ACTIVE VS PASSIVE MANAGEMENT
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Questions and Answers

What is the fundamental law of active management primarily concerned with?

  • Maximizing market cap indices.
  • Calculating the average market impact per transaction.
  • Determining the outcome of active management. (correct)
  • Ranking different types of investment strategies.

    • Which of the following equations represents the extended version of the information ratio (IR)?

  • $IR = IC + N - TC$
  • $IR = IC × N$
  • $IR = (active return) / (tracking error)$
  • $IR = IC × N × TC - TCost × TR × TE$ (correct)

    • In the context of active management, what does 'breadth' refer to?

  • The number of independent forecasts. (correct)
  • The total return of the portfolio over time.
  • The diversity of investment styles utilized.
  • The amount of leverage applied to investment positions.

    • What does a higher transfer coefficient indicate in active management?

    <p>Better efficiency of implementation.</p> Signup and view all the answers

    Which statement about common factors in active management is true?

    <p>Common factors can reduce the effectiveness of predictions.</p> Signup and view all the answers

    What does the efficient market hypothesis (EMH) state about asset prices?

    <p>Asset prices fully reflect all available information.</p> Signup and view all the answers

    Which of the following best describes the weak form of market efficiency?

    <p>Asset prices reflect only past market price information.</p> Signup and view all the answers

    According to the semi-strong form of EMH, which analysis method is claimed to be ineffective in leading to profitable strategies?

    <p>Technical analysis.</p> Signup and view all the answers

    What does the strong form of the efficient market hypothesis imply?

    <p>No one can earn any excess return, not even insiders.</p> Signup and view all the answers

    What is a key assumption underlying the efficient market hypothesis?

    <p>Investors are always rational and unbiased.</p> Signup and view all the answers

    What was the significant conclusion drawn from the 2012 study by Fama and French regarding fund returns?

    <p>Fund returns showed no correlation with managerial skill.</p> Signup and view all the answers

    Which implication is noted in the weak form of market efficiency regarding fundamental analysis?

    <p>It might produce excess returns.</p> Signup and view all the answers

    Which phenomenon does the efficient market hypothesis suggest should not exist?

    <p>Trend following based on price data.</p> Signup and view all the answers

    What does the efficient market hypothesis (EMH) suggest about market inefficiencies?

    <p>Smart market participants will exploit inefficiencies.</p> Signup and view all the answers

    In passive management, what is the primary objective?

    <p>To replicate the performance of a specific index.</p> Signup and view all the answers

    Which of the following best describes active management in a relative sense?

    <p>Deviating from an index to outperform its performance.</p> Signup and view all the answers

    What is a limitation mentioned for implementing the EMH in real life?

    <p>Noise trader risk and transaction costs.</p> Signup and view all the answers

    What is loss aversion in the context of behavioral finance?

    <p>The inclination to avoid losses over acquiring equivalent gains.</p> Signup and view all the answers

    What role does confirmation bias play in investment decisions?

    <p>Leading investors to seek out information that supports their beliefs.</p> Signup and view all the answers

    What distinguishes absolute active management from relative active management?

    <p>Absolute management does not reference any index.</p> Signup and view all the answers

    Which of the following is NOT a known behavioral bias in investment decisions?

    <p>Diversification effect</p> Signup and view all the answers

    What is a primary characteristic of an Exchange-Traded Fund (ETF)?

    <p>It aims to replicate the performance of an index.</p> Signup and view all the answers

    What type of analysis do ETFs use to maintain their value throughout the trading day?

    <p>Mark to market valuation</p> Signup and view all the answers

    Which of the following is a key disadvantage of passive investments like ETFs and index funds?

    <p>Systematic underperformance against benchmarks</p> Signup and view all the answers

    What does full replication in constructing an ETF entail?

    <p>Holding the exact same universe of stocks as the index</p> Signup and view all the answers

    Which of the following strategies is not typically associated with ETFs?

    <p>Vigorous active trading to outperform the index</p> Signup and view all the answers

    Which factor does NOT contribute to the underperformance of a passive investment?

    <p>Market efficiency</p> Signup and view all the answers

    What is a key feature that differentiates index funds from ETFs?

    <p>Index funds have only once-a-day liquidity</p> Signup and view all the answers

    The practice of lending stocks in ETFs is primarily to support what strategy?

    <p>Facilitating short selling</p> Signup and view all the answers

    What is the primary benefit of a synthetic structure in ETF implementation?

    <p>Ability to replicate index returns using financial derivatives</p> Signup and view all the answers

    What is an inherent risk associated with swap implementation in synthetic ETFs?

