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The Shift from Active to Passive Investing: Risks to Financial Stability?
Abstract
The past two decades have seen a significant shift from active to passive investment strategies. We examined how this shift affects financial stability through its impacts on (1) funds’ liquidity and redemption risks, (2) asset market volatility, (3) asset management industry concentration, and (4) comovement of asset returns and liquidity. Overall, the shift appears to be increasing some risks and reducing others. Some passive strategies amplify market volatility, and the shift has increased industry concentration but has diminished some liquidity and redemption risks. Evidence on the links between indexing and comovement of asset returns and liquidity is mixed.
... Factor investing has gained a lot of traction among practitioners and academia. The rise of smart beta ETFs initiated a greater trend toward using factor investing in passive portfolios (Blitz 2016;Kenechukwu et al. 2020). This rise has led to a discussion on whether traditional mutual funds are still worth their relatively high costs compared to ETFs. ...
... Another possible transmission process is through the inclusion of shares of ETFs in the portfolios of the other investment funds and regarding them as substitutes to cash holdings (Bhattacharya & O'Hara, 2020). In a complex study of the impact of the increasing role of passive investing (taking into account both passive mutual funds and ETFs) Anadu et al. (2020) demonstrated that the effects with regard to financial stability are multidimensional. The risks associated with increased market volatility and market concentration seem amplified yet the redemption and liquidity risks are moderated by the expansion of the passive funds. ...
... Another possible transmission process is through the inclusion of shares of ETFs in the portfolios of the other investment funds and regarding them as substitutes to cash holdings (Bhattacharya & O'Hara, 2020). In a complex study of the impact of the increasing role of passive investing (taking into account both passive mutual funds and ETFs) Anadu et al. (2020) demonstrated that the effects with regard to financial stability are multidimensional. The risks associated with increased market volatility and market concentration seem amplified yet the redemption and liquidity risks are moderated by the expansion of the passive funds. ...
... Another possible transmission process is through the inclusion of shares of ETFs in the portfolios of the other investment funds and regarding them as substitutes to cash holdings (Bhattacharya & O'Hara, 2020). In a complex study of the impact of the increasing role of passive investing (taking into account both passive mutual funds and ETFs) Anadu et al. (2020) demonstrated that the effects with regard to financial stability are multidimensional. The risks associated with increased market volatility and market concentration seem amplified yet the redemption and liquidity risks are moderated by the expansion of the passive funds. ...
... (2016). In developed market on the other hand, most of the investment is channelized through financial intermediaries (institutional investors) and household investors are shifting towards passive investingAnadu et al.(2020).15 According to RBI data only 4 percent of household financial investments are in stocks and bonds in 2018-19, while 37 percent is in the form of bank deposits, 19 percent in provident funds and other retirement saving schemes and 10 percent in government sponsored saving schemes. ...
This study investigates the tail-risk and returns relationship in an emerging equity market—India. We observe both the beta and the tail risk anomalies at the univariate portfolio level. However, after controlling for the lottery effects (MAX and idiosyncratic volatility), the relationship between the systematic tail risk measures and the expected returns turns positive for some of the proxies of tail risk, while the relationship between beta and expected returns becomes flat. The lottery effect explains the tail risk anomaly reported in the literate. These results suggest that investors care for probabilities of extreme changes in stock prices but do not care much about moderate variations in stock returns. Emerging markets have a significant presence of individual investors, who consider investing in the stock market as an opportunity to gamble and earn lottery-like payoffs, which results in an overvaluation of lottery stocks. Since these stocks also have high systematic risk and a high probability of extreme negative returns, we observe that the expected returns are negatively correlated with beta and left tail risk measures before controlling for the lottery effects. These results are robust after controlling for other relevant variables such as the size of the firm, book-to-market ratio, momentum, retail ownership, and illiquidity.
... Globally, a substantial shift has been witnessed from active investing towards passive investing by the investment community. The factors contributing to this shift include underperformance of actively managed funds relative to the benchmark index, increased compensation to the fund managers, investable stock index funds and low cost associated with passive investing (Anadu et al., 2020;Sushko & Turner, 2018). Passive investment domain consists of index funds often invested through mutual funds and Exchange Traded Funds (ETF's), both of which aim to mimic the performance of the benchmark index. ...
Exchange Traded Funds (ETF’s) are one of the beloved passively managed funds that offer both retail and institutional investors an access to highly profitable and wide- range of diversifiable financial assets. The study aims to assess the ability of Indian equity ETF’s in replicating the performance of their benchmark indices using a sample of 27 equity ETF’s traded on the National Stock Exchange of India during the pre-pandemic period from 01/01/2015 to 31/12/2019. Evaluation of the performance of sample ETF’s through risk-return analysis, risk-adjusted performance measures, tracking error analysis and multi-factor regression have revealed that the majority of the sample ETF’s outperformed their tracking indices but with notable tracking errors during the study period. Further, the study also indicates that the returns of the sample ETF’s have a significant and positive relationship with the returns of the index but are inversely related to risk and management fees. The results of this study will have major implications for investors in evaluating the performance of ETF’s and fund managers as well in taking suitable measures to reduce tracking errors that will help in successful replication of the benchmark along with undertaking initiatives that will enable the ETF’s to become price efficient.
