The hidden risks of hugging an index

Kevin Cousins, Head of Research, PSG Asset Management, writes that indexation is prone to growing imbalances and risks as equity markets are increasingly concentrated

Indexation and passive investments have become extremely popular over the past few decades. In theory, these strategies offer cost-effective access to markets and an easy way to construct portfolios. However, their efficacy (and continued success) is predicated on a few pivotal assumptions about how markets function. These assumptions may, however, be less foolproof than many investors realise, which has substantial implications for investors’ portfolios, especially in highly concentrated markets.

Index use tends to go unquestioned in the investment industry
Indices have become ubiquitous in the investment industry. Firstly, active managers use them as benchmarks (typically in their risk models), and secondly, they serve as the basis for passive investing. As such, there is hardly a corner of the investment industry that has remained untouched by the use of indices. However, this also means that their use tends to go largely unquestioned.

The effectiveness of indexation is predicated on a few key assumptions. John Bogle launched the first retail passive index fund, the Vanguard 500 Index, in 1975. Today, Vanguard’s assets under management (AUM) have grown to US$10 trillion and more than 50% of total US equity AUM is managed on a passive basis. Passive investing has proved popular because it offers lower fees, good performance and a simple strategy that is easy to understand (and replicate).

However, Bogle frequently highlighted that indexation works for some very specific reasons. To paraphrase him:

• Indexing works because it’s a free ride on the efforts of others. If there were no others, there’d be no free ride.
• The beauty of indexing is that it works because it’s not the dominant strategy. If it ever became the dominant strategy, we’d have problems. (Ref 2)
• If everybody indexed, the only word you can use is chaos, catastrophe… The markets would fail. (Ref 1)

Effective passive management requires a thriving active manager population
Ironically, passive investment needs active management to dominate the price formation process and ensure the market functions as intended. Left to its own devices, cap-weighted indexation is prone to growing imbalances and risks, as momentum tendencies in markets become exaggerated. And it is flows, rather than the existing stock of assets, that determine how markets function. Markets dominated by active manager flows tend to be equilibrium seeking, as these managers buy cheap and sell expensive, pushing stocks towards intrinsic value.

When active manager trades no longer dominate flows (which historically tended to happen only at cycle extremes) markets change character and become deviation amplifying, with higher prices attracting more buying and lower prices more selling. This creates an unstable market, very dependent on continued liquidity flows. Stocks typically end up trading far above any valuation underpin and risk severe declines or crashes when the flow of liquidity slows or reverses.

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