Passive investment strategies and financial bubbles

Thomas Fischer

No 212, Darmstadt Discussion Papers in Economics from Darmstadt University of Technology, Department of Law and Economics

Abstract: In this paper, a model of bounded rational investors investing their portfolio in a passive investment vehicle (e.g., an Exchange Traded Fund replicating a broad index) or an actively managed fund is presented. The model proposes that the quick reswitching of these short-term oriented investors induces momentum behavior in prices. Investors prefer passsive funds in time of low risk-free rates and when active funds charge high management costs. Actively managed funds have a lower volatility but are only able to outperform the passive funds in downturns. Simulations confirm the emergence of two regimes: a regime where prices are close to fundamentals and another regime with a positive bubble. The size and the length of this bubble increases for low market liquidity and high switching speed of investors. The market volatility increases for strong reswitching activities and short-term thinking of bounded rational investors. Negative bubbles (market prices lower than fundamentals) tend to occur if active portfolio managers exhibit high risk aversion, but are less frequent than positive bubbles.

Keywords: stock; market; passive; trading; financial; stability; arbitrage; trading; financial; bubbles; Heterogeneous; Agent; Model (search for similar items in EconPapers)
JEL-codes: C15 C62 D58 G11 (search for similar items in EconPapers)
Date: 2012
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https://www.econstor.eu/bitstream/10419/84867/1/690204434.pdf (application/pdf)

Related works:
Working Paper: Passive Investment Strategies and Financial Bubbles (2012)
Working Paper: Passive Investment Strategies and Financial Bubbles (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:darddp:dar_57576

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