Sep 17, 2009
Q&A
If a growing percentage of market participants pursued passive investment strategies, at what point would market efficiency break down? Is this a practical concern?

EFF/KRF: This is a complicated question that we address at length in "Disagreement, Tastes, and Asset Prices" (Journal of Financial Economics 2007). The answer depends to some extent on who turns passive. If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.

 
ABOUT FAMA AND FRENCH
Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.