By Cong Li
In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “information efficient.” As a result, with the information available at the time when the investment is made, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis.
There are three major versions of EMH: the “weak,” the “semi-strong,” and the “strong.” The “weak” hypothesis states that prices on traded assets (e.g. stocks, bonds, or property) already reflect all past available public information; the “semi-strong” hypothesis claims that all past publicly available information and current public information is already priced into securities; and the “strong” hypothesis states that all public information, and even private information, is reflected in a security’s price. Thus, given only the current and historical price/volume data, the belief is that we can’t realize any profit in an efficient market, and that there are no such things as “price/volume alphas.”
Is this true? No, it is not. Actually, with the development of information technology, information processing, automatic trading, etc., the market is already close to, but never at, full efficiency. Quantitative traders seek to profit from those inefficiencies.
Just how can we arbitrage from these inefficiencies?
Information ratio (IR) (defined as mean [daily_pnl]/std[daily_pnl], a measure of the risk-adjusted return of a financial security, or a portfolio) ...