The Investment Fund Puzzle

1 Introduction

1.1 Problems and Objectives

Mutual Funds are gaining popularity amongst investors, private and institutional, and being favoured over stocks. Nevertheless empirical studies prove that so called index funds or passive funds on average outperform actively managed mutual funds, since 1968 (Jensen), the majority of all empirical studies strengthen the theory that mutual funds on average do not outperform their benchmarks. It is to analyse why active man-aged funds under perform their passive peers. A further problem is that investors still prefer actively managed funds although it is widely proven that on average active funds underperform their benchmarks.

The objective of this study is to analyse, on the basis of empirical data, the performance of both active and passive managed mutual funds and explain why this divergence takes place. Furthermore is to be explained why investors still choose active funds over index funds.

1.2 Course of the Appraisal

In the first part of this study the main differences between active and passive managed funds, regarding portfolio structure, cost structure and investment strategy, are ex-plained.

Point 2.2 describes the mutual fund industry regarding the increase of assets under man-agement over the last decades and as well is looking at the increasing number of funds entering the market in the last decades.

The following part is an empirical analysis on the mutual fund performance in chrono-logical order, starting in 1945 and continuing, with minor gaps, until 2003, also men-tioning some hypothesis that refer to the observed performance in a specific period of time. In the next paragraph some theories on the performance and market efficiency are explained and relations to past performances are established.

The performance analysis is followed by the strategic implications that result from the earlier analysed performances of active and passive funds.

Later on it will be explained why investors still chose active funds over passive funds, even though overwhelming evidence supports passive investment strategies.

The last part before the conclusion sets up a model of pure passive investment.

2 Conceptual Principals

2.1 The Difference between Active and Passive Managed Funds

At the beginning of every investment process the question, of which investment strategy should be perused, has to be answered. On the long run this decision influences the as-sembly of the portfolio.

One can choose between active and passive portfolio management. Active and passive management are two different approaches, one trying to outperform the market and the other one trying to match it. A passive managed fund buys a well-diversified portfolio to represent a broad-based market index without attempting to search out mispriced se-curities. This way of investing is fairly cost-efficient, no analysis has to take place be-fore choosing the assets for the portfolio, because the index already specifies the assem-bly of the portfolio. That is why this way of investing is called "passive", because the manager does not have to choose any assets on his own but matches the index. A fund that performs an active investment style would attempt to achieve portfolio returns more than commensurate with risk, either by forecasting broad market trends or by identify-ing particular mispriced sectors of a market or securities in a market. The costs thereby incurred are due to researches that have to be done on the companies, trying to untangle the web around most of the companies. These researches are expensive but necessary to identify the mispriced assets that then will be implemented in the portfolio. In addition to that some more costs might rise because of a high activity within the portfolio, by selling and/or buying new assets additional transaction costs are generated, that is why these are called active managed mutual funds.

2.2 The Mutual Fund Industry

In the last decades the mutual fund industry grew from $2 billions in 1949 to $ 6.5 tril-lions in 2003, this corresponds to a compound annual growth rate of 16%. Alike the volume the number of funds grew, in 2003 8,300 mutual funds were recorded, out of this 8,300, 4,800 were stock funds and stock-oriented balanced funds, almost 1/6 was represented by bond funds and 1/3 were money market funds. Not only the quantity of funds increased, but also the objectives and policies they represent were broadened. Today the industry is dominated by less diversified funds that are less risk averse, only few funds still have highly diversified portfolios. Mornigstar only reported 560 of 3,650 funds that closely resembled the Standard & Poor's 500 Stock Index. Nowadays few funds are alike, almost every stock fund has an own specialisation, either by indus-try or by region or even both. The mutual fund market has become almost as distin-guished as the stock market and compared to half a century ago the range of perform-ance has become wider.

3 The Divergence in Active and Passive Managed Fund's Performance

3.1 Empirical Performance Analysis

At first it seams that theoretically, active managed funds cannot as a whole generate superior returns, even if the market efficiency was lower then assumed by most experts.

This theory is based on the assumption, that all investors taken as a whole, hold all stocks at their market capitalisation weight and an index will precisely reflect their re-turns. Therefore the related index will outperform the investors exactly by the amount spend in transactions. Projecting this scenario on active and passive managed funds this would mean that active managed funds would on average under perform passive man-aged funds due to higher cost.

One of the first performance analysis on mutual funds was done by Jensen, analysing a period from 1945-1965. Although the mutual fund market at that time was fairly man-ageable and the data not as numerous as in today's surveys, most analyses that took place later express similar results. In a 20 year period the 115 analysed funds, on aver-age, were not able to predict security prices well enough to outperform a randomly se-lected portfolio with equivalent risk, the so called "buy-the-market-and-hold-performance".

A later performance analysis done by Markiel, as well examining a time period of 20 years from 1971-1991, came to the conclusion that although the efficient market hy-pothesis might have suffered in the 1980's it

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