Passive Investing and Price Efficiency

Mina Lee (University of Washington - Saint Louis)

June 14, 2021, 15:00–16:00


Room Zoom

Finance Seminar


This paper studies how falling fees for delegated investments affect price efficiency in a theoretical framework, in which the investors' allocations, management fees, and asset prices are all determined in a general equilibrium. Importantly, investors optimally decide whether to participate in the financial market or simply hold the safe asset, and active managers trade strategically, adjusting the traded quantities according to market liquidity. Perhaps surprisingly, and in contrast to the broad theoretical literature, prices of the index fund become more efficient as passive fees decrease and more investors choose the uninformed index fund. Prices can become more efficient even when the inflow to passive funds comes at the expense of the outflow from active funds, as has been the case more recently since 2007. Combined with the observed downward trend in fees, the finding is consistent with recent empirical evidence that prices, especially those of S&P 500, have become more informative over time.