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Active versus Passive Investing: An Empirical Study on the US and European Mutual Funds and ETFs

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Abstract

Purpose – In the build-up of an investment decision, the existence of both active and passive investment vehicles triggers a puzzle for investors. Indeed the confrontation between active and index replication equity funds in terms of risk-adjusted performance and alpha generation, has been a bone of contention since the inception of these investment structures. Accordingly, the objective of this paper is to distinctly underscore whether an investor should be concerned in choosing between active and diverse passive investment structures. Design/ Methodology/ Approach – The survivorship bias free dataset consists of 776 equity funds which are domiciled either in America or Europe, and are likewise exposed to the equity markets of the same regions. In addition to geographical segmentation, equity funds are also categorised by structure and management type, specifically actively managed mutual funds, index mutual funds and passive exchange traded funds (“ETFs”). This classification leads to the analysis of monthly net asset values (“NAV”) of twelve distinct equally weighted portfolios, with a time horizon ranging from January 2004 to December 2014. Accordingly the risk-adjusted performance of the equally weighted equity funds portfolios are examined by the application of mainstream single-factor and multi-factor asset pricing models namely CAPM (1968), Fama French Three-Factor (1993) and Carhart Four-Factor (1997). Findings – Solely examination of monthly NAVs for a ten year horizon, suggests that active management is equivalent to index replication in terms of risk-adjusted returns. This prompts investors to be neutral gross of fees, yet when considering all transaction costs it is a distinct story. The relatively heftier fees charged by active management, predominantly initial fees, appear to revoke any outperformance in excess of the market portfolio, ensuing in a Fool’s Errand Hypothesis. Moreover, both active and index mutual funds’ performance, may indeed be lower if financial advisors or distributors of equity funds, charge additional fees over and above the fund houses’ expense ratios, putting the latter investment vehicles at a significant handicap vis-à-vis passive low-cost ETFs. This paper urges investors to concentrate on expense ratios and other transaction costs rather than solely past returns, by accessing the cheapest available vehicle for each investment objective. Put simply, the general investor should retreat from portfolio management and instead access the market portfolio using low-cost index replication structures via an execution only approach. Originality/ Value – The battle among actively managed and index replication equity funds in terms of risk-adjusted performance and alpha generation has been a grey area since the inception of mutual funds. The interest in the subject constantly lightens up as fresh instruments infiltrate financial markets. Indeed the mutual fund puzzle (Gruber, 1996) together with the enhanced growth of ETFs has again rejuvenated the active versus passive debate, making it worth a detailed analysis especially for the benefit of investors who confront a dilemma in choosing between the two management styles. Keywords: Active Management, Passive Management, Mutual Funds, Exchange Traded Funds, Asset Pricing Models, Modern Portfolio Theory

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There is overwhelming empirical evidence on the existence of country and industry momentum effects. This line of research suggests that investors who buy countries and industries with relatively high past returns and sell countries and industries with relatively low past returns will earn positive risk-adjusted returns. These studies focus on country and industry indexes that cannot be traded directly by investors. This warrants the question whether country and industry momentum effects can really be exploited by investors or are illusionary in nature because they exist only on non-tradable assets. We analyze the profitability of country and industry momentum strategies using actual price data on Exchange Traded Funds (ETFs). We find that, over the sample periods that these ETFs were traded, an investor would have been able to exploit country and industry momentum strategies with an excess return of about 5% per annum. These returns cannot be explained by unconditional exposures to the Fama-French factors. The daily average bid-ask spreads on ETFs are substantially below the implied break-even transaction costs levels. Hence, we conclude that investors that are not willing or able to trade individual stocks may use ETFs to benefit from momentum effects in country and industry portfolios.
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By breaking down ETFs in broad, sector and international market categories as well as in large, medium and small cap classes of capitalization we demonstrate that a substantially positive November effect influences the performance of all ETF market categories and classes of capitalization. We also reveal the existence of a strong reverse December effect along with a modest reverse effect that affect the ETFs' volatility. The modest November effect in risk is accompanied by a strong reverse November effect in tracking error related to all ETF categories and classes. Moreover, we provide slight evidence for persistence in ETFs' November performance and strong evidence for persistence in ETFs' November risk and tracking error. Further research indicates that the investing strategies which respect the November patterns in ETFs' performance can beat the buy and hold strategies on an average and accumulated level during a five-year period and that investors can gain significant returns if they allow themselves to be exposed in greater level of volatility.
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This paper consists a comprehensive empirical research on iShares exchange traded funds performance and trading characteristics. At first, we investigate the ability of iShares to accurately replicate the performance of their underlying indexes, finding that there is a significant tracking error among iShares and indexes returns, especially for iShares that track the international capital indexes of Morgan Stanley. In parallel, we exhibit that iShares mainly trade at a premium from their net asset value. Further, we demonstrate that tracking error is also induced by the premium and the trading volume of iShares. Besides, we find that premium is affected positively by tracking error, while volume, which reflects the liquidity of iShares, is oppositely related to premium. Besides, we demonstrate that the lagged premium has sufficient predictive power on return, since performance is estimated to be negatively related to lagged premium. Finally, we provide very limited evidence that the volume is negatively related to the lagged premium and lagged return. In contrast volume is influenced strongly positively by the intraday price volatility of iShares.
