The Heterogeneous Effects of Passive Investing on Asset Markets
46 Pages Posted: 14 Jan 2020 Last revised: 19 Oct 2021
Date Written: October 17, 2021
This paper shows that passive funds systematically underweight or omit illiquid index assets. As a result, ETF trading activity consumes liquidity and reduces market quality for liquid assets, but has no effect on illiquid assets. Focusing on the unconditional average effect of passive investing and ignoring the passive funds' index deviations underestimates the local treatment effect by up to 58%. Overall, the effects of passive investing on asset markets depend on how intermediaries replicate their target index.
Keywords: exchange-traded funds, passive investment, index, replication strategy, market quality
JEL Classification: G11, G12, G20
Suggested Citation: Suggested Citation