Correlated noise: Why passive investment might improve market efficiency

Over the last decades passive investment products have continuously increased their market share. The efficiency of financial markets is identified to be the main reason for this development. We propose a theoretical model framework which illustrates that the causality can also be reversed, i.e. shows that the efficiency of markets might improve as consequence of passive investment. We analyze a market in which agents process noisy correlated signals and trade a single asset, and we derive a closed-form expression for their expected payoffs. For competitive market makers, we provide a unique pricing expression which leads to a fully-revealing equilibrium and efficient markets. On the contrary, we show that a monopolistic market maker induces frictions in the price-discovery process with partially-revealing equilibria and inefficient markets. Agents with highly correlated noise improve their expected payoffs by reducing the information processing activity, and by doing so they even increase market efficiency.