EFB201 Financial Markets - Essay

Passive equity management has become predominant over the last decade as it helps in amplifying the investors’ trading patterns. It makes the tracking and construction of equity indices easier as they are perpetual securities (Sushko and Turner, 2018). However, it gives low return than the chosen benchmarks and are diversified and low-fees options. Active equity management, on the other hand, gives earns higher returns than their selected benchmarks (Sushko and Turner, 2018) which is why Smart Solutions opted to shift from Passive equity management to Active equity management. Smart Solutions had adopted for passive equity management since its commencement and attempted to match the S&P/ASX200 index. This did not require excessive financial planning and the diversified investment options were cost-efficient and passive. 

This paper will discuss the potential consequences of the passive-to-active equity management shift for financial stability of Smart Solutions by assessing the arguments for and against the efficient markets hypothesis and behavioural finance and the implications of these for the future direction of the fund. 

Wolla (2016) mentioned in his article how the “Efficient Market Hypotheses” can be applied while choosing an investment strategy. He says that the passive management strategy relies upon the efficient market hypotheses (EMH) where the prices fully reflect the information about its current and future earnings. This means that the investor should buy and hold a diversified portfolio and minimize investment costs. Smart Solutions was adopting this strategy and trying to beat the market index. For example, for the given index fund, Smart Solutions was to represent 1 percent of the value of the index S&P/ASX200, the index fund manager would invest, 1 percent of the mutual fund’s assets in Smart Solution’s stocks. On the other hand, the active management strategy opts for higher returns that outperform the stock market. This strategy relies on differentiating between the stock’s value and the market price (Wolla, 2016). 

EMH can also be seen in the works of many economists and financial analysts who tried to explain how the markets work. Eugene F. Fama (1970) defined EMH where the profit maximizers compete actively by predicting future market values of the individual securities, while all important information is available to them. He, then, conducted weak form, semi-strong and strong tests to determine whether the expected returns could be ‘abnormal’ through access to special information and to determine if there are specific funds which are better in disclosing such special information than others. EMH is linked with the idea of the “Random Walk” which suggests that if the information fully reflects the stock prices, then the price change occurring tomorrow is independent of the previous price changes (Malkiel, 2003). However, the stock market deviates from the rules of EMH in reality and for that Fama (1998) justifies it to be a lag in the response of prices to an event. Therefore, he states that, it is important to inspect the returns in the long term to get a full view of the market efficiency. Later, his workings suggest that “…the expected value of abnormal returns is zero, but chance generates apparent anomalies that split randomly between overreaction and under-reaction”. This over-reaction and under-reaction of prices is generated in the efficient market due to certain events (“…earnings surprises, stock splits, dividend actions, mergers, new exchange listings and initial public offerings” (Malkiel, 2003)), taking place and explaining the existence of anomalies. These anomalies arise in some of the models and the results dissolve when they are exposed to different models of normal expected returns, various methods for adjusting risks and when different statistical approaches are used (Fama, 1998; Malkiel, 2003). Hence, there is no single pattern to predict the price movements, so, the investors are not identical and make different decisions based on their different interpretations of the price movements causing anomalies. (Chuvakhin, 2002).

Now that we know that EMH is not the only way applicable in reality, investors can adopt different methods to come to a decision. This leads us to integrating behavior with the financial world, where cognitive and emotional biases play an important role in decision making. Why Smart Solutions decided to shift to active equity management will also be answered through the scope of behavioral finance. We can now see that any “…investor’s behavior is not only related to finance, but also influenced by a combination of psychological, sociological and financial variables making “behavioral finance” truly interdisciplinary” (Virigineni and Rao, 2017). Behavioral finance has several concepts and extensive research which can be applied and explained at several different instances. However, it depends on the environemnet and circumstances that which theory suits best. Likewise, Smart Solutions is also affected by these aspects and the shift from passive-to-active equity management seems to be different from a rational behavior, where previously, it was acting rationally by sensing attractive opportunities and managing its equity passively.

Virigineni and Rao (2017) have come forth with a contemporary framework of behavioral finance, where conventional finance considers EMH to be the basis of investors’ decisions. However, according to Virigineni and Rao (2017), it has certain limitations (as discussed above) and therefore, behavioral finance emerges consisting of cognitive psychology and limited arbitrage. He also mentions that the decisions are influenced by several biases including the “mental accounting, loss aversion, regret aversion, cognitive dissonance, anchoring, over-confidence, hindsight bias, representativeness and herding”. The traditional financial theory focuses on the trade-off between risks and returns, whereas, the behavioral fiancé means that the active equity mangers are overconfident that regarding the gains and oversensitive to losses (Byrne, 2013).

