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

Author

Listed:
  • Patrick E. McCabe
  • Mathias S. Kruttli
  • Emilio Osambela
  • Chae Hee Shin

    (Board of Governors of the Federal Reserve System (U.S.)
    Washington University in St. Louis
    University of Southern California
    National Bureau of Economic Research)

  • Kenechukwu E. Anadu

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 for 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

  • Patrick E. McCabe & Mathias S. Kruttli & Emilio Osambela & Chae Hee Shin & Kenechukwu E. Anadu, 2018. "The Shift from Active to Passive Investing : Potential Risks to Financial Stability?," Finance and Economics Discussion Series 2018-060, Board of Governors of the Federal Reserve System (US), revised 28 Aug 2018.
  • Handle: RePEc:fip:fedgfe:2018-60
    DOI: 10.17016/FEDS.2018.060
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    File URL: https://www.federalreserve.gov/econres/feds/files/2018060pap.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    Daily rebalancing; Leveraged and inverse exchange-traded products; Financial stability; Market volatility; Exchange-traded fund; Asset management; Passive investing; Mutual fund; Indexing; Index investing; Systemic risk; Inclusion effects;

    JEL classification:

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

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