Question

Financial Economics Problem

Efficient Market Hypothesis

Eugene Fama and Burton Malkiel are big proponents that markets are indeed efficient.

1. If this is the case, explain why a strategy to simply buy an Index Fund with the lowest possible costs is the best investment you could make.
2. How does this tie up with the Market Portfolio on the Efficient Portfolio Frontier developed by Harry Markowitz.

In your answer, compare two funds with two fee structures (one higher than the other) over a period of 10 years. Assume also the same investment strategies.

Answer 1

Answer a) In case of efficient market , the price movement(return) of stocks depend on the information . It means nobody can earn extra profit from market even after taking different risky position .Investors can only earn comparative  higher amount of profit by cost saving.

An index fund has the lowest cost of fund management , which proofs the strategy to simply buy an Index Fund with the lowest possible costs is the best investment you could make.

Answer b) The current strategy explains the selection of index fund is based on the pairwise relation between cost and return. The concept of selection of low cost index fund is very much similar to the concept of efficient market hypothesis, the frontier is designed as pairwise analysis of risk and return. Here, investor will prefer to invest in index fund with high return in case of cost are same. The graphical presentation of selction process of index fund will look like an efficient frontier.