Indexing into the Ditch -- Financial Crisis Root Causes -- Part I

Despite the widely held view that indexing is the safest way to invest, indexing helped recklessly drive our financial system and economy into the ditch last fall.

• While there’s consensus the financial crisis warrants “new rules of the road” and better policing to protect against systemic risk, all the rules and oversight in the world can’t keep us out of the ditch in the future if index vehicles continue to drive the wrong way against oncoming traffic.
• And “stress testing” whether bank vehicles can survive head-on crashes, completely misses the point that indexers should not be driving the wrong way on the freeway.

A major reason the system has become so unstable and dangerous to financial security is that over ten percent of money management vehicles on the road today are indexers, which by design drive the wrong way against the oncoming traffic of a market economy that allocates capital based on economic merit.

• As more vehicles follow the trend and mimic indexing, more vehicles are driving into the oncoming traffic of economic rationality. This chaos forces the non-indexers on the “road” to slow down, and in extreme cases like last fall’s crisis, can cause financial traffic gridlock.
• Making matters worse, index vehicles by design chase market momentum; it’s the driving equivalent of accelerators and brakes being designed to stick in place.
• Thus indexing encourages out-of-control vehicles and chaotic traffic flow that endangers everyone else on the road.

Index funds try to replicate the performance of a market index by proportionately owning shares or bonds of all the public companies that comprise the particular index.

• Overall index vehicles now represent $1.5 trillion or almost twelve percent of all mutual fund assets, and according to the Investment Company Institute, they have grown eightfold over the last decade.
• However, the impact of indexing is much greater than these numbers indicate.
  • First, indexing fosters a well-known herd effect where managed funds feel pressure to “closet index” in a perverse market regression to the mean.
  • Second, index funds are increasingly being traded as leveraged securities called leveraged Exchange Traded Funds (ETFs), which compound market volatility, especially at the end of a trading day. The Wall Street Journal columnist Jason Zweig has observed “ETFs buy in lockstep in the last few minutes of an up day for their index – and sell in a swarm at the end of a down day.” Recent research by Ananth Madhavan of Barclays indicates that ETFs “exacerbate volatility at the close.”
• Now so many try to “game the system” via indexing that the system has become “the index game,” and the market has become a derivative of its former self.

The monster flaw in index theory is the core assumption that indexing is benign and has no ill-effect on companies, markets, the economy or the financial system. Here’s the reality.

Indexing is destabilizing. Indexing naturally amplifies market volatility because it artificially creates a massive one-sided market: it generates substantial supply with no offsetting demand in a down market; and it generates substantial demand with no offsetting supply in an up market.

• This inherent amplification distortion fosters a momentum dynamic in the market.
• It seriously complicates the market’s natural ability to efficiently find price equilibrium because such a dominant segment of the market does not care about price, fundamentals, or investment horizon at all, only a relative ownership algorithm on that day.
• Therefore a company’s stock price perversely can never get too high or too low for an indexer because financial fundamentals, economic rationality, or time horizon have no bearing whatsoever to an index.
• The $1.5 trillion “index herd” chases the market wherever it goes like lemmings, always assuming that the market is functional, and blinded to the fact that indexing increasingly makes the market dysfunctional.

Indexing undermines capital formation and market efficiency. At core, capital markets are supposed to reward companies with strong fundamental prospects with the additional capital they need and seek, and starve companies of capital whose fundamental prospects, finances, actions, integrity, or track records don’t warrant investor trust.

• Indexing perversely does the opposite.
• Since indexing has long destabilized fundamental market equilibrium in its myopic pursuit of the regression toward the mean of a market, and since a purpose of indexing is to ignore market fundamentals and to make no attempt to price or value securities or bonds in a market, indexing corrodes capitalism’s market mechanism by regularly allocating less to the most promising or most trusted to give more to the least promising or least trusted companies.

Indexing is speculation. Mass indexing is automated speculation that increasingly short-circuits the market’s natural ability to self-correct and avert bubbles and crashes.

• Markets can’t work or function efficiently if they aren’t able to reach fundamental equilibrium and clear the market with a price based on fundamental value.
• If markets cannot reach fundamental equilibrium, and match buyers and sellers based on different fundamental assessments or time horizons because there is such an imbalance to the immediate term, and because of random relative algorithms, the markets have no predictability and hence no confidence or stability.
• By never questioning the side effects of indexing, regulators have let indexing get completely out of control, severely destabilizing the economy, and making markets more volatile, less rational, and inherently self-destructive.

Indexing hyper stresses the financial system. What exacerbated a sudden downturn into a global financial meltdown last fall was that indexers became the equivalent of mass automated short sellers of financial stocks and bonds, blind to price, demand, fundamentals, rationality, or government intervention.

• Worried about an old-style panic run on bank deposits, the government wisely increased FDIC insurance of bank deposits.
• What they completely missed was a new-style panic run on the equity and debt of financial companies by ETF speculators.
• If the equivalent of mass automated short selling by index program trading can evaporate most bank equity in a matter of days of weeks, the banking system could lose a huge source of historically safe capital reserves – company equity.

Congress and regulators have a choice to make: treat symptoms or causes.

• They can continue to deploy trillions in taxpayer funds to de facto replace the century old role of public stock equity as a source of capital reserves in the financial and company systems, or they can begin tackling a major cause of the systemic destabilization, dysfunction, and speculation – mass out-of-control indexing.
• Market bubbles and crashes will continue to destroy the economy, jobs and people’s financial security as long as our regulatory and tax policies condone and encourage mass index speculation.

The solution is simple but hard. We need smarter regulation that discourages irrational index speculation and encourages long term investment, economic growth and fundamental value creation.

• First, companies, especially banks and financial institutions, should have the freedom to opt out from selling shares of their public stock to index funds or ETFs. No public company nor its employees, shareholders, and pensioners, should be forced to endure mass speculators who have no interest whatsoever in the company’s solvency, fundamentals, track record, or future.
• Second, the SEC, CFTC and the IRS should re-classify indexing as speculation, not investment, and not reward speculative, non-productive index arbitrage with any favorable regulatory, tax or federal retirement treatment.
• Third, financial advisors should fairly represent indexing as speculative behavior that collectively can be highly destructive to capital formation, market efficiency, financial system stability, and economic growth.

Simply, mass index speculation is a major root cause behind the hyper-stress on the financial system and the unprecedented destabilization of the economy. Imagine how much more stability, investment and growth there could be if the indexing auto-pilots were not all driving markets, the economy and everyone into the ditch.

For an introduction and background into this "Financial Crisis Root Causes" series and the author, please click here.