Active management is the art of stock selecting and market timing. Passive management refers to a buy-and-hold approach to portfolio management. With respect to market behavior there are, at the extremes, two views. At one extreme is the efficient market hypothesis which insists that the prices are always fair and quickly reflective of information. According to this view, prices react to information slowly enough to allow some investors, presumably professionals, to systematically outperform markets and most other investors.
At the other extreme is the market failure hypothesis. A rather impressive group of investors worldwide believes it is difficult to beat markets and perhaps better not to try. Aside from these considerations of theory and evidence, there is a very practical advantage to passive management. For most asset classes there are long-time series of historical data that allow us to form reliable estimates of the risk of a given class and how closely the behavior of that class correlates with the behavior of other classes.
Active management refers to a portfolio management strategy wherein the manager makes specific investments with the goal of outperforming an investment benchmark index. Ideally, the active manager exploits market inefficiencies by purchasing securities that are undervalued. Depending on the goals of the specific investment portfolio, active management may also serve to create less volatility than the benchmark index. The reduction of risk may be instead of the goal of creating an investment return greater than the benchmark. The effectiveness of an actively-managed investment portfolio obviously depends on the skill of the
management. The most obvious disadvantage of active management is that the fund manager may make bad investment choices or follow an unsound theory in managing the portfolio. Malkiel (1999) advocated that there are rare to find exceptional financial managements.
Actively managed mutual funds must strive to overcome this cost disadvantage by assiduously searching for and identifying investment opportunities that have the potential to generate above-average earnings and price appreciation. This highly competitive and daunting task is sufficiently demanding that the majority of equity funds have been unable to provide long-term performance superiority in comparison with the broad market. Moreover, those funds that dominate market averages in a specific time frame are typically unable to sustain outsized performance momentum in subsequent years. We can always hear the familiar announcement in a mutual fund prospectus that "Past performance is no guarantee of future results."
On the other hand, passive management is a financial strategy to mimic the performance of an externally specified index. The concept of passive management is counterintuitive to many investors. It is widely interpreted as suggesting that it is impossible to systematically "beat the market" through active management, although this is not a correct interpretation of the hypothesis in weak form efficient market. In recent years, Exchange traded fund (ETF) has become a popular investment. It is an investment vehicle traded on stock exchanges and tracking the performance of specific indexes in the Stock Exchange. ETF replicates index stocks and it is a kind of passive management style. Therefore, it has the advantage of having the similar return as the indexes. ETF may be attractive because of their low costs, tax efficiency, and
investment trust. Contrarily, Bogle and Malkiel (2006) has argued that ETF represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification. Even though they concede that a broadly diversified ETF that is held over time can be a good investment.
To conquer the disadvantages of active style and passive style management, we try to combine active operation into passive portfolio and figure out competitive performance and downsized managed to the bench market. Standard technical apparatus in these treatments has been Markowitz’s (1952, 1959) Mean-Variance (MV) framework. The MV model requires the asset returns to be normally distributed or the decision-maker’s utility function to be of quadratic form (Hanoch and Levy, 1969). For this reason, the reliability of performance comparisons using MV criterion depends on the degree of non-normality of the returns and the non-quadratic utility function (Fung and Hsieh, 1999). In many circumstances these assumptions appear questionable (see Markowitz, 1952, 1959; Sharpe, 1964). Hence the research question to be investigated is whether stochastic dominance analysis is capable of presciently divining those mutual funds that are more prone to reward investors with extraordinary returns. When the assumptions of MV do not hold, the Stochastic Dominance (SD) efficiency criteria offer the most immediate extension (Bawa, 1982; Levy, 1992). SD accounts for the entire probability distribution (not just the first two moments) and applies for the general classes of non-satiated and/or risk-aversive preference functions.
The theory of stochastic dominance (SD) is consistent with expected investor utility maximization and involves no restriction on the class of investor utility functions. SD derives weak conditions for separation based on general probability
trade-off, stochastic dominance is a general and powerful approach.For the argument between active and passive portfolio management, the purpose of our empirical exploration presented herein is to conduct an investigation of the efficacy of stochastic dominance theory in deducing an efficient subset of exchanges trade fund from a prohibitively large and unwieldy population. It is not my intention to see which portfolio performance is overwhelm outperforms one another. The aim of this study is to provide superior filter in both bull and bear markets as opposed to buy-and-hold strategy as traditional ETFs persist.
The empirical exploration of the paper is to examine an intriguing and perplexing issue that continues to be debated in the investment analysis literature. Specifically, a familiar and prevalent tenet of contemporary portfolio theory is that the portfolios produced by mutual funds are only constructed from Mean-Variance trade off consideration. This highly competitive and daunting task is sufficiently demanding that the majority of equity funds have been unable to provide long-term performance superiority in comparison with the broad market. Moreover, those funds that dominate market averages in a specific time frame are typically unable to sustain outsized performance momentum in subsequent years. We also need to know if the CPT-TSD portfolio will sacrifice performance when we consider investors' S shape valuation function and probability weighting function.
This observation does not preclude the prospect of discovering extraordinary performance by a sparse subset of portfolios. Hence the research question to be investigated is whether CPT-TSD is capable of presciently divining the broad market that is more prone to reward investors with competitive returns. This paper enables
beyond the narrow micro-level study. This was one of the important topics that De Bondt , Shefrin and Staikouras(2008) suggested for future research. Besides, the paper examines the fitness of portfolio selection strategy and allocation tactics. Institutional investors or fund managers can adopt the recommended strategy-tactics on portfolio management.
The rest of the paper unfolds as follows. The next section introduces the basic utility assumption linked to stochastic dominance notions. We then describe different class stochastic dominance method in Section 3. In Section 4, the characteristics of Stochastic in Cumulative Prospect Theory will be discussed. In Section 5, we discuss the sample data set and methodology. Section 6 is the empirical results and detail portfolio analysis. Following that is the concluding section, we puts forth some interesting routes for theoretical and practical improvement and future research extension as well.