Index fund volatility

A relatively quick missive…

There have been several academic studies that have tried to track the effect of index funds on the upward momentum of the stock market. In case you didn’t know, an index fund is a mutual fund designed so that its performance very closely matches that of a financial market index. The most popular of these sorts of funds track the performance of the S&P 500. The problem with the funds is that as new monies are invested in them they trigger a commensurate amount of purchases into the various individual stocks that compose the index. Why is this a problem? It’s a problem because it helps to create a momentum machine. Think about it. If a stock market, such as the S&P 500 is going up very rapidly, what do most investors (ne speculators) do? That’s right, they immediately rush to get into the market to experience the euphoric wealth wave, yes? And by purchasing shares in an index mutual fund that is required to invest in the entire market, as represented by the index, it serves to drive the market up ever more. So this is the effect that academics have attempted to study. I am not certain of the dollar amounts invested in index mutual funds these days, but it used to be the case that it represented hundreds of billions of dollars of purchasing power. So the momentum effect would have been fairly large.

But what happens on the downside? When the market is getting pummeled? You guessed it, the effects on the downside would have to also be equally large. Again, let’s think about it. An index fund investor gets nervous because they see that their index has declined dramatically. Thus, they put in a redemption order to the mutual fund. To raise the cash necessary to pay the redeeming investor they are required to execute sell orders of all of the stocks in the mutual fund. The portfolio manager has no choice in this matter, she must sell. Ooops! You guessed it, that serves to cause the market to fall even faster, thus generated ever more selling. A vicious circle of panic-based selling is created.

The irony of course is that index mutual funds were created to help stabilize investor returns. However, when the autopsy of the most recent bull market is finally conducted, let’s not forget the volatility, and concurrent catastrophic loss of wealth that was doubtless caused by index mutual funds and their ostensibly deaf-dumb-blind portfolio managers that exacerbated an already bad situation. Ugh!

I am not suggesting that index mutual funds go away, just that these darlings of the investment world are held to account for their negative effect on asset values.

Jason