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Daniel Dieckelmann
Financial Stability Expert · Macro Prud Policy&Financial Stability, Systemic Risk&Financial Institutions
Emilio Siciliano
Andrzej Sowiński
Financial Stability Expert · Macro Prud Policy&Financial Stability, Market-Based Finance
Ni na voljo v slovenščini.

Passive investing and its impact on return co-movement, market concentration and liquidity in euro area equity markets

Prepared by Daniel Dieckelmann, Emilio Siciliano and Andrzej Sowiński

Published as part of the Financial Stability Review, November 2024.

There has been a continuing shift from active to passive investing in equity markets over the past decade, raising questions over the implications for financial stability. Passive investing aims to deliver a return which mirrors that of the overall market, often proxied by a broad index. Passive funds try to achieve this by replicating the benchmark portfolio fully, partially (by buying a subset of stocks in the index) or synthetically (by using derivatives on the broad indices). By contrast, active investing aims to outperform the market. The appeal of passive investing is based, among other things, on the assumption that, after fees, the average return on actively managed investments will be lower than that on passively managed investments. On the basis of empirical evidence supporting this assumption, investors have continued to reap these cost benefits by moving their funds from active to passive investment structures (Chart A, panel a).[1] While the euro area equity market continues to lag behind the US market in terms of passive ownership, it does share the same upward trend (Chart A, panel b). That said, euro area investors are more exposed to the impact of passive investing through their large US stock holdings (Chart A, panel c). Although it provides clear benefits to individual investors, passive investing might be associated with risks that, on a system-wide level, may undermine financial stability via multiple channels.[2] This box focuses on three such channels, namely the impact that can have on stock return co-movement in the euro area, on equity market concentration and on market liquidity clustering.

Chart A

While the global trend towards passive equity investment continues, euro area investors are exposed to the potential side effects of passive investing mainly through the US market

a) Cumulative flows into global equity funds, by management style

b) Share of passive ownership in equity markets, by region

c) Equity portfolio of euro area investors, by issuer region

(1 Jan. 2014-30 June 2024, left-hand scale: USD trillions, right-hand scale: percentages)

(1 Jan. 2014-30 June 2024, percentages)

(Q1 2024, percentages)

Sources: Bloomberg Finance L.P., EPFR Global and ECB calculations.
Notes: Panel a: AUM stands for assets under management. Panel b: calculated as the average for the members of the EURO STOXX (euro area), the S&P 500 (United States) and the S&P Global 1200 excluding euro area and US companies (rest of the world), weighted by market capitalisation. Panel c: shaded areas are the approximated share of passively managed exposures based on the average passive share for individual markets. A very recent study has found that the actual passive ownership share might be considerably higher than that reported because of “other kinds of passive investors, such as institutional investors with internally managed index portfolios and active managers who are closet indexing”. See Chinco, A. and Sammon, M., “The passive ownership share is double what you think it is”, Journal of Financial Economics, Vol. 157, July 2024.

Passive investing may increase co-movement among stock returns, making markets more volatile. As passive investment strategies aim to achieve a benchmark return, their trading activity is not driven by stock fundamentals. To minimise tracking error, passive managers buy the whole basket of index constituents in response to fund inflows (selling in the case of outflows) and adjust their portfolios in line with changes to the index composition. This basket trading may result in increased trading commonalities among stocks in broad equity markets and thus stronger return co-movement. The simultaneous buying (selling) of stocks within a specific index causes constituent stocks to co-move throughout the trading day, increasing correlation.[3] At the portfolio level, this increased return co-movement of constituent stocks results in higher return volatility for the portfolio as there are fewer diverging stock price movements to offset each other. For the euro area, empirical findings suggest that an increase in the share of passive investors in a stock’s ownership structure is associated with a higher correlation of that stock with the broad market (Chart B, panel a). Between the first quarter of 2010 and the first quarter of 2024, a 1 percentage point increase in the passive ownership share of a euro area stock was associated with an increase of around 0.005 in the correlation coefficient with the EURO STOXX index.[4] Therefore, a continued shift towards passive investing is likely to undermine the benefits of diversification for investors, making the performance of their portfolios more volatile.

