- The growth of ETFs, which are largely passive vehicles that do not redeem in cash (ETFs redeem shares in-kind), has likely reduced risks arising from liquidity transformation in investment vehicles. As of March 2018, ETFs that redeemed exclusively in-kind accounted for 92% of ETF assets, reducing the likelihood that large-scale redemptions would force funds to engage in destabilizing fire sales. In addition, there is evidence that passive mutual funds are less likely to hold highly illiquid assets that contribute to liquidity transformation risks. For example, as of the end of 2017, passive funds made up just 0.006% of the AUM of the relatively illiquid U.S. high-yield bond and bank-loan sector compared to 25% of assets in the investment-grade corporate bond sectors.
- Investor flows for passive mutual funds are less reactive to fund performance than the flows of active funds. Thus, passive funds may face a lower risk of destabilizing redemptions in episodes of financial stress. For example, from December 2007 through mid-2009, passive funds had cumulative inflows and active funds had aggregate outflows.
- Some passive investing strategies, such as those used by leveraged and inverse exchange-traded products, amplify market volatility through their rebalancing activity. These funds must trade in the same direction as market moves that occurred earlier in the day, buying assets (or exposures via swaps or futures) on days when asset prices rise and selling when the market is down.
- The shift to passive vehicles has increased asset management industry concentration, with a few large firms (such as Vanguard, BlackRock, State Street, Fidelity and Charles Schwab) dominating the industry, exacerbating potential risks that might arise from serious operational problems at those firms. For example, a significant idiosyncratic event (such as a cybersecurity breach at a large firm) could lead to massive redemptions from that firm’s funds, and thus potentially from the asset-management industry as a whole. Large, sudden redemptions could result in fire sales with broader financial consequences.
- While the growth in indexed-investing strategies could contribute to “index-inclusion” effects on assets that are members of indexes, such as greater co-movement of returns and liquidity, the evidence on trends in comovement and their links to passive investing is mixed.
- While prior research had found that inclusion in the S&P 500 Index led to a 3-4% increase in the stock price, the April 2017 study by Nimesh Patel and Ivo Welch, “Extended Stock Returns in Response to S&P 500 Index Changes,” found that this was no longer the case—the markets were becoming more efficient.
- While stocks with more ownership by ETFs display higher volatility than otherwise similar securities, such trading helps move aggregate market prices closer to fundamentals
- Inclusion in an ETF can increase an asset’s liquidity because it becomes easier to trade as part of the ETF basket—though the liquidity of assets traded individually may decline. For example, ownership is associated with reduced liquidity for investment-grade corporate bonds, but the effect on liquidity is positive for high-yield bonds
- In terms of comovement of returns, adding a stock to the index had a smaller effect on its market beta during the period 2001 to 2012 than in the previous decade, even as indexing had become more common.
Anadu, et al., noted that “If index-related price distortions become more significant over time, they may boost the profitability of active investing strategies that exploit these distortions and ultimately slow the shift to passive investing.” In other words, any problem should be self-correcting by the actions of sophisticated arbitrageurs.