Working Paper: NBER ID: w20480
Authors: Andrea M. Buffa; Dimitri Vayanos; Paul Woolley
Abstract: We derive equilibrium asset prices when fund managers deviate from benchmark indices to exploit noise-trader induced distortions but fund investors constrain these deviations. Because constraints force managers to buy assets that they underweight when these assets appreciate, overvalued assets have high volatility, and the risk-return relationship becomes inverted. Noise traders bias prices upward because constraints make it harder for managers to underweight overvalued assets, which have high volatility, than to overweight undervalued ones. We endogenize the constraints based on investors' uncertainty about managers' skill, and show that asset-pricing implications can be significant even for moderate numbers of unskilled managers.
Keywords: Asset Management; Equilibrium Prices; Market Efficiency; Noisetrader Demand; Manager Constraints
JEL Codes: D86; G12; G14; G18; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| constraints imposed on fund managers (G23) | fund managers' behavior (G40) |
| fund managers' behavior (G40) | equilibrium prices (D41) |
| constraints imposed on fund managers (G23) | overweight undervalued assets (G31) |
| constraints imposed on fund managers (G23) | underweight overvalued assets (G19) |
| overvalued assets (F31) | high volatility (C58) |
| noise trader demand increases (G19) | price of the risky asset rises (G19) |
| noise trader demand increases (G19) | expected return decreases (G17) |
| constraints on managers (D20) | price distortions for overvalued assets (G19) |
| fraction of unskilled managers (J24) | impact on asset pricing (G19) |