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Chapter 17: Q12. (page 368)

Why is it so hard for actively managed funds to generate higher rates of return than passively managed index funds having similar levels of risk? Is there a simple way for an actively managed fund to increase its average expected rate of return?

Short Answer

Expert verified

The actively managed funds face difficulty in increasing rates of return than passively managed funds because of the arbitrage process that drives up the prices of assets and higher trading costs.

The actively managed funds can increase the average expected rate of return by reducing the trading costs.

Step by step solution

01

Step 1. Difficulties in managing higher rates of return on actively managed funds

The actively managed funds are not able to generate higher rates of return. Firstly, because of arbitrage, the rate of return on both the funds or assets is equal. Constant buying and selling of the assets derives the prices up for actively managed funds and lowers the yield equal to passively managed funds.

Secondly, the actively managed funds incur higher management costs for arbitrage and managers鈥� salaries than those for index funds. At the same time, the index funds need not pay for the management of the funds. Therefore, higher trading and managing cost for passive funds reduces the rate of return on the funds.

02

Step 2. Alternative method for increasing the higher rates of return on actively managed funds

The actively managed funds can quickly increase the average expected rate of return by minimizing the trading costs. It will increase the average expected rate of return. However, it includes the risk of turning into passive funds because lower trading costs mean lesser activities. The fund will become less desirable for those who aim to beat the average rate of return in the market.

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Most popular questions from this chapter

The U.S. government issues longer-term bonds with horizons of up to 30 years. Why do 20-year bonds issued by the U.S. government have lower rates of return than 20-year bonds issued by corporations? And which do you think has the higher rate of return, longer-term U.S. government bonds or short-term U.S. government bonds? Explain.

Why is it reasonable to ignore diversifiable risk and care only about non-diversifiable risk? What about investors who put all their money into only a single risky stock? Can they properly ignore diversifiable risk?

What are mutual funds? What different types of mutual funds are there? And why do you think they are so popular with investors?

Suppose that the city of New York issues bonds to raise money to pay for a new tunnel linking New Jersey and Manhattan. An investor named Susan buys one of the bonds on the same day that the city of New York pays a contractor for completing the first stage of construction. Is Susan making an economic or a financial investment? What about the city of New York?

Next, consider another pair of assets, C and D. Asset C will make a single payment of \(150 in one year while D will make a single payment of \)200 in one year. Assume that the current price of C is \(120 and that the current price of D is \)180.

c. What are the rates of return of assets C and D at their current prices? Given these rates of return, which asset should investors buy and which asset should they sell?

d. Assume that arbitrage continues until C and D have the same expected rate of return. When arbitrage ends, will C and D have the same price?

Compare your answers to questions a through d before answering question e.

e. We know that arbitrage will equalize rates of return. Does it also guarantee to equalize prices? In what situations will it equalize prices?
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