Do not blame index funds and ETFs for market volatility
Scaremongering about crashes ignores the long-term success of diversified investments
Gregory Davis
The surging popularity of index investing makes it an easy target © Bloomberg
Markets are jittery. Volatility is increasing. Everyone seems to be expecting the market sell-off to sharpen. They disagree on the reasons: rising interest rates, increasing trade tensions, burgeoning government debt, additional Brexit uncertainty. Some people also add the growth of funds that track market indices like the FTSE 100 and the S&P 500.
I do not know what will cause the next market correction, but I can give you five reasons why index investing will not be the source. The surging popularity of index tracker funds makes them an easy target, particularly as the potential cause of an event that has not yet happened. But that is not a valid reason to point the finger at them. If anything, these current criticisms reveal confusion about the nature of both markets and indexing.
First off, volatility and bear markets pre-date index investing. Crashes and corrections were part of investing life long before the invention of index funds.
The first such fund began in the mid-1970s, many decades after arguably the most famous stock market crash of all time in 1929. The underlying causes of major market downturns usually lie in a combination of macroeconomic imbalances and speculative investing.
The second reason is that there is no discernible correlation between the growth of indexing and market downturns. Relatively recent bear markets — the 2000-2002 bursting of the technology bubble and the 2008-2009 financial crisis — attest to this. The percentage of fund assets in index-linked funds grew steadily, while the market rose and fell in a seemingly random pattern.
This should not be a surprise. Index fund assets are a small part of the overall market, which is the third reason. As such, they are unlikely to be a source of instability. They make up only about 10 per cent of the value of global equity and bond market capitalisation and even less of trading volumes. For US equities, easily the largest asset class among indexed strategies, sales and purchases related to the portfolio management of these strategies represent less than 5 per cent of the daily trading volume of the US stock exchanges.
Some market commentators argue that in a sell-off, index investors will all run to the exits at the same time, selling their funds and dragging down markets even lower. But my fourth reason for defending index investing is that there is no evidence to support this contention.
In 2000-02 and 2008-09, investors sought out, rather than sold, index funds, which experienced significant cash inflows. You could make the case that these ready-made portfolios were viewed as attractive safe harbours during tumultuous times precisely because they are often low cost and well diversified. But I think that growth was part of a structural trend. More and more long-term, buy-and-hold investors are switching to index investing.
The fifth reason relates to exchange traded funds — the investment fund structure many people use to follow indexing strategies. ETFs have experienced rapid growth over the past 20 years and are criticised for being a speculative trading tool and a source of price swings.
And yet, ETFs’ share of the overall market is small, around 13 per cent of global investment assets in 2017, according to Morningstar data.In addition, because of the way ETF trading is structured, most sales and purchases have no direct impact on the price of the underlying investments. They are therefore unlikely to drive market volatility.
US research by Vanguard indicated that for every $1 in ETF trading volume on exchanges, less than 10 cents resulted in primary market transactions in the underlying securities. Put another way, more than 90 per cent of ETF trading did not lead to the buying or selling of the ETF’s underlying investments.
Scaremongering about market crashes ignores the successes from the growth of indexing and ETFs. Index funds are an easy way for ordinary people to invest for their future.
With one trade, individuals can own a portfolio that is broadly diversified and low cost — two features that improve investment returns and are core to our investment philosophy at Vanguard.
Despite efforts to pin the blame for volatility on them, index funds are not going to go away. Neither, of course, is market volatility.
The writer is chief investment officer of Vanguard
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