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LOS e: Explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management.

Which of the following statements least likely describes the role of a portfolio manager in perfectly efficient markets? Portfolio managers should:

A)	construct a portfolio that includes financial and real assets.

B)	quantify client's risk tolerance, communicate portfolio policies and strategies, and maintain a strict buy and hold policy avoiding any changes in the portfolio to minimize transaction costs.

C)	construct diversified portfolios that include international securities to eliminate unsystematic risk.

A portfolio manager should quantify each client's risk tolerance and communicate portfolio policies and strategies. However, portfolio managers should monitor client's needs and changing circumstances and make appropriate changes to the portfolio. Adhering to a strict buy and hold policy would not be in the client's best interest. Portfolios need to be rebalanced and changed to meet client’s changing needs.

Under the efficient market hypothesis (EMH), the major effort of the portfolio manager should be to:

A)	achieve complete diversification of the portfolio.

B)	minimize systematic risk in the portfolio.

C)	follow a strict buy and hold strategy.

In an efficient market, portfolio managers must create and maintain the appropriate mix of assets to meet their client’s needs. The portfolio should be diversified to eliminate unsystematic risk. The appropriate systematic risk will depend on the clients risk tolerance and return requirement. Over time the needs of the client and environment will justify changes to the portfolio. The manager should also try to minimize transaction costs and at least try to match the performance of a benchmark.

If the efficient markets hypothesis is true, portfolio managers should do all of the following EXCEPT:

A)	Minimize transaction costs.

B)	Work more with clients to better quantify their risk preferences.

C)	Spend more time working on security selection.

In an efficient market all stocks are properly priced and reflect all publicly available information. Therefore, individual selection of stocks is not important the only thing that is relevant is the portfolio’s beta.

Which of the following statements concerning market efficiency is least accurate?

A)	If weak-form market efficiency holds, technical analysis cannot be used to earn abnormal returns over the long-run.

B)	Market efficiency assumes that individual market participants correctly estimate asset prices.

C)	Tests of the semi-strong form of the EMH require that security returns be risk-adjusted using a market model.

Market efficiency does not assume that individual market participants correctly estimate asset prices, but does assume that their estimates are unbiased. That is, some agents will over-estimate and some will under-estimate, but they will be correct, on average.

In a perfectly efficient market, portfolio managers should do all of the following EXCEPT:

A)	monitor their client's needs and circumstances.

B)	diversify to eliminate systematic risk.

C)	quantify their risk and return needs within the bounds of the client's liquidity, income, time horizon, legal, and regulatory constraints.

Portfolio managers cannot eliminate systematic risk (i.e., market risk) thru the use of diversification. Portfolio managers should try to eliminate unsystematic portfolio risk.

A)	The gains to be earned by information trading can be less than the transaction costs the trading would entail.

B)	There are no limitations to fully efficient markets because the trading actions of fundamental and technical analysts are continuously keeping prices at their intrinsic value.

C)	Information is always quickly disseminated and fully embedded in a security’s prices.

Market prices that are not precisely efficient can persist if the gains to be made by information trading are less than the transaction costs such trading would entail.

David Farrington is an analyst at Farrington Capital Management. He is aware that many people believe that the capital markets are fully efficient. However, he is not convinced and would like to disprove this claim. Which of the following statements would support Farrington in his effort to demonstrate the limitations to fully efficient markets?

A)	Stock prices adjust to their new efficient levels within hours of the release of new information.

B)	Processing new information entails costs and takes at least some time, so security prices are not always immediately affected.

C)	Technical analysis has been rendered useless by many academics who have shown that analyzing market trends, past volume and trading data will not lead to abnormal returns.

If market prices are efficient there are no returns to the time and effort spent on fundamental analysis. But if no time and effort is spent on fundamental analysis there is no process for making market prices efficient. To resolve this apparent conundrum one can look to the time lag between the release of new value-relevant information and the adjustment of market prices to their new efficient levels. Processing new information entails costs and takes at least some time, which is a limitation of fully efficient markets.