Working Paper: CEPR ID: DP15563
Authors: Hao Jiang; Dimitri Vayanos; Lu Zheng
Abstract: We study how passive investing affects asset prices. Flows into passive funds raise disproportionately the stock prices of the economy's largest firms, and especially those large firms that the market overvalues. These effects are sufficiently strong to cause the aggregate market to rise even when flows are entirely due to investors switching from active to passive. Our results arise because flows create idiosyncratic volatility for large firms, which discourages investors from correcting the flows' effects on prices. Consistent with our theory, the largest firms in the S&P500 experience the highest returns and increases in volatility following flows into that index.
Keywords: Market Efficiency; Mutual Funds; Indexing; Limits of Arbitrage
JEL Codes: G10; G11; G12; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Flows into index funds (G23) | Prices of large stocks (G13) |
| Flows into index funds (G23) | Prices of small stocks (G13) |
| Flows into index funds (G23) | Future returns of the small-minus-large index portfolio (G17) |
| Lagged flows into index funds (G23) | Future performance of small stocks (G17) |
| Concentration of index weights (C43) | Future returns of the small-minus-large portfolio (G17) |
| Market capitalization (G10) | Expected return of small-cap index stocks (G17) |