Active versus Passive Management of International Mutual Funds ...

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Risk adjusted return. The fund’s yearly return adjusted for the risk undertaken by the
fund manager is the risk adjusted return [73].
Summary
The introduction provided the background and history of the problem associated with
active versus passive management. The justification for the study and the research question were
identified. The next section, the literature review, will provide the support for the research
question of the study and will lead to the development of the hypotheses that will be addressed.
LITERATURE REVIEW
The literature review will encompass the studies and findings of various financial authors
predominantly from 1964 to the present. The information will be provided in chronological
order.
Keynes [56] acknowledged that our decisions are based on the state of long-term
expectation which includes not only our assessment of the probability of occurrence but our level
of confidence the desire outcome will be achieved. If our confidence level is high, then we will
be more likely to invest in a particular security. His belief was that the investor must select the
security that everyone else desires. This selection will lead to an increase in value of the
underlying asset as other investors will desire to obtain the same asset. This process of selection
of the optimal security created the need for investment analysis and portfolio management [56].
The first major break through in portfolio management was the identification of MPT by
Markowitz in 1952. Markowitz believed investors would seek maximum returns through
maximizing expected returns with acceptable levels of variances of these returns based on their
utility. He believed in diversification across industries with different economic conditions to
achieve this end [63]. The Markowitz model is based on the following assumptions of investor
behavior [63]:
1. Investments are considered based on the probability of expected returns while being
held.
2. Investors desire to maximize utility during the time the investment is held.
3. Risk is estimated based on the variability of expected returns.
4. Utility curves are a function of expected returns and variance.
5. Investors prefer higher returns for a given level of risk and they prefer less risk instead
of more risk.
Tobin [81] identified a weakness in the Markowitz model. Tobin showed the risk of
portfolio could be reduced by holding cash or cash equivalents. The rationale to hold such
instruments was to maintain transactional balances and investment balances. As interest rates
increased the propensity to hold cash balances increased. Portfolios would be constructed based
on investors’ risk tolerance using varying combinations of securities and risk free assets [81].
Sharpe [77] extended the work of the Markowitz model by analyzing the future
performance of securities to determine an efficient set of portfolios using the computer. This
work further identified that diversification will allow the investor to eliminate all of the risk
except economic activity cycles [76]. The study marked the development of the Capital Market
Theory for which Sharpe won the Nobel Prize. The risk-free asset would provide the risk-free
rate of return that would serve as the foundation for the expected rate of return. The capital
market line delineates the highest level of expected return in excess of the risk free rate per unit
of risk for any available portfolio of risky assets [68].