The general idea of efficiency in financial markets is that information is being processed almost instantaneously because active investors arbitrage away any arising price discrepancies.

On the other hand, more and more money is being allocated to passive investment vehicles (mainly ETFs) because of the empirical fact that active managers are not worth their fees and/or you cannot discern upfront those who will be worth their fees.

This obviously constitutes a paradox because if fewer and fewer active investors arbitrage away price discrepancies the case for passive investing begins to crumble...

I did a little googling and found lots of "opinions" on this, so the idea of this paradox as such is not new. What I did not find are any serious academic papers on the issue or some kind of consensus.

My question
To the best of your knowledge, is there some consensus on this matter and/or could you point me to good academic papers which thoroughly investigate this paradox (theoretically, by simulation or empirically)?

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    $\begingroup$ I cannot provide you with an academic paper (although I found some that are close). I think its referenced as the "active passive cycle". Maybe this helps with your research. (In my personal opinion, it depends on whether the investor thinks that there are active possibilities in the market. Then, he is willing to bear the risk of selecting a manager to harvest that premium. That means, at the moment, the opportunities are seen a rather scarce. With consolidation of the ETF market - especially in Europe - and new regulations - Mifid II - this could change for example) $\endgroup$ – vanguard2k Jul 6 '17 at 11:31
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    $\begingroup$ Another opinion: I'm not sure this is actually a paradox. I think the market is becoming more efficient even as the percent of passive money increases. That's because active management no longer consists of industry experts poring over financial statements, it consists instead of big data crunching by a new set of active players, resulting in new information being very quickly incorporated into market prices, and leaving old style active managers out in the cold. Due to the fact that computers can handle vast amounts of information for little cost, this results in a brutally efficient mkt. $\endgroup$ – dm63 Jul 6 '17 at 13:50
  • $\begingroup$ @dm63: Well, it would still be a paradox but your hypothesis is that passive investing isn't increasing overall (because active investing became much simpler)... interesting. $\endgroup$ – vonjd Jul 6 '17 at 13:55
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    $\begingroup$ On the theory side, Pastor Stambaugh (2012) is on point. $\endgroup$ – Matthew Gunn Jul 6 '17 at 19:19
  • $\begingroup$ @dm63 I think this is only the case if those who truly understand the market are able to articulate their understanding into algorithms. And i do not think this has quite happened yet - I think it will happen, of course, just that it has not quite happened yet. And then once it happens, I am skeptical that any algorithm can reliably deal with a regime change (ie once everything becomes controlled by computers...). $\endgroup$ – will Jul 7 '17 at 23:54

On more than a few occasions, I have attempted to extrapolate the current trend towards passive allocation to its logical conclusion: more passive allocation means more inefficiency.

I am not aware of any research which directly measures the correlation between market efficiency and active versus passive allocation. In general, the level of market efficiency should be hard to measure (see related topic: What are the empirical limitations to testing market efficiency?). However, I believe that the converse is indirectly measurable: pricing "anomalies" and/or risk-premia tend to dissipate following their discovery and/or the publication of a more efficient (i.e, "better") model.

If one concludes that the dispersion of knowledge regarding pricing inefficiencies has lead the market to become more efficient as market participants act on this knowledge, then one may tentatively accept the converse: the flight of capital away from active management may lead to greater inefficiency.

Examples of "alpha" diffusion and then decay abound. Notably:

  • Fama-French factors have decreased in efficacy over time. In the 2004 paper, "On the Cross-Section of Expected Stock Returns: Fama-French Ten Years Later", the authors found that "using the Fama-Mac Beth two-pass regression, that the size effect becomes insignificant during the post-1981 period, and the Book/Market effect becomes insignificant during the post-1990 period."
  • Following several papers on the momentum anomaly, notably with Carhart's 1994 paper, momentum's ability to predict future returns has notably diminished.
  • On a recent Master's in Business podcast with Barry Ritholz, guest Ed Thorp discusses the efficacy of the Black-Scholes model following its publication in 1973. Thorp had been using equations similar to the Black-Scholes for approximately five years before the paper was published. He noted in the interview that traders were slow to latch on to more rigorous pricing mechanisms, but eventually did so.

This concept of active versus management and inefficiency might be exemplified through a thought experiment in which all market participants woke up tomorrow fully believing in the absolute truth of EMH. These converts would then be motivated by the belief that active management is futile; allocation decisions would be purely driven by the mechanistics of MPT and mean-variance optimization. Throw out risk-premia, fundamental analysis, technical analysis, everything -- the market prices already reflect all expectations of future risk and reward. Given that it is impossible for the average money manager who charges fees to out-perform the "average", the shift towards passive management is justifiable. Yet, some price discovery through active allocation is necessary for the EMH to work.

The problems of herd behavior in the context of MPT are more eloquently outlined in the 2014 paper, "Modern portfolio theory and risk management: assumptions and unintended consequences", in which the authors define some problems underlying the assumption of MPT, namely: "information asymmetry and bounded rationality; the joint hypothesis problem and random walk hypotheses."

