7. Active vs Passive Investment 2 Flashcards
What is an index fund?
A passive investment fund that matches or tracks the components of an index. Thus cannot beat the market they are tracking. Tend to provide broad market exposure and thus have low operating expenses.
What is an insurance fund?
An investment fund that raises capital from insurance premium of insurance policyholders. They are obligated to maintain adequate reserves to ensure that they can fund their future liabilities (pay off insurance claims).
How can ETFs offer investors the improved returns that can be achieved from some forms of active management while doing so in a mechanical way that avoids the high management fees typically associated with actively managed funds?
ETFs can implement smart beta strategies. A smart beta ETF is an exchange-traded fund (ETF) that uses a rules-based system for selecting investments to be included in the fund portfolio. Examples of smart-beta ETFS:
- ETFs that invest in a specially constructed benchmark which employs an alternative non-value-based weighting designed to take advantage of known inefficiencies in market pricing that can generate better performance than investment in a conventional equal value weighted index.
- Funds invested in an index that focuses on particular stocks (or particular stocks within an index)(e.g., high growth stocks or small cap stocks)
- Momentum indices in which weightings depend on past growth in stock prices
What are other factors than returns must be considered when assessing the performance of an investment fund?
- The risk-return trade off (are the returns greater than other funds of comparable risk?)
- Check whether a fund’s success is due to a bubble
- Whether the fund has a history of performing well and overcoming recessions and other periods of financial difficulty/market down turns.
Why is it difficult today to achieve good returns using technical approaches (analysing past share price data)?
Because widespread use of computerised trading means that any data trends are quickly exploited.
What is the difference between hedge funds and active mutual funds?
Hedge funds:
- Can use more leverage
- Have less onerous reporting requirements
- Fee structures are strongly tilited towards rewarding performance
Why do many funds ALSO hold some AUM in cash or invest some AUM in money markets?
To manage their liquidity and be able to finance withdrawals.
Funds may switch in and out of cash:
- in an effort to “time the market”
- because of concerns about high levels of volatility which are limiting their willingness to take risk (‘risk appetite’).
What are some problems regarding fees with active mutual funds?
- Only a small proportion of actively managed MUTUAL funds charge performance-based fees (less incentive to try to outperform the market).
- Their returns do not tend to be high enough to compensate for their fees, when compared to many passive investment funds.
What are some problems with assessing the performance of actively managed funds?
- Survivorship bias: Underperforming funds are typically closed after a few years, so they are removed from databases, leaving a biased database of active fund performance.
- Some funds will outperform by chance/luck. Need to check if the returns from active allocations (allocations of the fund departing from benchmarks) are high enough to justify their high fees. Look at data over a long time frame.
- Investment strategies are not fixed.
- Even passive funds have some costs. Need to take into account fees of passive funds when comparing.
What are some criticisms of passive funds?
- They have little flexibility and are restricted to accurately track an index at all times.
— They often cannot make adjustments when an index performs badly and cannot mitigate losses. - Passive funds play no role in corporate governance.
- Passive funds play a minimal role in price discovery, as they do not directly assess whether their fund’s value reflects the intrinsic value of its assets. Instead, they rely on active market participants to determine prices through fundamental analysis and trading decisions.
- A high level of investment in passive funds could potentially contribute to financial instability/market volatility. Instead of taking advantage of buying opportunieis when prices fall, they will passively follow the market allowing prices to decline much more than if there are many active funds present.
The challenge then is to get the balance right between the proportion of funds actively and passively managed, and between the fees charged for active and passive management.
What is a good way to assess the performance of active fund managers in beating the market?
It is easy to beat the markets when the markets are doing well (growing) because you can use leverage. It is not easy to beat the markets when they are generally declining. Comparing active fund performance during bad times will show which ones are the most competent and best at managing risks while providing decent returns.
