The Shift from Active to Passive Investing : Potential Risks to Financial Stability?

Anadu, Kenechukwu E.; Kruttli, Mathias S.; McCabe, Patrick E.; Osambela, Emilio

doi:10.17016/FEDS.2018.060r1

Working Paper Revision

The Shift from Active to Passive Investing : Potential Risks to Financial Stability?

Abstract: The past couple of decades have seen a significant shift in assets from active to passive investment strategies. We examine the potential effects of this shift for financial stability through four different channels: (1) effects on investment funds’ liquidity transformation and redemption risks; (2) passive strategies that amplify market volatility; (3) increases in asset-management industry concentration; and (4) the effects on valuations, volatility, and comovement of assets that are included in indexes. Overall, the shift from active to passive investment strategies appears to be increasing some types of risk while diminishing others: The shift has probably reduced liquidity transformation risks, although some passive strategies amplify market volatility, and passive-fund growth is increasing asset-management industry concentration. We find mixed evidence that passive investing is contributing to the comovement of asset returns and liquidity.

Keywords: Financial stability; Market volatility; Asset management; Daily rebalancing; Indexing; Systemic risk; Passive investing; Mutual fund; Leveraged and inverse exchange-traded products; Exchange-traded fund; Index investing; Inclusion effects;