Passive Investing, Diversification Risk and Financial Stability

I. Gufler ()

CRC TR 224 Discussion Paper Series from University of Bonn and University of Mannheim, Germany

Abstract: This paper studies whether the rise of passive investing has reduced the equity market’s capacity to absorb aggregate shocks. Using a valuation-adjusted Bartik instrument, I show that a one-standard-deviation increase in a stock’s passive ownership raises its average pairwise return correlation by 9 percentage points. A structural demand system counterfactual reveals two opposing forces: common, price-insensitive passive demand synchronizes returns while dampening firm-specific volatility. For the market as a whole, synchronization dominates: with passive investors, the minimum volatility attainable in a long-only portfolio is 3.3% higher and diversification benefits are 2.1% lower, and about half of the loss stems from the growth of passive investing since the late 1990s. Active institutions, whose portfolios are more concentrated, bear about 5% less risk and gain slightly in certainty-equivalent terms, but lose 12% of their diversification benefits as risk shifts from firm-specific to common components. Passive investing thus trades lower private risk for a higher market-wide risk floor.

Keywords: Passive investing; Index funds; Exchange-traded funds; Diversification benefits; Stock return comovement; Systematic risk; Financial stability (search for similar items in EconPapers)
JEL-codes: G01 G11 G12 G23 (search for similar items in EconPapers)
Pages: 89
Date: 2026-11
New Economics Papers: this item is included in nep-fdg
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