DP13561 The Sound Of Many Funds Rebalancing
This paper proposes that computational complexity generates noise. In modern financial markets, it is common to find the same asset held for completely different reasons by funds following a wide variety of threshold-based trading rules. Under these conditions, we show that it can be computationally infeasible to predict how these various trading rules will interact with one another. Formally, we prove that it is NP hard to predict the sign of the net demand coming from a large interacting mass of funds at a rate better than chance. Thus, market participants will treat these demand shocks as random noise even if they are fully rational. This noise-generating mechanism can produce noise in a wide range of markets and also predicts how noise will vary across assets. We verify this prediction empirically using data on the exchange-traded fund (ETF) market.