Active vs Passive Investing: An Empirical Study on the US Equity ETFs

Abstract

Modern Portfolio Theory (MPT), the fundamental investment theory is built on the assumption of the efficient market hypothesis, which is widely accepted by academic financial economists. It is believed that securities markets are extremely efficient, and any information that hits the market will be reflected in the securities’ prices so beating the market is a daydream. If that’s true, passive investment, for example investing in an index tracking fund would be the best bet for an investor. But on the other hand, ever since the securities markets emerged, investors never stopped trying to find ways to beat the markets, commonly called seeking alphas (excess returns over markets). The always coexistence of both passive funds and active funds makes the conclusion unclear. The objective of this research is to distinctly underscore when it comes to investments, whether to choose passive or active investment structures via an empirical study on active US Equity ETFs (exchange-traded funds). The daily excess returns of 33 active US equity active ETFs over 3 years have been analyzed via a single-factor linear regression model suggested by Capital Asset Pricing Model (CAPM) against the daily excess return of a popular index tracking ETF: SPY with the hypothesis that active ETFs generate alphas. The model has a great fit with over 90% R-square on average for all ETFs under study but rejects the hypothesis in 95%confidence level. In other words, active investments can’t beat the market.  This result may shed light on investment selection for the broad ordinary investors.