The Effect of Passive Investment on Market Efficiency: An Empirical Study of the U.S. Equity Market (1989-2018)

Ingrid Alexandra Louise Petersson & Kasper S. R Thomsen

Student thesis: Master thesis


The past decades have seen the rise of an investment revolution. Just 40 years ago, the first index mutual fund was founded, today passive management occupies 30% of the market, and by 2024 at the latest, Moody’s expect passive investment to surpass active management. The impacts of this natural experiment are yet to be identified. In this paper, we attempt to identify the effect of increased passive investments on market efficiency. First, we conduct an extensive literature review, which provides the foundation for the development of three hypotheses. The literature provides support for either more, less, or equally efficient markets. In order to reach conclusions regarding our hypotheses, we collect 52,153,354 observations, a total of 437,101,186 data points, and conduct 658,118 unique event studies over the 30-year period ranging from 1989-2018. We use the results from the event study and their significance levels as a proxy for the level of market efficiency. Subsequently, we run two regression models in an additional attempt to isolate the effect of increased index investing. We find no evidence to suggest that the increase in indexing should have made highly indexed securities more or less efficiently priced compared to a basket of otherwise similar firms. Thus, we disprove our first and second hypotheses. However, we find weak evidence to support our final hypothesis, which suggests that the net effect of increased indexing is negligible. Thus, we find no conclusive empirical evidence to answer our research question. Furthermore, our results seem to suggest that securities have, on average, become more efficiently priced. The results seem to suggest that the detrimental implications of increased indexing on market efficiency proposed by some scholars and practitioners are yet to materialise. We go on to consider how these results fit in with the literature on market efficiency in general. We conclude that this thesis provides evidence in favour of the efficiently-inefficient view on market efficiency.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
Publication date2019
Number of pages151
SupervisorsLasse Heje Pedersen