The Fundamental Dangers Of Index Investing

The Fundamental Dangers Of Index Investing

(Source: Bloomberg)

The first American stock market index, the Dow Jones Transportation Average (DJT), was constructed in 1884, predating the now widely cited Dow Jones Industrial Average (DJI), constructed in 1896. The indices construction was premised upon increased market visibility, as readily available stock prices and market information were not commonplace. Business executives often had incentives to withhold information from investors and the lack of regulatory reporting requirements supported the lack of transparency; leaving many investors unwilling to participate in financial markets. (One the Economic Consequences of Index-Linked Investing; Wurgler)

Three-quarters of a century later, following the construction of the S&P 500 (SPY) in 1950, Jack Bogle and Vanguard founders listed the Vanguard Index Trust (VOO). The fund began trading with $11 million in assets under management (“AUM”) and quickly grew to $18 billion by 1995. (The First Index Mutual Fund; John Bogle) From the mid-1980s through the turn of the century, Vanguard significantly expanded its AUM and began adding index funds across various asset classes. The success of the funds led to an increased offering of index-tracking products that began in the 1990s and has continued its ascent well into today.

The benefits of index investing have been numerous for investors. The indices themselves make it possible to measure beta, an invaluable piece of information for portfolio construction. Indices are often used as moderately reliable forward-looking indicators, making information available across different areas to investors and economic actors alike. Fund managers can quickly access valuable information that may improve their investment decisions. An index investment vehicle creates the potential market exposure that would be difficult to replicate individually; available at a significant reduction in fees compared to active management.

Index investing, however, begins to run into significant problems when the strategies become widely adopted. The funds themselves become significant players, influencing markets while simultaneously taking on passive strategies. It essentially creates a level of meta investing, where decisions are based solely upon broad socioeconomic trends as opposed to business fundamentals. Investments can become decoupled from the performance of the businesses that reside within the fund. Additionally, increased fund flows will positively impact the performance of the stocks within the index, creating a high potential for a positive feedback loop. Money into the index funds creates positive performance of the index itself. Thus as the strategy increases in popularity, so too does the performance of the strategy.

Indices begin to take on characteristics of an individual investment and lose reliability as general market indicators. They instead exhibit investor’s sentiment towards the market hypothetically covered; evidence of this is demonstrated by Wurgler. The paper shows new securities added to an index see immediate increases in beta values, and their volatility begins to closely match that of the index; simultaneously becoming decoupled from the performance of similar securities not within the index. This can be referred to as “co-movement”, and the results of such begin to directly undermine the benefits of diversification that an index fund provides.

The benefits of index construction and investing are undermined as index investing grows, creating a number of issues for financial markets. Firstly, active managers’ performance is often compared relative to an index. Thus, as index strategies grow so too does the benchmark that fund managers must compete with. As a strategy to improve the probability of hitting performance metrics, active managers are encouraged to hold securities within the index as this reduces the probability of underperforming and compounds the performance of the index. As an example of the impact to fund managers, the S&P 500 exhibited a positive alpha over the period 1980 to 2005. (Wurgler) Secondly, many investment decisions are made with consideration to risk metrics, often measured using volatility and beta. As the indices increase in co-movements these measures of risk become impaired and past correlations become less indicative of the present underlying fundamentals. How the data diverges from reality and how the impacts can play out is extremely difficult to measure. But the widespread use of volatility and correlation, combined with the possibility of data unreliability, creates the widespread potential of unforeseen economic consequences.

The impact of index investing stretches outside the finance industry. In recent years the insatiable appetite for diversification amongst investors, along with the general success of index investing, has led to a growth in the type of asset class indices available. The financialization of commodities in particular has had widespread impacts. The distinct characteristics of many tradable commodities make the asset class sought after by investors to create portfolios with unique risk and return characteristics while filtering out management decisions that could impair direct investments in commodity-related businesses. The financialization also removes the significant barriers to entry for commodity investments as it greatly reduces the cost of carry for various commodities, increasing the number of participants available to invest. While the expansion of commodity indices may create increased opportunity for investors, it begs the question of the impact to commodity-dependent businesses and the wider economy.

