The paper, by a team of global equity strategists led by Robert Buckland, examines the "seismic shift" in global equity markets, as hundreds of billions globally flows out of managed investment vehicles and into passive investments, which are carefully calibrated to mirror the composition and performance of key indexes.

Passive funds offer exposure to equities for far lower management fees than is the case with active funds. In the past 12 months, Citi states, passive equity funds, usually in the form of exchange traded funds, have seen inflows of $442 billion globally, while active, managed funds have seen outflows of $534 billion.

Citi expects the proportion of money invested in passive vehicles to only grow, possibly rising to 50 per cent of market share in coming years.

The impact of large parts of equity markets being held by "passive investors" has been much debated in recent months.

Passive funds are equally weighted in all the companies in an index, and because they are intended to mirror an index rather than to outperform it, they can't sell out of index constituent companies for poor performance.

What critics say

Critics of passive investment argue that this risks investors being heavily exposed to stocks that have already risen strongly, and that it lessens the difference between the sharemarket performance of the best and worst performing companies.

Citi looked at this possibility, but concluded that across a range of global markets, correlations have not significantly increased in recent years.

"The biggest driver of correlation still seems to be market direction," the analysis notes. "If markets are rising then correlations tend to fall. They rise when markets are falling. There is little indication that the rise of passive funds has [yet] changed this traditional relationship."

Different trends

But the impact of passive funds is discernable in several other trends. One is the tendency for stocks about to be included in the S&P 500 to see high levels of buying in the five days immediately before, when such stocks gain, on average, 50 basis points.

"We can find evidence that stocks outperform ahead of an announcement that they are going into the S&P 500 index, perhaps because speculators are guessing that they may be included," the analysts wrote.

"They continue to outperform immediately after the announcement is made [around a week before inclusion], but fade away prior to the actual inclusion day. Then there is evidence of another burst of performance around the inclusion, as passive funds buy, but the effect soon fades away."

"Passive fund managers are wise to these effects and adopt various strategies to minimise the distortions created by index changes.

"However, this will become harder to do as their funds get bigger. Overall, there does seem to be evidence that active traders can use an 'index reconstitution' strategy to exploit the actions of passive funds."

This effect has been observed more widely than the US - the CSI300 index of Chinese stocks, for example, rose 3.4 per cent in a day last year on expectations its top stocks could be included in the MSCI Emerging Market index.

'Liquidity smile'

Another phenomena, dubbed "the liquidity smile", refers to the twin peaks of daily trading now seen in US equity markets. Historically, the largest volume of trades tended to be conducted early in the day, as companies tend to release news at this time.

But Citi's researchers note there are now two peaks of trading - one at the start, and the other at the end of the day, as exchange traded funds adjust their passive portfolios. The trend "may present an opportunity for active investors/traders to exploit".

Citi acknowledges the vital role played by fund managers in being "market makers". But, in a comment likely to raise eyebrows among Citi's fund management clientele, the researchers argue that the toll exacted for this service by fund managers is too high.

"Active managers and their research providers play an important part in the price discovery mechanism that is at the core of capitalism. However, maybe we were charging society too high a price to do this.

"At its core, the shift to passive investing is really about reducing that cost. And do we really need 51 ???CFAs [chartered financial analysts] for every stock in the MSCI World index? Does that really represent the optimum allocation of highly educated people?

"What if the shift to passive is partly about an industry that has traditionally charged high fees and earned super-normal profits being brought down to earth? Forty per cent profit margins are hard to defend in an industry where barriers to entry are low, alpha generation inconsistent and low cost disrupters on the prowl."