Alpha and the Efficient Market Hypothesis

This is a follow-up blog on my recent LinkedIn posts, “Alpha and Beta revisited”. You can find them here: https://www.linkedin.com/in/james-chu-investment-buddy/

Recently, I explained how Alpha and Beta were first defined and how they relate to the Capital Asset Pricing Model (CAPM). The Alpha was based on the common Jensen’s extension of the original CAPM, (see the Jargon Buster column in the February Tricio Monthly Insights – please contact us for a copy).

In the classic CAPM framework, the excess return of an asset—its return above the risk‑free rate—is explained entirely by its market Beta. This relies on another foundational idea in modern portfolio theory: the Efficient Market Hypothesis (EMH).

The EMH states that current asset prices reflect all available information. When new information becomes available, prices adjust quickly and simultaneously for all investors. No one has a systematic trading advantage, and each asset settles at an equilibrium price that reflects its risk relative to the market— the market Beta in CAPM. There should be no Alpha.

Over time, however, researchers observed that market Beta alone could not fully explain all stock returns. For example, small‑cap stocks often outperformed what CAPM would predict. This led academics such as Fama and French to introduce additional factors—such as size, value, and quality—to explain these return patterns.

Although these academics viewed their work as refinements of the overly simple CAPM, many still believed that the EMH broadly holds. They categorised its strength in three forms. And there is still no Alpha:

• Strong form: prices incorporate all public and private information.

• Semi‑strong form: prices reflect all public information; neither fundamental nor technical analysis can consistently add value.

• Weak form: prices reflect all past trading data. Fundamental analysis may add value, but technical analysis cannot.

When I studied the EMH for my professional exams, I found its assumptions elegant but detached from reality. Real‑world markets are filled with information asymmetry. Investors are not perfectly rational. Prices can remain abnormally high or low for prolonged periods based on sentiment, expectations, or herd behaviour. George Soros’s concept of reflexivity captures this well.

Some may argue that mutual fund data still show Alpha—returns that cannot be explained by Beta or other factors—which could indicate fund managers' skills. But can that Alpha stay constant and be consistent across an entire economic cycle? Can a manager truly be “all‑weather”? Examples such as Neil Woodford’s saga come to mind.

On the other hand, should we give more credit to managers who can dynamically adjust their exposures to factors and Beta well through a cycle? If a manager can (and is allowed to) successfully rotate between, say, momentum stocks and value stocks at the right time, is that a skill?

Today, individual investors can easily access market Beta through index‑linked ETFs. They can also enhance returns through factor‑based, or “Smart Beta,” ETFs. However, knowing when to tilt toward value, momentum, quality, or high‑dividend stocks is far from straightforward. Many investors who use these low-cost ETFs in their portfolios will still benefit from professional advice or well‑managed multi‑asset strategies.

James Chu CFA, Head of Investment Solutions