... For example, Sushko and Turner (2018) argue that the popularity of passive investing could affect aggregate investment fund flows and market price dynamics, resulting in higher correlations of asset returns, using world-wide assets under management (AUM) data. Anadu et al. (2020) empirically investigate the mechanisms by which the significant shift from active to passive investment strategies affects financial stability risks using U.S. data. Despite the rapid growth of passive investing in the global stock markets, however, its share still remains low in emerging markets (Sushko & Turner, 2018). ...
“BOXPI” is an acronym for the boxed Korea Composite Stock Price Index (KOSPI). Uniquely, KOSPI has remained within an extremely narrow range during 2012–2016 despite the global liquidity expansion. This study develops a continuous–time model to describe sector rotation and interprets the BOXPI phenomenon from industry portfolio perspectives. We find that the upper bound of the BOXPI can be interpreted as a consequence of the rotations from cyclical to defensive sector during that period. Furthermore, a Bayesian variable selection analysis shows that the lower bound of the BOXPI can be regarded as a result of low price–to–book ratio of the KOSPI in the BOXPI period.
... Passive equity funds have grown in popularity in the United States over the last decade, with $6.2 trillion AUM at the end of 2020, or $0.9 trillion more than U.S. active equity funds (Bloomberg Intelligence 2021). Passive products have gained market share from 42 percent in 2015 to 54 percent in 2020 because of the wide acceptance of the efficient market hypothesis, the relatively lower costs, and the evidence of underperformance of active managers (Anadu et al. 2020;Bloomberg Intelligence 2021). However, of the U.S. passive equity funds, only $48.6 billion AUM, or less than 1 percent, consider ESG factors and criteria to align with the Paris Agreement (Bryan et al. 2020). ...
This paper provides a comprehensive and evolving framework for Paris-aligned passive investing, developed through expert consultations, using existing Paris Agreement-related frameworks, taxonomies, data sources, and principles. The framework is then used to analyze existing popular US sustainable funds and EU Paris-Aligned Benchmark funds to see how well they fulfill the criteria, revealing considerable deficiencies in portfolio construction across the board.
... Цель факторного инвестора -получить премию, используя определенный стиль (или комбинацию стилей) инвестирования в долгосрочной перспективе. Таким образом, элементы факторного инвестирования имеют место быть как в индексных, так и в активных стратегиях [14]. Особенности всех трех видов инвестирования сведены в таблице. ...
... The research interest is mostly due to their capacity to deliver significant positive abnormal returns (Blitz and Fabozzi 2017). On the other hand, investment strategies and portfolio management trends have significantly changed (Anadu et al. 2020). In particular, it seems that passive investing, among others, promotes the mispricing of individual stocks because of index fund investing (Belasco, Finke, and Nanigian 2012). ...
This study provides evidence on how dividend policy affects earnings management. Our goal is to contribute to the literature by employing data from a sector (aerospace and defence) that to the best of our knowledge has never been studied before in terms of the relationship between earnings management and dividend policy. Our sample consists of 17 listed companies in the U.S. Stock Exchanges, examined for the 2012-2019 period. We employ panel data linear regression to conclude that the dividend policy positively affects the management's practice of discretionary accruals manipulation. Consequently, our results support the signalling hypothesis that points to the importance of a stable dividend policy. Specifically, we provide relevant and robust information on management decision making regarding value return to the shareholders of U.S. aerospace and defence companies. Finally, we provide future research proposals that may shed more light on this obscure relationship.
... Between 2008 and today, $1 trillion was shifted from active to passive investments, resulting in a decline of research spending of 56.5% compared to 2008. Nowadays, passive funds represent 41% of combined US Mutual Fund and ETF assets under management (Anadu, Kruttli, McCabe, and Osambela 2020). ...
Equity Research (ER) is a fundamental sector of the financial services industry, responsible for producing and selling informational content for investors to make more profitable investment decisions. In January 2018, a cost unbundling regulation was enacted in Europe, decreasing the industry’s appeal to investors. This paper investigates the effects of MiFID II on the strategic decisions of Equity Research providers in the US. By performing a qualitative analysis through interviewing eight industry insiders, the key variables of analysis were coverage (number of stock recommendations) and analyst count for ER firms. Using a fixed-effects regression over a 48-month period (before and after MiFID II), this study finds a positive association between industry coverage and analyst count on research providers. This result, I argue, could be related to the unintended consequences of the European regulation on the US industry, allowing US firms to gain competitive advantage and thus increase coverage and staffing.
... It should be noted though that the recent success of passive investing occurred in a long bull market and during most market corrections active managers tend to perform better 12 . The shift from active to passive investing also has impacts on the financial system, including increased industry concentration, the effect of index-inclusion, and amplified volatility due to leveraged and inverse ETFs (Anadu et al. 2020). Smart beta investing offers a third option alongside active and passive fund management. ...
