Effects of Passive Intensity on Aggregate Price Dynamics

• Published date: 01 August 2015
• Date: 01 August 2015
• DOI: http://doi.org/10.1111/fire.12071
• Author: Donald Lien,Sina Ehsani

The Financial Review 50 (2015) 363–391

Effects of Passive Intensity on Aggregate

Price Dynamics

Sina Ehsani

Saint Xavier University

Donald Lien∗

The University of Texasat San Antonio

Abstract

We find that passive intensity (PI), measured by the passive-linked share of total stock

market trading volume, is strongly related to the overall pattern of stock price movements.

A one-standard-deviation increase in PI is associated with an 8% higher price synchronicity.

We further investigate the channels through which this relation is established by separately

analyzing its impact on aggregate systematic and idiosyncratic volatility of stock returns. PI

has a positive effect on systematic volatility and a negative impact on firm-specific volatility.

Consistent with the effect of passive trading on price dynamics, we find evidence that PI

is negatively associated with mutual funds alpha dissimilarity. After controlling for market

and idiosyncratic volatility, a one-standard-deviation increase in PI corresponds to a 0.20%

decrease in fund dissimilarity. Our findings are robust after controlling for variousmacro and

corporate factors known to affect systematic or firm-specific volatility.

Keywords: passive investment, comovement,systematic volatility, idiosyncratic volatility

JEL Classifications: G10, G14

∗Corresponding author: Professor and Liu Distinguished Chair in Business, Department of Economics,

The University of Texas at San Antonio, One UTSA Circle, San Antonio TX 78249; Phone: (210) 458-

8070; Fax: (210) 458-5837; E-mail: don.lien@utsa.edu.

We thank seminar participants at The University of Texas at San Antonio, Midwest Finance Association

(2015) meeting, and Financial Management Association (2014) meeting, in particular the discussant (Tao

Guo) for helpful comments. We gratefully acknowledge the detailed and constructive comments of an

anonymous referee and the editor (Robert VanNess).

C2015 The Eastern Finance Association 363

364 S. Ehsani and D. Lien/The Financial Review 50 (2015) 363–391

1. Introduction

According to traditional finance theories, stock price is the risk-adjusted present

value of expected cash flows. In this framework, asset returns are correlated because

the variations in intrinsic value of assets (e.g., expected cash flows) are correlated,

and frictions or the trading behavior of a portion of investors should not affect price

comovement. Researchers have found patterns inconsistent with this argument and

have proposed several explanations to why asset returns exhibit different regimes

of comovement over time and across countries. Barberis and Shleifer (2003) and

Barberis, Shleifer and Wurgler (2005) suggest that comovement may be detached

from fundamentals because of frictions or irrational behavior of investors. Several

theoretical and empirical studies suggest a variety of factors from corporate finance

to business cycle for possible candidates. In this paper, we showthat passive intensity

(PI), measured by passive-linked share of total trading volume, is one possible factor:

it is strongly related to time series behavior of aggregate stock return synchronicity,

systematic volatility and aggregate idiosyncratic volatility.

Demand for low-cost diversification has given rise to the creation of index

funds. A passive product such as exchange-traded fund (ETF) is typically designed

to replicate the performance of an index or a segment (e.g., small cap stocks, value

stocks, etc.) of the market by investing a specific amount in each of the underlying

securities. In addition to diversification,ETFs have lower managerial expenses, are tax

efficient, can be traded like a stock throughout the day, and the creation/redemption

mechanism allows them to be traded in line with the funds underlying net asset

value. Unlike a stock price that is determined by supply and demand, a passive

products price should only reflect the underlying basket: local supply/demand or

trading volume does not change its fundamental value and should not affect its price.

Consequently, price or trading volumeof a passive product should not affect the price

dynamics of the underlying stocks and the market. Passive instruments are intended

to follow the price of the underlying basket, and should not be associated with price

discovery of the underlying securities.

The total dollar-volume of ETFs was a very small fraction of aggregate volume

when ETFs were introduced in mid-1990s. Two decades later, the dollar turnover of

only one ETF,the SPY, is roughly 10% of the total trading volume of all U.S. stocks.1

ETFs’ share of total volume has increased from less than 1% in 1990s to 30% in

recent years. This shift toward passive trading is the motivation of our research. We

seek to test whether the investment vehicle that now generates around 30% of total

exchange trading volume influences the price discovery process.

1Most passive securities continue to experience upward trend in inflows and trading volume. In 2012,

passive securities absorbed 41% of total net flows (Morningstar, 2012: Annual Global Flows Report).

According to a report availableat http://www.etftrends.com/2013/11/etf-asset-flows-reveal-investors-love-

for-stocks/, U.S. ETF net inflow was $156.4 billion during the first 10 months of 2013, with total assets

reaching $1.641 trillion by the end of October 2013. There were 1,524 ETFs in United States at the time

of this study in November 2013.