2021 Theses Doctoral

Essays in Passive Investing and Asset Pricing

Dovman, Polina

This dissertation studies topics in Passive Investing and Asset Pricing. The first chapter, "When do flows matter for asset prices: Evidence from adoption of ETF creation in Israel," focuses on the effect of capital allocation to passive investments on asset prices. We study a 2012 reform in Israel where all exchange traded products listed on the Tel Aviv Stock Exchange (TASE) adopted the Exchange Traded Fund (ETF) creation mechanism wherein designated market makers arbitrage between the index price and the net asset value of its benchmark.

The reform greatly decreased the cost of this arbitrage activity and translated into a significant increase in demand for passive investments. The effect was stronger for illiquid indices containing smaller stocks. We show that the price effects of the reform were dramatically higher for stocks located at the top of indices composed of smaller stocks relative to stocks at the bottom of indices composed of bigger stocks. A 1 p.p. increase in passive ownership as a percent of market capitalization leads to an 11.7% increase in the price of stocks. Our findings provide new evidence on how passive inflows can change the distribution of capital across indices, and in turn impact price efficiency.

In the second chapter, "Passive Investing and Algorithmic Trading," I examine the trading behavior of market participants against the growing demand for passive investing. I show that the growth of passive investing and algorithmic trading is complementary and mutually reinforcing. Algorithmic traders respond to a spike in demand for passive investments listed on the TASE following a major reform in the Israeli index market in 2012 by front-running the index inflows. Algorithmic traders accumulate stocks when index inflows are low and sell stocks when they are high. Based on this strategy, algorithmic traders earn a 12.7% annualized return in realized gains over passive strategies in the same period. Instead, Mutual Funds load on the index when inflows are high.