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Revision Date: August 29, 2007

M ART IA L C A P I TA L W H I T E PA P E R :

WH AT ABO UT THE E F F I C I E N T M A RK ET H Y P OTHE SI S?

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Those who believe in the Efficient Market Hypothesis, which includes the vast majority of professional investors worldwide, will say that it is impossible to sustain the kinds of returns Martial Funds has demonstrated in our backtest and in our short period of live investing. This White Paper talks about their concerns and our response. The Efficient Market Hypothesis, developed by Prof. Eugene Fama at the University of Chicago in the early 1960s, says that everything that can be known about a stock has already been incorporated into the price of that stock. From this hypothesis have come many of the theories that we use to explain the financial markets: the arbitrage principles of Miller and Modigliani, the portfolio principles of Markowitz, the Capital Asset Pricing Model of Sharpe, Lintner, and Black, and the Option-Pricing Model that won for Black, Sholes, and Merton the Nobel Prize. Investment professionals globally have embraced the Efficient Market Hypothesis. It is taught throughout the world in schools and in CFA licensing courses. It is used in particular by investment managers to explain their almost-index performance to their clients. Virtually all of current day financial theory is based in one form or another on the Efficient Market Hypothesis. The most important consequence of this hypothesis (for this discussion) is that it is not possible to outperform the market (adjusted for risk) over the long term. Random chance may allow a specific portfolio (a fund or privately-managed account) to do better in one year than the index, perhaps much better, but random chance will smile on some other portfolio manager next year so that over the long term, the hypothesis says, no managed fund can do better than the market. Our reply is two fold:  Look at the assumptions underlying the Efficient Market Hypothesis and judge for yourself if they are reasonable, and  Look at our results.

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© 2007 Martial Capital Ltd. Reproduction in whole or part without written permission is prohibited. Revision Date: August 29, 2007

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WHAT A BOU T T H E E FFI C I E NT MAR KET HY PO THESI S?
Among the assumptions the Efficient Market Hypothesis makes are:  Investors are rational.  Markets are rational.  There are no taxes – or, more specifically, taxes play no part in financial decision-making.  There are no transaction costs.  An investor is indifferent between a dollar in dividends and a dollar in capital gains.  A company (and its investors) are indifferent between a dolar of aditional debt and a dollar of additional equity. The list is much longer, but you get the point. Our second argument is straightforward: How long does a fund have to convincingly beat the index before a follower of the EMH agrees that someone has proved they can beat the market? Between 1977 and 1990 – 13 years – Peter Lynch at the Magellan Fund achieved an average annual return of 29% after fees and expenses1. Is that not an example of a fund having convincingly beaten the market? The biggest problem for advocates of the Efficient Market Hypotheses is that many funds have proven they can outperform the market. Peter Lynch at Fidelity. The Harvard and Yale Endowment Funds. Warren Buffet. Our own Martial Funds have (with our backtest period plus our live experience) beaten the market every year since 1990 in the case of our Canadian portfolio, and every year since 1998 in our US portfolio. This could not be possible if the Efficient Market Hypothesis was true. To reconcile this paradox let us look more closely at the academic studies that prove that no managed fund can beat the market over the long term. The essence of their argument is that there never has been such a fund. These studies show that the results of all managed funds looks more like a…