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 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 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 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 funds, exchange-traded funds, leveraged and inverse exchange-traded products, financial stability, systemic risk, market volatility, inclusion effects, daily rebalancing

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