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How Index Trading Increases Market Vulnerability

The rise of passive investment strategies may play a role in the market’s increasing fragility.

James X. Xiong, 01/31/2012

A more detailed version of this paper will be published in Financial Analysts Journal in 2012.

Index investing has experienced tremendous growth over the past two decades. This phenomenon is undoubtedly due, in part, to the appeal of index mutual funds and exchangetraded funds; they generally offer lowcost, comprehensive, diversified exposure to various market segments. Indexing’s appeal is compounded by the challenges of sourcing skilled active managers, which, of course, is a zero-sum—even negative sum-game after costs.

The popularity of index funds and ETFs, however, comes at the cost of “trading commonality,” or “basket trading,” across the market. Many stocks within an index being traded are simultaneously bought and sold. As a consequence, the stocks in an index tend to move together throughout the trading day.

At the same time, there has been a steady increase and convergence of U.S. equity betas across size and styles since 1997. Exhibit 1 plots the time series of equal-weighted cross-sectional beta estimates for U.S. stocks in four major equity size and style groups. We will return to this figure in detail later as A more detailed version of this paper will be published in Financial Analysts Journal in 2012. Index investing has experienced tremendous growth over the past two decades. This phenomenon is undoubtedly due, in part, to the appeal of index mutual funds and exchangetraded funds; they generally offer lowcost, comprehensive, diversified exposure to various market segments. Indexing’s appeal is compounded by the challenges of sourcing skilled active managers, which, of course, is a zero-sum-even negative sum-game after costs.


The popularity of index funds and ETFs, however, comes at the cost of “trading commonality,” or “basket trading,” across the market. Many stocks within an index being traded are simultaneously bought and sold. As a consequence, the stocks in an index tend to move together throughout the trading day.

At the same time, there has been a steady increase and convergence of U.S. equity betas across size and styles since 1997. Exhibit 1 plots the time series of equal-weighted cross-sectional beta estimates for U.S. stocks in four major equity size and style groups. We will return to this figure in detail later as we study how this rise in systematic risks connects with the rise in popularity of passively managed index funds and the associated increased trading commonality. Through a battery of tests, we examine the impact of trading commonality related to passive investing and how this affects systematic market risk.

Wurgler (2010)1 reviewed the consequences of index investing and suggests that index investing is distorting both stock prices and risk/return trade-offs. This, in turn, may distort a host of things, including corporate investment and financing decisions, investor portfolio allocation decisions, and assessments of fund manager skill. These effects could intensify if index-linked investing continues to gain popularity.

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