Essay \"Essay about active fund management firms vs passive fund management firms. \" - grade 85% PDF

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Essay about active fund management firms vs passive fund management firms. ...

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EFB201 Essay Active Equity Fund Management Firms Semester 2, 2016. Due: 4th October Tutor:

Words: 2024

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Table of Contents 1.0

Introduction...........................................................................................................3

2.0

Efficient Market Hypothesis..................................................................................3

2.1

3.0 3.1 3.2

4.0 4.1 4.2 4.3

Anomalies in the Efficient Market Hypothesis..............................................................4

Arguments Supporting Active Fund Management................................................4 Outperformance of the Market......................................................................................4 Unrestricted Choice in Shares........................................................................................4

Arguments Against Active Fund Management......................................................5 Agency Problem..............................................................................................................5 Consistency of Outperformance.....................................................................................5 Difference of Fees...........................................................................................................6

5.0

Recommendations..................................................................................................6

6.0

Conclusion.............................................................................................................7

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References..............................................................................................................7

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1.0 Introduction An equity fund management firm is a firm that invests in stocks, and they can either be actively or passively managed. Active management uses a manager or group of managers and aims to gain higher returns than that of passive management. These managers look to outperform the benchmark index for the relevant market they invested in. They can do this by applying financial analysis, where analysts gather and evaluate information about firms, industries and macroeconomic factors. Ideally, this allows them to select certain stocks that may be undervalued or overvalued in order to generate higher returns than that of the benchmark. Passive management mirrors the benchmark index, and because of this, there is no need for a manager to pick specific investments. There is much debate about which strategy (active or passive) is superior and each have their own benefits and detriments. This essay will outline the strengths and weaknesses of active fund management to determine which strategy the firm should utilize for the future development of the firm.

2.0 Efficient Market Hypothesis The Efficient Market Hypothesis (EMH) is the proposition that stock prices in a market reflect all available information in an unbiased fashion, therefore making it impossible to generate above average returns (Malkiel, 1991). This hypothesis is categorised into three different levels: Weak form, semi-strong form and strong form efficiency. Weak form efficiency suggests that the current price reflects past prices, which indicates that past prices have no correlation with future prices. Semi-strong form efficiency suggests that the current prices reflect all publically available information, and implies that one cannot profit with information that is available to everybody. Strong form efficiency incorporates all information, both public and private, and this type of efficiency proclaims that no one is able to make any abnormal returns (Malkiel, 1991). This hypothesis is based on the concept that a market is perfect, and assumes that all investors see and use information in exactly the same way. This means that because all information is available, everybody should achieve identical returns and there will never be anyone who will experience abnormal returns. However, this is not the case in the real world, as there are many firms and individuals who generate returns above or below the benchmark index. Passively managed firms believe in this theory as they invest in index funds, whereas actively managed firms believe that the EMH theory is inaccurate and therefore the market is inefficient. Nisar & Hanif (2012) undertook a study which focused on testing the market efficiency of developed markets in the Asia-Pacific region, which included the Australian All Ordinaries market. The study used runs tests and variance ratio tests and examined data from 1997 to 2011 to determine that the All Ordinaries market can be identified as a weak-form efficient market, and this evidence can be corroborated with Worthington and Higgs (2009). The All Ordinaries Accumulation Index is the benchmark used to compare the performance of funds, and the active fund management firm in focus has outperformed this index by 1% pa over the last ten years. Since the firm is outperforming the index, it shows that the stocks in the market are not efficiently priced, and analysts were able to identify stocks which would bring in higher returns. The EMH implies that in a weak-form efficient market such as the All Ordinaries, actively managed funds should not have much success. The improbably success indicates that behavioural finance could explain why the EMH may be inaccurate.

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2.1 Anomalies in the Efficient Market Hypothesis There is evidence to suggest that the EMH is inconsistent as there are many anomalies that do not align with the views of the hypothesis. The theory believes that markets are efficient, which rests upon the assumption that investors make rational, unbiased decisions. However, behavioural finance explains that emotion and psychology can influence decisions, causing investors to make irrational and unpredictable decisions and therefore refuting the EMH. Investors may be more affected by negative news as opposed to positive news, and this can influence the amount of risk that an investor accepts. Overconfidence in their abilities can also alter how they invest and investors may attempt to follow other successful investors in an attempt to outperform the market (Fuller, 2000). These behaviours have an effect on prices, as many investors may make bad decisions due to cognitive factors. Therefore, behavioural finance helps to explain decision making in investment and why investors attempt to outperform the market.