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In this paper we compare ETFs and Index Funds performance during the time period from 4/3/2001 to 11/20/2002, using a set of 16 ETFs and Index Funds that in pairs track the same indices. We estimate their average return and mean risk level, finding that they substantially produce quite similar results. We regress ETFs and index funds return on the return of the underlying indices and we find out that they don't achieve any excess return than this of their benchmarks. We compute ETFs and index funds average tracking error, confirming their analogous tracking ability. Finally, we present ETFs and index funds major sources of costs and, regressing average return on expense ratio, we exhibit a significant positive relation of our ETFs with their expense ratio. This relation is very shortly verified in index funds.
Article
We develop an equilibrium model to investigate whether an Exchange-Traded Fund (ETF) is a more efficient indexing vehicle than an Open-Ended Mutual Fund (OEF). We find that while flow-induced trading is costly to OEF investors, it is also beneficial to those investors who cause the flow -- it is simply a zero-sum game. Indeed, the OEF structure can be viewed as providing insurance for investors with liquidity shocks, and hence is beneficial for risk averse investors. However, this liquidity insurance is not without cost -- it can cause moral hazard %that induce excessive trading and reduce the OEF performance. Moreover, we find that investors with higher individual liquidity needs prefer to invest via the OEF since they benefit more from the liquidity insurance. Surprisingly, the OEF structure is still viable despite the concentration of higher-liquidity-need investors in the OEF. The reason is that flow-induced trading costs depend only on the aggregate liquidity need, not on individual liquidity needs, which cancel out at the fund level. As a result, OEFs and ETFs coexist in equilibrium with different liquidity clienteles. Finally, we derive empirical predictions that ETFs are better suited for narrower and less liquid underlying indexes, and for investors with longer investment horizons.
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In this paper I derive a risk-adjusted measure of portfolio performance (now known as Jensen's Alpha) that estimates how much a manager's forecasting ability contributes to the fund's returns. The measure is based on the theory of the pricing of capital assets by Sharpe (1964), Lintner (1965a) and Treynor (Undated). I apply the measure to estimate the predictive ability of 115 mutual fund managers in the period 1945-1964 - that is their ability to earn returns which are higher than those we would expect given the level of risk of each of the portfolios. The foundations of the model and the properties of the performance measure suggested here are discussed in Section II. The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance. It is also important to note that these conclusions hold even when we measure the fund returns gross of management expenses (that is assume their bookkeeping, research, and other expenses except brokerage commissions were obtained free). Thus on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses.
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The objective of this study is to compare the risk and return performance of exchange-traded funds (ETFs) available for foreign markets and closed-end country funds. We utilize 29 closed-end country funds (CEFs) for 14 countries over the sample period from April 1996 to December 2001. The performance proxies are mean returns and risk-adjusted returns. Results indicate that ETFs exhibit higher mean returns and higher Sharpe ratios than foreign closed-end funds, while CEFs exhibit negative alphas. This indicates that a passive investment strategy utilizing ETFs may be superior to an active investment strategy using CEFs. The findings reported here offer some insight on the relative advantages of each type of investment. Specifically, there may be some potential for additional types of ETFs that offer higher risk-adjusted returns than closed-end funds. Such ETFs may be able to offer higher risk-adjusted returns as part of an internationally diversified portfolio.
Article
Testing the two-parameter asset pricing theory is difficult (and currently infeasible). Due to a mathematical equivalence between the individual return/‘beta’ linearity relation and the market portfolio's mean-variance efficiency, any valid test presupposes complete knowledge of the true market portfolio's composition. This implies, inter alia, that every individual asset must be included in a correct test. Errors of inference inducible by incomplete tests are discussed and some ambiguities in published tests are explained.
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This paper identifies five common risk factors in the returns on stocks and bonds. There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity. There are two bond-market factors, related to maturity and default risks. Stock returns have shared variation due to the stock-market factors, and they are linked to bond returns through shared variation in the bond-market factors. Except for low-grade corporates, the bond-market factors capture the common variation in bond returns. Most important, the five factors seem to explain average returns on stocks and bonds.
Article
If options are correctly priced in the market, it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks. Using this principle, a theoretical valuation formula for options is derived. Since almost all corporate liabilities can be viewed as combinations of options, the formula and the analysis that led to it are also applicable to corporate liabilities such as common stock, corporate bonds, and warrants. In particular, the formula can be used to derive the discount that should be applied to a corporate bond because of the possibility of default.
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This article examines the characteristics and performance of an exchange-traded index fund known by the name of Standard & Poor's Depository Receipts or SPDR or Spiders. The Spiders' net asset value is kept close to market price by the ability to create and delete them by in-kind transactions. Spiders underperform the S&P Index by 28 basis points and low-cost index funds by 18 points. This is primarily due to the lost income caused by holding dividends received on the underlying shares in cash. Nevertheless, Spiders are the most actively traded stock and the instrument of choice for most hedging.
