The Value of Information: A Puzzle
TLDR
This paper measures the value of information in equity markets using price change and order flow covariance, finding it significantly lower than investor search fees.
Key contributions
- Measures total value of information for informed traders via covariance between price changes and order flow.
- Shows this covariance captures noise trader losses, which equal informed trader gains under competitive market making.
- Estimates the average stock's information value at $3.5 million/year, or 0.04% of market cap.
- Highlights this value is considerably lower than the 0.67% in fees investors pay annually searching for returns.
Why it matters
This paper presents a puzzling discrepancy: the measured value of information in equity markets is far less than what investors spend searching for it. This challenges assumptions about market efficiency and investor rationality, prompting discussion on potential resolutions for this significant gap.
Original Abstract
We show that under mild assumptions, the total value of information to informed traders in the market can be measured by the covariance between price changes and order flow. This covariance captures noise trader losses, which equal informed trader gains when market making is competitive. We estimate the value of information using high frequency data on US equities at about $3.5 million per year for the average stock. The aggregate value of information is about 0.04% of market cap, which is considerably lower than the 0.67% in fees investors pay each year searching for superior returns (French 2008). We discuss potential resolutions for these puzzling findings.
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