Indexed investing has grown many trillions of dollars since the time of its innovation in the 1970s by Vanguard’s Jack Bogle.

ETFs, termed the ‘kissing cousins’ of the mainline index vehicles by David M Hay of Evergreen Virtual Advisor (EVA), have grown from nothing to over 1300 funds.

Both these vehicles have become indispensible to the retail investor’s repertoire, but are, in essence, a form of ‘parasitic’ and brainless investing that were initially conceived as references or replica funds, operating to serve the purpose of a limited set of investors interested in this niche.

Indexed investing: The rise and rise of indexed funds and ETFs

Instead, these vehicles have become gargantuan strategies unto themselves, crowding out the hapless active money managers that seek to make investments on the basis of value or contrarian strategies that embody the basic tenets of investing such as buying low and selling high, says Hay in his July 25, 2014 issue of EVA.

According to the WSJ, the monthly net assets of the Vanguard Total Stock Market Index Fund at July end were $299.4 billion. “Vanguard now boasts the largest mutual fund in the world thanks to a shift by investors away from bonds and money managers who actively select individual holdings,” said the WSJ.

Legendary investor Warren Buffett lent more power to Vanguard’s elbow in March by revealing that he would like to allocate as much as 90% of his estate to “a very low-cost S&P 500 index fund,” and suggested Vanguard.

ETFs were not far behind. The WSJ reported that BlackRock, Inc. (NYSE:BLK), the world’s largest asset manager, received global inflows of $53 billion into its iShares ETF business through August 18, the highest among asset managers.

Hot money

According to Hay, these funds attract massive amounts of fickle money seeking momentum-based returns – money that is likely to stampede out as quickly as it gushed into the hands of bemused money managers now relegated to robotic investing by the power of the Index.

“Since this dynamic played out on the way up, meaning that index managers were forced to buy as prices rose ever higher during the boom phase, there is much farther to fall on the downside, warns  Hay. “Basically, the old-fashioned volatility modulator of investment professionals—using high prices to sell and low prices to buy—has actually been inverted!”

Indexed investing: Market distortions

This phenomenon is explained well by Hay’s partner, Charles Gave in ‘The Daily’ of July 25, 2014, published by Gavekal Dragonomics:

Active money management is essentially a ‘mean reversion’ strategy. That’s not so for indexation. In the indexation process, there is no attempt at price discovery. The only thing that matters is the relative size of the asset: the bigger the market capitalization, the more an investor should own. This means if the price of a large asset goes up more than the market as a whole, indexers have to buy even more of it. Thus indexation is a momentum-based strategy.

More dangerous, the flood of money chasing momentum has introduced serious distortions into the equity markets, which have long since distanced themselves from a basic logic – that equity pricing should reflect underlying cash flows like dividends.

The markets’ gyrations, around a ‘dividend’ line as shown in the chart below, shows “a major inefficiency is at work,” says Hay.

sp500-dividneds Indexed Investing

Wild market swings

Hay observes that there has been a structural change in the nature of market bubbles and crashes. Gone is their relative rarity and we now have in their stead ‘wild and woolly’ swings that have appeared with increasing frequency during the last 15 years.

“Since 2000, price fluctuations in the S&P 500 (INDEXSP:.INX) have returned to the extreme ranges of the Great Depression and in the immediate post-war years (when another depression was widely anticipated),” observes Hay, referring to the chart below.

wild-market-swings Indexed Investing

Though the Fed’s helicopter money machine could be one factor, Hay thinks the “proliferation of mindless investing is another prime suspect.”

Indeed, Hay makes a telling point about the 2000 meltdown in the NASDAQ index: “I would argue that the nearly 80% vaporization by the NASDAQ from 2000 to 2002, almost on par with the S&P 500’s 86% wipeout from 1929 to 1932, was also excessive weighted by the indexation phenomenon.”

Indexed investing: Free lunches and freeloading

The tech craze led to widespread extermination of the value investing fund manager, as investors sought hungrily to jump on to the seemingly endless gravy train. Hay appropriately calls it the first prime-time example of indexation run amok.

Charles Gave, Hay’s partner, calls mindless indexed investing a ‘freeloader’ strategy that has serious side-effects:

But a system where everybody wants to be a freeloader cannot work. The real problem here is that investment ‘consultants’ (read failed money managers) have defined risk as a deviation from the index against which the money manager is benchmarked. This is idiotic. It forces even mean reversion managers to become closet indexers.

Speculative manias in replay mode

If you thought the NASDAQ bubble was the end of it, think again. In 2007, the S&P 500 capitulated to the onslaught of housing related stocks and the financial sector and imploded in the shape of the great financial crisis.

“Since Italy is the third largest sovereign debt market in the world, those running Eurozone world index bond funds need to have huge exposure to Italian debt,” remarks Hay on how indexing compulsions affect EU debt. “In contrast they are forced to hold a minimal amount of debt from a small but fiscally sound country like Sweden.”

He warns of many “mini bubbles” playing out in today’s equity markets.

Indexed investing: A situation made to order for the contrarian manager

David Hay is not complaining.

Irrational, robotic investing that creates extreme price distortions is manna from heaven for the patient, ‘waiting-to-strike’ contrarian investor/manager with dry powder at his disposal.  The inevitable collapse of momentum, and the resultant price crash, would paralyze the index funds and ETFs as they try to cope with an avalanche of redemption calls.

“My strong suspicion is that it will be messy in the extreme, giving those who resisted the Fed’s siren song—to take on greater and greater risks—an extraordinary buying opportunity, one on which the legions of indexers won’t be able to capitalize,” says Hay.