How Index Trading Increases Market Vulnerability

Abstract

Assets invested in passively managed equity mutual funds and exchange traded funds (ETFs) have grown steadily in recent years, reaching more than one trillion dollars at the end of 2010. Through a battery of tests, we establish that the rise in popularity of index investing contributes to higher systematic market risk. More indexed equity assets corresponds to increased cross-sectional trading commonality, in turn precipitating higher return correlations among stocks. We further discover that equity betas have not only risen but converged in recent years; also consistent with the accelerating growth and importance of passive investing.

Keywords: market risk, risk management