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Most empirical studies of the static capital asset pricing model (CAPM) assume that betas remain constant over time and that the return on the value-weighted portfolio of all stocks is a proxy for the return on aggregate wealth. The general consensus is that the static CAPM is unable to explain satisfactorily the cross-section of average returns on stocks. The authors assume that the CAPM holds in a conditional sense, i.e., betas and the market risk premium vary over time. They include the return on human capital when measuring the return on aggregate wealth. The authors' specification performs well in explaining the cross-section of average returns. Copyright 1996 by American Finance Association.
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Several recent studies suggest that equity mutual fund managers achieve superior returns and that considerable persistence in performance exists. This study utilizes a unique data set including returns from all equity mutual funds existing each year. These data enables the author to more precisely examine performance and the extent of survivorship bias. In the aggregate, funds have underperformed benchmark portfolios both after management expenses and even gross of expenses. Survivorship bias appears to be more important than other studies have estimated. Moreover, while considerable performance persistence existed during the 1970s, there was no consistency in fund returns during the 1980s. Copyright 1995 by American Finance Association.
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This article investigates empirically the comovements of the conditional mean and volatility of stock returns. It extends the results in the literature by demonstrating the role of the commercial paper-Treasury yield spread in predicting time variation in volatility. The conditional mean and volatility exhibit an asymmetric relation, which contrasts with the contemporaneous relation that has been tested previously. The volatility leads the expected return, and this time-series relation is documented using offset correlations, short-horizon contemporaneous correlations, and a vector autoregression. These results bring into question the value of modeling expected returns as a constant function of conditional volatility. Copyright 1994 by American Finance Association.
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Exchange traded funds (ETFs) are a new variety of mutual fund that first became available in 1993. ETFs have grown rapidly and now hold nearly $80 billion in assets. ETFs are sometimes described as more 'tax efficient' than traditional equity mutual funds, since in recent years, some large ETFs have made smaller distributions of realized and taxable capital gains than most mutual funds. This paper provides an introduction to the operation of exchange traded funds. It also compares the pre-tax and post-tax returns on the largest ETF, the SPDR trust that invests in the S&P500, with the returns on the largest equity index fund, the Vanguard Index 500. The results suggest that between 1994 and 2000, the before- and after-tax returns on the SPDR trust and this mutual fund were very similar. Both the after-tax and the pre-tax returns on the fund were slightly greater than those on the ETF. These findings suggest that ETFs offer taxable investors a method of holding broad baskets of stocks that deliver returns comparable to those of low-cost index funds.
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In monthly U.S. data for 1959–1979 and 1979–1983, the state of the term structure of interest rates predicts excess stock returns, as well as excess returns on bills and bonds. This paper documents this fact and uses it to examine some simple asset pricing models. In 1959–1979, the data strongly reject a single-latent-variable specification of predictable excess returns. There is considerable evidence that conditional variances of excess returns change through time, but the relationship between conditional mean and conditional variance is reliably positive only at the short end of the term structure.
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Examines the arbitrage model of capital asset pricing as an alternative to the mean variance capital asset pricing model introduced by Sharpe, Lintner and Treynor. Overview of the arbitrage theory; Role of the arbitrage model in explaining phenomena observed in capital markets for risky assets; Influence of the presence of noise on the pricing relation. (Из Ebsco)
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This study examines the empirical relationship between the return and the total market value of NYSE common stocks. It is found that smaller firms have had higher risk adjusted returns, on average, than larger firms. This ‘size effect’ has been in existence for at least forty years and is evidence that the capital asset pricing model is misspecified. The size effect is not linear in the market value; the main effect occurs for very small firms while there is little difference in return between average sized and large firms. It is not known whether size per se is responsible for the effect or whether size is just a proxy for one or more true unknown factors correlated with size.
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Using a sample free of survivor bias, the author demonstrates that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds' mean and risk-adjusted returns. Darryll Hendricks, Jayendu Patel, and Richard Zeckhauser's (1993) 'hot hands' result is mostly driven by the one-year momentum effect of Narasimham Jegadeesh and Sheridan Titman (1993), but individual funds do not earn higher returns from following the momentum strategy in stocks. The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers. Copyright 1997 by American Finance Association.
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Mutual funds represent one of the fastest growing type of financial intermediary in the American economy. The question remains as to why mutual funds and in particular actively managed mutual funds have grown so fast, when their performance on average has been inferior to that of index funds. One possible explanation of why investors buy actively managed open end funds lies in the fact that they are bought and sold at net asset value, and thus management ability may not be priced. If management ability exists and it is not included in the price of open end funds, then performance should be predictable. If performance is predictable and at least some investors are aware of this, then cash flows into and out of funds should be predictable by the very same metrics that predict performance. Finally, if predictors exist and at least some investors act on these predictors in investing in mutual funds, the return on new cash flows should be better than the average return for all investors in these funds. This article presents empirical evidence on all of these issues and shows that investors in actively managed mutual funds may have been more rational than we have assumed.