Opinion: Index fund parasites are killing their host

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  • 5. October 2015

Jeffrey MillerJeffrey Miller
Partner,
Eight Bridges Capital Management

A man who does not think for himself does not think at all. – Oscar Wilde
Global stock markets are in a little bit of turmoil, and the reasons are many. A primary driver of the recent volatility is the increasing concentration of assets in investments where no one is driving the bus. Index funds are, by definition, parasites. These funds assume that the current price of a stock is the “correct” price at all times, and that trying to make a judgement about the company is futile. When Vanguard was small, it could be the parasite – charge really low fees, rely on the work done by active investors to adjust prices to reflect the fundamentals of the underlying business, and be the parasite along for the ride. But now, forty years later, the parasite has grown too large. Small amounts of money indexed to large companies don’t really impact the stock price. But large amounts of money do.  A parasite only survives so long as it doesn’t kill its host.

A little sincerity is a dangerous thing, and a great deal of it is absolutely fatal.  –  Oscar Wilde
The “Chicago School” theories on efficient markets and indexing were later combined with cheap computing power, which led to the rise of two parallel universes of investors who do not make judgments about the value of companies and their securities, but instead simply use the prices of those securities and/or the variability of those prices to judge their value and riskiness. Here is where the market’s structural weakness resides, in strategies that have gotten too large relative to their strategy’s capacity. In particular, ETFs and risk-parity strategies are the weak link in the market today.

Consistency is the last refuge of the unimaginative. – Oscar Wilde
ETFs are index funds on steroids, because while an index fund only needs to worry about inflows and outflows once a day, ETFs are constantly adjusting their holdings based on supply and demand during trading hours. Again, when the parasite was relatively new and small, the host market didn’t really notice them. They added volume but, critically, not much volatility. But as ETFs have come to be an asset class in and of themselves, somewhat removed from the underlying assets, the feedback loop has been reversed. Correlations are up because the driver of prices over short periods of time is simply money flows into an ETF. As index funds and ETFs have become the investment of choice for many investors, price movements within sectors have become more homogenous, and securities in them are more correlated to one another.

However, I believe that the weird feedback loops markets are experiencing lately is because all financial markets are now tied to one another as a second parallel universe of investor – the “risk-parity” investor, has garnered more assets under management.  These investors look at asset classes, like foreign bonds or emerging market equities or currencies, as just things to be modeled and leverage applied to based-on expectations for future returns and volatility. They then lever up the asset classes with lower expected volatility to get to a “market” level of volatility, and they then do this across asset classes globally.  Which led me to ask myself – if everyone is now an indexer, or a derivative of an indexer (ETF) who assumes that the prices being generated by the other indexers are “correct”, and none of them actually think about things like the businesses these companies are in, or their values, or what the possibility of disruption to the business is, then who is driving the bus?  In other words, who’s deciding what these companies are worth now that the parasites have taken over their hosts?

One of the many lessons that one learns in prison is, that things are what they are and will be what they will be. – Oscar Wilde
This massive movement of assets into indexed products is creating many opportunities for intelligent, rational, and most important, active fundamental investors to make money over time. I believe that we are nearing, if we haven’t already reached, a tipping point in markets in which the parasites have become the hosts, and the prior hosts can now become the parasites (in a good way of course, because I’m one of them), feasting off of the market disturbances that are occasionally created by these feedback loops and VAR model driven selloffs.  Index investors and their risk-parity cousins have become the hosts for a new version of parasite (fundamental, active investors who are not benchmark huggers) that takes advantage of these dislocations to buy great companies at distressed prices. The opportunities that await those that are flexible enough to take advantage of them will be tremendous.