3.0 Arguments Supporting Active Fund Management 3.1 Outperformance of the Market A benefit of functioning as an actively managed fund as opposed to a passively managed fund is that actively managed funds are able to outperform the market, whereas passively managed funds cannot. Actively managed firms use managers to exploit the inefficiencies in the market to gain higher profits than that of the benchmark (Aifa, 2016). A noteworthy case of an active management fund is the Tribeca Alpha Plus Fund. It is an Australian based fund, with a reputation for outperforming S&P/ASX 200 accumulation index. Since inception in 2006, this fund has outperformed the index by an average of 4.01% and has outperformed the index seven out of nine years (See Figure 1) (Tribeca, 2016). This fund provides evidence that if an actively managed fund is successful, there are potentially huge profits to be made.

Figure 1: Tribeca Alpha Plus Fund Performance (Grant Samuels Fund Management, 2016).

3.2 Unrestricted Choice in Shares By adopting an active approach to fund management, firms have no restrictions on investment choices. A market index represents the overall performance of a group of stocks, and tracks their performance over time. There is a huge variety of stocks ranging in size from micro-cap stocks, where firms have a market capitalisation of $50 million to $300 million to large-cap stocks, where firms have a market capitalisation of more than $5 billion. Many market indices are comprised of only a select amount of stocks, which are usually large-cap stocks, and this leaves many of the smaller-cap stocks out of the market index calculations. For example, the MSCI World Index is composed of over 1600 stocks, however there are over 15000 stocks that are available to invest in (Jones, 2014). Since the passive management strategy prefers to mirror the market index, the shares that are available to them are only the selected large stocks incorporated in the market index. By using the active management

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strategy, firms are able to reach and invest in stocks outside the ones selected for the index, and these small stocks are capable of outperforming large-cap stocks. There is evidence of this in February 2000, where the technology and telecoms sector took up 35% of the MSCI World Index (Jones, 2014). In that month, they significantly underperformed, and this had negative implications for passive fund management firms. By actively managing funds, firms are able to mitigate the risks associated the choice restriction of shares.

4.0 Arguments Against Active Fund Management 4.1 Agency Problem In an active fund management firm, a circumstance known as the “agency problem” may result in potentially disastrous complications. This occurs when the interests of the investors are not consistent with those of the managers (Ineichen, 2007). Lückoff (2011, pg. 79) supports this theory as he states that “Investors try to maximize (risk-adjusted) returns net of all costs such as transaction costs and commissions. In contrast, the portfolio manager tries to maximize his life-time income and his behavior is driven by career concerns.” There is ample evidence to validate that this problem has many consequences. In 2000, the energy company of Enron was one of the largest in America, however, it filed for bankruptcy shortly after in December of 2001. This can be attributed to accounting activity scandals, and the manipulation of share prices which led to the misrepresentation of profits and overestimated expectations of future cash flows (Clarke & Branson, 2012). Their share prices plummeted from a high of $90 in August 2000 to below $1 in November 2001 (see Figure 2). This was a result of the “agency problem” as the managers were misrepresenting accounting activities for their own self-interest rather than acting in the shareholder’s best interests. Since the active management strategy integrates managers in their firm, this problem is present, however, as the passive management strategy have no use for managers, the agency problem does not occur in passive fund management firms.

Figure 2: Enron Share Price 2000-2001 (World Economic Journal, 2013).

4.2 Consistency of Outperformance Although some active fund management firms are able to succeed in consistently outperforming the benchmark index, the majority do not. The 2016 Fat Cat Funds Report by Stockspot (2016), which is largest analysis of Australian managed funds, provides evidence to support this. Figure 3 shows that in a 1-year period, the percentage of actively managed funds which outperformed the index ranges from 25.2% to 42.1% in four major regions. It also illustrates that as time increases to 3-year, 5-year and 10-year periods, the success of

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actively managed funds decreases. Therefore, by reviewing the data, it can be assumed that the majority of active fund management firms are not consistently outperforming the index. Percentageof Ac velyManagedFundsOutperformingthe Index 50 45 40

Percentage

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42.1 34.3

38.6 35.9

36.9

30

30.1

25.2 25

22.6

19.1 20

16.8

15

11.6

15.2 10

8.6

5 0 1 year

3 year

5 year

10 year

TimePeriod US (S&P 500)

Eurozone (S&P Eurozone BMI)

Emerging Markets (S&P/IFCI Composite)

Australia (S&P/ASX 200)

Figure 3: Actively Managed Funds Performance (Data from Stockspot, 2016)