    <p>Counterparty risk</p> Signup and view all the answers

    What does automation in a passive investment approach primarily aim to reduce?

    <p>Costs associated with fund management</p> Signup and view all the answers

    What is the primary goal of active management in a relative investment approach?

    <p>To outperform an index through active stock selection</p> Signup and view all the answers

    In active management, what does the term 'absolute' refer to?

    <p>Building a portfolio independent of any index</p> Signup and view all the answers

    Which of the following describes a long/short hedge fund strategy?

    <p>Betting on both rising and falling stock prices</p> Signup and view all the answers

    What characteristic distinguishes traditional active management from hedge fund strategies?

    <p>Hedge funds utilize leverage and may engage in short-selling</p> Signup and view all the answers

    Which of the following is a potential downside of active investment?

    <p>Higher potential for underperformance</p> Signup and view all the answers

    What is the main strategy behind event-driven hedge fund investments?

    <p>Betting on specific corporate events, like mergers</p> Signup and view all the answers

    What is a major challenge faced by active investors trying to outperform the market?

    <p>Identifying and capitalizing on a select few outperformers</p> Signup and view all the answers

    How does factor investing typically begin?

    <p>By creating a new type of stock index for tracking</p> Signup and view all the answers

    Which type of investment profile is typical for a traditional absolute active management strategy?

    <p>Long-only investments without leverage</p> Signup and view all the answers

    What is a prominent feature of market neutral strategies?

    <p>Engaging in relative trading without net exposure</p> Signup and view all the answers

    Study Notes

    Efficient Market Hypothesis (EMH)

    • EMH proposes that asset prices fully reflect available information.
    • It is impossible to consistently "beat the market" on a risk-adjusted basis.
    • This was confirmed in a 2012 Fama and French study.
    • The study found fund return distributions mirrored those without skilled managers.
    • This makes consistent outperformance difficult.
    • Investors are assumed to be rational and unbiased in valuing securities.

    Weak Form of Efficiency

    • Asset prices incorporate all past market price data.
    • Technical analysis, using price trends, is typically ineffective.
    • Fundamental analysis (using company data) may lead to excess returns.
    • Price movements are random without fundamental data changes.

    Semi-strong Form of Efficiency

    • Asset prices reflect all publicly available information.
    • Technical and fundamental analysis cannot consistently beat the market.

    Strong Form of Efficiency

    • Asset prices incorporate all information, including private/insider information.
    • No one, not even insiders, can consistently earn excess returns.
    • This form is not typically supported by empirical evidence.

    Active vs. Passive Management

    • Passive management replicates an index (e.g., SMI, S&P500). Index constituents and weights are maintained.
    • Active management aims to beat the index. It deviates from index weights and potentially investment universe selection. Returns are compared based on risk-adjusted factors or absolute gains
    • Active management attempts to outperform the index in several ways, such as selecting stocks based on micro, market, or sentiment factors, or by seeking characteristics like high dividend payouts.

    Passive Investment (ETFs)

    • Exchange-traded funds (ETFs) trade on stock exchanges like stocks
    • Most ETFs track an index (e.g., SPI).
    • Valuations are fair market values at every point in time.
    • They exhibit tradability, functioning much like individual equities.
    • Prices are highly reliable; no intraday pricing risk is involved.

    Cost of Implementation

    • Passive investments can underperform benchmarks due to implementation costs (trading fees, salaries, etc.)
    • Costs are often high when trying to implement replica portfolios in real life.
    • Securities lending and trading strategies can address replication costs.

    Active Investment

    • Attempts to outperform markets by strategically selecting stocks or asset classes.
    • Relative active management is compared to reference indices (e.g., SPI).
    • Absolute active management seeks to generate specific returns regardless of a benchmark, given a certain universe of stocks.

    Factor Investing

    • This is a type of active management.
    • It aims at creating an index that is followed transparently.
    • Traditional indices are typically market cap-weighted.
    • Value, equal weighted, and trend-following indexes are also possible.
    • Factor investing can yield lower fees than ordinary active management.

    Fundamental Law of Active Management

    • Explains the relationship between active management effectiveness (IR), forecasts (IC), the number of forecasts (N), and the cost (TC) and efficiency of implementation.

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    MSc Banking and Finance Lecture 1 PDF

    Description

    Test your understanding of the Efficient Market Hypothesis (EMH) and its various forms: weak, semi-strong, and strong. This quiz covers the fundamental concepts behind market efficiency and the implications for investors and their strategies. Challenge yourself to see how well you grasp these critical financial theories.

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