Wednesday, October 6, 2010

ETF’s, Index Tracking Investment, And Irrational Markets

One of the seminal contributions to the macroeconomic literature of the last fifty years was the Lucas Critique, which in short states that changes in policy affects individual behaviour, which in turn means that you can’t reasonably expect that policies implemented would have the intended effects based on historical macro relationships. More generally, everything affects everything else, and you can’t take things in isolation.

While this is part and parcel of the now controversial doctrine of rational expectations (for which Robert Lucas won the Nobel Prize in 1995), the fundamental point that Lucas was driving at is still valid – you can’t assume that interrelationships will always stay the same, if you change something within a system. The mania over structured finance products that helped drive this past global financial crisis is a case in point, but it applies to virtually any financial product or government policy.

Which brings me to this article in The Star today:

What are ETFs and why is it beneficial to buy them?
Personal Investing - By Ooi Kok Hwa

LATELY, the number of ETFs that get listed on Bursa Malaysia has been increasing.

At present, we have a total of five ETFs listed in Malaysia. Unfortunately, we have noticed that not many investors are aware of these instruments and there is also a lack of understanding on the true value of these ETFs.

ETF stands for exchange-traded fund. Buying into ETFs is almost similar to buying normal mutual funds. The key differences are that investors can buy or sell ETFs in a stock exchange or go through an authorised participant whereas investors can only buy and sell mutual funds through unit trust companies or other financial institutions.

ETF originated in United States. During 1960s and 1970s, some fund managers in the US discovered that it was quite difficult to beat the stock market index. They discovered that it was better to buy stocks that mirrored the index composition as many fund managers found that they tend to underperform the index.

As a result, the ETF industry has been growing in the US from two ETFs in 1995 to more than 900 ETFs listed in the US now. At present, there are many types of ETFs available in the US, for example ETFs on stocks, bonds, commodities, currencies and countries. For stocks, ETFs can be further divided into different types of market capitalisation (big cap vs small cap), equity styles (growth investing vs value investing) as well as different types of sector funds (like ETF on stocks in technology, health care or financial institution sectors)...

...In Malaysia, sometimes we notice that some mutual funds may underperform their benchmark indices.

In short, we believe that there will be more ETFs getting listed on the stock market.

It will be to investors’ benefit to understand how they can add ETFs onto their investment portfolios as a cost effective investment alternative.

The article also goes into why ETF’s are beneficial for investors – low entry and exit costs, predictable performance, plus all the other advantages (and disadvantages) of unit trusts/mutual funds.

But, taking into account the Lucas Critique, there’s a not very obvious drawback to increasing investor interest in index-linked investing – demand for shares will increasingly be focused on index component stocks, and ignore the broader market.

In a new working paper, Professor Jeffery Wurgler of NYU outlines the problems (emphasis added):

On the Economic Consequences of Index-Linked Investing
Jeffrey Wurgler, NBER Working Paper No. 16376, September 2010


Trillions of dollars are invested through index funds, exchange-traded funds, and other index derivatives. The benefits of index-linked investing are well-known, but the possible broader economic consequences are unstudied. I review research which suggests that index-linked investing is distorting stock prices and risk-return tradeoffs, which in turn may be distorting corporate investment and financing decisions, investor portfolio allocation decisions, fund manager skill assessments, and other choices and measures. These effects may intensify as index-linked investing continues to grow in popularity…

B. Index Inclusion Effects

A stock is deleted from the S&P 500 when it falls below a threshold liquidity or is delisted, acquired, or otherwise determined by the S&P Index Committee to have become sufficiently less representative of the market than next available candidate...The press releases announcing the changes state that the inclusion of a stock is based not on any judgment as to investment merits but largely on liquidity and market representativeness; the lone requirement relating to economic fundamentals is four quarters of as-reported positive earnings, a simple piece of public information. The fact that Index inclusions are not associated with fundamental news allows for unusually clean estimates of the effect of demand per se on prices, which is the key question in light of the massive daily net flows faced by Index members...

...around the time of this writing, 8.7% of each stock that is newly added to the Index must be bought by Index fund managers—and rather quickly so, because their mandate is to replicate the Index. Whether they buy at a price that is “too high” is irrelevant.

On average, stocks that have been added to the S&P between 1990 and 2005 have increased almost nine percent around the event, with the effect generally growing over time with Index fund assets. Stocks deleted from the Index have tumbled by even more. Given that mechanical indexers must trade 8.7% of shares outstanding in short order, and an even higher percentage in terms of the free float, not to mention the significant buying associated with benchmarked active management—this price jump is easy to understand and, perhaps, impressively modest.

C. Comovement and Detachment

...But the inclusion effect is just the beginning. The return pattern of the newly-included S&P 500 member changes magically and quickly. It begins to move more closely with its 499 new neighbors and less closely with the rest of the market. It is as if it has joined a new school of fish...It is worth repeating that this pattern is occurring in some of the largest and most liquid stocks in the world.

These comovement patterns are where the real economic impact starts. Just as the initial price jump is a result of sudden index fund demand for the new stock, the increased comovement with other members of the S&P 500 is related to the highly correlated index fund inflows and outflows that they experience. To some degree, active managers with S&P benchmarks likely also contribute to this comovement...

...This price detachment is not just a theoretical concern. In an important paper, Morck and Yang (2001) find evidence that S&P 500 Index members have enjoyed a significant and increasing price premium, most likely due to the growth of indexing...As of 1997, they find an S&P membership price premium on the order of 40%.

There's a lot more, including positive feedback loops (leading to bubble and crash behaviour), perverse corporate investment incentives, perverse investment manager incentives, and reduced diversification effects. Wurgler's specialisation is in behavioural economics and corporate finance, but the paper is highly readable even for the layperson who's not familiar with either. The paper underscores more evidence of market inefficiency (i.e. irrationality) and underlines my own thoughts on the impact of an open capital account and unrestricted portfolio capital flows - stock valuations (and especially index-related stock valuations) will be driven more by sheer supply and demand rather than fundamental values.

Another NBER working paper further supports Wurgler’s results (abstract; emphasis added):

Index Investment and Financialization of Commodities
Ke Tang and Wei Xiong, NBER Working Paper No. 16385, September 2010


This paper finds that, concurrent with the rapid growing index investment in commodities markets since early 2000s, futures prices of different commodities in the US became increasingly correlated with each other and this trend was significantly more pronounced for commodities in the two popular GSCI and DJ-UBS commodity indices. This finding reflects a financialization process of commodities markets and helps explain the synchronized price boom and bust of a broad set of seemingly unrelated commodities in the US in 2006-2008. In contrast, such commodity price comovements were absent in China, which refutes growing commodity demands from emerging economies as the driver.

This one's more wonkish, but supports Wurgler's point (C) I quoted above - commodity movements via index linked investing have become increasingly divorced from fundamental valuations. In other words, we're looking at potential asset price bubbles driven by the distortionary effects of investor behaviour, and not fundamentally higher demand from fast growing emerging economies like China and Brazil.

Highly recommended reading, both of these.

Technical Notes

  1. Wurgler, Jeffrey, "On the Economic Consequences of Index-Linked Investing", NBER Working Paper No. 16376, September 2010
  2. Ke Tang and Wei Xiong, "Index Investment and Financialization of Commodities", NBER Working Paper No. 16385, September 2010

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