Active versus Passive Management of International Mutual Funds ...

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Markets. The comparison indices included: Morgan Stanley Capital Index World; Morgan Stanley Capital Index Europe; Australia and Far East; Morgan Stanley Capital Index Europe; Morgan Stanley Capital Index Pacific; and Morgan Stanley Capital Index Emerging Markets Funds. The period of the study was from 1976 to 2000. The results of the study showed that there is an advantage for active fund managers in the international mutual fund category as they outperformed the passive indexes in three of five categories [37]. The study documented the need for active management in the international sector. Blitzer [13] thought that statistical papers will continue to grow in popularity as new thoughts are developed on beating the index. The behavioral nature of investors makes this a reality. Fundamental indexing Arnott, Hsu, and Moore [6] started the newest revelation in financial engineering with the concept of fundamental indexing. They acknowledged that cap-weighted portfolios and indexes have advantages. Capitalization weighting is a passive strategy requiring little trading, therefore, transaction costs are low. A cap-weighted index provides an easy way to participate in a broad equity market, and cap-weighting is highly correlated with liquidity therefore; heavily traded stocks are emphasized. Considering these advantages, any alternative to indexing should strive to include these fundamentals. To this end, they based their concept of fundamental indexing on these advantages with an annual portfolio rebalancing [6]. To create the fundamental index companies were ranked by book value, trailing 5-year average cash flow, trailing 5-year average revenue, trailing 5-year average gross sales, trailing 5- year average gross dividends and total employment. The 1000 largest were then selected by each metric and included in the index. The financial statement data were obtained from CRSP/Compustat database. The portfolio was rebalanced once a year on the last trading day [6]. The results of the study showed the portfolios outperformed the S&P 500 by an average of 1.97 percentage points a year during the 43-year period. The results were considered robust since varying economic conditions were included in the period. The excess returns over the S&P 500 were from superior market portfolio construction, price inefficiency, and additional exposure to distress risk, or a combination of the three [6]. Brinson [21] supported the fact that bubbles have existed in the financial markets for centuries and will continue to exist in the future. He believed that value can be added by active management strategies during very long time periods, which allow the active manager to capture the anomalies as they occur in the economic cycles during short-term intervals. He further stated the investment managers should move away from using past performance for anything but accounting value. The market is efficient in the long term, but potentially inefficient in short intervals [21]. Treynor [82] supported the work of Arnott, Hsu, and Moore [6] and postulated why fundamental indexing provided added value. Market Valuation Indifferent Indexing avoids the cap-weighted indexing problem by linking the covariances of the portfolio weights with market price per share, true value per share and errors in market price per share. He believed that all stocks have random pricing errors. Therefore, by randomly investing one can take advantage of the market’s pricing errors [82]. Asness [10] continued the support for passive indexing with caveats. He believed an investor cannot use long term historical stock trends to determine the expected stock return. The fact that the stock market has not lost over time does not mean it will not lose in the future. Investors must realize they cannot all be in the market at the same time as a dollar invested 14
means someone sold their position. He recommended that investors should diversify widely, keep costs low, rebalance in disciplined fashion, spend less, make less heroic assumptions about future returns, not watch the markets in the short run, and work less on investing [10]. Siegel [79] added to the support for fundamental indexing. Fundamental indexing means that each stock in a portfolio is not weighted by its market capitalization, but rather by some other metric such as sales or dividends. His research has indicated dividend weighted indexes outperform capitalization weighted indexes and are valuable at withstanding bear markets. He noted that research by Bogle [17], Ellis [30], Malkiel [62], and himself that active fund managers fail to beat the index on average. He felt that fundamental indexation will improve passive