The question then may become, "how much active capital is required to provide an efficient price discovery mechanism?". To my knowledge, this remains an open question but I believe that the threshold whereby flight from active management leads to inefficiency may still be a ways off. Currently, I believe about half of the equity money managers are active versus passive. However, much of the assets under active management are actually passively managed (vis-a-vis, "closet indexing") as measured by a fund's "active share". While this seems like a lot of passive money, the dismal performance of hedge funds over the past decade is evidence that active management is still saturated. Moreover, the rise of algorithmic finance through vast computational power, data analytics, and instantaneous communication has probably left less room for active management to exploit anomalies and inefficiencies.

  • $\begingroup$ Very thorough answer! Thank you very much! $\endgroup$ – vonjd Jul 21 '17 at 9:02
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    $\begingroup$ @vonjd. Thank you for such a thoughtful question! $\endgroup$ – David Addison Jul 21 '17 at 19:37

First, you might find this recent paper by Israeli, Lee and Sridharan (Review of Accounting Studies, forthcoming) interesting. This is the abstract:

We examine whether an increase in ETF ownership is accompanied by a decline in pricing efficiency for the underlying component securities. Our tests show an increase in ETF ownership is associated with: (1) higher trading costs (bid-ask spreads and market liquidity); (2) an increase in “stock return synchronicity”; (3) a decline in “future earnings response coefficients”; and (4) a decline in the number of analysts covering the firm. Collectively, our findings support the view that increased ETF ownership can lead to higher trading costs and lower benefits from information acquisition. This combination results in less informative security prices for the underlying firms.

Second, Seth Klarman from Baupost published some interesting thoughts on this matter in his 2016 letter to investors (not public, but copies surface here and there):

One of the perverse effects of increased indexing and ETF activity is that it will tend to ‘lock in’ today's relative valuations between securities. When money flows into an index fund or index-related ETF, the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership). Thus today's high-multiple companies are likely to also be tomorrow's, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings. Conversely with money pouring into market indices, stocks outside the indices may be cast adrift, no longer attached to the valuation grid but increasingly off of it. This should give long-term value investors a distinct advantage. The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.

Third, I agree that there seems to be a contradiction: The "iron law of costs" (no correlation between gross fund performance and fees, hence a negative correlation between net fund performance and fees) means that investors will be worse off if they try to beat the market. Nevertheless, investors trying to beat the market actually contribute to valuable public goods, such as scrutiny of listed companies and the efficiency of capital allocation in the market.

I would argue that passive investing and index investing are not exactly the same thing and that this difference is crucial to understand this contradiction. In order to save costs, investors should abstain from trying to beat the market; the advantage of passive investing is that costs are lower. However, can the cost-saving goal of passive investing only be achieved by EXACTLY replicating an index (i.e., index investing) or could investors just as well simply build their own low-maintenance portfolio of 50-100 big companies? My point is thus that the goals of passive investing could largely be achieved without giving way to the disadvantages of index investing (in short, less efficient capital markets). In this spirit, the third resource that you might find interesting is The Kay Review of UK Equity Markets and Long-Term Decision Making, a report published in 2012 on behalf of the UK government. On this specific topic, Kay writes:

The objectives of ‘passive investment’ strategies may not be best achieved (other than tautologically) by replicating a benchmark index based on all stocks in a particular category, if that category is not defined by any criteria of relevance to the underlying beneficiaries. An indexed portfolio holds a wide range of stocks – the widest possible in any asset class – but holding a wide range of stocks is not the same as holding a diversified portfolio. An index fund is concentrated in a few sectors – in the UK index financials were once heavily represented, now oil and mining are [remember, this was written in 2012]. Telecommunications and pharmaceuticals are over-represented relative to their contribution to economic activity, because these activities are mostly conducted by large companies. House-building is mostly conducted by small businesses; automobile construction is not included in the UK index because it is mostly conducted by foreign companies. ‘Fundamental indices’ whose weights are related to the economic significance of companies or markets rather than based on market capitalisation are an attempt to devise passive strategies which avoid these defects, and also to escape the losses from long-run mean reversion which arise from the adoption of market weightings in index funds or benchmarks. Index funds are necessarily overweight in overpriced sectors and underweight in underpriced sectors and this is true even if one has no knowledge of which sectors are over or underpriced.

Should passive strategies be based on indices at all? Interest in passive strategies developed in the 1970s as a result of scepticism about the ability of asset managers to pick stocks successfully and concern about the level of fees and costs of turnover associated with many active management strategies. One large endowment described to us the development of a portfolio of large, global companies with the intention of building stakes in these companies and holding them indefinitely. Such a strategy may have lower trading costs than even a conventionally passively managed fund. We note that several asset managers are now developing similar investment strategies.

(Of course, one of the reasons why passive investing is often conflated with index investing is that investors are increasingly unwilling to tolerate even short bouts of underperformance versus the index. See p. 40-42 of the Kay Review for more details on these cultural / psychological / institutional mechanisms.)


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