The rise of passive investing, its effects on the underlying securities and implications on market efficiency

Abstract

Over the last couple of decades, stocks have become increasingly owned by passive methods of investing, a type of investing that mechanically follows stock indices, and where decision-making isn’t based on any research. This poses an interesting question about the pricing and efficiency of individual stocks that have had pressure from passive non-fundamental trading. Therefore, in this master’s thesis, I form time-series of passivity for individual stocks by aggregating the ownership of passive vehicles (index funds and exchange-traded funds) and analyse whether the quarterly flows and level of passivity alter the returns characteristics of stocks. I find a statistically significant negative, though small, effect of passivity on the realized quarterly skewness, and further analysis indicates that it is due to an elevated realized negative deviation, consistent with the idea that increases in passive ownership are associated with higher reversals due to passivity’s initial positive effect on prices and subsequent corrections induced by active investors. Additionally, I study the cross-section of stocks by running the same regressions by group, formed from the level of realized return on equity (ROE) and find that passivity’s effects are more prominent for stocks that have worse fundamentals, implying that the added non-fundamental buying pressure of passive institutions may have larger effects for stocks that wouldn’t perhaps otherwise be in much demand by investors, and have hence a higher share of non-fundamental trading out of the total trading. Finally, I study the potential long-term effects of passivity by forming event studies around index-deletions and find that the lagged level of passive ownership is a significant factor in explaining the abnormal returns around the deletions. Interestingly, the explanatory power of passive ownership is most prominent especially in the window leading up to the announcement of the index-deletion, implying that active investors may be more willing to take larger anticipatory bets against stocks that have had more non-fundamental flows by passive institutions in the past, consistent with the notion that each passive dollar may be adding something extra to the valuation levels of stocks and that arbitrageurs are limited in their capabilities in fixing this in the short-term. This study most closely relates to previous literature by Qin and Singal (2015), Coles et al. (2018), Baltussen et al. (2017) and Israeli et al. (2017).