How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing

60 Pages Posted: 7 Apr 2021

See all articles by Valentin Haddad

Valentin Haddad

University of California, Los Angeles (UCLA) - Anderson School of Management; National Bureau of Economic Research (NBER)

Paul Huebner

University of California, Los Angeles (UCLA) - Anderson School of Management

Erik Loualiche

University of Minnesota, Finance

Date Written: April 7, 2021

Abstract

We develop a framework to theoretically and empirically analyze investor competition on financial markets. The classic view assumes that markets are very competitive: if a group of investors changes its behavior, other investors react such that nothing happens in equilibrium. Our framework quantifies the strength of the competitive response. We estimate a demand system of institutional investors in the US stock market accounting for two layers of equilibrium: how investors compete with each other in setting their strategies and how prices adjust to clear asset markets. We find that investors react to the behavior of others in the market: when an investor is surrounded by less aggressive traders she trades more aggressively. This reaction reduces the equilibrium consequences of changes in individual behavior by 50%. However, it also implies that the stock market is far from the competitive ideal. A consequence of this result is that the large increase in passive investing over the last 20 years has led to substantially more inelastic aggregate demand curves for individual stocks, by 15%.

Keywords: Asset pricing model, Demand system, Institutional investors, Liquidity, Information, Portfolio choice

JEL Classification: G12, G23

Suggested Citation

Haddad, Valentin and Huebner, Paul and Loualiche, Erik, How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing (April 7, 2021). Available at SSRN: https://ssrn.com/abstract=3821263 or http://dx.doi.org/10.2139/ssrn.3821263

Valentin Haddad

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Paul Huebner

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

Los Angeles, CA
United States

Erik Loualiche (Contact Author)

University of Minnesota, Finance ( email )

110 Wulling Hall, 86 Pleasant St, S.E.
308 Harvard Street SE
Minneapolis, MN 55455
United States
612 625 5679 (Phone)

HOME PAGE: http://https://loualiche.gitlab.io/www/

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