Working Paper: NBER ID: w28253
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: Passive Investing; Asset Prices; Market Volatility
JEL Codes: G1; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| passive investing (G11) | asset prices (G19) |
| passive flows (F21) | prices of the largest stocks (G13) |
| passive flows (F21) | volatility of largest stocks (G17) |
| passive flows (F21) | market risk premium (G17) |
| mispricing due to noise traders (G19) | prices of overvalued stocks (G19) |
| passive flows (F21) | sensitivity to idiosyncratic cash flow shocks (G59) |
| passive flows (F21) | aggregate market (E10) |
| passive flows (F21) | feedback loop of prices and volatility (G13) |