ESG investing has recently been growing in popularity but the range of investment products available could still be widened. One possible approach is a combination of ESG ratings and the smart beta strategy that modifies index weighting based on a factor; thus, it contains elements from both active and passive fund management. The hypothetical funds created in this paper using this method achieved returns of over 50 per cent between 2015 and 2019, while the benchmark EURO STOXX 50 only provided a 19 per cent profit for investors during the five-year period. ESG ratings were found to be significant as a variable, suggesting that they can influence returns but other factors such as size or earnings growth have higher explanatory power. Also, while currently the possibilities for ESG investments are limited in Hungary, market players are starting to realise the potential of ESG, and with the suggested approach new investors could be attracted by funds
... Megjegyzendő ugyanakkor, hogy a passzív befektetés közelmúltbeli sikere egy hosszú bikapiacon következett be, és a legtöbb piaci korrekció esetén az aktív alapkezelők jellemzően jobban teljesítenek 12 . Az aktívtól a passzív befektetés felé való elmozdulásnak vannak a pénzügyi rendszerre irányuló hatásai is, ideértve a megnövekedett ágazati koncentrációt, az index-beleszámítás (index-inclusion) hatását, valamint a tőkeáttétellel működő és inverz ETF-ek miatt felerősödött volatilitást (Anadu et al. 2020). ...
Jóllehet az utóbbi időben nőtt az ESG-befektetések népszerűsége, még mindig bővíthető lenne a rendelkezésre álló befektetési termékek köre. Egy lehetséges megközelítés az ESG-értékelések és a smart beta stratégia olyan kombinációja, amely egy faktor alapján módosítja az indexsúlyozást, így mind aktív, mind passzív alapkezelésből tartalmaz elemeket. A dolgozatban e módszer alkalmazásával létrehozott hipotetikus alapok 2015 és 2019 között 50 százalék feletti hozamokat értek el, míg a benchmark EURO STOXX 50 mindössze 19 százalékos hasznot hozott a befektetők számára az ötéves időszak alatt. Az ESG-értékelések szignifikánsnak bizonyultak változóként, ami arra utal, hogy képesek befolyásolni a hozamokat, de más tényezők – például a méret vagy a nyereség növekedése – nagyobb magyarázó erővel bírnak. Ezenfelül miközben az ESG-befektetések lehetőségei Magyarországon jelenleg korlátozottak, a piaci szereplők kezdenek ráébredni az ESG potenciáljára, és a javasolt megközelítéssel az alapok új befektetőket vonzhatnának.
We create a simulated financial market and examine the effect of different levels of active and passive investment on fundamental market efficiency. In our simulated market, active, passive, and random investors interact with each other through issuing orders. Active and passive investors select their portfolio weights by optimizing Markowitz-based utility functions. We find that higher fractions of active investment within a market lead to an increased fundamental market efficiency. The marginal increase in fundamental market efficiency per additional active investor is lower in markets with higher levels of active investment. Furthermore, we find that a large fraction of passive investors within a market may facilitate technical price bubbles, resulting in market failure. By examining the effect of specific parameters on market outcomes, we find that that lower transaction costs, lower individual forecasting errors of active investors, and less restrictive portfolio constraints tend to increase fundamental market efficiency in the market.
In recent years, investors have shown significant interest in responsible investment products, including sustainable and ESG screened index funds. A natural concern for prospective investors in such funds is that a sustainable fund might underperform its classical unscreened counterpart. This paper argues that this underperformance risk can be analyzed by way of an option to exchange one asset for another, and we derive a simple formula that quantifies the fair annual insurance premium for covering this risk. Only a single parameter is needed to apply the formula. This parameter – a relative index volatility – is readily estimated from market data. Our empirical work utilizes data from BlackRock's ETF (iShares) universe to estimate the cost of insuring against underperformance risk of some common ESG screened funds. We find that the fair cost of underperformance insurance typically corresponds to sacrificing in advance between 0.5% and 3.0% of the annual return.
The US entrepreneurial finance market has changed dramatically over the last two decades. Entrepreneurs who raise their first round of venture capital retain 30% more equity in their firm and are more likely to control their board of directors. Late-stage start-ups are raising larger amounts of capital in the private markets from a growing pool of traditional and new investors. These private market changes have coincided with a sharp decline in the number of firms going public—and when firms do go public, they are older and have raised more private capital. To understand these facts, we provide a systematic description of the differences between private and public firms. Next, we review several regulatory, technological, and competitive changes affecting both start-ups and investors that help explain how the trade-offs between going public and staying private have changed. We conclude by listing several open research questions.
This article argues that the key mechanisms protecting portfolio investors in public corporate securities are indirect. They do not rely on actions by the investors or by any private actor charged with looking after investors’ interests. Rather, they are provided by the ecosystem that investors (are legally forced to) inhabit, as a byproduct of the self-interested, mutually and legally constrained behavior of third parties without a mandate to help the investors such as speculators, activists, and plaintiff lawyers. This elucidates key rules, resolves the mandatory versus enabling tension in corporate/securities law, and exposes the current system’s fragile reliance on trading.
Quantitative investment itself has very complex operational logic, and how to effectively analyze the dynamic causes of quantitative investment has always been an urgent problem to be solved. This paper proposes a dynamic quantitative analysis of investment based on the gray relational analysis model, which reduces the influence of subjective factors and improves the objectivity of evaluation results through the selection of reference sequences. The results show that the method has significant analytical performance and can provide users with good guidance for quantitative investment.
