Dynamic Asset Pricing with Passive Investing

Abstract: The paper presents and tests a model where active investors respond to news and interact with passive investors, defined as investors whose asset allocation does not change with the investment opportunity set. The model generates tractable solutions showing in closed form that stock prices reflect the present discounted value of dividends plus the wealth invested by passive investors. Thus, the wealth of passive investors affects stock price dynamics, and vice versa. Passive investors automatically reinvest the proceeds of their portfolios, expressing a procyclical demand which amplifies the response of prices to news. The precision of the information that asset prices convey about future fundamentals decreases when active investors have less incentive to hold assets, as when expected returns are low and volatile. Beyond the index inclusion effect, allocation mandates generate the asset class effect.