The exceptional model put forward by Stiglitz and Grossman (1980) provides the basis of this paper. Stiglitz and Grossman in this outstanding paper suggest that equity markets are shaped in an “equilibrium degree of disequilibrium”. In their opinion, it is impossible for a competitive economy to always be in equilibrium. Hence the assumption of perfect markets even for market information is completely ruled out as the market comprises of informed and uniformed investors. This unequal dissemination of information accounts for the practicality of their model in explaining how information asymmetry and market efficiency is correlated with superior ...view middle of the document...
The components of the model represent the following:
U_At – Average utility from active management for a certain period.
R_Pt – Average return from passive management for a certain period.
R_At – Average return from active management for a certain period.
δ – Level of market efficiency. If δ > 1, markets are not perfectly efficient, if δ = 1, markets are perfectly efficient.
R_At-R_Pt = the difference between the average return of an actively managed fund over the average return of a passively fund.
c_At – Cost (e.g. fees, margin etc.) of active management for a certain period.
Likewise, the model below expresses the utility gained by an investor from investing in a passively managed fund:
U_Pt (R_Pt,c_Pt )=R_Pt-c_Pt (2)
Note: for the utility function of passively managed fund investors δ is absent.
Following the Stiglitz-Grossman model:
U_At (R_Pt,R_At,c_At=U_Pt (R_Pt,c_Pt) (3)
This then signifies that markets are truly inefficient:δ>1 and R_At-R_Pt>0
Mutual fund performance:
Again, the debate on the performance of active management over passive counterparts has been reviewed by scholars. Malkiel (2003) argued that the cost of transaction and obtaining advantageous information are too high with regards to searching for concealed information that can yield surplus returns beyond the market benchmark given near market efficiency in global equity markets. Malkiel (2003) also suggest that there is strong evidence to show passive investment in all markets. Still on the cost active investing, French (2008) stresses that since the cost of active management is high; there is the arising need to look towards passive investment strategies. Sorenson et al (1997) shows that in 1997, a small percentage of mutual funds (about 11%) actually outperformed the S&P 500; agreeing with the conclusion to shift focus to passively managed investment strategies. However, these analyses are focused only on developed markets and do not precisely distinguish between emerging markets and developed markets.
Tax efficiency of Passive management:
Tax advantage is an important consideration to make when comparing actively managed mutual funds and passive fund returns. Poterba et al (2002) views on actively managed funds suggest that actively managed funds shifts the burden of capital gains from trading to their shareholders. Their study also shows that investment in US equities of mutual funds and passively managed funds (Exchange traded funds) generated similar returns when adjusted for tax notwithstanding the lower fees of the passively managed fund. Gardner et al (2005) also confirms this with emphasis on the tax advantage of passively managed funds over actively managed funds. The massive volume of mutual funds trading exacts more tax burden on their shareholders than passive fund shareholders.
Fund returns analysis:
Other studies have contributed to the debate between...