Does the rise in passive investment strategies have consequences for financial stability?

The shift to passive from active appears to be amplifying some risks to financial stability and mitigating others, according to a paper co-written by Kenechukwu Anadu, a senior financial markets specialist at the Federal Reserve Bank of Boston, and Mathias Kruttli, Patrick McCabe, Emilio Osambela and Chaehee Shin, who are all economists at the Board of Governors of the Federal Reserve System.

While the impacts of this shift have been widely debated, the paper focused on how it influences funds’ liquidity and redemption risks, asset market volatility, asset management industry concentration and co-movement of asset returns and liquidity.

The results were mixed. Specifically, the paper found passive investing reduces liquidity and redemption risks.

When products offer investors the option to redeem the investments on a daily basis in return for cash, this can create a first-mover advantage. “Moreover, because [mutual fund] investors typically chase performance — that is, they buy (sell) shares of funds that have recently registered positive (negative) returns — a negative shock to asset prices might cause [mutual fund] outflows that further depress prices and amplify the effects of the shock,” the paper said.

In a passive world, this is mitigated for mutual funds and ETFs that offer daily redemptions. Possible explanations include that most ETFs offer redemption in kind, not in cash; performance-related redemption risks are smaller in passive funds than in active; and there’s limited evidence that passive ETFs are less likely than active ones to hold illiquid assets, which contribute to liquidity transformation risks.

On the other hand, the shift to passive investing increases risks for asset market volatility.

While the flow into passive funds appears to have corresponded with less reactive investor behaviour compared to the use of active funds, which lowers the risk of destabilizing redemptions in episodes of financial stress, not all passive strategies feature the same characteristics, the paper said. “Some passive investment strategies may amplify price volatility for the assets they hold because these strategies require portfolio managers to trade in the same direction as recent market moves, even in the absence of investor flows.”

Specifically, strategies used by leveraged and inverse exchange-traded products can amplify market volatility because both these vehicles have to trade in the direction of the market, buying as asset prices rise and selling as they fall, accelerating the market’s movement in either direction. “Although a further shift to passive investing would not necessarily lead to growth of leveraged exchange-traded products, their expansion could amplify destabilizing effects on markets.”

Another risk increased by passive investing is concentration risk because passive managers are more concentrated compared to their active counterparts, the paper said.

“For passive funds, asset-selection ability is less relevant, so scale diseconomies may be less of a brake on growth. Second, on the demand side, because passive funds offer relatively minimal differentiation of portfolios and manager talent, investors may be more inclined to invest in the lowest-cost funds operated by large asset managers that are able to take advantage of economies of scale and scope.”

As a result of this concentration, major problems or events at one firm can pose an increasing risk to financial stability, noted the paper.

Finally, the paper found the effects of passive investing on asset valuation, volatility and co-movement growth to be uncertain. “The shift toward passive investing is largely synonymous with an increase in indexed investing, which may be affecting the valuations, returns and liquidity of financial assets that are included in indexes.”

Yet, the financial stability implications of index inclusion haven’t been broadly examined, it noted, highlighting some studies suggest passive investing may contribute to excess co-movement of asset returns and liquidity. “However, the evidence on trends and causality is mixed. Moreover, much of the research on index-inclusion effects has focused on equity markets, particularly those in the U.S. Further analysis, particularly of effects on liquidity and co-movement for fixed-income instruments and foreign assets, would be helpful in assessing how passive investing may be affecting financial stability through index-inclusion effects.”

If index-inclusion effects, like price distortions, become more significant, noted the paper, this could slow the move to passive investing because active managers can take advantage of these distortions.

Overall, passive investing’s impact on financial stability requires more study, the paper concluded. “For example, further empirical research on index-inclusion effects for fixed-income instruments would be useful in determining the degree to which the shift to passive investing may be contributing to risks. In addition, there is still relatively little evidence on differences in liquidity risk-management practices for active and passive funds.”