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CMA Final · Strategic Financial Management · Efficient Market Hypothesis

In a market, the expected return on Stock P is 14% per CAPM. A portfolio of 50 stocks like P selected on the basis of low P/E ratios earned an average of 19% over many years with the same beta. A researcher also notes that transaction costs and taxes reduce the return by 2% annually. An investor wants to conclude about semi-strong efficiency. Which conclusion is best supported by the net data?

Net abnormal return is 19% less 14% less 2% costs, equal to 3%. A positive net return from a rule using public P/E data points to a semi-strong anomaly, but the joint-hypothesis problem means the CAPM benchmark could also be mis-specified, so inefficiency is not proven.

  1. ANet abnormal return is 5%, so the market is certainly inefficient
  2. BNet abnormal return is 3%, which indicates a possible semi-strong anomaly (or a joint-hypothesis problem with the model)Correct
  3. CNet abnormal return is 7%, since costs should be added back
  4. DNet abnormal return is zero, since low P/E is public information

Explanation

Gross abnormal return = 19% - 14% = 5%. After costs of 2%, net abnormal = 3%. A persistent positive net return from a public-information rule suggests a semi-strong anomaly, though the joint-hypothesis problem means the CAPM benchmark itself could be wrong, so it is not certain proof. Option 5% ignores costs, 7% adds costs wrongly.

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