Chart B

Passive investing increases the return co-movement of stocks with the broad market and may result in higher market concentration and lower intraday liquidity

a) Effect of a 1 percentage point higher passive ownership share on return correlation with the EURO STOXX index

b) Market liquidity and stylised stock price impact of passive investing, by company size

c) Average share of the volumes traded on the closing auction in total trading volumes, and intraday liquidity indicator

(Q1 2010-Q1 2024)

(30 June 2024, x-axis: percentages, y-axis: basis points)

(1 Jan. 2015-30 June 2024, percentages)

Sources: Bloomberg Finance L.P. and ECB calculations.
Notes: Panel a: The estimate is based on a panel regression with stock and time fixed effects that regress correlation with the EURO STOXX index on the passive ownership share of constituent stocks, controlling for market capitalisation, liquidity, valuation and 1 autoregressive lag of the correlation coefficient. The interval is set at 95% confidence. The EURO STOXX index captures 90% of euro area free-float market capitalisation. The results also hold in a two-step regression set-up, using index inclusion as an instrumental variable for passive ownership share. Panel b: average price impact on the stocks included in the EURO STOXX (euro area) and the S&P 500 (United States), assuming that the demand from passive funds is equal to 0.1% of the index free float over the period of one month, proxied by the Bloomberg Liquidity Assessment model. Purchases by passive funds are assumed to be proportionate to index weights. Relative liquidity is proxied by the average turnover ratios, calculated as the value of transactions executed in the last 12 months divided by average capitalisation. Averages are weighted by index share. Panel c: closing auction occurs at the end of the trading session. This is when all new orders are no longer matched in real-time, but first aggregated, and then the final closing price is determined through an auction process. Average share for the stocks included in the EURO STOXX (euro area) and the S&P 500 (United States). Average turnover ratio is calculated as the value of transactions executed outside closing auctions divided by average capitalisation. For 2024 the turnover was annualised proportionately to the number of trading days remaining. Averages are weighted by market capitalisation.

Passive funds may increase equity market concentration, potentially exposing investors to heightened idiosyncratic risks from the largest companies. Since growing equity market concentration has raised some financial stability concerns recently, it is worth investigating the potential role of passive funds in this trend.[5] Partially replicating funds, for example, consistently overweight larger companies for the sake of operational simplicity, while keeping tracking error contained. Counterparties to derivative trades with funds that replicate synthetically are also likely to overweight the largest companies as part of their hedging strategy. However, most passive funds fully replicate their benchmarks, suggesting that replication style has a contained impact on concentration overall. That said, even if the demand from passive funds for individual stocks is proportionate to their index share, the impact on price might diverge across companies, depending on market liquidity. For the largest companies, market liquidity is typically higher in nominal terms but does not scale in proportion to their much larger capitalisation and index weights. Consequently, passive fund flows have greater potential to affect the prices of larger companies than the prices of smaller ones (Chart B, panel b).[6] As a result, continued inflows may increase the market capitalisation of the biggest entities, taking their index weights even higher and ensuring a larger share of demand from passive funds going forward.[7] This, in turn, might increase the concentration of market capitalisation and make equity markets more susceptible to idiosyncratic risks from the largest companies.

The ability of equity markets to absorb shocks may be inhibited by the growing concentration of liquidity at closing auctions impacted by passive investing. Passive funds avoid trading during a continuous trading session, preferring to trade at closing auctions where the final closing price is determined, to reduce the tracking error against their benchmark. This is evidenced by a significantly larger share of closing auction volumes on index rebalancing days, when activity by passive funds is higher (Chart B, panel c). On other days, passive funds trade at closing auctions to manage their flows. A structural preference of this kind may attract other market participants, in line with a “liquidity begets liquidity” mechanism.[8] This concentration of liquidity might feed into the deterioration of intraday liquidity observed over the last decade. While the impact of such a structural change on market efficiency is debatable,[9] it might reduce the ability of markets to absorb shocks during continuous trading sessions, making them less resilient overall.

