Simple Index Funds May Be Complicating the Markets
Index funds are often hailed for their low fees, solid performance and transparency.
Could they also be destabilizing the markets-and undermining the very diversification they have long promised?
Recently, leading investing experts-including Rodney Sullivan, editor of the Financial Analysts Journal, consultant James Xiong of Morningstar Investment Management and Jeffrey Wurgler, a finance professor at New York University-have been warning that index funds could destabilize the financial markets.
The rise of trading in index funds, these researchers say, is causing stocks to move more tightly together than ever before-as if they "have joined a new school of fish," as Prof. Wurgler puts it. That is reducing the power of diversification and could make booms and busts more likely and more extreme.
Unlike conventional funds run by highly paid stock-pickers who seek to buy the best securities and avoid the worst, index funds-including most exchange-traded funds, or ETFs-effectively buy and hold all the securities in a market benchmark such as the Standard & Poor's 500-stock index.
David Fuller's view In
recent years I have felt that high frequency algorithmic trading - also mentioned
in the article above - was the most important factor behind not only the unprecedentedly
high correlation among financial assets but also much of the volatility seen.
There have been many reports attributing over 60 percent of the trading volume
on Wall Street to HFT.
However,
it is also logical that the proliferation of index tracking funds would contribute
to equity correlation. Combined, HFT and tracker funds have led to the 'risk
on' and 'risk off' descriptions of market volatility which so unnerved investors
last year.
Is this
another 'new normal' or could markets revert to their earlier, less correlated
characteristics of the pre-2008 period?
We
are about to find out as stock markets extend their best start to a year for
well over a decade. Given that HFT and the fashion for tracking funds have not
gone away, this could be setting us up for a spasm of 'risk off' profit taking.
However,
Fullermoney knows better than to tell markets what to do. We remain observers
of the crowd, in the manner of naturalists. Interestingly, amidst the repetitive
Greek chorus, I have heard a couple of commentators refer to 'Goldilocks' in
the last few days. They are implying that the economic environment is neither
too hot nor too cold, although it would be a stretch too far to say that it
was just right.
Fullermoney's
biggest concern remains the price of crude oil (Brent
& WTI) which is a headwind for equities
and global GDP growth. Higher oil prices, unless quickly reversed, would also
cause a rethink among central bankers in growth economies who had been planning
to lower short-term interest rates.