A Random Walk to Passively Managed Funds?

Arnold (2013) states: ‘an efficient capital market occurs when securities, for example, shares, rationally reflect all the available information.’  When information comes to light, this will swiftly and rationally be reflected in the share price.   According to the efficient market hypothesis (EMH), no trader can make a greater return than the risk taken for buying that share.  If this was to happen, it would be occurring by chance.

Fama (1970), an important researcher in the area of capital market efficiency separates efficiency into three different levels or categories:

Strong Form – Publicly and Privately held information is reflected in Share Price

Semi-Strong Form –Share price fully reflects all relevant publicly available information

Weak Form –Share price fully reflects information in historical prices

In his paper in 1953, Maurice Kendall explored the movements in stock prices over time, looking for any trends or patterns as he went about his work.  In short, he was unable to find any trends in the fluctuations of the stock price and concluded that the stock price followed a ‘random walk.’

In the financial world, there seems to be a general view that stock markets are efficient with investors steadily shifting assets from actively managed funds into passive managed funds.  Actively managed funds have been severely underperforming the stock market.  At the end of 2013, index funds accounted for one dollar of every five invested in US mutual funds overall and more than one-third of the assets in US equity funds (Pozen and Hamacher, 2015).  The move to passively managed funds signals that there is strong support for the Efficient Market Hypothesis.

There are several arguments against the Efficient Market Hypothesis.  Malkiel (2003) argues that investors can collectively make mistakes and some market participants are less than rational.  As a result, pricing irregularities and even predictable patterns in stock returns can appear over time and even persist for short periods.  Malkiel (1980) also supported the view of Grossman and Stigliz who stated that the market cannot be perfectly efficient, or there would be no incentive for professionals to uncover the information that gets so quickly reflected in market prices.

Furthermore, the issue of Insider Trading is common in the business world today.  How can stock markets be efficient if this is happening behind the closed doors of listed companies? If information can be accessed by internal investors but not by external investors, surely a capital market cannot be deemed completely efficient.  Take for example the recent case of the former financial analyst for the US pharmaceutical giant Merck & Co. Inc. who pleaded guilty to charges related to insider trading.  His plot focused on using inside information about various intended corporate acquisitions to purchase shares in the company (Calia, 2015). 

To a degree, there is strong evidence that efficient capital markets exist.  However it is impossible to determine if capital markets are fully efficient.  If investors were only relying on publicly available information, I think they would quickly lose the ‘thrill’ of investing in the stock market. 

References

Arnold, G. (2013). Corporate financial management.  (5th ed.) Harlow, England: Financial Times/Prentice Hall


Calia, M. (2015). Former Merck Analyst Pleads Guilty to Insider Trading Charges. WSJ. Retrieved 20 February 2015, from http://www.wsj.com/articles/former-merck-analyst-pleads-guilty-to-insider-trading-charges-1424446449

Fama, E. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal Of Finance, 25(2), 383. doi:10.2307/2325486


Grossman, S. J., & Stiglitz, J. E. (1980). On the impossibility of informationally efficient markets. The American economic review, 393-408.  Retrieved 20^th February from http://www.jstor.org

Malkiel, B. (2003). The Efficient Market Hypothesis and Its Critics. Journal Of Economic Perspectives, 17(1), 59-82. doi:10.1257/089533003321164958


Pozen, R., & Hamacher, T. (2015). Has the death knell of active management been rung too soon?. The Financial Times. Retrieved 18th February 2015 from http://www.ft.com/cms/s/0/e153fbc6-a644-11e4-89e5-00144feab7de.html#axzz3ZNKMrKJ4

Has the UK Corporate Governance Code let Tesco Shareholders Down?

Five months have passed since we first heard of Tesco overstating its profits by £263 million and still the story continues to appear in the press on a frequent, if not weekly basis.  Recently, Tesco announced that it had agreed to pay £1.22m liquidated damages contractually owing to Philip Clarke, its former CEO and £970,800 due to Laurie McIlwee, its former Finance Director, despite the fact that findings of an investigation by the Serious Fraud Office into the profit overstatement are still to be released. (Quinn, 2015).This investigation could possibly reach adverse findings against the former executives negligent for the overstatement of profits.

