The hidden costs of passive investing : an empirical study on the impact of passive investing on the liquidity and price efficiency of Norwegian stocks

2020

In this thesis, we examine the relationship between passive ownership in the Norwegian

stock market and the liquidity and price efficiency of the underlying stocks. We suggest

that a shift from active to passive investing should be associated with a decrease in the

liquidity of individual stocks, as more shares are held in long-term deposits and more

trading is executed on a non-fundamental basis. The same shift, in addition to a reduction

in liquidity and an increase in the trading of stocks in large baskets, should all lead to a

decrease in the price efficiency of the underlying stocks.

In our analysis, we utilise a panel of 214 publicly listed Norwegian stocks in the period from

2000 to 2020, with monthly ownership and daily financial market data on the stock-level.

We find a negative relationship between changes in the passive ownership of a stock and

contemporaneous changes in its liquidity. The effect is smaller for larger stocks, which

could explain why we find a larger effect than the existing literature using our sample

of relatively illiquid Norwegian stocks. Further, we document a negative relationship

between changes in passive ownership and changes in price efficiency, as measured by

return synchronicity. We find that the effect is smaller for larger firms. Taking into

account our sample of relatively small firms, the effect is still small relative to the existing

literature. This could be explained by the frequent trading of stocks in baskets by ETFs,

which is less prevalent in the Norwegian market.

Keywords – Passive Investing, Liquidity, Price Efficiency, Asset Management