This paper uses the revision of the Tokyo Stock Exchange's circuit breakers in 2019 as a natural experiment to provide empirical evidence that passive investors’ executions are concentrated and affect intraday liquidity. After the revision, which attracts the passive traders to execute at the close, the stock more owned by passive funds: (i) has more concentrated execution at closing auctions; (ii) reduces its transaction costs more in continuous sessions; and (iii) has less price-efficient overnight return. These findings are consistent with the implication of the dynamic limit order market model in the previous research that indicated the passive investor has higher costs to wait for the execution. Our results imply the importance of the passive investors’ intraday behavioral change due to a shift in execution constraints, especially when the passive investments have a high market share.
ABSTRACT Using data on $18 trillion of assets under management, we show that actively managed institutional accounts outperformed strategy benchmarks by 75 (31) bps on a gross (net) basis during the period 2000–2012. Estimates from a Sharpe (1992) model imply that asset managers' outperformance came from factor exposures. If institutions had instead implemented mean‐variance efficient portfolios using index and institutional mutual funds available during the sample period, they would not have earned higher Sharpe ratios. Our results are consistent with the average asset manager having skill, managers competing for institutional capital, and institutions engaging in costly search to identify skilled managers.
Due to their low trading costs, ETFs are potentially a catalyst for short‐horizon liquidity traders. The liquidity shocks can propagate to the underlying securities through the arbitrage channel, and ETFs may increase the non‐fundamental volatility of the securities in their baskets. We exploit exogenous changes in index membership and find that stocks with higher ETF ownership display significantly higher volatility. ETF ownership increases the negative autocorrelation in stock prices. The increase in volatility appears to introduce undiversifiable risk in prices, because stocks with high ETF ownership earn a significant risk premium of up to 56 basis points monthly.
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Assets invested in passively managed equity mutual funds and exchange traded funds (ETFs) have grown steadily in recent years, reaching more than one trillion dollars at the end of 2010. Through a battery of tests, we establish that the rise in popularity of index investing contributes to higher systematic market risk. More indexed equity assets corresponds to increased cross-sectional trading commonality, in turn precipitating higher return correlations among stocks. We further discover that equity betas have not only risen but converged in recent years; also consistent with the accelerating growth and importance of passive investing.
In the present paper we analyze the relationship between index funds and asset prices. In particular, our analysis of daily index fund flows indicates a strong contemporaneous correlation between fund inflows and S&P market returns. We also document a strong negative correlation between fund out-flows and S&P market returns with the exception of outflows from a fund with very high initial investment requirement. These effects may be interpreted in two ways. Either investor supply and demand affects S&P market prices, or investors condition their demand and supply on intra-day market fluctuations. To sort out these effects, we examine trailing investor reaction to market moves. Our results suggest the market reacts to daily demand. However, only negative reactions appear due to past returns. We investigate whether index investor demand shocks ("liquidity shocks") are permanent or temporary and provide evidence that supports the hypothesis that they are permanent. This result may help ex...
I examine the economic incentives behind the mutual fund trading scandal, which made headlines in late 2003 with news that several asset management companies had arranged to allow abusive--and, in some cases, illegal--trades in their mutual funds. Most of the gains from these trades went to the traders who pursued market-timing and late-trading strategies. The costs were largely borne by buy-and-hold investors, and, eventually, by the management companies themselves. A puzzle emerges when one examines the scandal from the perspective of those management companies. In the short run, they collected additional fee revenue from arrangements allowing abusive trades. When those deals were revealed, investors redeemed shares en masse and revenues plummeted management companies clearly made poor decisions, ex post. However, my analysis indicates that those arrangements were also uneconomic, ex ante, because--even if the management companies had expected never to be caught--estimated revenue from the deals fell well short of the present value of expected lost revenues due to poor performance in abused funds. Why some of the mutual fund industry's largest firms chose to collude with abusive traders remains something of a mystery. I explore several possible explanations, including owner-manager conflicts of interest within management companies (between their shareholders and the executives who benefitted from short-term asset growth), but none fully resolves the puzzle. Management companies' decisions to allow abuses that harmed themselves as well as mutual fund shareholders convey a broader lesson, that shareholders, customers, and fiduciary clients be cautious about relying too heavily on firms' own self-interest to govern their behavior.
This paper studies Leveraged and Inverse Exchange Traded Funds (LETFs) from a financial stability perspective. Mechanical positive-feedback rebalancing of LETFs resembles the portfolio insurance strategies, which contributed to the stock market crash of October 19, 1987 (Brady Report, 1988). I show that a 1% increase in broad stock-market indexes induces LETFs to originate rebalancing flows equivalent to $1.04 billion worth of stock. Price-insensitive and concentrated trading of LETFs results in price reaction and extra volatility in underlying stocks. Implied price impact calculations and empirical results suggest that they contributed to the stock market volatility in the 2008-2009 financial crisis and in the second half of 2011 when the European sovereign debt crisis came to the forefront. Although LETFs are not as large as portfolio insurers of the 1980s and have not been proven to disrupt stock market activity, their large and concentrated trading could be destabilizing during periods of high volatility.
