Is Passive Efficient?: Is passive investment affecting market efficiency?

Abstract

In this thesis, the academic arguments for passive investing are discussed, such as the Efficient Markets Hypothesis and the Capital Asset Pricing Model. Following this discussion, a thorough examination of the core practical differences between active and passive asset management is presented. The thesis than looks at the implications of passive investing on the academic arguments. Specifically, three separate ways that passive investing can affect market efficiency. (i) The index inclusion affect, (ii) the effect of index inclusion on long term valuations of companies, and (iii) the effects of passive index funds on market synchronization. These are looked at to answer the following questions. Do passive index funds affect market efficiency, if so at what point do markets become inefficient because of these funds? The thesis looks at various academic studies of passive investment affecting market efficiency in these three separate ways. The central finding in this thesis is that passive investment does affect market efficiency. However, the effects are not disastrous, and the market remains amply efficient. The conclusion is reached that the market may be headed for a new equilibrium at the point when passive investment cannot increase without sacrificing considerable market efficiency.