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

Patrick E. McCabe, Mathias S. Kruttli, Emilio Osambela, Chae Hee Shin and Kenechukwu E. Anadu
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Chae Hee Shin: Board of Governors of the Federal Reserve System (U.S.)

No 2018-060, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

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.

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 (search for similar items in EconPapers)
JEL-codes: L1 G10 G32 G23 G20 G11 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2018-08-28, Revised 2018-08-28
New Economics Papers: this item is included in nep-cfn and nep-fmk
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DOI: 10.17016/FEDS.2018.060

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