The design of leveraged and inverse exchange-traded funds (ETFs) has raised concerns that they may exacerbate volatility in financial markets by mechanically rebalancing their portfolios in the same direction as contemporaneous returns. We show theoretically, however, that capital flows can lower ETF rebalancing demand and completely eliminate it in the limit. Using a sample of U.S. equity-based ETFs from 2006 to 2014, we find that capital flows substantially reduce ETF rebalancing demand, even during periods of severe market stress. After accounting for capital flows and standard risk factors, we find that the impact of ETF rebalancing on late-day returns and volatility is economically insignificant.
Systematc, rules-based investment strategies are where academia and practce are currently interacting strongly. My objectve in this editorial is to offer some thoughts on research on systematc investing, including three artcles in this issue, that can provide signifcant practcal benefts for academics, practtoners, and investors alike.
We provide novel evidence supporting the notion that arbitrageurs can contribute to return comovement via exchange trade funds (ETF) arbitrage. Using a large sample of US equity ETF holdings, we document the link between measures of ETF activity and return comovement at both the fund and the stock levels, after controlling for a host of variables and fixed effects and by exploiting the ‘discontinuity’ between stock indices. The effect is also stronger among small and illiquid stocks. An examination of ETF return autocorrelations and stock lagged beta provides evidence for price reversal, suggesting that some ETF-driven return comovement may be excessive.
This paper explores flow patterns in corporate bond mutual funds. We show that corporate bond funds exhibit a concave flow-to-performance relationship: their outflows are sensitive to bad performance more than their inflows are sensitive to good performance. Moreover, corporate bond funds tend to have greater sensitivity of outflows to bad performance when they have more illiquid assets and when the overall market illiquidity is high. These results point to the possibility of fragility in the fast-growing corporate bond market. The illiquidity of corporate bonds may generate a first-mover advantage among investors in corporate bond funds, amplifying their response to bad performance.
Over the last four decades, the concentration of institutional assets in equity markets has increased dramatically. We conjecture that large institutions are granular, that is, they cannot be reduced to a collection of smaller independent entities. Hence, the paper studies whether large institutional ownership has a significant impact on asset prices. We provide evidence of a causal effect of ownership by large institutions on the volatility of their stock holdings. As a potential channel for this effect, we show that large institutions generate higher price impact than smaller institutions. Their trades are larger and concentrated on fewer stocks than those of smaller firms. Moreover, the investor flows to units within the same family are more correlated than the flows to independent entities. Finally, the effect of large institutions on volatility is unlikely to be related to improved price discovery, because the stocks owned by large institutions exhibit stronger price inefficiency.
Using distinct features of corporate bond exchange-traded funds (ETFs), I find that financial innovation has a significant and long-term positive valuation impact on the systemically important underlying securities. A one standard deviation increase in ETF ownership reduces high-yield and investment-grade bond spreads by 20.3 and 9.2 basis points, respectively, implying an average monthly price increase of 1.03% and 0.75%. Two novel quasi-natural experiments exploit exogenous changes in ETF eligibility to confirm the effect. Examining theoretical explanations for the effect, I find that ETFs decrease liquidity trader participation, increase institutional ownership, and insignificantly or negatively impact the liquidity of individual bonds.
This paper studies Leveraged and Inverse Exchange Traded Funds (LETFs) from a financial stability perspective. Mechanical positive-feedback rebalancing of LETFs resembles the portfolio insurance strategies, which contributed to the stock market crash of October 19, 1987 (Brady Report, 1988). I show that a 1% increase in broad stock-market indexes induces LETFs to originate rebalancing flows equivalent to $1.04 billion worth of stock. Price-insensitive and concentrated trading of LETFs results in price reaction and extra volatility in underlying stocks. Implied price impact calculations and empirical results suggest that they contributed to the stock market volatility in the 2008-2009 financial crisis and in the second half of 2011 when the European sovereign debt crisis came to the forefront. Although LETFs are not as large as portfolio insurers of the 1980s and have not been proven to disrupt stock market activity, their large and concentrated trading could be destabilizing during periods of high volatility.
A natural liquidity mismatch emerges when liquid exchange traded funds (ETFs) hold relatively illiquid assets. We provide a theory and empirical evidence showing that this liquidity mismatch can reduce market efficiency and increase the fragility of these ETFs. We focus on corporate bond ETFs and examine the role of authorized participants (APs) in ETF arbitrage. In addition to their role as dealers in the underlying bond market, APs also play a unique role in arbitrage between the bond and ETF markets since they are the only market participants that can trade directly with ETF issuers. Using novel and granular AP-level data, we identify a conflict between APs? dual roles as bond dealers and as ETF arbitrageurs. When this conflict is small, liquidity mismatch reduces the arbitrage capacity of ETFs; as the conflict increases, an inventory management motive arises that may even distort ETF arbitrage, leading to large relative mispricing. These findings suggest an important risk in ETF arbitrage.
Evidence of excessive comovement among stocks following index additions (Barberis, Shleifer, and Wurgler, 2005) and stock splits (Green and Hwang, 2009) challenges traditional finance theory. We show that the bivariate regressions in this literature provide little information about the economic magnitude of excess comovement, with coefficients that are sensitive to unrelated factors. Using robust univariate regressions and matched control samples, almost all evidence of excess comovement disappears. In both examples, the stocks exhibit strong returns prior to the event, akin to momentum winners. We document that winner stocks exhibit increases in betas, generating much of the apparent excess comovement.
