36PERFORMANCE OF INSTITUTIONAL INVESTMENTSONE ISSUE FACING RETAIL INVESTORS WHO ARE LOOKING TO BUY AN INSTITUTIONAL INVESTMENT IS WHETHER TO INVEST IN AN ACTIVELY MANAGED FUND OR IN AN INDEX-TRACKER FUND. IF MARKETS WERE EFFICIENT ACTIVELY MANAGED FUNDS CANNOT BE EXPECTED TO CONSISTENTLY OUTPERFORM THE MARKET AND SO IT IS POINTLESS TO PAY THEIR MANAGEMENT FEES. IF MARKETS WERE EFFICIENT, INDIVIDUAL INVESTORS SHOULD INVEST IN LOW-COST INDEX-TRACKER FUNDS. HOWEVER THE EVIDENCE FROM BEHAVIOURAL FINANCE AND STUDIES OF MARKET ANOMALIES THROW DOUBT ON THE EFFICIENT MARKET HYPOTHESIS. IF MARKETS ARE NOT INFORMATIONALLY EFFICIENT, SHOULD INVESTORS CHOOSE TO INVEST IN ACTIVELY MANAGED FUNDS ON THE GROUNDS THAT IT IS POSSIBLE TO OUTPERFORM THE MARKET?MALKIEL (2003A) ARGUED THAT EVEN IF MARKET EFFICIENCY IS NOT ACCEPTED, RETAIL INVESTORS SHOULD STILL CHOOSE INDEX-TRACKER FUNDS. ONE POINT IS THAT INVESTMENT OUT-PERFORMANCE AND UNDERPERFORMANCE IS A ZERO-SUM GAME. IF SOME INVESTMENT MANAGERS OUT-PERFORM THE MARKET, OTHERS MUST UNDER-PERFORM THE MARKET. OBVIOUSLY, IN AGGREGATE, THE MARKET PERFORMS IN LINE WITH THE MARKET. INDEX-TRACKER FUNDS PERFORM IN LINE WITH THE MARKET. THE AGGREGATE MARKET MINUS INDEX-TRACKER FUNDS MUST THEREFORE PERFORM IN LINE WITH THE MARKET. ACTIVELY MANAGED FUNDS ARE THE AGGREGATE MARKET MINUS INDEX-TRACKERS. SO ACTIVELY MANAGED PORTFOLIOS, IN AGGREGATE, MUST PERFORM IN LINE WITH THE MARKET. IF SOME ACTIVELY MANAGED PORTFOLIOS OUTPERFORM OTHERS MUST UNDER-PERFORM. THIS SUGGESTS THAT, ON AVERAGE, ACTIVELY MANAGED FUNDS PERFORM IN LINE WITH THE MARKET BEFORE THEIR COSTS ARE CONSIDERED. WHEN COSTS ARE TAKEN INTO ACCOUNT ACTIVELY MANAGED FUNDS, ON AVERAGE, COULD BE EXPECTED TO UNDER-PERFORM THE MARKET. THE CONCLUSION SEEMS TO BE THAT INDIVIDUAL INVESTORS SHOULD INVEST IN INDEX-TRACKER FUNDS RATHER THAN WASTE MONEY ON MANAGEMENT FEES WHILST TAKING THE RISK THAT THEIR PARTICULAR MANAGERS ARE RELATIVELY POOR PERFORMERS. SOME FUNDS DO OUTPERFORM THE STOCK MARKET. IS SUCH OUT-PERFORMANCE DUE PURELY TO CHANCE, SINCE CHANCE WOULD GENERATE OUT-PERFORMERS AS WELL AS UNDER-PERFORMERS, OR IS INVESTMENT MANAGEMENT SKILL INVOLVED? IF SKILL WERE INVOLVED, IT WOULD BE EXPECTED THAT THERE IS PERSISTENCE IN RELATIVE PERFORMANCE; IN PARTICULAR MORE FUNDS WOULD SHOW CONTINUED OUT-PERFORMANCE THAN WOULD BE EXPECTED ON THE BASIS OF CHANCE. IF