The Sound of Many Funds Rebalancing
36 Pages Posted: 16 Apr 2016 Last revised: 11 Nov 2017
Date Written: November 10, 2017
This paper proposes that long rebalancing cascades (stock A’s price jumps, which causes a fund to buy stock A and sell stock B, which causes a second fund to sell stock B and buy stock C, which causes...) generate noise in financial markets. First, we use a random-networks model to show that, when funds follow many different threshold-based trading strategies, a change in stock A’s fundamentals can trigger a long rebalancing cascade that eventually affects the demand for unrelated stocks, like stock Z. Then, we prove that in a large market it’s computationally infeasible to predict whether a long rebalancing cascade will result in buy or sell orders for stock Z. The best you can do is compute stock Z’s susceptibility to these erratic non-fundamental demand shocks. By analogy, although the population of France is not a random number, whether this number is even or odd may as well be (Keynes, 1921). Finally, we use data on exchange-traded funds (ETFs) to give empirical evidence for our noise-generating mechanism. We find that, in the days immediately after a stock is announced as an M&A target, unrelated stocks on the other side of the market realize larger increases in trading volume when they are more susceptible to long rebalancing cascades. And, this additional trading volume is associated with higher levels of liquidity and more informed trading, suggesting that market participants view these long rebalancing cascades as noise.
Keywords: Noise, Exchange-Traded Funds, Index-Linked Investing, Trading Volume
JEL Classification: G02, G12, G14
Suggested Citation: Suggested Citation