Reviewed by Oct 05, 2020| 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.
According to the EMH, stocks are always trading on exchanges at their fair value, making it impossible for investors to buy undervalued stocks or sell inventories for inflated prices.
Expert stock selection or market timing would also make it difficult to outperform the overall market, and the only way an investor can generate higher returns is by buying riskier investments.
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.