The impact of active and passive investment on market efficiency: a simulation study

ABSTRACT

We create a simulated financial market and examine the effect of different levels of active and passive investment on fundamental market efficiency. In our simulated market, active, passive, and random investors interact with each other through issuing orders. Active and passive investors select their portfolio weights by optimizing Markowitz-based utility functions. We find that higher fractions of active investment within a market lead to an increased fundamental market efficiency. The marginal increase in fundamental market efficiency per additional active investor is lower in markets with higher levels of active investment. Furthermore, we find that a large fraction of passive investors within a market may facilitate technical price bubbles, resulting in market failure. By examining the effect of specific parameters on market outcomes, we find that that lower transaction costs, lower individual forecasting errors of active investors, and less restrictive portfolio constraints tend to increase fundamental market efficiency in the market.

KEYWORDS:

• Active investment
• passive investment
• financial market simulation
• fundamental market efficiency

Disclosure statement

No potential conflict of interest was reported by the author(s).

Supplementary material

Supplemental data for this article can be accessed online at https://doi.org/10.1080/15140326.2023.2188634

Additional information

Funding

We acknowledge support by the KIT-Publication Fund of the Karlsruhe Institute of Technology.

Notes on contributors

Patrick Jaquart

Patrick Jaquart is a postdoctoral researcher at the Institute of Information Systems and Marketing (IISM), Karlsruhe Institute of Technology (KIT). His research interests include asset pricing, financial market simulation, data science, and machine learning. His research has been published in journals such as The Journal of Finance and Data Science and proceedings of international Finance and Information Systems conferences.

Marvin Motz

Marvin Motz is a PhD student at the Institute of Information Systems and Marketing (IISM), Karlsruhe Institute of Technology (KIT). His research interests include sustainable finance, ecological investment, and asset pricing.

Lutz Köhler

Lutz Köhler is a research fellow at the Chair of Statistical Methods and Econometrics (ECON), Karlsruhe Institute of Technology (KIT). He currently pursues his graduate studies at KIT. His research interests include asset pricing, financial market simulation, and data science.

Christof Weinhardt

Christof Weinhardt is director of the Institute for Information Systems and Marketing (IISM) at the Karlsruhe Institute of Technology (KIT). He is also a director and founder of the Karlsruhe Service Research Institute and director of the Research Center of Information Technology. Since the beginning of 2019, he is Editor-in-Chief for the Journal Business & Information Systems Engineering (BISE). Professor Weinhardt was a member of the expert group Business & Economics of the German National Research Foundation and has acted as expert adviser in the Enquete Commission of the German Parliament for Internet and Digital Society. He has published more than 150 articles and books and has received a number of awards for his research and teaching.