With Greater Uncertainty Comes Greater Volatility

Abstract

Some academics and market participants argue that the growth of indexing causes market volatility. However, while the percentage of assets in indexed strategies has grown over the past twenty-five years, market volatility has risen and fallen in a somewhat random pattern, peaking around economic and financial crises. In this article, we test two measures of market volatility for their potential relationship with growth in indexing assets and selected macroeconomic factors. Our analysis demonstrates that macroeconomic factors have a strong correlation with and are useful predictors of market volatility; on the other hand, growth in indexing assets does not exhibit any causal relationship with market volatility.

TOPIC: Volatility measures, financial crises and financial market history

Key Findings

• • Macroeconomic factors and market volatility have a strong positive correlation while correlation between market volatility and growth of indexing is negative and relatively small in absolute terms.

• • Granger causality tests suggest that macroeconomic factors do have a causal relationship with and are useful predictors of market volatility. Growth of indexing, however, does not have such a relationship and is not a useful predictor of market volatility.

• • Macroeconomic factors such as economic policy uncertainty—not the growth of indexing assets—are responsible for elevated market volatility.