The Efficient Market Hypothesis – A Concept Rather Than Reality In Asia-Pacific

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Alexander Kostyra's picture

The quest for high returns and diversification has drawn attention to financial markets in the Asia‑Pacific (APAC) region. Whether their importance in global capital markets will continue to grow, largely depends on their market efficiency, a crucial prerequisite for proper resource allocation decisions by individuals and institutions. Ever since Eugene Fama postulated the Efficient Market Hypothesis (EMH), which posits the impossibility to outperform the market on a risk-adjusted basis, its validity and credibility in various markets have been subject to intractable debates. This essay aims to resolve the controversy by examining the hypothesis’ credibility in consideration of efficiency test results of APAC stock indices and recent developments in this region.

According to Ghosh, efficiency of securities markets is chiefly determined by three factors: the variety of investor bases, information to price accurately and transaction costs.[i] The 1997/98 Asian Financial Crisis prompted policy-makers to be wary of rapid market liberalization and shook domestic investor’s confidence in this region to the core; thereby, it has unequivocally affected the contemporary development stages of these factors in many APAC countries. Does the EMH nevertheless hold in this region? To answer this question, one needs to distinguish between weak-form, semi-strong-form and strong-form efficiency, each building on the preceding form by enlarging the spectrum of information that stock prices reflect. I assessed weak-form efficiency in the Asia-Pacific region by scrutinizing whether stock market indices have followed the autoregressive process

Returns are computed as rt = ln(Pt/Pt-1), where Pt is the daily index closing value adjusted for stock splits and dividends at time t, obtained from Yahoo! Finance. The results for 13 major APAC indices (see Figure I) yield two important insights. First, they reject the general validity of the EMH in this region. Only three indices have been weak‑form efficient in more than eight years since 2000: the Shanghai Composite, KOSPI and Hang Seng. Even when classifying these indices as weak-form efficient, based on the fact that statistically significant autoregressive processes occur in fewer than half of the number of years in the sample period, other efficiency forms cannot be supported. Recent studies by Eom (South Korea)[ii], Zhao (Hong Kong)[iii] and Truong (China)[iv] find post-earnings announcement drifts within the respective markets for the post-2000 data sample and thereby reject semi-strong-form efficiency. Second, no conclusive trend of improved efficiency among the 10 non-weak-form efficient indices emerges during the last four years of the sampling period. The striking violation of the EMH by major APAC stock market indices can indeed be related to recent financial markets developments in this region within Ghosh’s framework.

Investor bases in APAC countries are much less dispersed than their Anglo-Saxon counterparts and are dominated by large ‘buy-and-hold’ institutional and strategic investors. Moreover, regional cross-border investments are merely marginal – in 2006, Asian investments accounted for 10% of the continent’s foreign portfolio holdings[v] – which, in particular, affects the aim of broad investor bases adversely in smaller stock markets with few non-Asian shareholders. Reforms to ameliorate these issues were passed with different scopes and at different times across the region. In China, the allowance of domestic B-share ownership (2001), the introduction of QFII (2002) and the 2005 non-tradable share reform have significantly increased the free-float ratio and dispersed ownership. Contrariwise, Malaysia maintained its New Economic Policy program, which enforced higher Bumiputra stock ownership at the expense of foreign investors, until 2009. A link with exchanges in Singapore and Thailand to promote regional investments was established by Bursa Malaysia in late 2012, but its ultimate effect remains to be seen. Foreign investors in India were restricted to invest through institutional channels (e.g. mutual funds) until 2012, when the QFI reform to broaden investor classes was passed. Differences in de-regulative political efforts might therefore explain a higher median free float ratio in China (51.1%) than in Malaysia (39.2%) and India (40.4%).[vi] Higher free float may enhance market efficiency because it usually entails higher market liquidity as more tradable shares are outstanding.

Good corporate governance is essential for reliable and timely information to accurately price securities. The annual Roundtable on Corporate Governance (since 1999) and its released White Paper on Corporate Governance in Asia (2003) have been important roadmaps for corporate governance reforms, whose necessity became apparent after weak governance mechanisms were identified as one cause of the Asian Financial Crisis, across the APAC region. Varying degrees of success have been achieved in implementing these Western-inspired principles within national corporate governance codes, which were mainly introduced between 1999 (Korea) and 2009 (India), particularly due to cultural differences.  While New Zealand and Australia rank among the top six nations in the 2010 GMI Corporate Governance Country Rankings, China, Japan and Indonesia are among the bottom five, despite China’s Securities Act (1999) sought improvements in the quality of listed companies to increase the stock market efficiency by tightening controls against stock price manipulation and false information disclosure.[vii] Since 2010, weaknesses in some governance systems reemerged. Indonesia still lacks effective policies against market manipulation and enforcement of securities regulations[viii] and the Japanese parliament only recently passed a bill to penalize pre-event information leakage by insiders, which may explain the weak-form inefficiency of the Nikkei since 2009 as investors can act upon the information twice after the leakage and after the actual event – making technical analysis profitable.[ix]