The authors analyze the development of various risk commonalities in Europe and the United States, as well as in emerging markets, and find a substantial increase in the co-movements in trading patterns, price returns, and liquidity risk within equity markets. They test the hypothesis that index-linked investing is a major driver for the increase in risk commonality. By aggregating the data in a cross-regional perspective, the authors capitalize on the different levels of indexation in the markets and find statistically significant and economically relevant evidence that the growth in index-linked investing is related to the increased co-movement within equity markets. The results suggest a significant increase in market fragility around the globe, leading to an increased danger of more severe reactions to unanticipated events going forward. Portfolio managers are well-advised to account for the increased proportion of index-linked investing within their risk management tools, diversification approaches, and active management strategies.
We study the relation between the ownership structure of financial assets and non-fundamental risk. We define an asset to be fragile if it is susceptible to non-fundamental shifts in demand. An asset can be fragile because of concentrated ownership, or because its owners face correlated or volatile liquidity shocks, i.e., they must buy or sell at the same time. We formalize this idea and apply it to mutual fund ownership of US stocks. Consistent with our predictions, fragility strongly predicts price volatility. We then extend the logic of fragility to investigate two natural extensions: (1) the forecast of stock return comovement and (2) the potentially destabilizing impact of arbitrageurs on stock prices.
We derive a parsimonious rational model of active portfolio management that reproduces many regularities widely regarded as anomalous. Fund flows rationally respond to past performance in the model even though performance is not persistent and investments with active managers do not outperform passive benchmarks on average. The lack of persistence in returns does not imply that differential ability across managers is nonexistent or unrewarded or that gathering information about performance is socially wasteful. The model can quantitatively reproduce many salient features in the data. The flow-performance relationship is consistent with high average levels of skills and considerable heterogeneity across managers.
Assessments of the risks to financial stability often focus on the degree of leverage in the system. In this report, however, we question whether subdued leverage of financial intermediaries is sufficient grounds to rule out stability concerns. In particular, we highlight unlevered investors as the locus of potential financial instability and consider the monetary policy implications. Our focus is on market “tantrums” (such as that seen during the summer of 2013) in which risk premiums inherent in market interest rates fluctuate widely. Large jumps in risk premiums may arise if non-bank market participants are motivated, in part, by their relative performance ranking. Redemptions by ultimate investors strengthen such a channel. We sketch an example and examine three empirical implications. First, as a product of the performance race, flows into an investment opportunity drive up asset prices so that there is momentum in returns. Second, the model predicts that return chasing can reverse sharply. And third, changes in the stance of monetary policy can trigger heavy fund inflows and outflows.Using inflows and outflows for different types of open-end mutual funds, we find some support for the proposition that market tantrums can arise without any leverage or actions taken by leveraged intermediaries. We also uncover connections between the destabilizing flows and shocks to monetary policy. We draw five principal conclusions from our analysis. First, in contrast with the common presumption, the absence of leverage may not be sufficient to ensure that monetary policy can disregard concerns for financial stability. Second, the usual macroprudential toolkit does not address instability driven by non-leveraged investors. Third, forward guidance encourages risk taking that can lead to risk reversals. In fact, our example suggests that when investors infer that monetary policy will tighten, the instability seen in summer of 2013 is likely to reappear. Fourth, financial instability need not be associated with the insolvency of financial institutions. Fifth, the tradeoffs for monetary policy are more difficult than is sometimes portrayed. The tradeoff is not the contemporaneous one between more versus less policy stimulus today, but is better understood as an intertemporal tradeoff between more stimulus today at the expense of a more challenging and disruptive policy exit in the future.Of course, our analysis neither invalidates nor validates the policy course the Federal Reserve has actually taken. Any such conclusion depends on an assessment of the balance of risks given the particular circumstances, which lies beyond the scope of our paper. Instead, our paper is intended as a contribution to developing the analytical framework for making policy judgments. But our analysis does suggest that unconventional monetary policies (including QE and forward guidance) can build future hazards by encouraging certain types of risk-taking that are not easily reversed in a controlled manner.
Since September, 1976, stocks newly included into the Standard and Poor's 500 Index have earned a significant positive abnormal return at the announcement of the inclusion. This return does not disappear for at least ten days after the inclusion. The returns are positively related to measures of buying by index funds, consistent with the hypothesis that demand curves for stocks slope down. The returns are not related to S & P's bond ratings, which is inconsistent with a plausible version of the hypothesis that inclusion is a certification of the quality of the stock.
The value of exchange traded fund (ETF) assets has increased from $66 billion in 2000 to almost a trillion dollars in 2010. We use this massive expansion in ETF assets to study what drives ETF flows. Using a data set of over 500 ETFs from 2001 to 2010, we show that ETF investors chase returns in the same way as mutual fund investors. While there is an active debate about whether return chasing by mutual fund investors represents the pursuit of superior talent, the existence of return chasing in this passively managed environment should not represent a search for skilled managers. We also show that ETF flows increase following high volume, small spreads, and high price/net asset value ratios. Finally, we find little evidence of superior market timing in ETF flows. Our results suggest that return chasing in both mutual funds and ETFs is more likely the result of naïve extrapolation bias on the part of investors that has contributed to the growth of the ETF industry.
