Question

The active management industry is built on the notion that in exchange for paying a fee to active managers (say 1% of your investment), you can earn an excess return by investing with them. Explain what an excess return is, how it is measured, and discuss which form or forms of the efficient market hypothesis you must believe in (and why) in order for it to make sense to invest with an active manager.

Answer 1

Active return is the return that an investor earns not by replicating the benchmark, but it earns the returns above the benchmark returns by employing a portfolio manager. A portfolio manger will use his skills by selecting stocks that can beat the market and design portfolios to deliver higher returns which is the active return.

The concept of excess returns may also be applied to returns that exceed a particular benchmark, or index with a similar level of risk. Positive excess returns demonstrate the investment outperformed the risk less rate or benchmark, while negative excess returns occur when an investment underperforms in comparison to the risk less rate or benchmark.

For example, if the current risk less rate is 2% and the portfolio being examined received a return of 8%, the excess return would be the 6% difference

The Efficient Market Hypothesis, or EMH, is an investment theory whereby share prices reflect all information and consistent alpha generation is impossible.

As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments. So, it does not make sense to invest with an active manger in any forms of market efficiency which is the weak form, semi -strong form and the strong form.