Popularity of passive investments could contribute to increased market volatility

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AAs the popularity of passive investments such as exchange-traded funds continues, some warn that the growing adoption of index investing has contributed to greater distortion of price signals and volatility in US markets.

” The steps [have] are becoming less efficient because of the rise of passive investing,” Valentin Haddad, associate professor of finance at UCLA Anderson School of Management, told the Financial Times.

According to recent academic research, “How is the competition in the stock market?” Haddad, along with Paul Huebner and Erik Loualiche, examined transactions conducted by institutional investors and found that the large increase in market share of passive investors over the past two decades “has led to much higher aggregate demand curves. more inelastic for individual stocks, by 15%.

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

At the same time, an increase in the share of passive investments lowered the overall elasticity of the market.

The academics also found that nearly half of the decline in the proportion of active investors translated into a reduction in the overall elasticity of demand.

“Passive money pays no attention to any information. Proponents of the efficient market hypothesis say it’s okay because more will come,” Haddad said.

“But not enough people show up to trade. You have less market information, less aggressive trading, less accurate pricing and a more volatile market,” he added.

Haddad even argued that the rise of algorithm-based high-frequency traders was not enough to offset the decline in market efficiency caused by a reduction in fundamentally motivated active market participants.

“HFT makes up for it to some extent. This makes prices liquid, but it doesn’t help in the longer term. No one is here to have a long-term view,” Haddad added.

Stock prices would be more accurate and volatility lower if more traders were actively involved in the market ecosystem, Haddad said.

Another academic, who declined to be named, argued the results were “not necessarily surprising,” pointing to the size of big index fund sponsors like BlackRock, Vanguard and State Street Global Advisors, and their contribution to the float. public companies.

However, he told FT that “there is not yet reliable evidence that indexing consistently impedes stock price discovery”, even going so far as to state that indexing has facilitated price discovery. by increasing the supply of loanable shares and thereby permitting short selling.

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