30.3 EFFICIENT MARKET HYPOTHESIS AND RETURNS TO CTAs

At first glance, the presence of trends (negative trends in particular) in futures markets appears to violate the basic tenets of the efficient market hypothesis. According to the efficient market hypothesis, investors should not be able to earn abnormally high returns in perfect financial markets, because prices incorporate all available information, and therefore profitable opportunities are arbitraged away. This means that systematic trend-following strategies employed by most CTAs should not allow investors to earn abnormally high rates of return. In this context, an abnormally high return is defined as a rate of return on invested capital that is in excess of what the riskiness of the investment strategy would imply.4

Before discussing the implications of this theory for investors who allocate to CTAs, additional details about the efficient market hypothesis must be provided. The efficient market hypothesis proposes three forms of efficiency. The most basic form is referred to as weak form efficiency, which proposes that past prices cannot be used to predict future price changes such that the investor could earn abnormally high rates of return. This clearly implies that any type of technical analysis cannot be used to create profitable trading opportunities. Next follows semistrong form efficiency, which proposes that past prices as well as currently available public information cannot be used to create profitable trading ...

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