Thus, since 2007, indexing or passive activities have risen from approximately 7% to 9% of total managed assets to almost 40%. As you shift assets from active managers to passive managers, they buy an index. The index is capital weighed, which means more and more money is going into fewer and fewer stocks.

?We’ve seen this act before. If you didn’t own the nifty 50 stocks in the early 1970s, you underperformed and, thus, money continued to go into them. If you were a growth stock manager in 1998-1999 and you were not buying “net” stocks, you underperformed and were fired. More and more money went into fewer and fewer stocks. Today you have a similar case with the FANG stocks. More and more money is being deployed into a narrower and narrower area. In each case, this trend did not end well.

When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.

We are witnessing the development of a “perfect storm.”

Eoin Treacy's view

Will ETFs contribute to the next major stock market decline? How could they not? They represent a significant proportion both of daily traded volume and act as repositories for substantial inventories of stock.  In tandem with the prevalence of automated trading systems we already have evidence of dislocations in the spate of flash crashes we have largely become inured to. 

The better question is when these factors are likely to pose the existential question a number of commentators have asked this week as volatility in the Nasdaq has picked up. David has long said central banks have killed off more bull markets than all other factors combined. This week was also notable because central banks globally have certainly turned more hawkish. 

This graphic highlights the trend with the Fed’s tightening bias well understood, while the ECB is only on the cusp of beginning to talk about tightening. Australia on the other hand is at an important juncture. 

With quite a bit of volatility in government bond prices this week the yield curve spread (10-year – 2-year) steepened this week with investors willing to give central bank hawkishness some additional credence. An inverted yield curve, where the spread moves below zero, has been a lead indicator for almost every US recession since 1940. Right now it is still at almost 90 basis points so it is reasonable to conclude what we are seeing in stock markets is a rotation out of high momentum shares primarily in large cap tech and into banks, biotech and even commodities.