The Risk Implications of Passive Investing

Abstract

Developing on previous literature, this study identifies the risk implications that greater passive investing may entail. I find that a one percent increase in daily passive ownership is associated with a 0.00148% percent increase in the daily turnover of a stock and a 0.00271 unit increase in its daily equity beta, which indicates that passive investing may increase both idiosyncratic and systematic risk. I subsequently find that a one percent increase in daily passive ownership increases a stock’s intraday volatility by 0.000782, which reveals that the current growing passive investing trend may bring with it greater aggregate risk. This greater volatility is not necessarily negative, however, because I find that a one percent increase in daily passive ownership is associated with a 0.0138% increase in a stock’s daily Sharpe Ratio, risk-adjusted return. Using multiple models with varying horizon and explanatory variables, I identify rebalancing as the underlying mechanism behind the increase in volatility and risk-adjusted returns that greater passive ownership entails.