The biggest problem is with exchange-traded funds (Etfs), has to do with the concept of indexing itself.
Other Indices cover, the different asset classes (equities, bonds, currencies, commodities), geographic markets or investment styles and strategies. An index is effectively a basket of securities, it is provides a proxy for the price movements, investment performance and the relative performance of an individual portfolio.
Except that the financial markets have abused this concept, which creates difficulties for investors in Etfs and other indexed holdings.
First of all, there are now several indices. An amazing 770,000 benchmarks have been discarded in the world by 2019, according to the Index, an Industry Association, and a still life (a ridiculous 2.96 million other indices in the world. In comparison, there are around 630,000 companies listed in the stock exchange around the world.
Secondly, each index is maintained by its provider, using its own methodology. The Performance depends on the index weighting. Where a fixed-number-of-stocks are used, the value is affected by changes in the holdings with the highest price, while market capitalization weighted indices such as the S&P 500 index
we are affected by the changes in the most important stocks. The changes in the index constituents, as determined by the rebalancing rules can have a significant impact on the results.
Thirdly, the indexing changes the practice of investment and financial markets. Active managers, often, “the secrets of indices, where the majority of the portfolio has been structured to follow a benchmark index, with a slight over – and under-weighting or on specific sectors or stocks to be consistent with the prospects. In an indexed world, and purchases or sales to participants based on the inclusion or exclusion of the index or the weightings of the index, rather than a single investment fund.
Fourth, the indexing changes the process of issuing new shares. The Underwriters are focused on having a security included in the relevant indices, so that investors tracking the index will be obliged to purchase the shares. This creates the problem of “the index of tourism, where an investor should buy securities, regardless of value considerations. This is especially true with smaller markets and emerging markets, where investors, lack of detailed knowledge, or research, is to make investments that they may later regret.
Fifth, the indexing does not apply uniformly to different asset classes. In a market capitalization-weighted stock market indices such as the S&P 500, investors may find themselves increasing exposure to a stock whose value is rising. In the case of a bond index is calculated on the balance of the volumes, investors can take more exposure to an entity that is to become more indebted. A successful company, whose market capitalization increases merit an increase in investment. A company that is borrowing more and therefore has greater representation in an index, can not the additional merit of the exhibition.
The Bond indices are based around a specific rating levels are also problematic. In an environment like the current one, degradations, in particular of the investment to non-investment grade will force some investors to divest-and-other-purchase, to align with the weightings of the index. After the bursting of the internet bubble, one such situation occurred with WorldCom bonds. Non-investment-grade bond investors have been forced to buy large quantities of the obligations of the company and because it was such a large part of certain indices, regardless of their point of view on the survival of the company.
Commodity indexes pose their own challenges. As assets have industrial uses, changes of price, have used second-order, the demand and supply effects. An Investment based on an index, may not take this into account.
Sixth, the indexing creates the illusion, or diversification. Many indices, in particular in emerging markets or certain asset classes are dominated by a small number of large companies, or constituents, of the creation of a significant concentration of risk. In The energy sector, it is now around 5% of the S&P 500 index, for example, compared to 13% in 2007. Investors may be over – or under-exposed different segments.
Seventh, indexing generally focuses on relative rather than absolute returns. For example, a portfolio that falls 10% while the underlying index loses 20%, would save only 10 percentage points of the outperformance. However, the investor has still lost money.
Eighth, the index focuses on the relative, rather than absolute risk. The calculation is, if this is your portfolio, it is more or less risky than the index. This distracts from the actual exposure, which is to cash losses and potential levies.
Ninth, the investment in the indexes of creates a self-reinforcing dynamic that amplifies the movements of the market, both on the top and the bottom.
Finally, the indexing of the investments are marketed frequently depending on liquidity shown by the generous rules of the game. Unfortunately, the funds are more liquid than the underlying investments it holds. A study by the IMF be found, for example, an investment fund in the U. s. high-yield corporate bonds can take up to 60 days to liquidate your assets.
The impact of indexing has been profound. But it is much better for investment or risk management. Instead, it has made financial markets more unstable.
Satyajit Das is a former banker. His latest book is the A Banquet or the Consequences (published in North America The Age of Stagnation). He is also the author of Extreme Money and Traders, Guns And Money.