Wednesday, February 15, 2006

Index funds & stock picking

Stephen Reynolds, over at John Quiggin's blog, steered me towards an interesting paper by Utpal Bhattacharya & Neal Galpin, 'Is Stock Picking Declining Around the World?'. This paper has made a splash - it is an "Economics focus' in the January 28, 2006 issue of The Economist. I started off a thread at John Quiggin's place by asking what happens in a speculative market when every one assumes the market is efficient and all investment is Index Fund Investment? It turns out that this is a well-understood issue. My question arose from my ignorance of important literature.

Sanford Grossman & Joseph Stiglitz answered it in 1980 (here). Their argument: if everyone believes markets are efficient they won't be. If no one picks stocks, information cannot be built into prices and so there arises the opportunity to gather information, pick stocks and make trading profits. This creates the question Bhattacharya and Galpin (BG) ask: How many stock pickers will there be in equilibrium? What is the steady state equilibrium fraction of stock pickers?

The BG argument develops a way of measuring the extent of stock picking in a market. They then use this metric to measure stock picking around the world. They find:

  • There is more stock-picking in emerging than in developed country markets. In 2004 it was lowest in the US at 29% and highest in China at 80%. Stock picking is highest in countries with low public disclsure of stock-specific information.
  • Stock picking is declining everywhere. For example, in the US it has declined from a high of 60% in the 1960s to a low of 24% in the 2000s.

This suggests modern diversification theories of investment (based on Markowitz-Tobin ideas) have won. But 'News of the death of stock picking will be an exaggeration' for Grossman-Stiglitz reasons. If no one picks stocks, opportunities to gather information arise that will yield trading profits. Passive investors 'free ride' on the efforts of others and never bother to 'kick tires' creating incentives for others to do so.

Using a simple theoretical model BG estimate that stock picking will eventually converge to 11% of all trades in the US economy. This is surprisingly low. In this equilibrium, 89% of all trades will be passively based on diversification ideas not on 'picking winners'.

Some of the BG results are puzzling. A basic question is why passive investing accounts for such a big share of US trading when passive funds hold such a small share of investor assets. Passive mutual funds invest just 16% of the funds held by so-called 'active funds'. The answer according to the Economist is that active funds are much less active than they claim, departing from the index and incurring non-systematic risk only at the margin of their portfolios.


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