Jan 9, 2012
We often hear the claim that some markets are less efficient than others—small company stocks, emerging markets, foreign exchange, and so on. Is there any evidence to support this assertion?

EFF: Nothing convincing we know of. 

KRF: It is interesting to consider a few of the arguments behind this conclusion. One of the simplest is that there are neglected assets. If no one is paying attention to a group of small stocks, for example, how could their prices possibly be accurate? Although I am skeptical, this argument may have had some merit 150 years ago. It seems implausible today, however, given modern technology and the hundreds of billions of dollars investors spend each year trying to find pricing errors. 

A closely related argument is that investors in some markets are ripe for the picking because they are just not as sharp as the rest of us. This seems to be the logic behind some investors' belief that emerging markets are less efficient than developed markets. It does not take much thought to reject the premise of the argument. People are bright and highly motivated in markets around the world. But even if we ignore that fact, there are so many developed-market investors looking for opportunities in emerging markets (and so many emerging-market investors looking for opportunities in developed markets), it again seems implausible that differences in ability produce differences in the level of efficiency. 

Perhaps the most sophisticated justification for these claims is based on Shleifer and Vishny's (1997) limits of arbitrage argument. This theory suggests that if there are pricing errors, they will be larger in markets with relatively high trading costs and other frictions. For example, in many regions of the US, residential real estate commissions are 6%. These costs prevent informed real estate investors from setting up trading strategies to exploit relatively large deviations from the "right" price. In other words, pricing errors may persist because active strategies designed to exploit them are hampered by trading costs and other frictions. 

The limits of arbitrage put an upper bound, not a floor, on the size of pricing mistakes. Competition among investors who are trading anyway—for example, those moving to a new community, in the case of real estate—can keep the price close to the right price. It is an empirical question whether they do. 

Recent empirical papers by Mitchell, Pedersen, and Pulvino (2007) and Pedersen (2009), among others, suggest that the limits of arbitrage are important during times of stress. There were many apparent violations of the law of one price during the financial crisis, for example. It is not so clear, however, that the limits are important at other times. Patterns in the cross-section of stock returns, for example, are generally larger among small stocks. Some suggest this is evidence that trading costs, idiosyncratic volatility, and other frictions prevent arbitrageurs from keeping small stock prices in line. In Fama and French (2008), however, Gene and I show that there is far more variation in the characteristics of small stocks than there this is among big stocks. Thus, if expected returns are linked to these characteristics for rational reasons, more variation in the expected returns of small stocks is warranted.

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to Dimensional Fund Advisors LP.