Passive Index Funds And The Concentration Of Risk

Passive Index Funds And The Concentration Of Risk

The following is a summary of our recent Big Picture podcast, “The Concentration of Risk,” which can be accessed on our site here or on iTunes here.

Right now, risk is growing. We’re in the middle of a Fed rate-raising cycle, which is usually a key factor in triggering a downturn, while investor complacency is running high with the S&P 500 experiencing the shallowest drawdown on record this year.

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Even more, the soaring use of passive index ETFs has concentrated risks, bidding up valuations among a handful of companies where not a single US stock now shows up in Benjamin Graham's deep value screen.

Warnings on the Horizon

The elements of risk are building, Financial Sense Newshour host Jim Puplava warned, and, when considering the Anatomy of a Bubble, we are likely in the final phase of the advance.

Consider Ned Davis on Passive Investing Bubble, Business Cycle, and Risks Ahead

“I see us in the latter innings. A lot of people look back and say, well, we are nowhere near where we were in 2000 or even 1929—that the run-up in the final ends of those bull markets was spectacular. For example, after Allan Greenspan in 1996 famously said that the market might be at a level of irrational exuberance. After that the Nasdaq turned around and doubled in value in a very short period of time. So, people are taking comfort from the fact that…this is not as big a bubble as 1929 or 2000, but I think if you look at any other market top…I think you'd have to say we are in the very late innings.”

As Davis also remarked in that interview, we are seeing a “passive investing bubble,” which has led to a smaller number of institutions controlling a larger percentage of the equity market than ever before.

Index Funds Dominate the Market

This is especially important to understand because of trading volumes.

Through September 2015, shares of the 100 largest ETFs, valued at $1.5 trillion, were turning over at an annualized rate of $14 trillion, a turnover of almost 900 percent, Puplava stated.

By comparison, the annualized turnover volume of the 100 largest stocks, valued at $12 trillion, is $15 trillion for the same period, a turnover of a little over 100 percent.

“Trading in the 100 largest ETFs thus represents 89 percent of stock trading,” Puplava calculates.

Because of the way stocks are weighted in indexes, and thus the percentage of index funds they take up, certain stocks end up as a larger percentage of index funds.

“I would expect to see … many of these stocks that are common to all major indexes gap down tremendously,” Pupalva said. “Imagine what happens when fear sets in and markets drop like they did in 2008. … It’s all concentrated in financial institutions, and it’s concentrated in index funds.”

This could easily lead into a major stock market correction, with selling leading to more selling, and no buyers stepping in to prop up markets.

Right now, investors should be derisking their portfolios, Puplava stated. Because the Fed is raising rates and we appear to be near the end of the business cycle in terms of age and valuation, it’s much better to be safe here.

“The good thing is, if you are derisking … you’ll have the opportunity of a lifetime to buy great companies at great prices,” Puplava said. “The key is to understand this macro environment, the risks that are out there, the consequences of a rate raising cycle, recessions and bear market history. Nobody … can tell you when the market will top. All we can do is warn you.”

Article by Financial Sense

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