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 being able to exploit market inefficiencies and earn excess risk-adjusted returns.

Similarly, Chief Investment Officers (CIOs) of pension funds or endowments 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 to the extent that an efficient market implies fair prices and optimal allocation of resources while 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:

A. Worse than active management

B. Better than active management

C. The same as active management

Solution

The correct answer is B.

The gross performance of active and passively managed funds, in the long run, should be roughly equal. Since actively managed funds, on average, charge higher fees for investing in a given asset class, the net performance of passive management in a perfectly efficient market is likely to be better than active management.

Reading 38 LOS 38a:

Describe market efficiency and related concepts, including their importance to investment practitioners

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