Efficient Market Hypothesis

Cheveley Partners builds client equity exposure by placing roughly 75% in low-cost broad index funds and the remaining 25% in a handful of concentrated active managers plus a small private credit sleeve. This CORE-AND-SATELLITE construction is chosen mainly because it:

1. A.Guarantees the portfolio will beat its benchmark, because the satellite managers can only add returnActive satellites can and do subtract return. No structure guarantees outperformance.
2. B.Holds down aggregate cost and deviation from the benchmark by indexing the bulk of the portfolio, while confining higher fees and active risk to a deliberately sized minorityCorrect. The structure is about budgeting active risk and cost, not about guaranteeing outperformance.
3. C.Removes the need for an investment policy statement, because the core is passively managedThe IPS governs objectives, constraints and the allocation itself. Passive implementation makes it more useful, not unnecessary.
4. D.Eliminates market risk, because index funds are not exposed to market declinesAn index fund falls with its index. Indexing removes manager risk, not market risk.

Why: A core-and-satellite portfolio indexes the majority of the assets, which holds down the aggregate expense ratio, turnover and deviation from the benchmark, and then confines active risk and higher fees to a deliberately limited satellite allocation. The client still bears full market risk on the core, and the satellites may underperform. The approach controls the SIZE of the active bet rather than promising that the bet will pay.

A client tells his IAR that he screens companies using published earnings reports, analyst estimates and news coverage, and consistently beats the market doing it. The IAR believes markets are efficient in the SEMI-STRONG form. What does that belief imply about the client approach?

1. A.His fundamental approach should work, because semi-strong efficiency rules out only technical analysis based on past pricesThat is the WEAK form conclusion. Weak form leaves fundamental analysis viable; semi-strong extends the argument to all public information.
2. B.His results are more likely luck than skill, because analysis of public information cannot persistently generate excess returns if prices already reflect itCorrect. Semi-strong efficiency covers all public information, so a strategy built entirely on public data has no informational edge.
3. C.His approach should work, because semi-strong efficiency asserts that prices reflect nonpublic information as wellPrices reflecting nonpublic information is the STRONG form. It would make his edge even less plausible, not more.
4. D.Semi-strong efficiency implies prices are always at intrinsic value, so no investor can ever lose money on a public securityEfficiency is a claim about information, not about outcomes. Efficiently priced securities still fall, sometimes sharply, when new information arrives.

Why: Semi-strong form efficiency holds that prices already reflect all publicly available information - past prices and volume, financial statements, news, analyst research. If that is true, neither technical analysis nor fundamental analysis of public data can produce persistent excess returns, because the information is already in the price by the time the client acts. Only material NONPUBLIC information would offer an edge under the semi-strong form, and acting on that is illegal.

Odessa Ferrant argues that poring over published earnings reports, analyst estimates and press releases cannot produce consistently superior risk-adjusted returns, because all of that information is already impounded in market prices. She concedes, however, that a corporate insider holding undisclosed information could still profit. Her position corresponds to which form of the efficient market hypothesis?

1. A.The semi-strong form.Correct. The semi-strong form holds that all publicly available information is already reflected in prices, while leaving room for an informational edge from non-public information.
2. B.The strong form.Wrong. The strong form says even private information is reflected, so insiders could not profit. Odessa expressly concedes they could.
3. C.None of the three forms, because conceding that insiders can profit is inconsistent with market efficiency.Wrong. Conceding an insider edge is fully consistent with - indeed definitional of - the weak and semi-strong forms.
4. D.The weak form.Wrong. The weak form says only past price and volume data are reflected, which would leave fundamental analysis of public filings potentially profitable - the opposite of Odessa's claim.

Why: The three forms are distinguished by HOW MUCH information is already reflected in prices. The weak form says only past prices and volume are reflected, which would leave fundamental analysis potentially useful. The semi-strong form says all PUBLICLY available information - financial statements, news, analyst work - is already reflected, so neither technical nor fundamental analysis of public data yields consistent excess returns, but non-public information could. The strong form says even private and inside information is reflected, so no one, including insiders, can consistently outperform. Odessa dismisses public-information analysis but allows insiders an edge: that is precisely the semi-strong form.

Prospective client Casimir Wrenfield tells adviser Thea Bergstrom that a friend on the board of a listed company routinely tells him about acquisition talks before they are announced, and that trading on it has been extremely profitable. He asks her to manage money using the same approach. Setting aside the obvious legal problem, what does his experience imply about market efficiency?

1. A.It is evidence against the STRONG form, which claims that prices already reflect all information including material nonpublic information.Correct. Profitably trading on undisclosed information shows that information was not yet in the price, contradicting the strong form specifically.
2. B.It is evidence against the weak form, which claims that prices reflect all past price and volume information.Incorrect. The weak form concerns historical price and volume data and technical analysis. Nonpublic acquisition talks are outside its scope entirely.
3. C.It is evidence against the semi-strong form, which claims that prices reflect all publicly available information.Incorrect. The information here was NOT public, so the semi-strong form makes no claim that it should have been reflected in the price.
4. D.It confirms all three forms simultaneously, since the profits show that prices eventually adjusted to the news.Incorrect. Prices adjusting AFTER announcement is consistent with efficiency, but earning excess returns beforehand is the point, and that contradicts the strong form.

Why: The efficient market hypothesis is usually framed in three forms according to which information set is already reflected in prices. The weak form holds that prices reflect all past price and volume data, so technical analysis cannot produce persistent excess returns. The semi-strong form holds that prices reflect all publicly available information, so fundamental analysis of published data cannot either. The STRONG form holds that prices reflect all information, public and private, including material nonpublic information, so not even an insider could earn excess returns. Consistently profitable trading on undisclosed acquisition talks is direct evidence against the strong form: the information plainly was not yet in the price. Empirically this is the form least supported by evidence, which is precisely why insider trading is prohibited by law rather than left to be arbitraged away. The adviser must decline and cannot participate in the arrangement.