Correlated Noise: Why Passive Investment Might Improve Market Efficiency

Abstract

Over the last decades passive investment products have continuously increased in importance. The efficiency of financial markets is often identified as the main reason for this development. We propose a theoretical framework which reverses the causality by showing that market efficiency might improve as a consequence of passive investments. We analyze a market in which agents process noisy signals and trade a single asset, and we derive closed-form expressions for their expected payoffs. Depending on the objective of the market maker, we investigate efficient and inefficient markets. For the case where the market maker is interested in a level playing field, we provide a unique pricing expression leading to a fully informationally efficient market. By contrast, profit-maximizing market makers induce inefficiencies. In the latter case, traders with highly correlated noise improve their expected payoffs by reducing the information processing activity, and by doing so they increase market efficiency.

Keywords: Forecast precision; Efficient markets, Inefficient markets, Passive investment

JEL Classification: M4, G14