Market Efficiency

Market efficiency describes the extent to which available information is quickly reflected in the market price. Market efficiency is highly important to active investment managers as their advantage depends on exploiting market inefficiencies and earning excess risk-adjusted returns.

Investment officers must seriously consider the efficiency of any market they invest in to determine how much to invest in active management over passive management. If a market is completely efficient, passive management is often the better choice due to lower costs, but active management tends to be the better choice in highly inefficient markets.

Governments and market regulators are also concerned with market efficiency because an efficient market implies fair prices and optimal allocation of resources. In contrast, inefficient markets may ultimately lead to irrational resource allocation and below-average returns for unsophisticated investors.

Question

Net of fees in efficient markets, passive management is likely to perform:

1. Worse than active management.
2. Better than active management.
3. The same as active management.

Solution

The correct answer is B.

In efficient markets, the prices of securities reflect all available information, making it difficult for active managers to consistently outperform the market. Passive management, which typically involves tracking an index, incurs lower fees compared to active management. Since active management strategies involve higher fees and transaction costs, these additional costs often lead to underperformance compared to passive management on a net-of-fees basis in efficient markets..