The next financial crisis (only the dead have seen the end of these) will have something to do with Exchange Traded Funds (ETFs) with leverage, as it always is, no doubt the accelerant. I say this because crises in the past have usually come from something that starts out as a good idea but then gets pushed too far.
Junk bonds, mortgage backed, derivatives, cross border lending, credit default swaps and securitization are activities and instruments all still alive and well today but at various points in the last 20-years their use has caused conniptions as their employment, well, simply got out of hand.
To understand what the problem with ETFs, in time, might be I’ve been doing some reading and in the course of my inquiry came across the paper I’m highlighting this week which goes to the root of what may be one problem ahead i.e. that of what I’ll call here dumb-indexing (there are other problems I’ll highlight in coming weeks).
Although the paper is five years old it’s based on observations of the US market and as that’s always a few years ahead of practices in Asia I think it relevant for investors in the China markets today. Currently retail investors dominate these markets but the growth of ETFs combined with a growing institutional presence means dumb-indexing will become a more and more important explanatory variable for stock price movements in future.
So what are the problems of dumb-indexing? According the paper’s author, Mr. Jeffrey Wurgler of the Stern School of Business at NYU, there are many but I’ll briefly summarize his top ten:
1. Stock markets have only a finite ability to absorb index-shaped demand for stocks
2. Stocks included in an index are added irrespective of their investment merits
3. Index sensitive managers have no regard to what price they pay to get exposure to an index
4. Index stocks will therefore always be expensive. Possibly by as much as 40%
5. Index stocks move in a convoy i.e. like other index stocks and less like the market overall
6. This behavior encourages trading that increases risk
7. The risk/return equation is stood on its head. High risk stocks now return less than low risk ones
8. Index sensitive managers will, all things being equal, prefer high beta stocks; yet more risk
9. It raises perceived beta that leads, via the very flawed CAPM, to less productive investment
10. Due to the convoy nature of price moves investors are getting lower diversification and higher exposure to risk than they may believe
Much of this will come as no surprise to value investors but market dislocations are never about patient thoughtful folk who do their homework. No, they’re usually about a pants-on-fire crowd trying to get out at the same time from something somebody sold them whilst not fully understanding underlying risk. Sound familiar (ahem! accumulators anyone)?
You can access the paper in full at http://www.nber.org/papers/w16376
More next week on specifically why ETFs are bad for you; and the answer will surprise.
Happy Sunday.