Question

A work colleague was bragging that the actively managed mutual fund he selected among your employer’s 401(k) electives outperformed the S&P 500 over the past 3 years. The colleague (who did not take FINC 561) claims that it’s a great fund, that the manager is a genius and is urging you to invest in that fund as well.

However, you believe that markets are efficient. Do you take your colleague’s advice? Explain your rationale by applying concepts of market efficiency learned so far in the course. Include whether the mutual fund’s performance violates or disproves efficient markets and why or why not?

Answer 1

We find a positive relationship between alpha and weak-form market efficiency. Most funds are unable to outperform the market systematically, although a few are able to exploit relatively inefficient markets. Top performing funds are characterised by a better management of downside risk in times of market distress, whilst simultaneously exploiting learning effects when markets return to equilibrium. By conditioning fund performance on the state of the underlying market, we propose a conditional alpha ratio, which helps to better understand fund performance and can improve the fund selection process for investors.

Researchers have found that mutual funds do not seem to be able to earn greater net returns (after sales expenses) than those that can be earned by investing randomly in a large group of securities and holding them. Furthermore, these studies indicate, mutual funds are not even able to earn gross returns (before sales expenses) superior to those of the native buy-and-hold strategy. These results occur not only because of the difficulty in applying fundamental analysis in a consistently superior manner to a large number of securities in an efficient market but also because of portfolio over diversification and its attendant problems- two of which are high book-keeping and administrative costs to monitor the investments, and purchases of securities with less favorable risk-return characteristics. Therefore, it would seem that the mutual-fund studies lend some credence to the efficient-market hypothesis.