Active vs. Passive Investing and the Efficiency of Individual Stock Prices

In equilibrium, active investing must be compensated with returns from gathering costly information about stock values (e.g., Grossman and Stiglitz, 1980). In return, active investors serve to promote price discovery in stocks. However, substantial trading is required by active, informed investors, who may prefer to trade in the same stocks as passive, uninformed investors to hide their intentions and better profit from their private information (e.g., Admati and Pfleiderer, 1988). Thus, both active and passive investors must coexist in the market for a stock to allow the efficient transfer of information into the stock price. This paper analyzes the relation between active and passive mutual fund ownership and trading activity in U.S. stocks during 1993 to 2006, and the resulting efficiency of stock prices. Our study finds that active funds are drawn to the same stocks as passive funds, and that active funds increase the price efficiency of stocks through their trades. We also find that stocks with “excessive” levels of passive fund ownership and trading exhibit more long-term pricing anomalies as well as a larger price reversal following trades.