Passive investing continues to provide investor benefits but might also adversely affect market functioning, thus highlighting the importance of investor heterogeneity. Elevated fees in actively managed funds are continuing to push investors towards less costly passively managed structures. As this box shows, while at present the passive ownership share of euro area stocks is still only half that of the United States, there is an upward trajectory in both regions, and euro area investors are increasingly exposed to the impact of passive investing through their US stock exposures. In aggregate, empirical evidence suggests that rising passive ownership is associated with an increase in the correlation of stocks with the broad market, a heightened concentration of market capitalisation and a “lumping” of liquidity around the closing auction. These relationships could undermine the benefits of diversification for investors and reduce the ability of markets to absorb shocks, potentially leading to larger price volatility in the end. Higher volatility could, in turn, inhibit the role played by markets in funding the real economy if price uncertainty caused corporations to put off decisions to raise capital. Overall, the findings in this box imply that active investors play an important role in improving the efficiency of price formation. This should be taken into consideration when designing policies, such as leverage limits, which affect their trading capacity. Such investors might be better off aligning stock prices with their fundamentals and supporting market liquidity in times of stress, thus partly mitigating spillovers from the rise in passive investing.

  1. See, for example, Sharpe, W.F., “The Arithmetic of Active Management”, Financial Analysts Journal, Vol. 47, No 1, Jan.-Feb. 1991, pp. 7-9, on the theoretical argument and Sushko, V. and Turner, G., “The implications of passive investing for securities markets”, BIS Quarterly Review, Bank for International Settlements, March 2018, on empirics.

  2. These channels include, among others, reduced market liquidity, lower market efficiency, elevated stock price volatility, stronger stock return co-movement, as well as reduced redemption risks and increased concentration in the asset management industry. See, for example, Anadu, K., Kruttli, M., McCabe, P. and Osambela, E., “The Shift from Active to Passive Investing: Potential Risks to Financial Stability?”, Finance and Economics Discussion Series, No 2018-060R1, Board of Governors of the Federal Reserve System, August 2018, revised June 2020.

  3. See, for example, Barberis, N., Shleifer, A. and Wurgler, J., “Comovement”, Journal of Financial Economics, Vol. 75, Issue 2, February 2005, pp. 283-317, and Da, Z. and Shive, S., “Exchange traded funds and asset return correlations”, European Financial Management, Vol. 24, Issue 1, January 2018, pp. 136-168.

  4. For reference, the average return correlation coefficient of a euro area stock with the EURO STOXX index between the first quarter of 2010 and the first quarter of 2024 is 0.50.

  5. See the section entitled “Benign pricing of risk keeps asset prices vulnerable to shocks”, Financial Stability Review, ECB, May 2024.

  6. The effect might be limited if the inflow into passive funds is funded by the outflow from active funds present in the same market. In such a scenario, the net price impact is also dependent on the structure of active-fund holdings.

  7. Such an amplification loop stemming from price impact can persist longer when the prices of larger companies exhibit a strong upward trend. In such cases, risk-return considerations make active investors less likely to align prices with fundamentals by underweighting or short selling the relevant stocks. See, for example, Jiang, H., Vayanos, D. and Zheng, L., “Passive Investing and the Rise of Mega-Firms”, SSRN, June 2024.

  8. See, for example, Bogousslavsky, V. and Muravyev, D., “Who trades at the close? Implications for price discovery and liquidity”, Journal of Financial Markets, Vol. 66, November 2023. A high share of the volumes traded during the closing auction in the euro area may also result from the activities of US investors, for whom the trading session starts shortly beforehand.

  9. See, for example, Comerton-Forde, C. and Rindi, B., “Trading @ The Close”, SSRN, 28 September 2022, and Bender, M., Clapham, B. and Schwemmlein, B., “Shifting Volumes to the Close: Consequences for Price Discovery and Market Quality”, SSRN, 20 March 2024.