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

RPA Working Paper, 18-04, 2018

30 Pages Posted: 28 Sep 2018

See all articles by Kenechukwu Anadu

Kenechukwu Anadu

Federal Reserve Banks - Federal Reserve Bank of Boston; Babson College

Mathias Kruttli

Board of Governors of the Federal Reserve System; University of Oxford - Oxford-Man Institute of Quantitative Finance

Patrick E. McCabe

Board of Governors of the Federal Reserve System

Emilio Osambela

Board of Governors of the Federal Reserve System

Chaehee Shin

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: August 27, 2018

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 on 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 co-movement 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 co-movement of assets. Finally, we use our framework to assess how financial stability risks are likely to evolve if the shift to passive investing continues, noting that some of the repercussions of passive investing ultimately may slow its growth.

Keywords: Asset Management, Passive Investing, Index Investing, Indexing, Mutual Fund, Exchange-Traded Fund, Leveraged and Inverse Exchange-Traded Products, Financial Stability, Systemic Risk, Market Volatility, Inclusion Effects

JEL Classification: G10, G11, G20, G23, G32, L1

Suggested Citation

Anadu, Kenechukwu and Kruttli, Mathias and McCabe, Patrick E. and Osambela, Emilio and Shin, Chaehee, The Shift From Active to Passive Investing: Potential Risks to Financial Stability? (August 27, 2018). RPA Working Paper, 18-04, 2018 . Available at SSRN: https://ssrn.com/abstract=3244467

Kenechukwu Anadu (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

Babson College ( email )

231 Forest St.
Babson Park, MA 02457-0310
United States

Mathias Kruttli

Board of Governors of the Federal Reserve System ( email )

20th and C Streets, NW
Washington, DC 20551
United States

HOME PAGE: http://www.federalreserve.gov/econresdata/mathias-s-kruttli.htm

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

Eagle House
Walton Well Road
Oxford, Oxfordshire OX2 6ED
United Kingdom

HOME PAGE: http://sites.google.com/site/mathiaskruttli/home

Patrick E. McCabe

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Emilio Osambela

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Chaehee Shin

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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