Active and Passive Investing
52 Pages Posted: 15 Oct 2018 Last revised: 8 Jun 2020
Date Written: February 1, 2019
We model how investors allocate between asset managers, managers choose their portfolios of multiple securities, fees are set, and security prices are determined. The optimal passive portfolio is linked to the “expected market portfolio,” while the optimal active portfolio has elements of value and quality investing. We make precise Samuelson's Dictum by showing that macro inefficiency is greater than micro inefficiency under realistic conditions - in fact, all inefficiency arises from systematic factors when the number of assets is large. Further, we show how the costs of active and passive investing affect macro and micro efficiency, fees, and assets managed by active and passive managers. Our findings help explain empirical facts about the rise of delegated asset management, the composition of passive indices, and the resulting changes in financial markets.
Keywords: asset pricing, market efficiency, asset management, search, information
JEL Classification: D4, D53, D8, G02, G12, G14, G23, L1
Suggested Citation: Suggested Citation