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

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.

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.

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.