The Sound of Many Funds Rebalancing

57 Pages Posted: 7 Mar 2019 Last revised: 11 Mar 2019

See all articles by Alexander Chinco

Alexander Chinco

University of Illinois at Urbana-Champaign - College of Business

Vyacheslav Fos

Boston College - Department of Finance; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2019

Abstract

This paper proposes that computational complexity generates noise. In modern financial markets, it is common to find the same asset held for completely different reasons by funds following a wide variety of threshold-based trading rules. Under these conditions, we show that it can be computationally infeasible to predict how these various trading rules will interact with one another. Formally, we prove that it is NP hard to predict the sign of the net demand coming from a large interacting mass of funds at a rate better than chance. Thus, market participants will treat these demand shocks as random noise even if they are fully rational. This noise-generating mechanism can produce noise in a wide range of markets and also predicts how noise will vary across assets. We verify this prediction empirically using data on the exchange-traded fund (ETF) market.

Keywords: Complexity, Indexing, noise, thresholds

JEL Classification: G14

Suggested Citation

Chinco, Alexander and Fos, Vyacheslav, The Sound of Many Funds Rebalancing (March 2019). CEPR Discussion Paper No. DP13561. Available at SSRN: https://ssrn.com/abstract=3346352

Alexander Chinco (Contact Author)

University of Illinois at Urbana-Champaign - College of Business ( email )

Champaign, IL 61820
United States

Vyacheslav Fos

Boston College - Department of Finance ( email )

Carroll School of Management
140 Commonwealth Avenue
Chestnut Hill, MA 02467-3808
United States

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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