Lecture 5: Active versus Passive Asset Management

Transcription

1 Lecture 5: Active versus Passive Asset Management Manuela Pedio Portfolio Management Spring 2016

2 Overview What do passive and active really mean? Predictability: a necessary condition for active asset management Predictability and the efficient market hypothesis 2

3 What do passive and active really mean? Funds (and fund managers) are generally divided into "passive" and "active" (today will focus especially on equity funds) o A passive manager selects a benchmark and tries to replicate it with the lowest possible "tracking error" (i.e., a measure of the closeness of the fund to the stated benchmark) o Tracking error = the square root of the variance of the differences in the returns between actual ptf returns and the benchmark o An active manager makes forecasts on future asset returns and acts on the basis of these forecasts It is not always that easy to find the line across which passive management becomes active management The easiest example of a passive fund is one that replicates a market index but generally also a fund that applies algorithmic strategies based on past data (e.g. investing in the 10 stocks that paid the highest dividend in the last 3 years) are deemed to be passive 3

4 What do passive and active really mean? Here we will accept the definition of Elton, Gruber, Brown and Goetzmann and consider forecasts as an essential element for active management ACTIVE MANAGER OUTPERFORM TWO DIFFERENT APPROACHES TO BENCHMARK PASSIVE MANAGER TRACK 1. Market timing 2. Sector selectors 3. Stock selectors 1. Buy all the stocks in the same proportions 2. Use a subset of stocks to replicate the benchmark 4

5 What do passive and active really mean? Active managers ask a higher compensation (management fees) as they believe that they are able to beat the market ACTIVE MANAGER OUTPERFORM 1. Take also diversifiable risk (alpha risk) TWO DIFFERENT APPROACH TO BENCHMARK PASSIVE MANAGER TRACK 1. Only undiversifiable risk (beta risk) 2. High turnover 2. Low turnover 5

6 Predictability: a necessary condition An active asset management approach (which is more expensive than simply tracking an index) is reasonable only if returns are predictable From the Dimension of Active Management, Warning and Siegel (2003) 6

7 Predictability and the efficient market hypothesis The efficient market hypothesis (EMH) says that security prices fully reflect the available information If market is efficient and all the available information is used to determine the price, then the only reason for the price to move is that some "unexpected news" arrives In practice, price can be represented as: The price expected at time t+1, based on all the information available at time t Unexpected movements due to new information; errors must be serially uncorrelated, such that an error at time t is NOT USEFUL to predict errors at time t+1 7

8 Predictability and the efficient market hypothesis To be more precise, there are three different «degrees» (forms, statements) of the EMH EMPIRICAL TEST USUALLY FOCUS ON THE SEMI- STRONG FORM 8

9 Predictability and the efficient market hypothesis The EHM has been largely disputed in the academic literature because it should not hold at all points in time when information is costly Grossman and Stiglitz (1980) have discussed a deep logical inconsistency with the EMH Their key claim is that if information is costly, then the EMH cannot hold because prices cannot perfectly reflect all information available o The profits derived from speculation are the result of being faster in the acquisition and correct interpretation of existing and new information o As the «better informed» traders make profits at the expense of the less well informed, market prices are moved towards efficiency o E.g., «smart money» sell stocks when these are over-valued vs. fundamentals and this makes the price efficient, by moving it closer to what fundamentals justify 9

10 Predictability and the efficient market hypothesis The EHM has been largely disputed in the academic literature because it should not hold at all points in time when information is costly However, because of the need of this process that rewards smart money, asset markets cannot be efficient at all points in time o The process of impounding of information in prices takes some time, particularly when investors are unsure of the true model generating fundamentals o This process may be further made slow when irrational or «noise» traders are present and counfound the price action As discussed by Stiglitz (1983), it is the slow process of correction of market prices towards the EMH that creates the space for active portfolio management Because news and noise traders affect different assets at different times, one can think of ptf managers being passive on each asset in the long run, but possibly active over the short term 10