Publications

We study whether the rise of passive index investing compresses the measured equity risk premium (ERP) by changing the composition of aggregate equity demand. As a growing share of market demand is delegated to passive vehicles that mechanically track benchmark indices, observed ERP measures may increasingly reflect the presence of investors whose demand is less responsive to short-run valuation signals, rather than the compensation required by the price-setting margin alone. To examine this hypothesis, we construct a proxy for the ETF penetration in the market as the ratio of cumulative net inflows into the three largest S&P 500 index ETFs (SPY, IVV, and VOO) to the S&P 500 price level, and relate it to a forward-looking supply-side estimate of the ERP based on a Gordon-growth decomposition of the S&P 500 dividend yield. Using 127 monthly observations from January 2015 through July 2025, we estimate a reduced-form vector autoregression and a structural VAR identified through sign restrictions following Uhlig (2005). In the reduced form, increases in ETF penetration systematically precede declines in the measured ERP. The structural estimates imply a cumulative ERP compression of 84 to 98 basis points over four months following a one-percentage-point penetration shock, with the 68 percent credible band excluding zero across four alternative specifications. While sign restrictions narrow rather than fully eliminate the set of admissible structural models, the results are consistent with our view that passive flows affect not only prices and returns, but also the interpretation of standard ERP measures. Furthermore, since our penetration proxy captures only a subset of passive ownership, the estimated magnitudes should be interpreted as conservative estimates of the broader effect of passive investing.