Efficiently Inefficient Markets for Assets and Asset Management

• Author: LASSE HEJE PEDERSEN,NICOLAE GÂRLEANU
• Published date: 01 August 2018
• Date: 01 August 2018
• DOI: http://doi.org/10.1111/jofi.12696

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 4 •AUGUST 2018

Efficiently Inefficient Markets for Assets

and Asset Management

NICOLAE G ˆ

ARLEANU and LASSE HEJE PEDERSEN∗

ABSTRACT

We consider a model where investors can invest directly or search for an asset man-

ager, information about assets is costly, and managers charge an endogenous fee. The

efficiency of asset prices is linked to the efficiency of the asset management market: if

investors can find managers more easily, more money is allocated to active manage-

ment, fees are lower, and asset prices are more efficient. Informed managers outper-

form after fees, uninformed managers underperform, while the average manager’s

performance depends on the number of “noise allocators.” Small investors should re-

main uninformed, but large and sophisticated investors benefit from searching for

informed active managers since their search cost is low relative to capital. Hence,

managers with larger and more sophisticated investors are expected to outperform.

ASSET MANAGERS PLAY A CENTRAL role in making financial markets efficient, as

their size allows them to spend significant resources on acquiring and process-

ing information. The asset management market is subject to its own frictions,

however, since investors must search for informed asset managers. Indeed, in-

stitutional investors fly literally around the world to examine asset managers,

assessing their investment process, trading infrastructure, risk management,

and so on. Similarly, individual investors search for asset managers, some via

local branches of financial institutions, others via the internet or otherwise.

In this context, a number of questions arise naturally: How does the search

for asset managers affect the efficiency of security markets? What type of

manager is expected to outperform? And, which type of investors should use

active investing?

∗Nicolae Gˆ

arleanu is at the Haas School of Business, University of California, Berkeley, and

NBER. Lasse Heje Pedersen is at AQR Capital Management, Copenhagen Business School, New

York University, and CEPR; http://www.lhpedersen.com. We are grateful for helpful comments

from Utpal Bhattacharya; Jules van Binsbergen; Ronen Israel; Stephen Mellas; Jim Riccobono;

Tano Santos; Andrei Shleifer; Morten Sørensen; and Peter Norman Sørensen; as well as from sem-

inar participants at Harvard University, New York University,Chicago Booth, UC Berkeley, AQR

Capital, CEMFI, IESE, ToulouseSchool of Economics, MIT Sloan, Imperial College, Cass Business

School, Tinbergen Institute, Copenhagen Business School, and Boston College; and conference

participants at NBER Asset Pricing, Queen Mary University of London, the Cowles Foundation at

Yale University, the European Financial Management Association Conference, the 7th Erasmus

Liquidity Conference, the IF2015 Annual Conference in International Finance, the FRIC’15 Con-

ference, ABFER (2016), and the Karl Borch Lecture. Pedersen gratefully acknowledges support

from the European Research Council (ERC grant no. 312417) and the FRIC Center for Financial

Frictions (grant no. DNRF102).

DOI: 10.1111/jofi.12696

1663

1664 The Journal of Finance R

We seek to address these and related questions in a model with two levels of

frictions: investors’ costs of searching for informed asset managers and asset

managers’ cost of collecting information about assets. Despite this apparent

complexity, the model is highly tractable and delivers several new predictions

that link the levels of inefficiency in the security market and the market for

asset management: (1) if investors can find managers more easily, more money

is allocated to active management, fees are lower, and security prices are more

efficient; (2) as search costs diminish, asset prices become efficient in the limit,

even if the costs of collecting information remain large; (3) managers of assets

with higher information costs earn larger fees and are fewer, and the assets

with higher information costs are less efficiently priced; (4) informed managers

outperform after fees while uninformed managers underperform after fees; (5)

the net performance of the average manager depends on the number of “noise

allocators” (who allocate to randomly chosen managers) and, under certain

conditions, is zero or negative; (6) searching for informed active managers is

attractive for large or sophisticated investors, while small or unsophisticated

investors should be uninformed; and (7) managers with larger and more so-

phisticated investors are expected to outperform.

