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Rise of Passive Investing Poses Risks: Fed Report

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The shift from active to passive investing is not without risk for financial markets and investors.

A recently updated report from the Federal Reserve Bank of Boston and the Federal Reserve Board acknowledges benefits from the shift: It may increase liquidity and reduce redemption risks in financial markets while cutting costs and improving performance for individual investors, since most active funds don’t outperform over the long haul. But the researchers warn that growth of passive investing also poses potential hazards.

The shift to passive magnifies industry concentration among asset managers, which can increase risks when one or more large firms have operational problems. It may also increase the correlation of returns and liquidity among stocks included in the same index and, in the case of leveraged funds, increase the volatility of financial markets.

It “is affecting the composition of financial stability risks … mitigating some risks and increasing others,” the report authors write.

Those effects could become more pronounced if the growing popularity of passive funds continues, and there is little evidence that it won’t.

From 1995 to 2018, cumulative net flows to passive mutual funds and ETFs totaled $4.7 trillion, compared with $2.0 trillion for active funds, according to the authors’ calculations based on data from Morningstar. As of Aug. 31, total assets of passive U.S. equity mutual funds and ETFs topped the total assets of actively managed U.S. equity funds for the first time ever at $4.27 trillion vs. $4.25 trillion, according to Morningstar.

(Related: Passive Overtakes Active in US Stock-Fund Assets: Morningstar)

“This milestone has been a long time coming,” according to Morningstar. “Over the past 10 years, active U.S. equity funds have had $1.3 trillion in outflows and their passive counterparts nearly $1.4 trillion in inflows.”

That’s not the case for U.S. bond funds. Active bond funds still have far more assets than passive funds — $2.66 trillion vs. $1.45 trillion — although flows into passive bond funds over the 12 months ended Aug. 31 were almost 50% larger: $160.8 billion vs. $109.3 billion for active funds, according to Morningstar. Vanguard, which is owned by its investor-shareholders, manages almost one-quarter of the $19.2 trillion in fund assets that Morningstar tracks.

The Fed report, which essentially reviews existing research about the active-to-passive shift in fund assets, concludes with a call for more research. The topics that need more study, according to the report, include the impact on bonds when added to passive fixed income indexes, known as index inclusion effects, and the differences in liquidity risk management practices between active and passive funds. 

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