The Prospect theory may be applicable here, which argues that, when choosing between gambles, people compute the gains and losses for each one and select the one with the highest prospective utility (Barberis and Thaler, 2003). Kahneman and Tversky (1979) proposed the Prospect Theory which treated gains and losses differently and attaches risk-seeing with losses and risk aversion with gains, overweighs outcomes received with certainty over uncertain outcomes (Thaler, 1980). Smart Solutions is moving to the active management equity in order to earn higher fees. Secondly, the beliefs of the managers of equity of Smart Solutions also influence the decision after they studied the information availability of the prices (Barberis and Thaler, 2003). As the Smart Solutions is not following the “trending” regime, they may be have come to this decision through interpreting their private information rather than the public information, and worked out their own future cash flows (Barberis and Thaler, 2003; Daniel, Hirshleifer and Subrahmanyam (1998, 2001)). They must have analysed and judged that this shift would be better off. This incorporates the “mental accounting” as presented by Thaler (1999), where he explained it through three components: how outcomes are perceived and experienced, assignment of activities to specific accounts and the frequency with which accounts are evaluated. According to Thaler (1999), mental accounting “enhance(s) our understanding of the psychology of choice….and it is….the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities”. 

It is possible that the Smart Solutions’ active management of equity fund prove to be successful and later, it is the opposite. In a study by Flam & Vestman (2017), it was found that the actively managed equity mutual funds in Sweden beat their index of comparison 1993-2001. However, they were unable to beat the index the remaining years 2002-2013. The success in the first year was mere good luck as later it was found that there was lack of stock-picking skills. If active management would be a success for Smart Solutions or not is not certain and involves risks. Teo and O/Connell (2003) explained in their work that a reasonable explanation for the increase in risk following the profits could be linked to overconfidence theories and models of changing loss aversion, however, neither of these completely explain the stop-loss behavior. They say that “Our conclusion is that modifications of overconfidence and dynamic loss aversion models that permits losses to have much stronger effects than gains offers the best hope of adequately accounting for the observed investor behavior” Teo & O'Connell (2003). 

The key to make active equity management successful is to forecast the expected returns appropriately. Figure 1, extracted from an article of the crowd-sourced content service, Seeking Alpha, shows active managers can outperform during bear markets (when there are falling stock prices) (Wilson, 2016). However, Wilson also mentions that in the near future, bear markets are not expected, which may be of concern to Smart Solutions. In 1997, 11% of the mutual funds outperformed the S&P500 of the markets in US, Europe and Asia (Sorenson et al, 1998). In 2016, the active management worked with S&P/ASX 300 Index, with even the 75th percentile manger was surveyed to outperform this index (shown in Figure 2). This could be explained by inexperienced local and offshore investors who had different investment goals and different targets (the MSCI Index was used for the most of the offshore managers instead of the S&P/ASX 300 Index). The perpetual concentrated equity, perpetual share-plus long short and perpetual ethical SRI, all outperformed the index (Buisman, 2016). 

However, an article in the Financial Review by Commins (2019) shows that only 13% of the actively managed Australian shared funds could beat the market index S&P/ASX 200, which was worse than the year 2018 in which 41% outperformed the market index of that year. Commins (2019) also mentions how the increasing fees were becoming a burden for the active fund managers. Australia, Canada and Japan are the countries which showed only minor positive returns for the average active managers over the last ten years and, opposite to that, Indian active managers vastly outperformed the market index in the past decade (Horstmeyer, 2019). Vanguard is known for being successful in active management of its funds in US and non-US markets, including Australia (Shapiro, 2019). On the other hand, Western Australia's The Dual Momentum Fund and the Australian equities operation of British giant Janus Henderson and Tribeca Investment Partners are those which could not be successful in active management (Boyd, 2019). 

Passive equity management is most commonly used around the globe as it is a safer option of tracking the index rather than the risky stock picking, however, some firms prefer to use active equity management which might or might not be successful for them. In Australia, firms have been seen to be inclined towards active management over the recent years, but the results were positive or negative is another debate. Reports and financial sources provide the understanding that active management does work in Australia, although not vastly outperforming the market index. There is a need for an extensive research on the active equity management and how it works in Australia. 

If Smart Solutions is shifting to the active equity management from the safer passive equity management, it should have a good analytic and judgmental stock picking skills. If the purpose for Smart Solutions is to charge high fees, it should be good in mental accounting as charging higher fees may not be sometimes be effective and keeping in mind EMH, no one can beat the market index consistently over the long run, except by chance. And studies also show that lower-cost passively managed funds outperform higher cost actively managed funds in all categories. Smart Solutions should calculate first that how much fees would be appropriate to charge in order to earn excessive returns through active equity management. It is only the survival of the fittest in equity management. “Increasing the focus on costs and transparency, and leveraging developments in factor investing may be the key to active management success in the future” (Pappas, 2017).