By way of background, the key benchmark is that security markets are

perfectly efficient (Fama (1970)), but this leads to two paradoxes. First, no

one has an incentive to collect information in an efficient market, so how does

the market become efficient (Grossman and Stiglitz (1980))? Second, if asset

markets are efficient, then positive fees to active managers imply inefficient

markets for asset management (Pedersen (2015)).

Grossman and Stiglitz (1980) show that the first paradox can be addressed by

considering informed investing in a model with noisy supply.However, when an

agent has collected information about securities, she can invest on this informa-

tion on behalf of others, so professional asset managers arise naturally (Admati

and Pfleiderer (1988), Ross (2005), Garc´

ıa and Vanden (2009)). We therefore

introduce professional asset managers into the Grossman-Stiglitz model.

One benchmark for the efficiency of asset management is provided by Berk

and Green (2004), who consider the implications of fully efficient asset man-

agement markets (in the context of exogenous and inefficient asset prices).

In contrast, we consider an imperfect market for asset management due to

search frictions, consistent with the empirical evidence of Sirri and Tufano

(1998), Jain and Wu (2000), Hortac¸su and Syverson (2004), and Choi, Laibson,

and Madrian (2010). We focus on investors’ incentive to search for informed

managers and managers’ incentives to acquire information about assets with

endogenous prices, abstracting from how agency problems and imperfect con-

tracting distort asset prices (Shleifer and Vishny (1997), Stein (2005), Cuoco

and Kaniel (2011), Buffa, Vayanos, and Woolley (2014)).

We employ the term efficiently inefficient to refer to the equilibrium level of in-

efficiency given the two layers of frictions in the spirit of the Grossman-Stiglitz

notion of “an equilibrium degree of disequilibrium.” Paraphrasing Grossman-

Stiglitz, prices in efficiently inefficient markets reflect information, but only

partially, so that some managers have an incentive to expend resources to

Efficiently Inefficient Markets for Assets and Asset Management 1665

obtain information, but only part of the managers, so investors have an incen-

tive to expend resources to find informed managers.

Our equilibrium works as follows. Among the group of asset managers, an

endogenous number decide to acquire information about a security. Investors

must decide whether to expend search costs to find an informed asset manager.

In an interior equilibrium, investors are indifferent between searching for

an informed asset manager versus uninformed investing (and both of these

options dominate the investor collecting information herself).1When an

investor meets an asset manager, they negotiate a fee. Asset prices are set in

a competitive noisy rational expectations market. The economy also features

a group of “noise traders” (or “liquidity traders”) who take random security

positions as in Grossman-Stiglitz. Likewise, we introduce a group of “noise

allocators” who allocate capital to a random group of asset managers, for

example, because they place trust in these managers as modeled by Gennaioli,

Shleifer, and Vishny (2015).

We solve for the equilibrium number of investors who invest through man-

agers, the equilibrium number of informed asset managers, the equilibrium

management fee, and the equilibrium asset prices. The model features both

search and information frictions, but the solution is surprisingly simple and

yields a number of clear new results.

First, we show that informed managers outperform before and after fees,

while uninformed managers naturally underperform after fees. Investors who

search for asset managers must be compensated for their search and due dili-

gence costs, and this compensation comes in the form of expected outperfor-

mance after fees. Investors are indifferent between active and uninformed

investing in an interior equilibrium, so larger search costs must be associated

with larger outperformance by active investors. Noise allocators invest partly

with uninformed managers and therefore may experience underperformance

after fees. The asset-weighted average manager (equivalently, their average

investor) outperforms after fees if the number of noise allocators is small and

underperforms if the number of noise allocators is large. When the average

manager outperforms, searching investors would have an incentive to “free

ride” by choosing a random manager if this were free, but all manager alloca-

tions require a search cost in our baseline model. In a model extension with free

search for a random manager, the equilibrium outperformance of the average

manager is zero or negative.

The model consequently helps explain a number of empirical regularities

on the performance of asset managers that are puzzling in light of the litera-

ture. Indeed, while the “old consensus” in the literature was that the average

mutual fund has no skill (Fama (1970), Carhart (1997)), a “new consensus”

has emerged that the average hides significant cross-sectional variation in

1Investors do not collect information on their own, since the costs of doing so are higher than

the benefits to an individual due to the relatively high equilibrium efficiency of the asset markets.

This high equilibrium efficiency arises from investors’ ability to essentially “share” information

collection costs by investing through an asset manager.