One of the most persistent criticisms of the shift toward passive investing is that it’s somehow destabilizing markets. The story goes like this: as more money flows into index funds, stock prices become disconnected from fundamentals, and volatility rises. It’s an intuitive worry, and it’s not conjured out of thin air—prior research by Ben-David, Franzoni, and Moussawi (“Do ETFs Increase Volatility?“ 2018) and Coles, Heath, and Ringgenberg (“On Index Investing,” 2022) has established as an empirical fact that stocks with higher index fund ownership do exhibit higher volatility.
Shmuel Baruch and Xiaodi Zhang, authors of the July 2026 study “Stock Volatility and Index Fund Ownership,” asked what is causing that increased volatility. Is it being caused by new money flooding into markets through index products—money from investors who otherwise wouldn’t be participating at all? Or is something else going on?
The distinction matters for how we should think about the growth of indexing. If new, less-informed capital pouring in through 401(k)s and index ETFs is jolting prices around, that’s a real structural concern about market fragility. If instead the pattern reflects sophisticated investors simply reallocating—shifting some of their existing capital from picking individual stocks to buying the index—that’s a very different, less alarming story.
The Key Insight: Where Would the Disturbance Show Up?
Baruch and Zhang’s contribution is a clever identification strategy. They reason that if new external money entering through index funds were driving stock-level volatility, that disturbance couldn’t be confined to individual stocks. Because index funds trade baskets of stocks together (through authorized participants who create and redeem shares), any noise from new index investors must flow through to the systematic, market-wide component of stock returns—and ultimately show up in the volatility of the index itself, not just its individual members.
By contrast, if the increase in volatility instead reflects existing informed investors reallocating away from individual stock picking and toward index-centric strategies (i.e., factor investing), the effect should look very different. Fewer analysts scrutinizing an individual company’s fundamentals means that the company’s price can drift further from fair value between information updates—raising idiosyncratic volatility—without any corresponding effect on the market, since aggregate demand for the index itself hasn’t been disturbed.
In other words, external flows should show up in systematic and index-level volatility. Internal reallocation should show up only in idiosyncratic, stock-specific volatility.
What They Built and Tested
The authors constructed a simple yet rigorous price-discovery model (extending a 1987 framework from Jack Treynor’s “The Bean Jar Experiment”) with two types of traders: index traders, who buy and sell only index fund shares, and stock traders, who trade individual names. The model formally derives what should happen to volatility under each explanation, and it produces a striking magnitude prediction: for a broad, value-weighted index like the S&P 500, if external inflows were pushing up the variance of a typical constituent stock, the model implies the variance of the index fund itself should rise by an amount thousands of times larger—3,627 times, in their September 2025 calibration.
They then took this to the data: a large panel of U.S. stocks from 1980 to 2022, using CRSP and Thomson Reuters ownership data. Three steps:
-
First, they reconfirmed the baseline finding—higher lagged index fund ownership predicts higher subsequent stock volatility. Nothing new there.
-
Second, they decomposed each stock’s volatility into systematic and idiosyncratic components using a standard market-model regression. This is the crucial test. If external flows were the culprit, systematic volatility should rise with index ownership too.
-
Third, as a final falsification check, they ran the regression at the index level itself—regressing S&P 500 and DJIA volatility directly on economy-wide index fund market share.
Key Findings
The results line up cleanly with the reallocation story, not the external-flow story:
-
Index fund ownership is strongly and significantly related to idiosyncratic volatility, but bears no statistically significant relationship to systematic volatility.
-
At the index level, there’s no statistically significant relationship between index fund market share and the volatility of either the S&P 500 or the DJIA, or their flagship ETFs (SPY and DIA). The point estimate for the S&P 500 was smaller than the coefficient found for individual stocks—the opposite of what the external-flow theory predicts.
Their findings led the authors to conclude: “We find no evidence that index ownership is associated with higher market-level volatility.” Put simply: stocks are getting noisier at the individual level, but the market as a whole shows no sign of getting noisier alongside them.
Why This Happens
The authors’ explanation is that as more capital shifts toward index-centric strategies, fewer market participants are left doing the hard work of researching and trading on individual company fundamentals. With less active price discovery at the stock level, prices can wander further from fair value on any given name—raising that stock’s idiosyncratic volatility—even though the aggregate market’s pricing remains just as anchored as before, since the money moving into indexing was already invested and simply changed form.
Key Investor Takeaways
For everyday investors and advisors, three things are worth taking away from this paper:
-
This evidence challenges one of the more common arguments used to caution against the shift to passive investing—namely, that broadening index fund access somehow makes markets structurally fragile. This study finds no evidence of that in the data; the increase in volatility associated with indexing appears to be a byproduct of internal reallocation among existing, sophisticated investors, not a symptom of naive capital destabilizing prices.
-
The rise in idiosyncratic (stock-specific) volatility is itself a useful data point in support of diversification and against individual stock-picking. If fewer analysts are digging into any single company, individual stock prices can become noisier and less reliably anchored to fundamentals—an argument for owning many stocks rather than betting heavily on a handful you believe you understand better than the market does.
-
Don’t confuse “stock volatility went up” with “markets are becoming unstable.” This paper is a good reminder that headline correlations often need to be decomposed before they support the conclusion people want to draw from them. The volatility that gets attributed to the “index fund takeover” of markets isn’t showing up where a genuinely destabilizing effect would have to appear—at the level of the market itself.
None of this means passive investing has no effect on markets—it clearly changes who does the work of price discovery. But this paper offers real evidence against the more dramatic claim that indexing is quietly building fragility into the system. The data instead point to a much less dramatic, and much more familiar, story: investors reallocating their strategies, not new and uninformed money flooding in.