Essays on passive investing

This thesis contains two essays related to passive investing and passive investment vehicles. In the first essay, I introduce a general equilibrium model with active investors and indexers. The presence of indexers causes market segmentation, and the degree of segmentation is linked to the relative wealth of indexers in the economy. Any shock to this relative wealth generates excess comovement by inducing correlated shocks to discount rates of index stocks. The wealthier the indexers are, the greater the resulting excess comovement is. In the data, I find that S&P 500 stocks tend to comove more with other index stocks and less with non-index stocks, but this was not the case until the 1970s when indexing gained in popularity. I use passive holdings of S&P 500 stocks as a proxy for the wealth of indexers and find that changes in passive holdings are positively related to changes of excess comovement in S&P 500 stocks. In the second essay, I use liquid exchange traded funds to study the issue of international mutual fund predictability. Mutual fund returns are predictable when the Net Asset Value is computed from prices that do not reflect all available information. This problem was brought to the public eye with the late trading and market timing scandal of 2003, which led to SEC intervention in 2004. Since these events, mutual fund managers have been more active in adjusting NAV, reducing predictability by about half. The simple trading strategy I present yields annual returns of 33% from 2001 to 2004 and 16% from 2005 to 2010. Even after accounting for trading restrictions in mutual funds, an arbitrager could earn annual returns of 2.73% from 2005 to 2010, suggesting the problem is not fully resolved. The main methodological contribution of this essay is to develop a filtering approach based on a state-space model that embeds the fund manager problem, thus accounting for unobserved actions of fund managers. I also show that predictability increases significantly when information sources suggested by prior literature, such as index and futures returns, are supplemented by premiums on related exchange traded funds.Business, Sauder School ofGraduat