Passive Investing and the Rise of Mega-Firms

Abstract

We study how passive investing affects asset prices. Flows into passive funds raise dispropor- tionately the stock prices of the economy’s largest firms—even when the indices tracked by the funds include all firms. Passive flows also raise the largest firms’ return volatility the most, and raise the aggregate stock market even when they are entirely due to investors switching from active to passive. These effects arise because of the re-pricing of systematic and large firms’ idiosyncratic risk. We estimate that passive investing caused the 50 largest US firms to rise 30% more than the US stock market over 1996–2020.

Keywords: passive investing, fund flows, asset pricing, size distribution of firms

JEL Classification: G10, G11, G12, G23