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The Impact of Passive Investments on the Market Efficiency

Student: Dmitriy Devyataev

Supervisor: Alexander V. Larin

Faculty: Faculty of Economics

Educational Programme: Economics (Bachelor)

Year of Graduation: 2020

Annotation. Market efficiency is understood as reflecting all available relevant information in asset prices. The result of efficiency is the inability to extract risk-free profit due to the lack of undervalued or overvalued assets. Passive investments are gaining popularity among economic agents. The question is, how can passive investments influence the efficient market hypothesis? The purpose of this work is to study effect of passive investments on the efficient market hypothesis. For this, a number of tasks were performed. First, the study and review of the theoretical foundations of the efficient market hypothesis and empirical tests of the hypothesis. Secondly, identification of the types of tests to be performed and data collection. Third, hypothesis testing and interpretation of results. Fourth, the development of market simulation in Python and the interpretation of the results. A study of theoretical and empirical work indicates the presence of a negative impact of passive investment on the implementation of the efficient market hypothesis. Simulation results indicate that restricting short positions can lead to a shift in prices from rational values. It was also shown that an increase in the number of passive investors can affect the degree of efficiency of stock valuation. The effect of including and excluding shares from the index was shown. The inclusion of stocks in the index led to its overvaluation, and the exclusion led to undervaluation. Empirical testing of the hypothesis has also been conducted. To do this, we used the method of event studies and cumulative abnormal returns. An assessment was made of the effect of including the stock in the S&P 500 between 2012 and 2020. It was revealed that the inclusion of shares in the S&P 500 for the period from 2012 to 2020 on average led to an increase in the average cumulative abnormal return by 0.7% in the 1st period after inclusion. Moreover, the results indicate an increase in the average cumulative abnormal return until the announcement of inclusion. A possible interpretation of this effect may be the improvement of trading systems and forecasting tools. Some investors could predict the stock and the date it is included in the index and buy it in advance. Another interpretation is the possible availability of important news for companies in the vicinity of the inclusion announcement day. This news may significantly affect returns and cumulative excess returns.

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