Effects of Passive Intensity on Aggregate Price Dynamics

Abstract

We find that passive intensity (PI), measured by the passive‐linked share of total stock market trading volume, is strongly related to the overall pattern of stock price movements. A one‐standard‐deviation increase in PI is associated with an 8% higher price synchronicity. We further investigate the channels through which this relation is established by separately analyzing its impact on aggregate systematic and idiosyncratic volatility of stock returns. PI has a positive effect on systematic volatility and a negative impact on firm‐specific volatility. Consistent with the effect of passive trading on price dynamics, we find evidence that PI is negatively associated with mutual funds alpha dissimilarity. After controlling for market and idiosyncratic volatility, a one‐standard‐deviation increase in PI corresponds to a 0.20% decrease in fund dissimilarity. Our findings are robust after controlling for various macro and corporate factors known to affect systematic or firm‐specific volatility.

Passive Institutional Ownership, R2 Trends, and Price Informativeness

“…In their seminal paper, Grossman and Stiglitz (1980) suggest that the equilibrium number of informed investors needed for informational efficiency depends endogenously on structural factors that determine the size of the arbitrage profit. Ehsani and Lien (2015) corroborate this prediction by finding a positive correlation between cumulative equity ETF trading volumes and the aggregate market model R 2 , a proxy for stock market fragility (e.g., Kamara, Lou and Sadka, 2008). Given that the risk-adjusted margins of passive investors currently exceed those of active investors, the reward needed to induce investors to acquire costly information might not be achievable.…”

“…Our analyses find a positive association between a stock's passive institutional ownership growth and the trend of its market model R 2 . This association dominates any effect ETF ownership has on stock correlations, contrary to some studies that investigate ETF holdings' impact on market efficiency (e.g., Ehsani and Lien, 2015;Israeli, Lee and Sridharan, 2015). In addition, we investigate whether passive institutional ownership either positively or negatively impacts stock price informativeness.…”

“…This association dominates any effect ETF ownership has on stock correlations, contrary to some studies that investigate ETF holdings' impact on market efficiency (e.g., Ehsani and Lien, 2015;Israeli, Lee and Sridharan, 2015). Its trades are based on maintaining a benchmark index and passive institutions buy and sell stocks in lockstep.…”

“…Examples of such hard-to-trade assets include high yield bonds, foreign equities, commodities, and other securities traded over-the-counter. Ehsani and Lien (2015) corroborate this prediction by finding a positive correlation between cumulative equity ETF trading volumes and the aggregate market model R 2 , a proxy for stock market fragility (e.g., Kamara, Lou and Sadka, 2008). Brogaard, Ringgenberg and Sovich (2016) suggest that a reduction in the informativeness of commodity prices, caused by a rise in commodity index investing, is responsible for excess volatility in cash flows and stocks returns from firms heavily exposed to commodity prices as part of their operations.…”