Using changes in the MSCI Standard Country Indices for 29 countries between 1998 and 2001, we document that stock returns and volumes exhibit “index effects” in international markets similar to those detected by the studies of US stocks. The stocks added to the indices experience a sharp rise in prices after the announcement and a further rise during the period preceding the actual change, though part of the gain is lost after the actual change date. The stocks that are deleted from the indices, on the other hand, witness a steady and marked decline in their prices. Trading volumes increase significantly and remain at high levels after the change date for the added stocks. There are also considerable cross-country variations in these effects. Tests using data on various measures reflecting the different hypotheses fail to turn up any evidence in support of information effects. Our evidence appears to be more supportive of the downward sloping demand curve hypothesis. There is some evidence of price-pressure and mild evidence of liquidity effect, particularly in Japan and UK.
This study demonstrates that the cross-sectional variation of systematic risk and systematic liquidity has increased from 1963 to 2008. Both have increased significantly for large-capitalization companies but have declined significantly for small-cap companies. These findings have several implications for investment managers, including the declining ability to diversify return volatilities and liquidity shocks by holding liquid, large-cap stocks. The findings suggest that the vulnerability of the U.S. equity market to unanticipated events has increased over the past few decades.
The equity indexes of the Frank Russell Company are widely used as performance benchmarks for investment managers. Once a year, at the end of June, the Frank Russell Company reconstitutes its stock market indexes. We document economically and statistically significant abnormal returns associated with the annual reconstitution from 1996-2001. The cross-sectional variation in abnormal returns is explained by both permanent changes in liquidity associated with changes in index membership and temporary effects related to price pressure. Our results suggest that passive index funds pay a steep price for minimizing tracking error by rebalancing on the date of reconstitution. Conversely, there are substantial rewards to supplying immediacy to such funds. However, trading on index revisions involves risks arising from sectoral movements and from timing risks as positions are unwound. Indeed, we document dramatic return volatility on the actual day of reconstitution that reflect unanticipated order imbalances.
Leveraged and inverse Exchange-Traded Funds (ETFs) have attracted significant assets lately. Unlike traditional ETFs, these funds have “leverage” explicitly embedded as part of their product design. While these funds are primarily used by short-term traders, they are gaining popularity with individual investors placing leveraged bets or hedging their portfolios. The structure of these funds, however, creates both intended and unintended characteristics that are not seen in traditional ETFs. This note provides a unified framework to better understand the underlying dynamics of leveraged and inverse ETFs, their impact on market volatility and liquidity, unusual features of their product design, and questions of investor suitability. We show that the daily re-leveraging of these funds can exacerbate volatility towards the close. We also show that the gross return of a leveraged or inverse ETF has an embedded path-dependent option that under certain conditions can lead to value destruction for a buy-and-hold investor. The unsuitability of these products for longer-term investors is reinforced by the drag on returns from high transaction costs and tax inefficiency.
The study reported here examined the long-term impact of Russell 2000 Index rebalancing on portfolio evaluation. A buy-and-hold index portfolio outperformed the annually rebalanced index in the 1979-2004 period by an average of 2.22 percent over one year and 17.29 percent over five years. Although short-term momentum and the poor long-term returns of new issues partially explain these returns, index deletions were found to provide significantly higher factor-adjusted returns than index additions. Some small-capitalization fund managers appear to capture a portion of these benefits. The strongest performing funds enhanced their factor-adjusted returns by an average of 1.45 percent per year by holding index deletions and/or avoiding index additions. Among the weakest performing funds, higher returns from holding index deletions were offset by the poor returns of new issues added to the index. Thus, index methodology may provide a structural incentive for portfolio managers to drift from their benchmarks.
A market index summarizes the performance of a group of securities intonumber.1 The use of stock market indices in particular has been growingexponentially for years. Since Charles Dow introduced his indices in1884, the number of distinct stock market indices reported in The WallStreet Journal has increased roughly 5 percent per year, as shown inFigure 1. Today’s Journal reports not just the Dow JonesIndustrial Average (DJIA) and the S&P 500; it also reports on theTurkey Titans 20 and the Philadelphia Stock Exchange Oil Service Index.Markets are being tracked in more and more detail, and Figure 1 suggeststhat there is no end in sight.2
Keynote remarks by Eric S. Rosengren, President and Chief Executive Officer, Federal Reserve Bank of Boston, at the Stanford Finance Forum, Graduate School of Business, Stanford University, June 3, 2011
The paper provides empirical evidence that strategic complementarities among investors generate fragility in financial markets. Analyzing mutual fund data, we find that, consistent with a theoretical model, funds with illiquid assets (where complementarities are stronger) exhibit stronger sensitivity of outflows to bad past performance than funds with liquid assets. We also find that this pattern disappears in funds where the shareholder base is composed mostly of large investors. We present further evidence that these results are not attributable to alternative explanations based on the informativeness of past performance or on clientele effects. We analyze the implications for funds’ performance and policies.
