Question

Why should you not invest in actively managed U.S. equity funds? Give two strong theoretical reasons (one assuming that the market is efficient and one that it is not) and one strong empirical reason

Answer 1

If the market is efficient enough, the all the information pertaining to a stock is already reflected in the stock price. Hence, no alpha or abnormal returns can be generated by actively managed investment style. Hence, efficieny of market implies that the returns from passively managed investment style and actively managed investment style are bothe same. If the returns are same, then there is no reason to go to actively managed investment as it will add an additional amount of cost incurred in term of number of transactions, brokrage, research expenses, etc.

If the market is not efficient, then there are opportunities to generate the alpha return or abnormal return by following actively managed invetment style. But there ae lot of costs associated with active investment. These cost of selecting of stock, reserach fees, rebalancing of portfolio on periodical basis, brokrage cost. All these cost reduce the amount of Net return. While in case of passively managed investment, the amount of expenses incurred is the least. Hence when the Net returns from both investment style is ame, then a risk averse investor would like to go for passive investment style than active managed investment style.

As a proof, 99 percent of the US euity fund which are actively managed and sold in the Europen Region failed to generate returns that are enough to beat S&P 500 for the past 10 years.