Passive Investing and the Rise of Mega-Firms
We study how passive investing affects asset prices. Flows into passive funds raise disproportionately the prices of the largest stocks in the index, while also making them more volatile. If, in addition, stocks are mispriced because of noise traders, then passive flows raise the most the prices of the overvalued stocks among the index’s largest. Passive flows drive the aggregate market up even when they are entirely due to a switch from active to passive. Underlying these results is that passive flows make prices more sensitive to idiosyncratic future cash-flows. We provide empirical evidence in support of our model’s mechanisms.
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