Vector Analysis

I build a rational expectations model consistent with the empirical finding that active funds underperform index funds by as much as their fees. Uninformed households receive privately observed wealth shocks that lead them to rebalance, thereby inducing noise in stock prices. As a result, they fail to attain the buy-and-hold index fund return. The equilibrium net buy-and-hold alpha of informed active funds is negative to make active and index funds equally attractive. I find in the data that high index fund flows forecast low returns and low index fund returns relative to active fund returns. This differential impact can account for most of the buy-and-hold advantage of index funds over active funds