Don't blame the hedge funds! How conventional index trackers make the stock market more volatile

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 business prospects. In reality it is simply computers saying that company A is twice as big as company B, so allocate twice as much money to it.  That is hardly a logical way to allocate capital in the 21^st century.  

The problem is not just that index money is dumb money.  The index is even dumber. Simply listing the largest 100 or 500 companies by market capitalisation to make an index is not actually very smart. The reason it is not can be called the “car park” problem.

Imagine a town where one car cark contains the 100 most expensive cars. No other measure like fuel economy, luggage capacity or number of seats is considered; just price. The chances are it will be full of Ferrari’s, Porches and maybe the odd Bentley. Suppose one of these cars leaves to drive to another town and the car park is obliged to fill the gap with another car. What are the chances of it being a seven seat people carrier, a van or a fuel efficient city runabout? Pretty much zero wouldn’t you say? No, it will be another German or Italian car of impeccable breeding and limited practicality.  That car park is self-selecting on price in exactly the same way as an index selects a company on market capitalisation.

Even worse is that within that index the largest weighting then goes to the largest company. With that sort of mathematics it is easy to see why corporations are focussed on growing the size of their company by market capitalisation rather than any other measure. Takeovers are the quickest way to achieve that even though it is well known that many destroy value. That does not matter though if all executives want is the largest slot in the car park. 

Fortunately owners and employees of hedge funds are smart enough to spot this. And, at the opportune moment, they can short the stock by borrowing it from index funds before everyone else realises that the flashy car is overpriced. It is that moment of price correction when the true instability of the market imbalances caused by price weighted index funds becomes apparent. And it can be rather upsetting. But it is wrong to blame the hedge funds for exploiting miss-pricing in the market. It makes more sense to point the finger at those who allocate capital on the basis of market capitalisation alone.  

Of course that is not to say that hedge funds are the best solution to this problem. Their fee structures, limited availability and erratic performance do not make them suitable for the mass affluent. Surely it makes more sense to allocate capital to companies though the use of some fundamental measure rather than price. Taking price out of the equation for a tracker fund means it can construct a portfolio efficiently without the need for another agent, like a hedge fund, to periodically wrench valuations back into line with reality. The partnership of index and hedge funds does work, but it makes for a bumpy ride and is unnecessary when there are smoother alternatives.