if markets are efficient, is there any benefit to active management? Explain yes
ID: 2806741 • Letter: I
Question
if markets are efficient, is there any benefit to active management? Explain
yesterday, the Dow Jones industrials gained 54 points. However, 1,704 issues declined in price while 1,367 advanced. Why might a technical analyst be concerned even though the market index rose on this day?
Consider a Treasury bill with a rate of return of 5% and the following risky securities:
Security A: E(r) = .15; standard deviation = ..2000
Security B: E(r) = .10; standard deviation = .1500
Security C: E(r) = .12; standard deviation = .3160
Security D: E(r) = .13; standard deviation = .2500
If you were going to form a complete portfolio consisting of the risk free asset and one risky asset from above, which risky asset would you choose.
Explanation / Answer
If markets are efficient then active management has very little role to play. However active management can be useful because in the times of recession active management can add a lot by decision making (buy or sell).
You should go for the Security A. Security A has earning potential of 15% and Standard deviation of 20%. This implies against one unit of risk or standard deviation income is contributed of 0.75 (15% / 20%). This highest among all listed securities.
Let’s see the table risk contribution of each securities:
Security
Return
Standard Deviation
Earnings ratio against each unit of risk (Return / SD)
A
15.00%
20.00%
0.75
B
10.00%
15.00%
0.67
C
12.00%
31.60%
0.38
D
13.00%
25.00%
0.52
Profit earning potential against each unit of risk for security A is higher than B, C and D.
Security
Return
Standard Deviation
Earnings ratio against each unit of risk (Return / SD)
A
15.00%
20.00%
0.75
B
10.00%
15.00%
0.67
C
12.00%
31.60%
0.38
D
13.00%
25.00%
0.52
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