Question

a. Explain why the rising percentage of passive investments in    

    the stock market (Index funds and ETFs) will decrease

    market efficiency. Explain market efficiency first then          

    answer the question.

b. You are investing in an ETF that tracks the US stock

     market, what would you recommend doing in a down cycle

     and why?

c) Explain why active bond investments would outperform

     passive ones (bond index funds and bond ETFs)?

Answer 1

a.

Market efficiency:

Market efficiency is a broad term that refers to any metric or quantitative value that measures information dispersion in a market. In an efficient market all the entire information is transmitted to everyone instantly without any cost. So it means in an efficient market the market price is an unbiased estimate of the true value of the investment. Asset prices in an efficient market fully reflect all available information to market participants. so its not possible to make money by trading assets in an efficient market. Market efficiency does not implies:

a) Market efficiency does not say that the price of an asset is its true price. It only says that it is impossible to consistently estimate whether the asset price will move up or down. All it requires is that the prices can be greater than or less than true value, as long as these deviations are random.

(b) As the deviations from true value are random it means there is always a 50% probability that stocks are under or over valued at any point in time.

(c) Due to the randomness in the market price no analyst or investors should be able to consistently find under or over valued stocks using any investment strategy.

There are 3 version of market efficiency:

In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past.
In semi-strong-form efficiency, share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.
In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns.

A high level of trading in passive funds will have a negative impact on the informational efficiency of the stock market. It will impact the trading costs, as those will ris, stocks will become more correlated with each other than they used to be, thus reducing the ability of investors to reduce the risk through diversification and lastly it will also impact the valuation, depending upon whether a stock is in a widely traded index or not.

So the actively managed portfolios should focus more on the free cash flow fundamentals that drive longterm value creation, and invest with a long time horizon to avoid the impact introduced by passive investors.

------------------------------------

b.

Some important features of passive investing in down market situation are- firstly. the cost of investment is relatively low. This makes the expense ratio of an index-based ETFs quite low. Second, on markets recovery, constituents of the benchmark index rally first before stocks outside the benchmark index follow. Thirdly, it has been seen that historically, the constituents of the benchmark index do not fall as much as stocks outside indices. And finally, index ETFs have a certain amount of ‘assured liquidity’ due to the very structure of the product. So passive investments can track the market down during a recession, and they are poised well to rebound in the future.The goal of a passive investment is to meet stock market performance and not to beat the index's benchmark.So using some basic strategies, even in a downturn an ETF investor can earn the profit on it. Historically, in a low-volume market environment, passive strategies are hard to beat. Some of them are as mentioned below:

Dollar-Cost Averaging (DCA) -buying a certain fixed-dollar amount of an asset on a regular schedule, regardless of the changing cost of the asset.
Asset Allocation  allocating a portion of a portfolio to different asset categories, such as stocks, bonds, commodities
Sector Rotation ETFs also make it relatively easy for beginners to execute sector rotation, based on various stages of the economic cycle.
Betting on Seasonal Trends ETFs are also good tools for beginners to capitalize on seasonal trends.

-----------------------------------------------

c.

Passively managed funds – also called as index funds – invest in a portfolio of bonds designed to match the performance of a particular index. Index funds hold the securities that are the constituents of index, or a representative of the index holdings. When the composition of the index changes, so do the fund’s holdings. So the fund managers don't seek to produce returns greater than the benchmark but it should be inline with that of benchmark. Following are the advantages of a passive Bond ETF over active ETF -

Fees: Actively funds incur more trading costs and require greater resources to research and portfolio management than passively managed funds, so active funds has a higher expense ratio. Sometimes, this is worth it, but in a long run very few actively managed funds can sustain indices outperformance over an extended period of time. So the higher fees of active managers tend to reduce their returns.

Results: The most important difference between active and passive management. Even though there are many active funds that has the capability to outperform the market in any given year, over time, however, index funds tend to come out on top. One reason is, that we already know by now, fees – the gap between the two types of funds is large enough that the difference compounds over time. Secondly, the market is so efficient – i.e., analyzed by such a large number of investors – that it’s extremely difficult for a manager to deliver consistent outperformance over the long term, leavin the passive investors with a sustainable return movement with the index.

Performance : It is assumed that the active fund fund will be able to beat the market over time. That may, in fact, occur, but it can't be considered something that is sustainable in a varying market conditions. Whereas passively managed funds produce returns that are in line with the market, actively managed funds can experience wide annual variance turnover around the index return.

Turnover and taxes: As actively managed funds are steadily shifting their portfolios in response to market conditions, they have a much higher turnover than index funds. And an index fund only change when the underlying index changes. This can result in a higher tax reducing the after-tax returns.

-----------------------------------------

# Please upvote if the solution helps.

# For feedback- Please use the comments section in case of any concern/clarifications.