Brogaard, Ringgenberg, and Sovich assess the impact of the financialization of commodities through the construction of investable commodity indices. Measuring the profitability of indexed-commodity related businesses before and after 2004, the point at which the authors suggest commodity financialization to have generally taken place, to businesses with commodities that did not undergo financialization. Their findings show that businesses operating within industries that underwent commodity financialization saw significant reductions in operating profits following 2004. While revenues increased over the period, they did not increase in proportion to the 6% increase in costs, ultimately reducing operating profits by 40%. The authors of the study “suggest that index investing distorts the price signal thereby generating a negative externality that impedes firms’ ability to make production decisions.” (Brogaard, Ringgenberg, and Sovich). In summary, indexed commodities begin to exhibit price movements that are decoupled from the reality of the underlying market fundamentals, causing deterioration in capital allocation decisions by businesses related to these commodities. The study did not find a similar occurrence when applying the same assessment to the controlled case (non-indexed commodity businesses). It should be noted that the study cannot predict whether index commodity firms were net winners or losers as a result of financialization, due to the fact that the study only reviewed operating profits, which is not synonymous with firm welfare. The benefits of risk-sharing and trading gains are not taken into account.

The issue posited by the index commodities can be applied generally to economic markets. A rapid growth in financial products, for investing or risk mitigation, has led to an alarming level of interconnectedness. As systems grow in complexity so too does their probability for failure, as the probability of unforeseen events increases. As economies become more interconnected the fundamentals that impact distinctive markets begin to shift, and investment decisions based on previous market characteristics could leave individuals dangerously exposed. This was evident in part in the fall out of the 2008 recession. While a recession in subprime mortgages was possibly foreseeable by a well trained professional, the near-collapse of money market funds was less so. With leverage and financialization growing following the Great Recession there is still a high probability of a Black Swan event.

The impact of widespread index investing could be significant in financial markets and the broader economy. It creates an increased risk for all investors as the general market begins to exhibit higher levels of co-movements. For the individual investor, this poses a significant problem. Index funds have generally been a cost-effective means to earn a diversified market rate, but as indices begin moving with higher degrees of co-movement, the benefits of diversification are to an extent lost. In addition, the increased risk of index bubbles leaves many investors potentially exposed to significant losses in the event of a sustained panic selling that would be largely impossible to see ahead of time due to the interconnectedness of financial markets. The best remedy for investors to navigate this landscape comes from basic fundamental principles.

An allocation to gold (GLD) typically protects against the dangers of over financial engineering. While many cryptocurrency enthusiasts and market participants, in general, see gold as a bygone relic, what talent they poses in creativity they wildly lack in basic history. Gold has long been the currency of choice for civilizations across time and culture. While silver also acts as a go-to currency, its industrial applications make the metal slightly less desirable, purely from a wealth protection standpoint, than gold. Gold has long been cherished as the metallic embodiment of purity and enlightenment; it has had much cultural, religious, and monetary significance over human history. Adding it to one’s portfolio is as close to a sure way to maintain wealth as is possible.

It should be cautioned that holding gold, or silver for that matter, is not advisable for short or medium-term horizon investors. The dollar value of the metal fluctuates violently at times and one could be stuck with a significant paper loss if sold prematurely. The true benefits of gold arise from its virtually assured tradability. While financial assets such as stocks, bonds, and fiat currencies can come and go, a holding of gold within one’s portfolio is as sure of a long term preservation of wealth possible. This does not mean buying in at any price is desirable, but at current gold prices, there are still comfortable entry points. A common strategy for determining the intrinsic gold price is a comparison to aggregate money supplies, an overview of the strategy can be found here.

Avoiding fully invested index strategies is the next best step for the individual investor. While some exposure to specific assets and markets through indices certainly has its values, investors should be cautious of the points made through this paper. Identification of specific mutual funds with active management would likely be a better alternative in most instances, the number of available funds creates a selection for acceptable fees, and while still not as cheap as index investing, the strategy at least provides some protection compared to indices that would be fully exposed. Much of the mutual fund industry is impacted by the indexes that it uses and thus the full impact of these potential risks is difficult to measure.

The best strategy for any individual investor is to first optimize their personal finances and savings. Good cash flow will often pay dividends in one’s long term savings that chasing higher returns cannot match. The risk to individuals invested broadly in the market could be severe. There has seemingly never been a time in recent history when the stock market and broader economy have been more at odds. This is saying a lot considering the events of 2000 and 2008. Individual security selection could very well be the best alternative for active investors to avoid the potential risks aligned with index investing. Investors should include the percentage of ownership by index funds in their due diligence of securities. Identifying businesses not within an index would remove some of the risks discussed previously, but also comes with its own risks. Companies not within an index could potentially have a higher cost of borrowing and thus come with greater liquidity risk in the event the business had difficulty raising new capital.

Author’s Note: Thank you for taking the time to read my work. If you found this article intriguing and/or useful, please like and leave a comment below. For more articles, be sure to follow my page and subscribe for email alerts.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Originally published on Seeking Alpha

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