RELATIVE PERFORMANCE OF ACTIVELY MANAGED FUNDS ARISES FROM CHANCE RATHER THAN SKILL, THE IMPLICATION REMAINS THAT RETAIL INVESTORS SHOULD CHOOSE INDEX-TRACKER FUNDS. IF ANY PERSISTENCE IN OUT-PERFORMANCE WERE THE RESULT OF INVESTMENT MANAGEMENT SKILL, ONE MORE CONDITION SHOULD BE MET BEFORE INDIVIDUAL INVESTORS CHOOSE ACTIVELY MANAGED FUNDS; THERE SHOULD BE MEANS OF ASCERTAINING WHICH INVESTMENT MANAGERS DEMONSTRATE THE SKILL THAT LEADS TO PERSISTENT OUT-PERFORMANCE. FURTHERMORE THE TECHNIQUES FOR ASCERTAINING WHICH MANAGERS HAVE SKILL SHOULD BE EASY TO USE, AND SHOULD GIVE PRECISE RESULTS (IT IS OF LITTLE USE TO AN INDIVIDUAL INVESTOR IF THE TECHNIQUE MERELY CHANGES A 50:50 CHANCE OF CORRECTLY CHOOSING TO A 55:45 CHANCE OF CORRECTLY CHOOSING). THERE IS ALSO THE RISK THAT IF EVERYONE IDENTIFIES THE OUT-PERFORMERS, SO MUCH MONEY WOULD BE SWITCHED TO THE OUT-PERFORMERS THAT THEY ARE UNABLE TO CONTINUE THE OUT-PERFORMANCE. EMPIRICAL EVIDENCE ON PERFORMANCETHE EVIDENCE AIMS TO ANSWER THE QUESTIONS:1. DO FUNDS, ON AVERAGE, BEAT THE STOCK MARKET?2. DOES THE RELATIVE PERFORMANCE OF FUNDS PERSIST?3. IS PERSISTENCE PREDICTABLE?DO FUNDS, ON AVERAGE, BEAT THE STOCK MARKET?RETURNS ARE NOT THE ONLY DIMENSION OF PERFORMANCE. RISK MUST ALSO BE CONSIDERED. HIGH RETURNS WITH HIGH RISK ARE NOT NECESSARILY BETTER THAN LOW RETURNS WITH LOW RISK. ONE APPROACH IS TO COMPARE FUND RETURNS WITH A BENCHMARK RETURN, WHICH IS ADJUSTED FOR RISK.JENSENS ALPHATHIS DERIVES A BENCHMARK RATE OF RETURN USING THE SECURITIES MARKET LINE FROM THE CAPITAL ASSET PRICING MODEL. THE SECURITIES MARKET LINE PROVIDES A THEORETICAL RATE OF RETURN COMPRISING TWO COMPONENTS. THE FIRST COMPONENT IS A RISK-FREE RATE OF RETURN (E.G. THE INTEREST ON BANK DEPOSITS), THE SECOND COMPONENT IS A REWARD FOR ACCEPTING RISK. THE REWARD FOR ACCEPTING RISK IS THE PRODUCT OF THE PORTFOLIO BETA (THE BETA OF THE PORTFOLIO BEING EVALUATED) AND THE MARKET EXCESS RETURN. THE MARKET EXCESS RETURN IS THE DIFFERENCE BETWEEN THE RETURN ON A STOCK INDEX PORTFOLIO, AND THE RETURN ON RISK-FREE ASSETS. RB = RF + bP( RM - RF ) RB IS THE EXPECTED RATE OF RETURN ON THE ASSESSED PORTFOLIO, RM IS THE RETURN ON THE STOCK INDEX PORTFOLIO, RF IS THE RISK-FREE RATE OF RETURN, AND bP IS THE BETA OF THE PORTFOLIO BEING ASSESSED. BY USING THE BETA OF THE PORTFOLIO UNDER ASSESSMENT, COMPARISON OF THE OBSERVED AND EX