Conventional wisdom holds that the simple market capitalisation weighted index fund is about as safe an investment in equities as you can get. It may surprise some investors in such funds to know that they are in fact adding to instability in the market. Every now and then that instability manifests itself as a large correction but fingers are usually pointed at hedge funds as the culprits, not index funds. In fact it is the index funds that create the distortions and the hedge funds that restore normality. Usually, their actions are in the form of short selling, and that is facilitated by those self-same index trackers through stock lending.
In nature there are a number of combinations where seemingly incompatible forms of life coexist in a powerful symbiosis. The Clown fish of the Great Barrier Reef cleans the Sea Anemone and is protected by it from predators. Its own unique mucus prevents it from being killed by the animal it is helping. But the world of finance has created one of the oddest double acts. It is only the forces acting for good in hedge funds that can limit the evil impact of dumb money in cap weighted index funds. And the scary thing is that both need each other to survive.
Index funds are known for their low cost passive approach. But there is a cost to that low cost. They need the income from lending out stock to help keep their fees down. And the institutions that want to borrow that stock are the favourite bad boys of the media and the regulators; the hedge funds. But without them working to restore the correct valuations the stock market would gradually morph into a strange creature that had a few mega-companies at the top and a mass of small companies that had no access to equity capital at the bottom.
It is of course possible to argue that large overvalued stocks are an unfortunate, but necessary, side effect of the move to index funds. As long as they stay overvalued there is no problem. But they don’t. At some point reality eventually sets in and a stock price starts tumbling. If it was hugely overvalued to start with the fall can be precipitous. And that is when investors get worried. They assumed funds were being invested by sagacious men who looked at balance sheets, cash flow and…
