market efficiency.

In addition, after examining the small firm in January effect anomaly, book to market ratio anomaly and post earnings announcement price drift anomaly, we could see that Australian market especially for small firms was influenced by January effect, book to market ratio and post earnings announcement anomaly, which indicate market inefficiency of Australia market. On the other hand, for the US market, the last three anomalies all applied to US market also, and it seems that US market is also not market efficiency.

PART 1

An efficient market exists when the stock price fully reflects all the information available . There are several ways to test whether the market is efficient. The main tests include event study, the patterns in stock return, predictors of broad market return, test of anomalies and the inside information . These tests are conducted by using risk models to calculate the excess return of the market , the market is said to be efficient if there is no excess return to be found .

Event study exams the influence on stock price by a specific event and a single-index model is used :

rt = a + brmt + et => et = rt вЂ"( a + brmt )

rt : stock return during the period t

a : average rate of return during period t with no market return

brmt : sensitivity to market return

et : part of stock return due to firm-specific event

And we call et abnormal return.

There are also other tests, such as patterns in stock return and predictors of broad market return which are early tests for the market efficiency and are included in the weak form tests .

The first test is conducted by exam the past stock prices to find the trend . It will need to calculate the serial correlation of stock market return . If it is positive serial correlation, then it means what followed by the positive returns is a positive return, otherwise, it is a negative return . There are problems associated with this test. For the short horizons, a research conducted by Conrad and Kaul and Lo and Mackinlay found that the correlation coefficient is quite small for the weekly return which suggested that there is no strong evidence of the existence of patterns in stock returns over short horizons . However, for the long run, researchers do find that it tends to have a negative correlation coefficient .

The second test is based on the variables such as dividend/price ratio, earnings yield, and spread between yields on corporate bonds, and using these variables to predict market returns . If we can say that market returns are predicted by predicting risk- adjusted abnormal returns then probably the market is inefficient . However, the difficulty here is uncertainty about whether the return we get is result from the predictability by using the indicator in risk premium or risk- adjusted abnormal returns .

Test of anomalies are included in semi strong tests . These tests are normally conducted by applying the CAPM model that is used to adjust the risk . That is, the risk adjusted returns are gained by testing both risk adjustment and market efficiency hypothesis .

There are several examples of anomalies. The small firm in January Effect is about the effect of size . It found that smallest sized firms tend to have a higher return despite the risk are already been adjusted by using CAPM, and it most occurred in January .

The neglected firm Effect is actually another way to explain the above example of anomalies, as established by Arbel and Strebel that due to less information available related to small firms so it makes small firms more risky . Besides the liquidity effects is another reason to explain the abnormal return of the small firms . When the stocks are ness liquid it may incur a high cost for transactions, and for small firms it is likely that their stocks will not be as liquid as big firms’ .

The other examples include Book to Market Ratio. Researches by Fama and French and Reinganum found that there is a relationship between book to market ratio and returns so it is possible for investors to look at the book to market ratio to predict the return and own abnormal return . The finding makes a big doubt as to the market efficiency .

The last one is Post Earnings Announcement Price Drift. For an efficiency market the price of stock should reflect the information immediately after the release, however, what in reality is that price continued to rise or fall through a period after the announcement date and so was the abnormal returns . It is called Post Earning Announcement Drift.

The last test is inside information. In a case that insiders make big return because of knowing the inside information, the market is said to be inefficient . As the price of stock is not fully reflect all the available information.

Besides, for all the tests above, there is one common problem related to the tests. That is, as the test conducted by using risk models, it may then need to take into account of the efficiency of the models used .

PART 2

A market anomaly exists where findings cannot be reconciled with the efficient market hypothesis or when returns when risk adjusted are still abnormal. Prior to examining the anomalies in the US and Australian markets, it is necessary to examine the different forms of market efficiency, rendering the violation of specific anomalies to the level of market efficiency. The weak form of market efficiency maintains that all current prices reflect all past information, including information derived from technical analysis,