Present Value Models to Value Equity
Present value models are based on a fundamental tenet of economics stating that... Read More
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.
In the same way, Chief Investment Officers (CIOs) of pension funds or endowments have to think about how efficient a market is before deciding how much to invest in active or passive management. When a market is very efficient, it’s usually better to go with passive management because it’s cheaper. On the other hand, in highly inefficient markets, active management often makes more sense.
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:
- Worse than active management.
- Better than active management.
- The same as active management.
Solution
The correct answer is B.
In the long term, the gross performance of active and passively managed funds should be about the same. However, because actively managed funds typically have higher fees for investing in a particular asset class, the net performance of passive management is likely to be better than that of active management in a perfectly efficient market. This is because higher fees can eat into the returns of actively managed funds, potentially reducing the net performance.