Presidential Address: Investment Noise and Trends

Abstract

During the past few decades, the fraction of the equity market owned directly by individuals declined significantly. The same period witnessed investment trends that include the growth of indexing as well as shifts by active managers toward lower fees and more index‐like investing. I develop an equilibrium model linking these investment trends to the decline in individual ownership, interpreting the latter as a reduction in noise trading. Active management corrects most noise trader–induced mispricing, and the fraction left uncorrected shrinks as noise traders' stake in the market declines. Less mispricing then dictates a smaller footprint for active management.

Scale and skill in active management

“…We argue that a larger industry features more competition among active funds, which impedes the funds' performance. In addition, the rise of delegated asset management could have diminished active managers' profit opportunities by reducing individual equity ownership, a potential source of noise trading (Stambaugh, 2014). Third, does evidence exist of industrylevel decreasing returns to scale in international data?…”

“…If we assume that individuals make worse trading decisions than professionals, the share of equity owned by individuals can be viewed as a proxy for the amount of mispricing in equity markets. An increase in the size of professional management coincides with a decrease in the individuals' share of equity, which reduces the pool of mispricing that can be exploited by active managers (Stambaugh, 2014). This mechanism can thus in principle induce a negative relation between fund performance and the size of aggregate professional management.…”

Do Funds Make More When They Trade More?

“…French (2008) characterizes his estimated cost of active management as a societal cost of price discovery. Stambaugh's (2014) calibration of a general equilibrium model implies that active management corrects a large portion of the mispricing that would otherwise exist in the presence of noise traders. Our results support this view of active management's societal value, given our evidence that funds have skill and that they more actively apply that skill when mispricing is more likely.…”

“…6 One might imagine funds trading with many intermediaries that access different sources of liquidity or act at slightly different times. A similar approach is taken by Stambaugh (2014) in a general equilibrium model of active management and price formation.…”

When fund management skill is more valuable?

“…Conducting a lucky bias analysis, as in Barras, Scaillet, and Wermers (), which allows us to examine what percentage of significant fund performance (alpha) is due to management skill and not to luck alone, we find that the percentage of skilled fund managers decreases considerably after controlling for lucky bias, while the portion of skilled fund managers who deliver significant alphas is much higher in high than low sentiment periods. This finding demonstrates the scarcity of skilled fund management and the increasing share of index funds over recent times (Stambaugh, ).…”