Active versus Passive Management of International Mutual Funds ...

Efficient market hypothesis
In 1970, Fama published the EMH theory. The theory is concerned with whether or not
stock prices fully reflect all available information. The weak form of the EMH theory tests
historical information and is fairly well supported. The semi-strong form tests all publicly
available information. The strong-form tests whether or not advantages can be gained by
insiders. As stated earlier, the weak form is fairly well supported, as is the semi-strong form.
Support for the strong-form is not as well documented [35]. If one believes in the EMH, then one
would believe that mutual fund managers cannot beat the market, and should therefore invest in a
passive index.
Treynor and Black [83] contributed to the debate regarding ownership of the index or
seeking active management. Their question was whether or not a manager should balance
underpriced long securities positions and underpriced short securities positions or should the
portfolio be diversified until only market risk remains. In their model, they assume that security
analysis can improve the performance of the portfolio. They conclude that it is useful to
rebalance a portfolio. A portfolio consists of three parts: a riskless part, a diversified part, and an
active part. The active part will depend upon security analysis and be independent of the active
index [83].
Origin of index funds
Samuelson [70] restated that most money managers would not outperform the market. If
they do, their returns are reduced by the transaction costs making it more appropriate to hold a
specifically weighted segment of the market. The thinking, therefore, was to emulate the market
with an index fund [70].
Ellis [30] reiterated the call of Samuelson [70] to form index funds, as he could not find a
group of managers that would consistently beat the market. Since individuals continue to believe
they can beat the market, active management will continue as a concept of one’s self-esteem and
self-worth. He termed investing in the market a “Loser’s Game,” as the more you tried to win the
better chance you had to lose. He did not state that the evidence led to a passive or index fund,
but the null hypothesis was hard to disprove [30]. Bogle took the challenge and started the first
index fund in 1975, called the Vanguard 500 index trust. The fund started with $11 million under
management and by 1995 reached $18 billion [19].
Transaction costs and benchmark measures
Ambachtsheer and Farrell [3] found that successful active management is not dependent
on any specific valuation method. They found that successful active management is dependent
on the ability to make judgments with predictive content that can be placed into unbiased
valuations. The managers must then deal with the transaction costs and risk control. The use of
computers in providing the processing needs was essential [3].
Lehmann and Modest [59] argued that it was necessary to have a benchmark for normal
performance. The usual proxy for the market portfolio was the Capital Asset Pricing Model
benchmarks. In their research they utilized the Arbitrage Pricing Model. The study examined 130
mutual funds from January 1968 through December 1982, finding considerable differences
between the performance measures given by the Capital Asset Pricing Model and Arbitrage
Pricing Model benchmarks. The importance of the study indicated that knowing the benchmark
was critical when comparing mutual fund performance [59].
Essayyad and Wu [32] conducted a study that compared the performance of 18
international mutual funds as identified in Wiesenberger Investment Company Services. Their
study addressed the period from January 1, 1977 to June 30, 1984. Previous studies incorporated
8