Question

4. In class, we saw that active fund managers broadly deliver returns less than the returns of their benchmarks (slide 14 of the annotated Slide Deck: Investment Companies, Part 2, posted on BB Learn). Try to come up with several explanations for this return differential. Which explanation strikes you as the most probable?

Answer 1

There are several explanations for this return differential. First of all it should be noted that financial markets are extremely complex adaptive systems and hence accurate forecasting is not always possible for active fund managers. Secondly active fund managers have to face with portfolio constraints and this leads to accurate forecasts not getting fully translated into portfolio positions. Thirdly a large portion of the gross alpha (returns above the benchmark index) that is generated by the active fund managers is generally lost due to the higher expenses that the fund managers have to incur as well as due to higher tax liabilities that is generated due to higher trading volumes of active fund managers.

The explanation that strikes me as most probable is the first explanation i.e. financial markets are extremely complex adaptive systems and hence accurate forecasting is not always possible for active fund managers. This is because the financial market is filled with positive feedback loops. There are also non-linear effects that are caused by interaction of competing strategies. As such accurate forecasting often becomes impossible for active fund managers who are often pressed for time and are also affected by emotions and influences of others.