The hidden risks of ETFs

867-crash-634 — Three decades on, another crash could be brewing

Following the global stockmarket crash of October 1987, one financial product drew more criticism than any other. "Portfolio insurance" was the financial innovation of its day an automated trading strategy designed to "hedge" against losses by using derivatives to profit from sell-offs when the market was going down. But when prices crashed hard, the trading programmes got caught up in a feedback loop whereby selling led to more selling.

Passive investments now account for more than a third of equity assets under management in the US, and their popularity is only growing. The question now, says John Authers in the Financial Times, is "whether their scale is such that they are distorting the market". Opponents argue that they do so by encouraging a constant flow of money into the stocks with the largest market capitalisations (most big stockmarket indices are weighted by market cap).

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Victor Haghani of Elm Partners argues that this doesn't necessarily matter put simply, if you put £1,000 into an index fund, and the biggest stock in the index rises (assume the overall index stays flat), then you don't need to buy more of it it merely accounts for a bigger proportion of your £1,000. So the idea that index funds turn the market into one big "momentum" trade (buy what rises, sell what falls) isn't necessarily true.

However, that doesn't take account of investors' psychology. An index fund may not in itself be a momentum play, but it does provide an easy, cheap way to access the market and the promise that it's equally easy to get out. As the FT's John Dizard puts it, "many people believe they have a free out-of-the-money option to put their equities to the market when they get fretful". Mark Lapolla of Sixth Man Research argues, also in the FT, that the ease of trading ETFs means they are now at the core of many institutions' risk-management strategies.

The implication is that if we get a sudden sell-off (and the market has been becalmed for a long time, so it might not take much to trigger a panic), then a rush for the door by passive investors would exacerbate any slide greatly. Meanwhile, the market itself is a lot more expensive than in 1987. That suggests any recovery would take a lot longer than it did back then. We still like passive funds they're cheap and they'll beat the average active manager. But the market stretches all good things until they hit breaking point and index funds will be no different.