There has been a steady growth of index funds since the 1970s. Whether index mutual funds or the more recent exchange traded funds (ETFs), these investment vehicles allow individual and institutional investors alike to track a broadly defined index with minimum management fees. Prior to that, practically all investors engaged in active portfolio management, whether directly or through an intermediary, hoping to select securities that would deliver better than average returns. Such investing involves acquisition of information and its analysis, which in the aggregate delivers price discovery to the market. In contrast, indexing is an informationless strategy involving little more than mechanical buying and selling of securities proportional to their weight in the index. It passively relies on the ability of the rest of the market to determine prices correctly.
The ratio of active and passive trading in the market is of great social importance. If too small, the quality of price discovery may suffer. If too large, resources may be burnt unnecessarily. This paper explores individual incentives towards active trading in an applied theoretical setting and discusses the recent fall in the above ratio as well as its likely future trend.
Fama (1970) defines an efficient market as one in which prices always fully reflect available information. When any investor comes to the market to trade on relevant information, others have almost surely traded on that already and so it is impossible to consistently achieve abnormal profits. The Efficient Market Hypothesis (EMH), however, is little more than a conjecture about the outcome of the complex price formation mechanism in financial markets and its proper empirical testing is difficult. A closer examination of the market structure suggests that in theory, markets might easily not be efficient. Grossman and Stiglitz (1980),for instance, argue that markets cannot be informationally efficient all the time since there would be no incentives for costly private acquisition of information if it were immediately and fully reflected in prices.
Apart from a great number of individual investors pursuing various active investment strategies directly, there is a sizable active asset management industry which specializes in promising individual and institutional clients superior investment opportunities relative to relevant benchmark indices. In the US, for instance, the number of stock/hybrid mutual funds, most of them actively managed, is similar to the number of all publicly traded stocks. Compared to passive index tracking, active strategies are associated with less risk diversification, larger transaction costs and capital gains taxes due to higher portfolio turnover and, most importantly, with relatively high fees for delegated portfolio management.
Download
Passive Investors, Active Traders and Strategic Delegation of Price Discovery
