Rise of Passive Investing - Effects on Price Level, Market Volatility, and Price Informativeness

Abstract

In this paper, I answer growing concerns pertaining to the rapid growth of passive investment strategies over the last two decades. I construct a rational expectations equilibrium model allowing investors to choose different modes of investment (active, passive, and delegated active), introduce agent heterogeneity, and estimate the model using data from 2000 to 2017. The model considers investment fees as exogenous, and variations in these fees influence the shifts in the distribution of investors selecting different investment vehicles. I find that the growth of passive investing did not increase the overall price level, thus contradicting the common ETF bubble hypothesis, which postulated that rapid growth in passive strategies may lead to the detachment of prices of these securities from fundamentals. Furthermore, the model suggests that this shift in investing has contributed to increasing asset price volatility, consistent with empirical findings. We estimate that about 10% of current market volatility can be attributed to the rise of passive investing. It also resulted in diminished price informativeness due to weakened information acquisition. Further reduction in passive management fees will strengthen these effects. Reductions in fees associated with delegated active investing may have an ambiguous effect on the proportion of passive investing but will result in enhanced price volatility and reduced informativeness, akin to the dynamics observed in passive fee reductions.