Passive Investing Is Reshaping the Stock Market—But Not Only for the Better

Oct. 07, 2024

The explosive growth of passive investing is reshaping the stock market, leading to increased volatility and less efficient pricing. Investors who once actively picked stocks are now more likely to track an index, and new research suggests this shift is making the market more vulnerable to sharp price swings.

A recent study by Swedish House of Finance’s Paul Huebner, UCLA’s Valentin Haddad, and University of Minnesota’s Erik Loualiche reveals how the rise of passive investing is affecting the market due to imperfect competition. Their research suggests that as passive strategies dominate, the demand for individual stocks becomes more inelastic—meaning that changes in price have less impact on how much of the stock is bought or sold—disrupting the typical equilibrium and price-setting mechanisms that help stabilize the market.

Challenging the Conventional View of Market Competition

The authors challenge the conventional wisdom that financial markets are ruthlessly competitive, with less aggressive traders always replaced by others.

"If you stop looking for $20 bills on the floor, someone else will replace you," they say, describing the traditional view.

However, their findings present a more nuanced picture. When investors are surrounded by less aggressive traders—such as passive funds with zero price elasticity—the increased trading aggression from other investors only offsets about two-thirds of the initial impact. As a result, the stock market is less efficient.

Impact on Market Volatility and Liquidity

The study reveals that the rapid growth of passive funds has made stock demand 11% more inelastic, significantly affecting price elasticity in the U.S. stock market. By analyzing the strategic responses of institutional investors, the researchers show how passive investing disrupts the market's ability to stabilize prices.

Using data from institutional portfolios, the study highlights how passive investing has weakened the strategic interactions that usually maintain price elasticity. As passive investing grew from $11 billion to $2.8 trillion between 1993 and 2020, it profoundly impacted market dynamics. A substantial portion of the stock market now exhibits lower price elasticity, making it less responsive to shifts in supply and demand. This shift, the researchers note, could result in greater price volatility, reduced liquidity, and diminished price informativeness.

Constraints on Investor Reactions to Market Changes

Despite the decline in aggregate elasticity, the authors emphasize that the stock market is not becoming entirely inefficient.

Investors still respond to opportunities, but their ability to do so is constrained by factors such as informational frictions, market power, and contractual limits.

"While the effects of competition in strategies are strong, the stock market is far from the common view," they note, adding that the rise of passive investing only partially explains the shift in market dynamics; advances in financial technology and greater access to data have also significantly influenced investment strategies and market behavior.