This has once again raised the question whether or not the board of Tesco has acted in the best interests of its shareholders.  Some shareholders may question why Tesco is paying compensation to these senior executives who may have been liable for the recent overstatement of profits.  It may be seen as ‘rewarding’ these former executives rather than punishment. Another point of view may find it commercially beneficial for the company to pay the former executives now rather than later in order to avoid an expensive legal battle in the future, particularly when the compensation for loss of office is contractually owing.  In fact, in its announcement Tesco stated, ‘defending costly claims would not be in the company’s best interests’ (Treanor, 2015).  This point along with the fact that the findings of the Serious Fraud Office’s Investigation are still to be released may justify Tesco’s decision to make these compensation payments now, rather than later.

When news of the accounting scandal first surfaced in October 2014, the need for strong Corporate Governance was highlighted once again, with questions asking why Tesco has not learned from the examples of Enron and the collapses of banking institutions during the financial crisis as a result of poor Corporate Governance.  The Tesco executives may have overstated profits in order to cover up its poor performance in the months prior to the overstatement, with the company facing intense competition from Aldi and Lidl which resulted in Tesco losing market share (BBC News, 2014).  The Executives may have been thinking about their own job security and potential performance related payments if they intentionally meant to overstate the profits, therefore putting the reputation of the company at risk.  If this was the case, it supports the Agency Theory proposed by Jenson and Meckling (1976) who stated that managers engage in their own interests for their own benefit rather than that of the firm’s shareholders.

At the time of the scandal, the Financial Times (2015) offered a possible explanation for the overstatement of profits, suggesting that supermarkets have a complex relationship with suppliers which can add a degree of subjectivity to profits.  The article also argued that a flaw in the UK Corporate Governance Code could be a contributor to the scandal – with the ‘comply’ or ‘explain’ approach being of strong significance.  Within the Code it states: ‘an alternative to following a provision may be justified in particular circumstances if good governance can be achieved by other means’ (Frc.org.uk, 2015).  PwC, as auditors may have fulfilled its role by flagging concern to directors who then dismissed it.  This had the result of potentially misleading  investors.

While the accounting scandal and the recent subsequent announcement of paying compensation to former executives have raised questions about Tesco acting in the best interests of shareholders, I think the scandal would not have occurred if the UK Corporate Governance Code did not have the ‘comply’ or ‘explain’ approach.  The overstatement could have been dealt with internally between Tesco and PwC before it reached the public domain if the UK Corporate Governance Code was mandatory and did not permit non-compliance.  Tesco’s shareholders were therefore prejudiced by the weakness in the Code.  I think this is a key issue which the Financial Reporting Council needs to address.  If the UK Corporate Governance Code was a more ‘rule-based’ instead of ‘principle-based’ set of guidance companies would not have the opportunity to exploit the gaps a ‘principle-based’ set of guidance provides.

Financial Times,. (2015). Picking up the pieces after Tesco’s stock affair - FT.com. Retrieved 3 February 2015, from http://www.ft.com/cms/s/0/341f1c2a-5b75-11e4-a674-00144feab7de.html#axzz3QgQAQJvM

Jensen, M., & Meckling, W. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal Of Financial Economics, 3(4), 305-360. doi:10.1016/0304-405x(76)90026-x

Treanor, J. (2015). Tesco to spend £2m in payouts to former executives. the Guardian. Retrieved 3 February 2015, from http://www.theguardian.com/business/2015/feb/03/tesco-2m-payments-executives-supermarket-accounting-scandal

Quinn, J. (2015). Tesco u-turn on £2.1m pay for former bosses - Telegraph. Telegraph.co.uk. Retrieved 3 February 2015, from http://www.telegraph.co.uk/finance/newsbysector/epic/tsco/11386304/Tesco-u-turn-on-2.1m-pay-for-former-bosses.html