An investing trend that's grown rapidly in recent years may be making the stock market riskier and more volatile

• Passive investing has skyrocketed in popularity in recent years.
• Yet, that could be making active investing riskier, Apollo chief economist Torsten Sløk says.
• With a less active market, volatility is higher, and gains are concentrated in large-cap shares.

Passive investing has boomed in recent years, allowing mutual funds and ETFs to scale rapidly and investors to buy and hold for long periods.

At the same time, its popularity could be exacerbating the market’s volatile swings and the rising concentration in a handful of key stocks, Apollo’s chief economist Torsten Sløk says.

Passive investing has been a hit partly because it is lower risk than active investing. By putting assets into externally managed funds like ETFs or retirement savings plans like 401(k)s, investors get returns that match the market’s trajectory.

Active investors, meanwhile, have to react quickly to market developments, switching strategies when economic conditions change. This can lead to greater short-term gains as well as losses.

Passive investing tends to yield higher net returns in the long run in comparison, making it relatively safer and more popular amongst risk-averse traders, but in the process, it’s made active investing riskier, Sløk says.

“Higher passive ownership can increase volatility, lower market liquidity, and increase market concentration in large cap names such as the so-called ‘Magnificent Seven,'” Sløk wrote in a recent paper.

He said that the massive shift toward passive investing has resulted in greater price spikes and dips as investor demand has become less reactive to stock prices. It’s also resulted in a less actively traded market, where mispricing can be greater and last for longer.

Those two factors drive greater market volatility, which has been on the rise recently. The Cboe volatility index up almost 30% in the last six months.

With more active investors turning passive, there are also fewer investors shorting stocks, Sløk said. If the trend continues, shorts will be “squeezed out” more easily, which will boost volatility in large-cap shares and put upward pressure on their prices.

He said that makes it riskier to short large-caps, which will only fuel a greater shift to passive flows.

“In short, when active investors turn passive, large-cap stocks will benefit disproportionately. This dynamic can be observed in the price-to-earnings (P/E) ratios of large- and mega-cap stocks, which have been consistently high and growing,” he wrote.

Passive investing has rocketed in popularity in the past three decades, accounting for 50% of total equity investing in mutual funds and ETFs globally, almost double what it was in 2012, Sløk said.