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Premise

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:

https://www.federalreserve.gov/econres/feds/the-shift-from-active-to-passive-investing-potential-risks-to-financial-stability.htm

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:

  1. 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))
  2. Upon a risk event, the large degree of comovement of fund flows and stocks would propagate shocks
  3. 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.

Question

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?

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I’d start by briefly noting that “the Fed” didn’t say anything; that’s a research paper (by some smart people), but it’s disclaimed and doesn’t necessarily reflect the views of anyone other than the authors.

Having said that, I would then rephrase your question as follows: “what happens if everyone decides to cash in their retirement funds at once?” The answer to that would be: they would all get a very poor return, but thankfully that’s unlikely.

Very little of the question as posed has anything to do with active vs. passive strategies. “Passive” players aren’t different types of players, they’re the same types engaging in different strategies because they have different beliefs. If I invest my 401(k) in a Vanguard index fund vs. an actively managed fund with the same targets, I’m still the same person with the same risk tolerance, and I’m still subject to the same shocks from the real economy.

It’s always extremely important to keep in mind the underlying motivations and stylized behaviors of different types of players, and thankfully, retail investors do tend to avoid panic selling their holdings at market lows. This is simply because they tend to have long time horizons (most passive investors are simply saving for the future and not drawing on their assets for current income, in which case they’d hopefully have shifted to fixed income). This also largely takes fire sale dynamics off the table. Fire sales happen generally when leveraged players are forced to mark-to-market. Most retail index investors are completely unlevered, so draw-downs mostly represent buying opportunities. So because the underlying type hasn’t changed, the fact of being invested in passive strategies doesn’t really change much.

If that were not true, you’re right, the investors would suffer huge losses, but even then, it wouldn’t really be a financial crisis, and there wouldn’t be any good logic for official sector intervention. I say that it wouldn’t constitute a financial crisis because losses on equity are just someone’s investment losses (and likely soon someone else’s gains). From a financial stability standpoint, equity does not matter, debt matters. People often conflate the two, because when debt is distressed, so is equity, but that is confusing a symptom (distressed equity) with the disease (distressed debt). Keep in mind that the post-2000 equity market losses rivaled the 2006-2009 mortgage market losses (which were debt) in magnitude, but only in the latter did we see a financial crisis. In contrast, large-scale inabilities for companies to access debt markets reflect a broad tightening of credit conditions— a liquidity crisis, which is what Bagehot described and what is generally an object of concern for central banks. So while the official sector will intervene when debt markets break down, it is not within the official sector’s purview to attempt to allocate gains or losses.

Having said all that, in the spirit of trying to fully answer your questions, there are ex ante tools that exist to basically discourage opportunistic redemptions from funds. They do not really apply differently to passively vs actively managed funds, though; they instead exist to ensure that one’s redemptions don’t negatively impact other fund holders. There are a whole litany of such tools, including gates, fees, swing pricing, minimum balance at risk, and others.

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