How Index Trading Increases Market Vulnerability

The authors found that the rise in popularity of index trading—assets invested in index funds reached more than $1 trillion at the end of 2010—contributes to higher systematic equity market risk. More equity index trading corresponds to increased cross-sectional trading commonality, which precipitates higher return correlations among stocks. Consistent with the accelerating growth of passive trading, the authors found that equity betas have not only risen but also converged in recent years.