Reviewed by Jan 05, 2021| Updated on
The Efficient Market Hypothesis (EMH), alternatively referred to as the Efficient Market Theory, is a hypothesis where share prices reflect all information and that consistent alpha production is impossible.
Though EMH is a pillar of modern financial theory, it can be controversial at times. Believers claim that looking for undervalued stocks or trying to forecast market movements from either a fundamental or technical review is futile.
Theoretically, neither technical nor fundamental analysis can consistently produce risk-adjusted excess returns (alpha), and outsized risk-adjusted returns can only result within the information.
Efficient market hypothesis proponents conclude that investors could do better by investing in a passive, low-cost portfolio due to the randomness of the market.
The EMH is backed by data collected by Morningstar, Inc. in its Active/Passive Barometer analysis of June 2019. Morningstar compared the returns of active managers in all categories against a composite comprising related index funds and exchange-traded funds (ETFs).
The study found that only 23% of active managers were able to outperform their inactive colleagues over ten years, starting in June 2009. Global equity funds and bond funds found higher performance rates. US large-cap funds reported lower performance rates. Investors have generally fared better by investing in low-cost index funds or ETFs.
While at some point, a percentage of active managers outperform passive funds, the long-term challenge for investors is to be able to identify who will do so. Less than 25% of active managers with top performance can consistently outperform their passive manager counterparts over time.