Complementarity of Passive and Active Investment on Stock Price Efficiency

I investigate the collective impact of passive and active investment on stock price efficiency using a quasi-natural experiment. I document an improvement in efficiency due to an exogenous increase in passive investment, specifically in stocks widely held by actively managed funds. These active funds are compensated with higher realized returns after an exogenous increase in passive investment. I use the reconstitution of Russell indexes as an instrument. My findings suggest that active funds seek out inefficient stocks and ultimately experience superior returns due to the improvement in efficiency from passive investment. An increase in analyst following and a decrease in analyst forecast dispersion are identified as economic channels of the efficiency improvement. Overall, my results highlight the complementary role of passive and active investment on price discovery due to symbiotic nature of their existence. ∗I am deeply indebted to my advisor Suzanne S. Lee for her invaluable guidance and support. I am also very grateful to Sudheer Chava, Alex Hsu, and Soohun Kim for their constant support and encouragement. I would like to thank Narasimhan Jegadeesh, Jeffrey Busse, Clifton Green, Rohan Ganduri, Peter Simasek, Nikhil Paradkar, and the seminar participants at Georgia Tech for their helpful comments and suggestions. I am responsible for any errors. Youngmin Choi is a doctoral student at the Scheller College of Business, Georgia Institute of Technology, 800 West Peachtree St NW, Atlanta, GA 30308; email: [email protected].