Outside the Box: These are just some of the ways ETFs and index funds are making financial markets more unstable

Mutual Funds

The biggest problem with exchange traded funds (ETFs) has to do with concept of indexing itself.

Indices cover different asset classes (equity, bonds, currencies, commodities), geographical markets or investing styles and strategies. An index, effectively a basket of securities, is provides a proxy for price movements, returns and relative performance of an individual portfolio.

Except that financial markets have misused this concept, which creates problems for investors in ETFs and other indexed holdings.

First, there are now multiple indices. An astonishing 770,000 benchmark indices were scrapped worldwide in 2019, according to the Index Industry Association, still leaving a ridiculous 2.96 million indices globally. In comparison, there are around 630,000 companies now traded publicly around the world.

Second, each index is maintained by its provider, using its own methodology. Performance depends on index weightings. Where a fixed number of stocks are used, value is impacted by changes in holdings with the highest price, while market-capitalization weighted indices such as the S&P 500

are impacted by changes in the largest stocks. Changes in index constituents, even within established rebalancing rules, can have a large effect on outcomes. 

Third, indexation alters investment practices and financial markets. Active managers frequently “shadow index,” where the bulk of the portfolio is structured to follow a benchmark index with modest over- and underweighting of individual sectors or stocks consistent with one’s outlook. In an indexed world, purchases or sales become based on inclusion or exclusion in indices or on index weights, rather than pure investment merits. 

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Fourth, indexation alters the new stock-issuance process. Underwriters are focused on having a security included in relevant indices, so that investors tracking the index will be forced to purchase shares. This creates the problem of “index tourism,” where an investor must buy securities irrespective of value considerations. This is especially so with smaller markets and emerging markets, where investors lacking detailed knowledge or research make investments they may regret.

Fifth, indexation does not apply uniformly to different assets. In a market-capitalization weighted stock index, such as the S&P 500, investors may find themselves increasing exposure to a specific stock whose value is rising. In the case of a bond index based on outstanding volumes, investors may assume increasing exposure to an entity which is become more indebted. A successful company whose market cap increases may merit increased investment. A company that is borrowing more and therefore has a larger representation in an index may not merit additional exposure.

Bond indices based around specific rating levels are also problematic. In an environment like the current one, downgrades, especially from investment to non-investment grade, will force some investors to divest and others to purchase to align with index weights. After the dot-com bubble burst, such a situation occurred with WorldCom bonds. Non-investment grade bond investors were forced to purchase large quantities of the company’s bonds because it constituted such a large portion of some indices, irrespective of their view on the firm’s survival.

Commodity indices pose their own challenges. As assets have specific industrial uses, changes in price have second-order demand and supply effects. Investment based on an index may not take those into account.

Sixth, indexation creates the illusion of diversification. Many indices, especially in emerging markets or certain asset classes, are dominated by a few large firms or constituents, creating significant concentration risk. The energy sector is now around 5% of the S&P 500, for example, versus 13% in 2007. Investors could be over- or underexposed to individual segments.

Seventh, indexation generally focuses on relative rather than absolute returns. For example, a portfolio that falls 10% while the underlying index loses 20% would record a 10 percentage-point outperformance. Yet the investor has still lost money.

Eighth, indexation focuses on relative rather than absolute risk. The calculation is whether your portfolio is more or less risky than the index. This distracts from the real exposure which is to cash losses and potential drawdowns. 

Ninth, investment in indices creates self-reinforcing momentum that amplifies market movements both on the way up and down.

Finally, indexed investments are marketed frequently based on liquidity exemplified by generous redemption rules. Unfortunately, funds are assuming greater liquidity than the underlying investments which they hold. An IMF study found, for example, that a fund investing in U.S. high-yield corporate bonds might take up to 60 days to liquidate holdings.

The impact of indexation has been profound. But it has done little to better investing or risk management. Instead, it has made financial markets more unstable.

Satyajit Das is a former banker. His latest book is A Banquet of Consequences (published in North America as The Age of Stagnation). He is also the author of Extreme Money and Traders, Guns & Money.

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