Efficiently Inefficient Markets for Assets and Asset Management∗

We consider a model where investors can invest directly or search for an asset manager, information about assets is costly, and managers charge an endogenous fee. In equilibrium, the efficiency of asset prices is linked to the efficiency of the asset management market: (1) if investors can find managers more easily then more money is allocated to active management, fees are lower, and asset prices are more efficient; (2) as search cost diminish, asset prices become efficient in the limit, even if informationcollection costs remain large; (3) managers of complex assets earn larger fees and are fewer, and such assets are less efficiently priced; (4) good managers outperform after fees, bad managers underperform after fees, and the net performance of the average manager depends on the number of “noise allocators.” ∗We are grateful for helpful comments from Morten Sørensen as well as from seminar participants at Haas School of Business, University of California, Berkeley and Copenhagen Business School. Pedersen gratefully acknowledges support from the European Research Council (ERC grant no. 312417) and the FRIC Center for Financial Frictions (grant no. DNRF102). †Gârleanu is at the Haas School of Business, University of California, Berkeley, NBER, and CEPR; email: [email protected]. Pedersen is at Copenhagen Business School, New York University, AQR Capital Management, and CEPR; www.lhpedersen.com. The efficiency of market prices is one of the central questions in financial economics. 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 implies inefficient markets for asset management (Pedersen (2015)). When one has collected information about securities, one can invest on this information on behalf of others, so professional asset managers arise naturally as a result of the returns to scale in collecting and trading on information (Admati and Pfleiderer (1988), Ross (2005), Garcia and Vanden (2009)). Therefore, professional asset managers are central to understanding market efficiency. Indeed, we must understand the efficiency of asset markets jointly with the efficiency of the markets for asset management. One benchmark for the efficiency of asset management is provided by Berk and Green (2004), which considers the implications of perfectly efficient asset-management markets (in the context of exogenous and inefficient asset prices). However, fire sales resulting from asset managers’ outflows contribute to the limits of arbitrage (Shleifer and Vishny (1997)), the contractual features that arise in equilibrium can distort asset prices (Stein (2005), Cuoco and Kaniel (2011), Buffa, Vayanos, and Woolley (2014)), and empirical evidence suggests that investors face search frictions associated with finding asset managers (Sirri and Tufano (1998), Jain and Wu (2000), and Hortaçsu and Syverson (2004)). We seek to shed further light on the efficiency and interactions of the markets for assets and asset management by considering a general equilibrium with two levels of frictions: (i) investors’ search frictions for finding and vetting asset managers and (ii) asset managers’ cost of collecting information about assets. We show that there exists an efficient level of inefficiency of both asset markets and the markets for asset management, and the efficiencies of these markets are closely linked in equilibrium. Our model thus accommodates the paradoxes While these papers focus on effects that arise as a result a manager’s distorted incentives or forced sale, we assume that managers invest in their clients’ interest, thus focusing on managers’ incentives to acquire information about assets and investors’ incentive to search for good managers in a general equilibrium.