4.3 Difference of Fees Actively managed funds tend to have significantly higher fees than those of passively managed funds, and this can potentially negate any higher returns that actively managed funds experience. An active fund management firm is able to make a profit if the excess returns after fees is above the benchmark index for the relevant market. Because an active management strategy seeks to outperform the index, managers are employed to analyse different aspects of firms and the economy to determine which shares to invest in. This will result in an increase of expenses for the firm, and will also result in higher share turnovers. This is much more costly than a passive management strategy because share turnovers incurs a greater tax burden (Australian Institute of Superannuation Trustees, 2010). Therefore, the profits of an outperformance of the benchmark index may be nullified due to managerial fees and expenses.

5.0 Recommendations Based on the research and evidence gathered, it is recommended that the active equity fund management firm in focus should switch to a passive equity fund management firm. Although an actively managed fund has great potential benefits, the disadvantages outweigh them. Since managers are utilised to outperform the benchmark index, it creates problems within the firm. The agency problem exists when a manager does not act in the shareholder’s best interests, and it can have potentially catastrophic effects. As passively managed funds do not employ any managers, this problem is non-existent, and therefore switching to this strategy is a safer option for the survivability of the firm. In the long run, most active fund management strategies do not consistently outperform the benchmark index. It is suggested that a passive management strategy should be undertaken as the outcome is more reliable and steady. The firm has currently outperformed the All Ordinaries accumulation index by 1% pa, and 6

charges fees of 2% pa. This trend is not efficient, as the firm is effectively generating profits below the benchmark index after fees. If a passive fund management strategy is pursued, the firm will perform on par with the benchmark index and have to pay significantly less expenses. Therefore, due to these significant factors, I recommend that the firm should assume a passive equity fund management approach for improved success and long-term survivability.

6.0 Conclusion An equity fund management firm invests in stocks, and whether a firm should take on an active or passive approach is widely debated by investors. The efficient market hypothesis is important to passive fund management, as this strategy relies on a market being efficient in order for the firm to be successful. On the other hand, the active fund management strategy challenges this theory, and attempts to make profits by outperforming the benchmark index. Active fund management has many arguments for and against the strategy, however, the firm in focus should assume the passive fund management approach, and this will ultimately assist the firm to achieve a greater success.

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7.0 References Aifa. (2016). Passive investing works in all markets. Australian Independent Financial Advisors. Retrieved from http://www.aifa.com.au/articles/portfolio-construction/passiveinvesting-works-in-all-markets Australian Institute of Superannuation Trustees. (2010). Investment Management Fee Research. Retrieved from http://www.aist.asn.au/media/43411/aist_research_report_webv.pdf Clarke, T. & Branson, D. (2012). The SAGE handbook of corporate governance. London: SAGE. Cremers, M., Ferreira, M., Matos, P., & Starks, L. (2016). Indexing and active fund management: International evidence. Journal Of Financial Economics, 120(3), 539-560. Fuller, R. (2000). Behavioral Finance and the Sources of Alpha. Pension Plan Investing. Gitman, L. (1976). Principles of managerial finance. New York: Harper & Row. Grant Samuel Funds Management. (2016). Tribeca Alpha Plus. Retrieved from http://www.gsfm.com.au/our-funds/tribeca-alpha-plus-fund/ Ineichen, A. (2007). Asymmetric returns. Hoboken, N.J.: Wiley. Jones, A. (2014). The hidden risks of going passive. Schroders. Lückoff, P. (2011). Mutual fund performance and performance persistence. Wiesbaden: Gabler Verlag. Malkiel, B. (1991). Efficient Market Hypothesis. The World Of Economics, 211-218. Nisar, S. & Hanif, M. Testing Market Efficiency: Empirical Evidence from Developed Markets of Asia Pacific. SSRN Electronic Journal. Stockspot. (2016). Fat Cat Funds Report. Stockspot Pty Ltd. Retrieved from https://www.stockspot.com.au/static/reports/Stockspot-FatCat-Report-2016.pdf Tribeca. (2016). Tribeca Alpha Plus Fund. Retrieved from http://tribecaip.com.au/funds/alpha-plus/?COLLCC=1619184924 World Economic Journal. (2013). Wag the Dog. Retrieved from http://worldeconomic.com/index.php?name=touch_articles_wej&op=page&pid=212 Worthington, A. & Higgs, H. (2009). Efficiency in the Australian stock market, 1875–2006: a note on extreme long-run random walk behaviour. Applied Economics Letters, 16(3), 301306.

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