In 2017, passively invested assets totaled 37% of mutual funds and ETFs; by 2021 this number is closer to 50% if not more. After the market downturn in (March) 2020, the Fed updated their research paper which evaluated potential risks to financial stability stemming from passive investing:
The piece does not have a strong position on the question, citing mixed empirical findings for the affirmative and negative as well as unclear causality. However, let's briefly play devil's advocate and imagine a worst case scenario:
- Passive assets under management (AUM) increases above some tipping point, decreasing the heterogeneity of investors and inducing a systemically huge non-diversifyable risk (Ben-David, Franzoni, Moussawi (2017))
- Upon a risk event, the large degree of comovement of fund flows and stocks would propagate shocks
- As price insensitive players, passive investors simply redeem at market price, yet as active managers have incentive structures not to sell at distressed levels, the dilemma in so many words becomes: what happens when passive wants to sell and there is not active to buy?
Under more benign assumptions, active may simply benefit from distortions caused by passive, but in the extreme scenario we are assuming in this article, perhaps monetary policy may need to have a playbook to prevent a financial crisis. I'm not going to pretend to know exactly all the mechanics of what would happen if events 1, 2 and 3 unfold (market goes to zero, liquidity crises, ect), but that's besides the point. For the purposes of the question, let's just assume this scenario can unfold.
Assuming the Federal Reserve / SEC wants to address the risks outlined above, what macroprudential tools would be relevant and what could be done ad hoc?