Presidential Address: Sophisticated Investors and Market Efficiency

Stock-market trading is increasingly dominated by sophisticated professionals, as opposed to individual investors. Will this trend ultimately lead to greater market efficiency? I consider two complicating factors. The first is crowding—the fact that, for a wide range of “unanchored” strategies, an arbitrageur cannot know how many of his peers are simultaneously entering the same trade. The second is leverage— when an arbitrageur chooses a privately optimal leverage ratio, he may create a firesale externality that raises the likelihood of a severe crash. In some cases, capital regulation may be helpful in dealing with the latter problem. IN THE LAST 20 YEARS or so, there have been profound changes in the way that money is managed. One indicator of these changes is the rapid growth of the hedge fund industry, whose assets on a global basis have gone from $39 billion at year-end 1990 to $1.93 trillion as of the second quarter of 2008.1 Hedge funds are commonly thought of as the prototypical sophisticated investors, for a couple of reasons. First, many of their investment strategies are based on extensive quantitative modeling, much of which has its roots in academic research in finance.2 Second, hedge funds often implement these strategies in an aggressively leveraged fashion. The growth of hedge funds is part of a broader trend toward professional asset management. French (2008) documents that, in the stock market, individual investors have been largely supplanted by institutions. Direct individual ownership of U.S. equities, which was 47.9% in 1980, fell to 21.5% by 2007. At ∗Jeremy C. Stein is from Harvard University and NBER. Presidential Address delivered to the American Finance Association, San Francisco, January 4, 2009. I am indebted to Sam Hanson for outstanding research assistance. I also thank John Campbell, Harrison Hong, Robin Greenwood, Borja Larrain, Andrei Shleifer, Erik Stafford, Dimitri Vayanos, Ivo Welch, and seminar participants at Harvard for helpful comments and suggestions. 1 These numbers are from Hedge Fund Research (HFR). 2 Of particular interest to many “quant” funds has been the large body of empirical work documenting various patterns of predictability in stock returns, many of which are strikingly robust over time and across countries. A partial list includes: the value-glamour effect (Fama and French (1992), Lakonishok, Shleifer, and Vishny (1994)); medium-run momentum (Jegadeesh and Titman (1993)); post-earnings announcement drift (Bernard and Thomas (1989, 1990)); and the low returns to firms with high levels of past accruals, equity issuance, or asset growth (Sloan (1996), Daniel and Titman (2006), and Cooper, Gulen, and Schill (2008), respectively). See Asness, Moskowitz, and Pedersen (2008) for a recent synthesis.