8-2014 Presidential Address : Investment Noise and Trends

During the past few decades, the fraction of the equity market owned directly by individuals declined significantly. The same period witnessed investment trends that include the growth of indexing as well as shifts by active managers toward lower fees and more index-like investing. I develop an equilibrium model linking these investment trends to the decline in individual ownership, interpreting the latter as a reduction in noise trading. Active management corrects most noise-trader induced mispricing, and the fraction left uncorrected shrinks as noise traders’ stake in the market declines. Less mispricing then dictates a smaller footprint for active management. *Presidential address to the American Finance Association, Philadelphia, Pennsylvania, January 2014. Stambaugh is with the Wharton School of the University of Pennsylvania. The author is grateful to Martijn Cremers, Rick Green, Ron Kaniel, Stijn Van Nieuwerburgh, Antti Petajisto, Nick Roussanov, Luke Taylor, and Yu Yuan for helpful comments or assistance. Special thanks go to Ľuboš Pástor for valuable comments and discussions. NOISE TRADING HAS BEEN a familiar concept in finance since the 1980s. In the following decades, noise traders have increasingly populated the finance literature, but their real-life presence in the stock market may have declined. Why? First, noise trading is more often associated with individuals than institutions. Fischer Black describes noise traders as “people who trade . even though from an objective point of view they would be better off not trading. ” The behavioral finance literature points to numerous factors that lead individuals to make unproductive investment decisions. Second, there has been a substantial downward trend in the fraction of U.S. equity owned directly by individuals. As displayed in Figure 1, since 1980 that fraction has fallen by more than half, from 48% to around 20% based on estimates by French (2008), who also suggests the pool of investors most likely to make mistakes may have thus shrunk. This decline in individual ownership continues a trend that began essentially at the end of World War II, when households held more than 90% of U.S. corporate equity. Explanatory factors likely include government tax and retirement policies (Rydqvist, Spizman, and Strebulaev, 2014). The past few decades also witnessed changes within the investment management industry. Passive investing—“indexing”—became popular as an alternative to active investment management, while active managers, particularly mutual funds, lowered their fees and in aggregate became more index-like in their investing. Active management’s loss of market share is evident in Panel A of Figure 2, which plots the fraction of equity mutual fund assets actively managed (thicker line) and the fraction of institutionally owned equity that is actively managed (thinner line). Nearly all equity mutual fund assets were actively managed in 1980, but the fraction dropped to 83% by 2012. Over the shorter period for which data are available, the actively managed fraction of institutionally owned equity fell from 81% in 1986 to 59% in 2006. Panel B plots the average percentage fees paid by investors in active mutual funds (thicker line) and the average fee paid by institutional investors for active management. While the fee paid by institutional investors stayed rather flat around 0.4%, the fees paid by mutual fund investors fell substantially, from 2.3% in 1980 to 1.0% in 2012, due largely to reductions in (ammortized) load charges. Active management lost market share to indexing while also becoming more similar to indexing as an investment. For example, Panel C of Figure 1 displays the history since 1980 of the index tracking error for the aggregate portfolio of actively managed equity mutual funds in the dataset constructed by Pástor, Stambaugh, and Taylor (2013). The value plotted for a given year is the annualized standard deviation of the market-adjusted monthly return for the subsequent 60 months. A significant downward trend is evident, with the tracking error falling from 2.2% in 1980 to 1.2% in 2006. The trend in active management’s becoming less active appears not only in its tracking error but also in its stock holdings. Cremers and Petajisto (2009) define “active share,” which summarizes the deviations between an active manager’s relative stock weightings and market-