The Sound of Many Funds Rebalancing

Abstract

Abstract This paper proposes that computational complexity generates noise. The same asset is often held for completely different reasons by many funds following a wide variety of threshold-based trading rules. Under these conditions, we show it can be computationally infeasible to predict how these various trading rules will interact with one another, turning the net demand from these funds into unpredictable noise. This noise-generating mechanism can operate in a wide range of markets and also predicts how noise volatility will vary across assets. We confirm this prediction empirically using data on exchange-traded funds. (JEL G00, G02, G14). Received May 28 2019; editorial decision December 16 2020 by Editor Thierry Foucault. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.