Passive investing is on the rise. A recent report by Moody's forecasts that such funds will exceed actively managed ones in the US in the 2020s. You might think this means stock markets will become more inefficient, because passive investors buy stocks according to their market capitalisation rather than because they've researched their genuine merits.
In fact, though, this is not necessarily the case.
To see why, we should look at betting on matches played at the Queens Club tennis tournament which takes place every June. In even-numbered years, the tournament clashes with a major football competition: the World Cup or European Championships. In these years, betting markets on the tennis are thinner because casual gamblers prefer to bet on the football.
This raises the question: when is the tennis betting market more efficient: in the odd-numbered years when less-informed gamblers are active in it or in even years when they are not and the expert tennis gamblers have more weight?
Alasdair Brown and Fuyu Yang at the University of East Anglia have studied this and found that the market is significantly more efficient in the even years when the less informed gamblers are more active.
Mug punters make the market more efficient. This raises the possibility that increased numbers of passive investors might help make stock markets more efficient, not less.
If this seems paradoxical, it shouldn't. It's a corollary of a point made back in 1980 by Sanford Grossman and Joe Stiglitz. If markets are to be efficient, somebody must go to the bother of researching stocks. But they need an incentive to do so. Uninformed investors provide such an incentive: investors do their research in the hope of making money at the expense of uninformed investors.
In tennis betting, the uninformed investor is the casual gambler who's distracted by football. In stock markets, it's passive funds. The presence of both provides others with an incentive to do proper research.
Such incentives, however, are self-defeating. Once the market becomes efficient, the incentive to do research will decline, so researchers will exit the market creating inefficiencies.
It might be that we get a stableish equilibrium here. Lasse Heje Pedersen at New York University says markets are "efficiently inefficient": they are just inefficient enough to reward those who do their research and take risks. Alternatively, markets might be cyclical, as MIT's Andrew Lo has argued: stock-picking strategies wax and wane as markets become efficient and then inefficient again.
For me, the point here is that bigthink ideology is useless. The question - are markets efficient? - cannot be answered generally. Instead, the answer - and the specific type of inefficiency - will vary from time to time and place to place.
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Chris blogs at http://stumblingandmumbling.typepad.com