Effects of Passive Intensity on Aggregate Price Dynamics

Published date01 August 2015
Date01 August 2015
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
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).
C2015 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.

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