One Cause of Market Turbulence: Computer-Driven Index Funds
Posted February 9, 2018 8:39 p.m. EST
A decade ago, the center of gravity on Wall Street was raucous trading desks and stock exchange floors. These days, the locus has shifted to far quieter places, where computers are in charge.
The transition has been years in the making, but its effect has been on full display over the past week. After propelling the market to historic highs, passive investment strategies — which follow a simple set of rules and are carried out by sophisticated computer programs, not humans — are among the factors fueling the market’s recent plunge.
This is the new reality of today’s stock market: Funds that track financial indexes have become a dominant force, and they can act as accelerants, adding momentum to the market’s rise and fall.
This week, as markets shuddered, exchange-traded index funds were responsible for 38 percent of total stock trading on some days, an astonishing figure given that these funds were just a curiosity 10 years ago. Indexing giants like BlackRock and Vanguard now own vast swaths of the market and are the largest shareholders in just about all the major companies in the Standard & Poor’s 500 index.
In many ways, this stampede toward passive investing — in which people put their money into funds that track indexes and broader market themes as opposed to relying on human stock pickers — is uncharted territory. Now the key question is how this transformed market holds up during a financial storm that lasts more than a few days.
“These flows have had a big effect on the market,” said Peter Tchir, a strategist at Academy Securities. “And when people want to get out, there is a similar effect.”
Cheaply priced exchange-traded and index funds have pumped trillions of dollars into the stock market since early 2009. They now own close to 40 percent of stocks in the United States, according to research by Bank of America Merrill Lynch.
Unlike mutual funds, ETFs are listed on public exchanges, which makes many of them very easy to trade even if the securities they hold may not be. On Thursday, for example, the second most actively traded security in the equity market was a BlackRock fund that invests in large companies in emerging markets.
As stocks plunged Thursday afternoon, the global markets desk at BlackRock, the world’s largest asset manager, was calm. There were no traders or portfolio managers barking “Buy!” or “Sell!” — just a cluster of 15 people in front of computer screens monitoring the firm’s fleet of passive investment funds.
There was a lot to keep an eye on.
BlackRock, which manages $6 trillion overall, is the leading issuer of exchange-traded funds, with $1.3 trillion under management. But as the market fell and trading in BlackRock funds accelerated, there was little sign of panic or emotion among the ETF specialists at the firm.
They fielded phone calls from clients and let the computers do their work.
Martin Small, who oversees U.S.-based ETFs at the firm, said the high share of ETF trading was positive for the markets. That is because on days when fearful investors want to sell, large, easy-to-trade ETFs serve as a critical release valve.
“Everything worked,” Small said. “Volumes were higher and more people were watching, but our funds did what they were supposed to do.”
Investing on the basis of what machines, as opposed to humans, do has been a trend in financial markets for years. What’s different now is that so much money has poured into a specific type of computer-driven trading.
From cost-conscious millennials to the world’s largest pension and sovereign wealth funds, ETFs have become a preferred investment choice. In addition to all the major stock and bond indexes, they enable investors to get a piece of the action in arcane areas like junk bonds, bank loans and stocks in Pakistan. There is even an ETF that tracks companies that make whiskey.
The popularity of ETFs has concentrated unparalleled financial power in BlackRock and Vanguard, the two biggest providers of index funds and ETFs. Together, they sit on $10.5 trillion in assets and control 65 percent of the 1,700 exchange-traded funds that exist.
Relying on sophisticated computer programs, they funnel investor money into the stocks and bonds that make up indexes around the world. As the flows have grown in volume, much of these funds have gone toward index heavyweights like Amazon, Apple and Facebook, pushing their valuations ever higher.
This makes some regulators, academics and investors nervous. What happens, they ask, when passive investors own 80 percent of stocks as opposed to the 40 percent they control today?
Active fund managers — human stock pickers — will be marginalized, the argument goes. And that could cause harm, because they are the ones who buy when others sell. So when stocks suddenly plummet, there will be fewer funds to step in, extending the fall. An analyst at Sanford C. Bernstein even compared passive investing to Marxism, in its sweeping conformity and its degradation of the independent-minded, active investor.
“For years, this has been an ETF market — its robots buying stocks just as they were programmed to do,” said Steven Bregman of Horizon Kinetics, a firm that hunts for undervalued stocks. “But so much money has gone into just a few hundred stocks. Everyone owns the same stuff. So when they want to get out, who are they going to sell to?”
Compounding these worries is the rise of algorithm-driven trading strategies at large hedge funds. They get their buy and sell signals not from a human but from indexes that measure sharp swings in the market. Earlier this week, they were big sellers when the VIX index — a measure of anticipated market volatility — skyrocketed.
ETF proponents argue that their industry’s growth is just the latest stage of the stock-indexing revolution that began in the early 1970s. That was when John C. Bogle founded Vanguard and began to launch index funds.
His argument, which soon became a form of religion to his followers, was that over the long term, a cheap fund that tracks a broad index will perform better than expensive alternatives managed by stock pickers who believe they can outfox the market.
Wesley R. Gray of Alpha Architect, a rules-based investment firm, is one such true believer. He argues that his computer models do a better job creating stock portfolios than humans can ever do.
So when stocks sank this week, he barely glanced at his trading screens. Whether the market goes up or down does not matter to him because the computers control his suite of exchange-traded funds — not him.
“If the market goes down 4 percent, I don’t even care,” Gray said. “That is the beauty of systems. Once you build it, there is literally nothing left to do.”