Passive investing has increased U.S. stock volatility, study finds

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Even the rise in market turnover caused by the emergence of algorithm-driven high-frequency traders could not compensate for the decline in market efficiency caused by the reduction in more fundamentally driven active investors.Courtney Crow/The Associated Press

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The rise of passive investing is distorting price signals and pushing up the volatility of the U.S. stock market, according to academic research.

The analysis raises fresh questions about the widespread adoption of index-based investing, a trend that has allowed investors to save billions of dollars a year in the shape of lower fees – seemingly without hurting returns.

“Markets [have] become less efficient from the rise in passive investing,” says Valentin Haddad, associate professor of finance at UCLA Anderson School of Management.

Mr. Haddad and two other U.S. academics examined trades by institutional investors and found that the rise in passive investors’ share of the market over the past 20 years “has led to substantially more inelastic aggregate demand curves for individual stocks by 15 per cent.”

Passive investors have a “demand elasticity” of zero, that is they don’t buy more of a stock if it becomes cheaper or less as it becomes more expensive.

An increase in the share of passive investment thus pushes the market’s aggregate elasticity down.

Market theory suggests this should not really matter – that when a trader is surrounded by less aggressive traders they themselves become more aggressive, cancelling out the effect and maintaining the market’s competitiveness.

But the academics found this “pass-through” was only about 0.6, meaning that almost half of the decline in the proportion of active investors translates into a reduction in overall demand elasticity.

“Passive money is not paying attention to any information. Efficient market hypothesis proponents say it’s not a big deal because others will come in,” says Mr. Haddad, who co-authored the paper, “How Competitive is the Stock Market?,” with Paul Huebner and Erik Loualiche.

“But not enough people are showing up to trade. You have less information in the market, less aggressive trading, less accurate prices and a more volatile market,” he says.

Mr. Haddad contends that even the rise in market turnover caused by the emergence of algorithm-driven high-frequency traders could not compensate for the decline in market efficiency caused by the reduction in more fundamentally driven active investors.

“High-frequency trading does offset it to some extent. It makes prices liquid but it doesn’t help on the longer-term horizon. Nobody is there to take a long view,” he says.

Felix Goltz, research director at Scientific Beta, a data provider, says the paper added to the growing body of research that shows the impact that passive investing has on markets is “huge.”

Mr. Goltz cites the “price effect” – in essence, another phrase for an inelastic demand curve – that occurs when a stock enters an index and passive investors have to buy it.

“Even if the price goes up only marginally because of these investors, you can make the case that rational investors should not buy the stock because there are alternatives, there are perfect substitutes, so there can’t be any impact on the price of such a stock. But there is evidence that there is an effect,” he says.

“These effects have been documented with the S&P 500: a stock increases its price when it enters the index and the opposite happens if it is kicked out.”

In the case outlined by Mr. Haddad et al, Mr. Goltz says investors were buying a stock “even though the price has gone up,” so demand is more inelastic and “you can have additional volatility from shifts in demand.”

He says the rise of passive funds investing on the basis of environmental, social and governance (ESG) principles could exacerbate the problem.

With ESG, “the preference [to buy stocks in the index] is becoming stronger,” Mr. Goltz says. “People think [companies] are doing something harmful to society if they are not in the index so they care more about whether a stock is included.”

As a result, “demand should be more inelastic for stocks included in ESG benchmarks. That should lead to higher prices for these stocks,” Mr. Goltz adds.

Consequently they “would have lower long-term returns. If you don’t care about these [ESG] tastes, you can buy stocks that have higher long-term returns.”

Another academic, who declined to be named, says the findings were “not necessarily surprising,” given the size of the big index managers such as BlackRock Inc., Vanguard Group Inc. and State Street Global Advisors, and how much they have absorbed of the float of public companies.

However, he says that “there is no reliable evidence yet that indexing systematically hampers the price discovery of stocks.”

Indeed, on balance, he says indexing may aid price discovery by increasing the supply of lendable shares and thus enabling short selling.

While accepting that the growth of passive investing has provided benefits to investors, Mr. Haddad believes pricing would be more accurate and volatility lower if more active traders were encouraged into the market.

“There is still a very healthy [active] financial sector but it’s shrinking and we need some of these guys,” he says.

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