Tests of Strong Form Efficiency

Tests of Strong Form Efficiency

The strong form hypothesis represents the extreme case of market efficiency. The strong form of the efficient market hypothesis maintains that the current security prices reflect all information both publicly available information as well as private or inside information. This implies that no information, whether public or inside, can be used to earn superior returns consistently.

The directors of companies and other persons occupying senior management positions within companies have access to much information that is not available to the general public. This is known as inside information. Mutual funds and other professional analysts who have large research facilities may gather much private information regarding different stocks on their own. These are private information not available to the investing public at large.

The strong form efficiency tests involve two types of tests. The first type of tests attempt to find whether those who have access to inside information have been able to utilize profitably such inside information to earn excess returns. The second type of tests examine the performance of mutual funds and the recommendations of investment analysts to see if these have succeeded in achieving superior returns with the use of private information generated by them.

Jaffe, Lorie and Niederhoffer studied the profitability of insider trading (i.e. the investment activities of people who had inside information on companies). They found that insiders earned returns in excess of expected returns. Although there have been only a few empirical studies on the profitability of using inside information, the results show, as expected, that excess returns can be made. These results indicate that markets are probably not efficient in the strong form.

Many studies have been carried out regarding the performance of American mutual funds using fairly sophisticated evaluation models. All the major studies have found that mutual funds did no better than randomly constructed portfolios of similar risk. Firth studied the performance of Unit Trusts in the United Kingdom during the period 1965—PP He also found that unit trusts did not outperform the market index for their given levels of risk. A small research has been conducted into the profitability of investment recommendations by investment analysts. Such studies suggest that few analysts or firms of advisers can claim above average success with their forecasts.

The results of research on strong form EMH may be summarized as follows:

Inside information can be used to earn above average returns.

Mutual funds and investment analysts have not been able to earn superior returns by using their private information.

In conclusion, it may be stated that the strong form hypothesis is invalid as regards inside information, but valid as regards private information other than inside information.