6.1. Market Efficiency and Investment Strategies

Question 1

Active vs. passive management

Answer 1

Passive:
• track benchmark index
• try to replicate return of the benchmark at little costs
• little fees

Active:
• try to beat benchmark index
• manager chooses from entire set of available securities in the market
• mid to high fees

Question 2

Positive risk-adjusted return by active management?

Answer 2

• depends on manager’s information
• cost exploiting of manager’s information advantage
• costs of active management

Question 3

Tracking error

Answer 3

• analyze the deviation between fund and index returns

Definition 1:
• calculate the average difference between fund and index over all periods

Definition 2:
• calculate the standard deviation of the difference
• difference in absolute terms

Definition 3:
• regress the fund’s return on the index return
• compute the regression residuals and determine their standard deviation
• difference in absolute or relative terms

Question 4

Physical replication

Answer 4

Physical replication:
• fund purchases the underlying stocks
• stock’s weight corresponds to the weights in the benchmark
• fund return is very close to the index return
• fund can generate additional revenue by lending part of their portfolio holdings
• relatively high transaction costs

Question 5

Synthetic replication

Answer 5

Synthetic replication:
• fund uses derivates to replicate the index
• lower transaction costs and less trading
• counterparty risk
• rollover transactions when contracts expire
• legal restrictions
• taxation; since 2018 synthetically replicating funds may no longer qualify as equity funds

Question 6

Passive investment instruments

Answer 6

Index funds:
• standard open-end mutual funds
• can be purchased and sold at NAV at market close

Index ETFs:
• number of shares is fixed
•traded at stock exchange at market prices

Index certificates:
• bonds of the issuing bank where the underlying asset is the index
• some certificates have a fixed maturity date, some don’t
• can be traded at an exchange, however, the market is typically not very liquid and the issuing bank acts as primary market maker

Question 7

Advantages of index ETFs over index funds:

Answer 7

• Usually lower total expense ratio
• number of ETFs shares is fixed. Not affected by trading of fellow investors.
• can be traded during the trading day

Question 8

Disadvantages of ETFs

Answer 8

• broker commission, no-load index funds offer investors trading for free.
• share price can deviate from the NAV
• bid-ask spread
• liquidity / limited market depth. Trading large quantities can be costly

Question 9

Main weakness of index certificates

Answer 9

Default risk: Lehman Brother’s bankruptcy costs German retail investors who had purchased Lehman certificates €2 billions.