The biggest problem with ETFs is related to the concept of indexing itself.
The indices cover different asset classes (stocks, bonds, currencies, commodities), geographic markets or investment styles and strategies. An index, actually a basket of stocks, provides a representation of the price movements, returns and relative performance of an individual portfolio.
Except that the financial markets have abused this concept, which creates problems for investors in ETFs and other indexed holdings.
First of all, there are now multiple indexes. According to the Index Industry Association, 770,000 benchmarks worldwide were deleted in 2019, leaving another 2.96 million ridiculous indices worldwide. In comparison, around 630,000 companies are now listed on the stock market worldwide.
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Second, each index is maintained by its supplier, using its own methodology. Performance depends on the weightings of the index. When a fixed number of shares is used, the value is affected by changes in the highest price holdings, while market capitalization weighted indices such as the S&P 500
SPX
are affected by larger inventory changes. Changes in the components of the index, even within the framework of the established rebalancing rules, can have a major effect on the results.
Third, indexing is changing investment practices and the financial markets. Active managers are often 'parallel indices', where the bulk of the portfolio is structured to track a benchmark with moderate overweight and underweight in individual sectors or stocks consistent with the prospect of each. In an indexed world, purchases or sales are based on inclusion or exclusion in indices or index weights, rather than mere investment benefits.
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Fourth, indexing changes the new process for issuing shares. Subscribers focus on the inclusion of a security in the relevant indices, so that investors who follow the index will be forced to buy stocks. This creates the problem of "index tourism", in which an investor must buy securities regardless of value considerations. This is especially true in small and emerging markets, where investors who lack knowledge or detailed research make investments that they may regret.
Fifth, indexing is not applied uniformly across different assets. In a market capitalization-weighted market index like the S&P 500, investors may find themselves increasingly exposed to a specific security that is increasing in value. In the case of a bond index based on volumes in circulation, investors may gain increasing exposure to a more leveraged entity. A successful business whose increased market capitalization may warrant additional investment. A business that requests more loans, and therefore has more representation in an index, may not deserve additional exposure.
Bond indices based on specific rating levels are also problematic. In an environment like the current one, downgrades, particularly from investment to the non-investment grade category, will force some investors to give in and others to buy to align with the weightings of the Clue. After the burst of the internet bubble, such a situation occurred with WorldCom bonds. Investors in non-investment grade bonds were forced to buy large amounts of the company's bonds because it formed such a large part of some indices, regardless of their opinion on the survival of the company.
Commodity indices pose their own challenges. Since the assets have specific industrial uses, price changes have second-order demand and supply effects. Index investments can ignore them.
Sixth, indexing creates the illusion of diversification. Many indices, particularly in emerging markets or certain asset classes, are dominated by certain large companies or components, creating a significant concentration risk. The energy sector now accounts for around 5% of the S&P 500, for example, up from 13% in 2007. Investors could be overexposed or underexposed to individual segments.
Seventh, indexing generally focuses on relative rather than absolute returns. For example, a portfolio that drops 10% while the underlying index loses 20% would return above 10 percentage points. However, the investor still lost money.
Eighth, indexing focuses on relative risk rather than absolute risk. The math is whether your portfolio is more or less risky than the index. This diverts attention from actual exposure to cash losses and possible reductions.
Ninth, investing in indices creates a self-reinforcing dynamic that amplifies upward and downward market movements.
Finally, indexed investments are frequently traded on the basis of liquidity illustrated by generous redemption rules. Unfortunately, the funds assume more liquidity than their underlying investments. IMF study he discovered, for example, that a fund that invests in high-yield corporate bonds in the United States. USA liquidation of assets can take up to 60 days.
The impact of indexing has been profound. But it has done little to improve investment or risk management. Instead, it has made the financial markets more volatile.
Satyajit Das is a former banker. His latest book is A banquet of consequences (published in North America under The era of stagnation) He is also the author of Extreme money and Traders, weapons and money.
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