Active versus passive investing : an empirical study on US and European mutual funds and ETFs

Abstract

The confrontation between active and index replication equity funds in terms of riskadjusted performance and alpha generation has been a bone of contention since the inception of these investment vehicles. The mutual fund puzzle (Gruber, 1996) jointly with the recent explosive growth of ETFs has again rejuvenated the active versus passive debate, making it worth a comprehensive analysis predominantly for the benefit of uninformed investors who are in a quandary when choosing between the two management styles. The research examines the risk adjusted performance of active and passive investment vehicles by analysing 776 American and European actively managed mutual funds, index mutual funds and passive exchange traded funds (“ETFs”) which are geographically exposed to the United States and Europe, specifically by constructing twelve equally weighted equity fund portfolios for the period January 2004 to December 2014. Application of mainstream single-factor and multi-factor asset pricing models namely CAPM (1968), Fama French Three-Factor (1993) and Carhart Four-Factor (1997) models including an enhanced variant of the standard market model developed by the researcher encompassing gold, oil and United States dollar index risk factors are employed. As a side analysis, a dummy variable to identify seasonality patterns is included in the regression equations for the diverse actively and passively managed equity fund portfolios. When considering solely net asset value (“NAV”) thereby overlooking supplementary costs such as initial fees, findings suggest that active management is equivalent to index replication in terms of generated alphas and risk-adjusted returns, validating prevailing literature in that actively managed structures do not outperform passive vehicles. This triggers investors to be neutral gross of fees, yet when considering all expenses into the equation it is a distinct story, as the former are typically less cost efficient compared to passive vehicles. Without any prejudice towards active management, the relatively heftier overheads vis-à-vis index replication methods, appear to revoke any outperformance (if any) in excess of the market portfolio thereby ensuing in the Fool’s Errand Hypothesis, albeit anomalies do exist. Yet active management is acknowledged for keeping high levels of market efficiency, which nevertheless is not a main priority for the individual investor predominantly passive investors who act as free riders. The researcher urges investors to progressively concentrate on equity funds’ expense ratios and other transaction costs rather than solely past returns, by accessing the cheapest available vehicle for each investment objective, regardless of being an active mutual fund, passive mutual fund or index replication ETF.