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The Shift from Active to Passive Investing: Potential Risks to Financial Stability?

Author

Listed:
  • Anadu, Kenechukwu E.

    () (Federal Reserve Bank of Boston)

  • Kruttli, Mathias S.

    (Federal Reserve Board)

  • McCabe, Patrick E.

    (Federal Reserve Board)

  • Osambela, Emilio

    (Federal Reserve Board)

  • Shin, Chae Hee

    (Federal Reserve Board)

Abstract

The past couple of decades have seen a significant shift in assets from active to passive investment strategies. We examine the potential effects of this shift on financial stability through four different channels: (1) effects on investment funds’ liquidity transformation and redemption risks; (2) passive strategies that amplify market volatility; (3) increases in asset-management industry concentration; and (4) the effects on valuations, volatility, and comovement of assets that are included in indexes. Overall, the shift from active to passive investment strategies appears to be increasing some types of risk while diminishing others: The shift has probably reduced liquidity transformation risks, although some passive strategies amplify market volatility, and passive-fund growth is increasing asset-management industry concentration. We find mixed evidence that passive investing is contributing to the comovement of assets. Finally, we use our framework to assess how financial stability risks are likely to evolve if the shift to passive investing continues, noting that some of the repercussions of passive investing ultimately may slow its growth.

Suggested Citation

  • Anadu, Kenechukwu E. & Kruttli, Mathias S. & McCabe, Patrick E. & Osambela, Emilio & Shin, Chae Hee, 2018. "The Shift from Active to Passive Investing: Potential Risks to Financial Stability?," Supervisory Research and Analysis Working Papers RPA 18-4, Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbqu:rpa18-4
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    References listed on IDEAS

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    More about this item

    Keywords

    asset management; passive investing; index investing; indexing; mutual fund; exchange-traded fund; leveraged and inverse exchange-traded products; financial stability; systemic risk; market volatility; inclusion effects; daily rebalancing;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • L1 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance

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