Transaction costs are chiefly influenced by market and complementary infrastructure, and may induce price predictability by rendering exploitation of arbitrage opportunities unprofitable. These costs are significantly higher across the APAC region than in developed Western markets: on average 68.1bps in Singapore, Hong Kong, Australia and New Zealand, 71.5bps in Japan and 88.6bps in the Rest of APAC, compared to 43.7bps in the USA.[x] Ghosh concludes that market infrastructure in this region is fairly advanced as “clearing and settlement systems with recommended features to minimize the various risks associated with pre-settlement and settlement of securities [exist]”[xi], although Asian central counterparties have struggled significantly with implementing the new CPSS-IOSCO principles for financial market infrastructure. Yet, the development of complementary infrastructure, which affects transaction costs by providing hedging and alternative financing opportunities (e.g. smaller bid-ask spread due to higher liquidity), remains patchy. Whereas Asia-Pacific surpassed North America as the world’s largest derivatives market in 2010 – driven by the exchanges in Korea, India and China, which are among the world’s largest derivatives markets – the repo market is still underdeveloped, having a size relative to GDP of 1.8% in Asia ex-Japan (50-60% in Europe and USA).[xii] Short-selling has also been less prevalent in Asia than in the US, mainly due to high borrowing costs and tighter restrictions, such as stringent uptick rules[xiii], but the short-selling liberalization in various Asian financial markets in 2013, most notably in China, Japan and Malaysia had a positive effect on trading volumes in these countries. A potential positive effect on market efficiency cannot be evaluated yet.

Although the preceding analysis cannot establish a direct causal relationship between market efficiency and financial market developments in Asia-Pacific, it certainly provides an explanation for the violation of the EMH by the majority of APAC indices. However, two inexplicabilities arise at this point: Why do APAC indices at least not exhibit a conclusive trend towards weak-form efficiency despite recent measures to improve market liquidity and efficiency? How can marginal differences in Ghosh’s framework across countries be reconciled with significant differences in their market efficiency (e.g. China has a slightly broader investor base, but weaker corporate governance mechanisms than other countries in Asia-Pacific. Yet, the Shanghai Composite is the most efficient market.)? One explanation would be a flawed efficiency test method. While I acknowledge that potential issues such as thin trading in these markets have not been addressed, other studies which employ more rigorous tests find similar results. Another, more compelling reason is that the assumption of ideal, rational markets which trade at their fair values and always reflect available information is in itself not credible. Even Fama found statistically significant serial correlations, but did not consider them being violations of market efficiency due to economic insignificance.[xiv] Based on the sample data from APAC stock indices, I strongly contest this claim. First-order autocorrelation in itself accounted for up to 22% of the variation in index value changes (KLSE in 2010), which is not only economically important as this finding might be used to design profitable trading strategies but also disproves the underlying assumption of the EMH. I do not deny that specific markets may conform to the EMH at certain times; nonetheless it is not a theory that can generally be used to explain stock prices in reality. After all, the EMH has not been more than a mere concept in Asia-Pacific between 2000 and 2013.


[i] Ghosh, S 2006, East Asian Finance: The Road to Robust Markets, The World Bank, Washington D.C.

Available from: Google Books, viewed 06.01.2014

[ii] Eom, Y, Hahn, J & Sohn, W 2011, ‘Post-Earnings-Announcement Drift and Foreign Investors’ Trading
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<> viewed 06.01.2014

[iii] Zhao, W 2008, ‘Is earnings surprise the real king?: post-earnings announcement drift on the Hong
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<> viewed 06.01.2014

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<> viewed 06.01.2014

[v] García-Herrero, A, Wooldrige, P & Yang, DY 2009, ‘Why Don’t Asians Invest in Asia? The
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[vi] Nielsen, P & Fegley, B 2011, ‘Asian Emerging Markets Will Grow on You’, Saturna Capital
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[vii] Chung HY 2006,’ Testing Weak-Form Efficiency of the Chinese Stock Market’, Master’s thesis,
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[viii] Gill, A, Allen, J & Yonts, C 2012, ‘CG Watch 2012: Corporate governance in Asia’, CLSA,
<> viewed 09.01.2014

[ix] Brunnermeier, M 2005, ‘Information Leakage and Market Efficiency’, The Review of Financial Studies,
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[x] Global Cost Review Q2 2013, ITG Peer Analysis, <>
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[xi] Ghosh, S, op. cit., p. 114

[xii] Davis, A 2013, ‘Repo markets in Asia set to grow on the back of Basel III’,
basel-iii> viewed 10.01.2014

[xiii] Hodgson, J 2008, ‘Asia unlikely to follow U.S. short-selling crackdown’,
viewed 10.01.2014

[xiv] Fama, E 1970, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, The Journal of
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