Does the Fed/SEC have tools to address shock-propagation from correlation of fund flows?
I’d start by briefly noting that “the Fed” didn’t say anything; that’s a research paper (by some smart people), but it’s disclaimed and doesn’t necessarily reflect the views of anyone other than the authors.
Having said that, I would then rephrase your question as follows: “what happens if everyone decides to cash in their retirement funds at once?” The answer to that would be: they would all get a very poor return, but thankfully that’s unlikely.
Very little of the question as posed has anything to do with active vs. passive strategies. “Passive” players aren’t different types of players, they’re the same types engaging in different strategies because they have different beliefs. If I invest my 401(k) in a Vanguard index fund vs. an actively managed fund with the same targets, I’m still the same person with the same risk tolerance, and I’m still subject to the same shocks from the real economy.
It’s always extremely important to keep in mind the underlying motivations and stylized behaviors of different types of players, and thankfully, retail investors do tend to avoid panic selling their holdings at market lows. This is simply because they tend to have long time horizons (most passive investors are simply saving for the future and not drawing on their assets for current income, in which case they’d hopefully have shifted to fixed income). This also largely takes fire sale dynamics off the table. Fire sales happen generally when leveraged players are forced to mark-to-market. Most retail index investors are completely unlevered, so draw-downs mostly represent buying opportunities. So because the underlying type hasn’t changed, the fact of being invested in passive strategies doesn’t really change much.
If that were not true, you’re right, the investors would suffer huge losses, but even then, it wouldn’t really be a financial crisis, and there wouldn’t be any good logic for official sector intervention. I say that it wouldn’t constitute a financial crisis because losses on equity are just someone’s investment losses (and likely soon someone else’s gains). From a financial stability standpoint, equity does not matter, debt matters. People often conflate the two, because when debt is distressed, so is equity, but that is confusing a symptom (distressed equity) with the disease (distressed debt). Keep in mind that the post-2000 equity market losses rivaled the 2006-2009 mortgage market losses (which were debt) in magnitude, but only in the latter did we see a financial crisis. In contrast, large-scale inabilities for companies to access debt markets reflect a broad tightening of credit conditions— a liquidity crisis, which is what Bagehot described and what is generally an object of concern for central banks. So while the official sector will intervene when debt markets break down, it is not within the official sector’s purview to attempt to allocate gains or losses.
Having said all that, in the spirit of trying to fully answer your questions, there are ex ante tools that exist to basically discourage opportunistic redemptions from funds. They do not really apply differently to passively vs actively managed funds, though; they instead exist to ensure that one’s redemptions don’t negatively impact other fund holders. There are a whole litany of such tools, including gates, fees, swing pricing, minimum balance at risk, and others.