Scale and Price Efficiency

Abstract

We describe a mechanism whereby rational learning and trading by investors induce a specific pattern of mispricing in the cross-section of stocks. In equilibrium, less capital-constrained investors allocate proportionately more learning resources to larger stocks and extract more profits, while price efficiency increases monotonically with stock size. Empirical investigation of institutional trading, mutual fund portfolios, and information acquisition activities supports these predictions. In the cross-section of stocks, size tends to explain mispricing better than any explicitly measured friction documented in prior literature, suggesting that most of the variation in mispricing can be attributed to scale-induced incentives.

Keywords: price efficiency, institutional trading, mutual funds

JEL Classification: G11, G14