Passive versus active applications of industry exchange traded funds (etfs) : an empirical investigation on the S&P Global 1200 Index

Abstract

The notion of market efficiency posits that stock prices fully reflect all available information in a timely manner. The efficient market hypothesis (EMH) proposed by Fama (1970) systematically rules out the profitability of information driven investing, and implicitly promulgates a passive market capitalisation weighted investment strategy such as indexing. The appeal of passive strategies has largely been driven by the growth of passive tracking instruments, which allow investors to earn underlying index performance by purchasing a single security such as an exchange traded fund (ETF). On the contrary, proponents of behavioural finance suggest that investors are irrational and subject to psychological biases. Furthermore, the noisy market hypothesis of Siegel (2006) asserts that the deviations from the economic ideal of rationality proposed by the EMH, introduces noise in the market which could lead prices to deviate from their intrinsic values. The resultant drag in performance of market capitalisation weighted indices suggests that the optimal cap-weighted market portfolio promulgated by the modern portfolio theory (MPT) of Markowitz (1952), ceases to be the most mean-variance approach to asset allocation. With the goal of testing the applications of ETF’s, this study first evaluates the performance of passive sector ETF’s in the global equity market. In addition, motivated by the potential inefficiencies of capweighted portfolios, the study tests optimisation based asset allocation techniques, and technical analysis based market timing strategies.