Study: Stock Demand Has Become 11% Less Elastic Over the Last 20 Years Due to the Growth of Passive Investing

Vyacheslav Dvornikov

Feb 6, 2025

The rise in passive investing may be the cause of such sharp fluctuations as those that occurred last Monday when markets took notice of the linguistic model from the Chinese startup DeepSeek. This is according to a new study that will soon be published in the prestigious American Economic Review. According to the authors from UCLA Anderson School of Management, Stockholm School of Economics, and Carlson School of Management at the University of Minnesota, active investors react too slowly to price changes, exacerbating volatility. In an environment dominated by index funds, the impact of each trade on prices is amplified. 

According to one of the study's authors Valentin Haddad, a finance professor at UCLA, belief in market efficiency is a kind of magical thinking. If some investors become passive and active ones do not change their strategy, prices become less stable.

The research question goes beyond theory, notes Bloomberg. A less efficient market can lead to a misallocation of capital among U.S. companies and undermine investment strategies based on fundamental analysis. The study supports concerns about "broken markets," previously warned by well-known investors like David Einhorn (Greenlight Capital). Additionally, Cliff Asness (AQR Capital Management) and Torsten Slok (Apollo Global Management) mentioned this work when discussing the impact of passive investing on the market. A draft of the study was published back in 2021. 

The authors analyzed data from Form 13F reports, which large investors with assets over $100 million must submit quarterly, and data on individual stocks. This helped them determine how actively managed funds trade in response to price changes, especially in the case of stocks largely owned by index funds. The latter acquire shares in proportion to their capitalization, paying little attention to their actual value.

The conclusions are discouraging: over the past 20 years, demand for stocks has become 11% less elastic due to the rise of passive investing. This means that active managers are increasingly reluctant to buy stocks even if they consider them undervalued. This, in turn, makes the market less liquid and less sensitive to fundamental information. David Einhorn has already stated that markets are "broken" due to the declining role of active investors focused on the fair value of companies.

The study also offers several explanations for why active investors are not becoming more aggressive, i.e., not increasing the number of trades. Firstly, many managed funds are constrained by their investment mandates and trading frequency requirements. Secondly, some active managers simply try to "hug the benchmark," avoiding significant deviations from indices.

However, the study does not make a definitive conclusion that the world's largest stock market has become less efficient — there is too much "noise" in the data, making assessment difficult. Another study, published in 2022, did not find substantial evidence of a decline in market efficiency due to passive investing.

Nevertheless, the work of Haddad and his colleagues Paul Huebner and Eric Lualice finds support among those who believe that the dominance of passive strategies destabilizes markets. Michael Green, a former hedge fund manager and one of the most well-known critics of the growth of passive investing, highlights the study's finding that large-cap stocks have even less investor demand elasticity. This means that the larger the company, the weaker the demand responds to changes in its price. Therefore, any trade can more significantly shake the market, as evidenced by the fluctuations last Monday.

The study indicates that the popularity of passive investing has already begun to affect the market's ability to properly allocate capital, writes Bloomberg. "If the price falls without fundamental reasons, someone has to buy up that drop, and that stabilizes the market — that's how the pricing mechanism works," it explains. "The less elastic the demand, the weaker the market will smooth out such fluctuations because passive funds simply do not respond to price changes."