How Index Trading Increases Market Vulnerability

Abstract

The authors found that the rise in popularity of index trading—assets invested in index funds reached more than $1 trillion at the end of 2010—contributes to higher systematic equity market risk. More equity index trading corresponds to increased cross-sectional trading commonality, which precipitates higher return correlations among stocks. Consistent with the accelerating growth of passive trading, the authors found that equity betas have not only risen but also converged in recent years.

Assets invested in passively managed equity mutual funds and exchange-traded funds (ETFs) have grown steadily in recent years, reaching more than $1 trillion by the end of 2010. The level of passively managed assets now reaches more than half the level of assets in actively managed mutual funds. ETF trading now accounts for roughly one-third of all trading in the United States. This increased popularity and level of trading associated with passive investing, however, is not inconsequential.

In our study, we investigated the impact on market risk of increased index-related trading. We found that the growth in passively managed equity assets meaningfully corresponds to a decrease in the ability of investors to diversify risk in recent decades. We discovered that this is due, in part, to an increase in cross-sectional trading commonality associated with the rise in passive investing.

As evidence, we found that both pairwise correlations and cross-correlations between return volatility and volume volatility have significantly increased since 1997. Furthermore, we showed that the diversification benefits of equity investing have decreased for all styles of stock portfolios (small-cap, large-cap, growth, and value). These findings are particularly important for investors because the decline in diversification benefits can be coupled with increased market volatility and company-specific volatility. These changes have introduced additional challenges for risk management in equity portfolio construction.

Also consistent with the accelerating growth of passive equity assets, we found that in the past decade, equity betas for all styles of stock portfolios have not merely risen but have converged to similar values. Therefore, for both large- and small-cap portfolios, the diversification benefits for investors have diminished dramatically since 1997. This finding suggests that an investor who wishes to maintain the same excess return volatility level after 1997 would need to meaningfully increase the number of stocks in her portfolio, both large- and small-cap stocks.

Taken together, our results suggest that the fragility of the U.S. equity market has risen over recent decades. Furthermore, the ability of investors to diversify risk by holding an otherwise well-diversified U.S. equity portfolio has markedly decreased in recent decades. All equity investing, indexed or otherwise, is thus plainly a more risky prospect for investors. Investors can improve their investment processes by incorporating the impact of increased trading commonality into their risk-modeling framework.

Editor’s Note: Rodney N. Sullivan, CFA, is editor of the Financial Analysts Journal. He recused himself from the referee and acceptance processes and took no part in the scheduling and placement of this article. See the FAJ policies section of cfapubs.org for more information.