Question

Finance research has shown that managers of actively managed mutual funds or exchange traded funds (ETF), on average, do not outperform the overall stock market as measured by the S&P 500 index (see chapter 7 PP slides and your book). In some years, more than 80% of fund managers were unable to beat the overall stock market return. The year 2013 is a good example when the S&P 500 yielded nearly 29% return, which was better than the average return on 95% of actively managed stock portfolios with similar risk. (a) If you believe these results which seem to support informational efficiency of equity markets in U.S., what would be your investment strategy so that your average long-run returns are better than the returns realized by more than two-third (75%) of professional money managers of actively traded funds. Explain. (b) If equity markets are informationally efficient and rational to a larger extent, how would you explain the stock market bubble of 2008 in the presence of efficient markets. 

Answer 1

 

(a) In case the equity markets are informationally efficient and actively managed funds cannot beat the index, then an efficient investment strategy would be to invest in the index portfolio and save on the expense of active fund management. With the efficiency of market, any arbitrage opportunity would be non-existent and hence index investing with saving on fund management expense should be able to beat the money managers of actively managed funds.

b)

The bubble of 2008 was mainly driven by property market and the rise in housing prices. The companies which dealt in the real estate markets saw their prices soar, and since property market does not have the same efficiency as the stock market, so this led to a rally in the stock market as well. Also the stock market fell quite rapidly post the rise in 2008 which negated the rise to a large extent. Also the fund managers had to face significant losses because of the crash post 2008. So the bubble was followed by a crash and hence this proves that sustained “alpha “ or greater than normal returns are not possible in an efficient market.