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Linking EMH to Behavioral Finance while shifting from Passive-to-Active Equity Fund Management

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).