The Big Picture, Part 2 | The Literature on Active Management and Market Efficiency

May 16, 2019

Efficient markets are one of the cornerstones of developed economies – and active management is the driver of market efficiency. Active managers research issuers, analyze assets and establish market prices for securities through their buying and selling.

Which raises an important question: What happens to market efficiency if investors shift from active to passive management?

A new white paper from the Active Manager’s Council, titled “Active Management and Market Efficiency: A Summary of the Academic Literature,” takes a close look at the academic literature addressing this question. It builds on the theoretical framework outlined by Professor Russ Wermers in his recent paper, “Active Investing and the Efficiency of Security Markets.”

The Council’s white paper summarizes the conclusions of over 50 academic studies examining six topic areas, specifically:

• How changes in index composition affect the pricing of securities
• The impact on pricing efficiency of the shift to passive investing
• The connection between return comovement (or correlation) and passive index investing
• Whether trading in ETFs and other index products transmits volatility to the underlying securities and the markets in general
• The impact of the introduction of leveraged and inverse ETFs
• The relationship between the level of index investing and the liquidity of the securities in the index

Taken together, these studies suggest that the growth in passive investing and decrease in active investing has had a negative effect on market efficiency. In sum, “pricing efficiency has declined, return comovement has increased, securities prices are more volatile, and liquidity has decreased and exhibits greater comovement.”

“Pricing efficiency has declined, return comovement has increased, securities prices are more volatile, and liquidity has decreased and exhibits greater comovement.”

The white paper also includes an overview of the characteristics of market efficiency, the benefits of increased market efficiency, the role of active management plays generating market efficiency, and the theoretical impact on market efficiency of increasing use of passive management. It provides a concise introduction to a critical topic for policymakers and other industry observers interested in the health of the markets.

The Investment Adviser Association formed the Active Managers Council to foster education and thought leadership regarding active management, curate and sponsor research on active and passive management, and engage on relevant public policy issues.