Question

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

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

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’ 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.

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.