indexing as the prices of securities are subject to temporary shocks called noise. These shocks may last for days or years. He called these temporary shocks the noisy market hypothesis [79]. He believes the way an investor can capture these anomalies is through fundamental indexation. Hsu [47] supported fundamental indexing as his research indicated that cap-weighted portfolios are sub-optimal. The benefits of a cap-weighted portfolio include: minimal management fees, portfolio rebalancing as prices fluctuate, assigning the greatest weights to the largest companies, and a broad based cap weighted portfolio that is automatically Sharpe Ratio maximized. He provided mathematical proof that a cap weighted portfolio was sub-optimal if the prices are noisy and do not fully reflect the firm fundamentals [47]. Fundamental index debate Asness [9] joined the camp of Bogle and Malkiel in his thoughts that fundamental indexing supported by Arnott and Siegel was no more than a new version of value investing and therefore should not be called an index. He felt investors were not looking at anything that had not already been debated in the past. Investors were being presented a clever marketing package [9]. Arnott [5] provided further insight and support for fundamental indexing in response to the concepts challenged by Asness [9], Bogle [17], and Malkiel [61]. The starting point of the argument was that most investors cannot outperform the capitalization-weighted portfolio. The proponents of fundamental indexing believed that there was a pricing error or noise that created a size effect, a value effect, long-horizon mean-reversion, and performance drag for cap-weighted indexes relative to a valuation-indifferent fundamentally based index [5]. The size effect was defined as small and midcap companies outperforming large-cap companies and the value effect was companies with low price-to-earnings ratios, low price-to-book value ratios, low price-tosales ratios and high dividend yields tend to outperform growth stocks [5]. Based on the noise or pricing error fundamental indexes have been able to create/add value to investment portfolios. Arnott [5] showed 210 basis points of excess returns during a 43- year period. Arnott [5] agreed with his challengers that if only cap-weighted strategies can be an index than fundamental indexing is an active strategy. The arguments to this point seem to be descriptive rather than value added to investment portfolios. Rosella and Pugliese [69] postulated that active management may be back in vogue with the increasing popularity of exchange traded funds (EFT). The normal premise of an ETF is to mimic an underlying index of securities. An actively managed EFT would seek to provide an actively managed strategy over the index much like fundamental indexing. Miller [64] asserted that the passive indices included in his study collectively outperformed the active indices on a risk adjusted basis. His study included data from the Thomson Financials InvestmentView software and matched the categories of active mutual funds to appropriate corresponding passive indices. 15
Page 1 and 2: Active versus Passive Management of
Page 3 and 4: suspect that anomalies would disapp
Page 5 and 6: investors [6]. Siegel [79] added to
Page 7 and 8: Portfolio performance measures Trey
Page 9 and 10: hypothetical portfolios as a means
Page 11 and 12: covered funds from 1992 to 1996 and
Page 13: where anomalies continue to exist.
Page 17 and 18: called the Noisy Market Hypothesis.
Page 19 and 20: 19 indices, Morgan Stanley Capital
Page 21 and 22: б i = the standard deviation of th
Page 23 and 24: 23 indices’ weekly Sharpe ratios.
Page 25 and 26: 25 (alpha); a further indication th
Page 27 and 28: tend to outperform active managers
Page 29 and 30: 02/27/1995 -0.655 ‐0.268 ‐0.156
Page 31 and 32: 10/21/1996 ‐0.989 ‐0.383 ‐0.2
Page 33 and 34: 06/15/1998 ‐0.225 ‐0.170 ‐0.0
Page 35 and 36: 02/07/2000 0.810 0.183 0.010 0.204
Page 37 and 38: 10/01/2001 0.473 0.123 0.287 0.380
Page 39 and 40: 05/26/2003 0.568 0.782 0.329 0.908
Page 41 and 42: 01/17/2005 0.149 ‐0.131 ‐0.208
Page 43 and 44: 09/11/2006 0.468 0.511 ‐0.054 0.9
Page 45 and 46: 45 05/05/2008 ‐0.072 ‐0.508 ‐
Page 47 and 48: 10/16/1995 ‐1.952 0.430 0.006 0.2
Page 49 and 50: 05/12/1997 1.006 0.498 0.169 0.912
Page 51 and 52: 12/07/1998 0.350 ‐0.220 ‐0.001
Page 53 and 54: 07/03/2000 ‐0.041 ‐0.034 0.857
Page 55 and 56: 01/28/2002 ‐0.173 ‐0.505 ‐0.0
Page 57 and 58: 08/25/2003 0.118 0.159 0.338 0.450
Page 59 and 60: 03/21/2005 ‐0.583 ‐0.508 ‐0.6
Page 61 and 62: 10/16/2006 0.583 0.311 0.245 10/23/
Page 63 and 64: 63 05/12/2008 1.075 1.218 0.506 1.0
Page 65 and 66:
25. Cremers, M., & Petajisto, A. (2
Page 67:
63(6), 31-37. 68. Reilly, F. K., &
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