In this Research Note we review the recent academic research on the impact of the growth of passive investing on market efficiency and market effectiveness.
The growth of passive investing has undoubtedly created substantial benefits for investors by lowering the cost of investing (directly by providing low cost investment vehicles and indirectly by increasing the competition for investor mandates). Yet, active fund management too creates substantial benefits for investors by supporting the research, trading, and monitoring that is essential for an equity market to work well.
Active fund management is necessarily more costly than passive fund management, and these costs can cause active funds to (on average) underperform the market. Consequently, each investor individually has an incentive to take market quality as given and opt for lower cost passively managed funds. If a sufficient proportion of investors do opt for passive management, then it is possible that these individually sensible choices may in aggregate lead to investor detriment due to their adverse impact on market quality and so on overall economic performance.
The task of designing a regulatory regime that enables market participants to create the well working equity market that the economy requires while simultaneously minimizing the cost of bringing about and sustaining that market therefore poses complex questions for regulators.