Building on Vijh (Rev. Financial Stud. 7 (1994)), we use additions to the S&P 500 to distinguish two views of return comovement: the traditional view, which attributes it to comovement in news about fundamental value, and an alternative view, in which frictions or sentiment delink it from fundamentals. After inclusion, a stock's beta with the S&P goes up. In bivariate regressions which control for the return of non-S&P stocks, the increase in S&P beta is even larger. These results are generally stronger in more recent data. Our findings cannot easily be explained by the fundamentals-based view and provide new evidence in support of the alternative friction- or sentiment-based view.
Since October 1989, Standard and Poor's has (when possible) announced changes in the composition of the S&P 500 index one week in advance. Because index funds hold S&P 500 stocks to minimize tracking error, index composition changes since this date provide an opportunity to examine the market reaction to an anticipated change in the demand for a stock. Using post-October 1989 data, the authors document significantly positive (negative) postannouncement abnormal returns that are only partially reversed following additions (deletions). These results indicate the existence of temporary price pressing and downward-sloping long-run demand curves for stocks and represent a violation of market efficiency. Copyright 1997 by University of Chicago Press.
This paper shows that S&P 500 stock betas are overstated and the non–S&P 500 stock betas are understated because of liquidity
price effects caused by the S&P 500 trading strategies. The daily and weekly betas of stocks added to the S&P 500 index during
1985–1989 increase, on average, by 0.211 and 0.130. The difference between monthly betas of otherwise similar S&P 500 and
non–S&P 500 stocks also equals 0.125 during this period. Some of these increases can be explained by the reduced nonsynchroneity
of S&P 500 stock prices, but the remaining increases are explained by the price pressure or excess volatility caused by the
S&P 500 trading strategies. I estimate that the price pressures account for 8.5 percent of the total variance of daily returns
of a value-weighted portfolio of NYSE/AMEX stocks. The negative own autocorrelations in S&P 500 index returns and the negative
cross autocorrelations between S&P 500 stock returns provide further evidence consistent with the price pressure hypothesis.
This paper studies the flows of funds into and out of equity mutual funds. Consumers base their fund purchase decisions on prior performance information, but do so asymmetrically, investing disproportionately more in funds that performed very well the prior period. Search costs seem to be an important determinant of fund flows. High performance appears to be most salient for funds that exert higher marketing effort, as measured by higher fees. Flows are directly related to the size of the fund's complex as well as the current media attention received by the fund, which lower consumers' search costs. Copyright The American Finance Association 1998.
This study analyzes the effects of changes in S&P 500 index composition from January 1986 through June 1994, a period during which Standard and Poor's began its practice of preannouncing changes five days beforehand. The new announcement practice has given rise to the 'S&P game' and has altered the way stock prices react. The authors find that prices increase abnormally from the close on the announcement day to the close on the effective day. The overall increase is greater than under the old announcement policy, although part of the increase reverses after the stock is included in the index. Copyright 1996 by American Finance Association.
Attempts to identify price pressures caused by large transactions may be inconclusive if the transactions convey new information to the market. This problem is addressed in an examination of prices and volume surrounding changes in the composition of the S&P 500. Since these changes cause some investors to adjust their holdings of the affected securities and since it is unlikely that the changes convey information about the future prospects of these securities, they provide an excellent opportunity to study price pressures. The results are consistent with the price‐pressure hypothesis: immediately after an addition is announced, prices increase by more than 3 percent. This increase is nearly fully reversed after 2 weeks.
Weights in the Toronto Stock Exchange 300 index are determined by the market values of the included stocks' public floats. In November 1996, the exchange implemented a previously announced revision of its definition of the public float. This revision, which increased the floats and the index weights of 31 stocks, conveyed no information and had no effect on the legal duties of shareholders. Affected stocks experienced statistically significant excess returns of 2.3 percent during the event week, and no price reversal occurred as trading volume returned to normal levels. These findings support downward sloping demand curves for stocks. An obvious event with which to examine the slope of demand curves for stocks is one that changes supply. In the absence of new information, a shift in supply should not affect stock prices if demand curves for stocks are flat. Scholes (1972), using a sample of secondary equity distributions, asks whether stocks are "...unique works of art..." or merely ...
- Caitlin D Dannhauser
- Jeffrey Pontiff
State Street Temporarily Stops Cash Redemptions for Muni-Bond ETFs
- Chris Dietrich
Dietrich, Chris. 2013. "State Street Temporarily Stops Cash
Redemptions for Muni-Bond ETFs." Wall Street Journal
(21 June).
The Shift from Active to Passive and Its Effect on Intraday Stock Dynamics
- Goldman Sachs
Goldman Sachs. 2019. "The Shift from Active to Passive and Its
Effect on Intraday Stock Dynamics." QES Edge.
Can ETFs Contribute to Systemic Risk?” European Systemic Risk Board
- Marco Pagano
- Antonio Sánchez Serrano
- Joseph Zechner
Office of Financial Research. 2018. "Annual Report to
Congress."
Pagano, Marco, Antonio Sánchez Serrano, and Joseph
Zechner. 2019. "Can ETFs Contribute to Systemic Risk?"
European Systemic Risk Board, Reports of the Advisory
Scientific Committee, No. 9 (June).
The Granular Nature of Large Institutional Investors.” Centre for Economic Policy Research Discussion Paper
- Ben-David
- Francesco Itzhak
- Rabih Franzoni
- John Moussawi
- Sedunov