Market Pulse: A downside of index investing
September 19, 2018
We've written many times about the attractiveness of index funds.
These funds have grown around six times faster than those tended by active fund managers who select stocks to buy. But does their popularity pose a risk for stocks?
The head of JPMorgan's quantitative analysis group believes that investors' love affair with index investing and passive management has left a void that used to be filled by wealthy investors and managers who would step in and buy when there were sharp drops (J.P. Morgan himself in 1929, others in the 1987 crash, March of 2009, and recent flash crashes).
They bought based on fundamentals, yields and the earnings outlook, but that was then. Index funds driven by algorithms, not analysis, and firms using fast-trading programs, dominate today's market and will increasingly drive it in the future.
They won't be buying when stocks start to fall, and worse yet their algorithms will probably trigger even more selling. That would create great buying opportunities for people with cash and for corporations with share buyback programs. All possible.
Another factor mostly overlooked is that the number of publicly traded stocks has fallen due to mergers and many acquisitions by private equity firms. The Wilshire 5000 index once had 5000 stocks, literally 100 percent of U.S. market value. As this year began there were only 3,492 stocks in the index and there must be fewer now.
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So more and more money is going into fewer and fewer stocks. A very large percentage is in the 50 biggest companies. That's not healthy.
Over many years I've considered what could go wrong with a bullish market outlook. In all cases what some said could go wrong didn't go wrong. Y2K was not a catastrophe, the 1987 crash didn't cause a depression nor did the 2008-09 financial crisis.
Yes, JPMorgan's concern about passive investing has merit, the shortage of stocks is a valid point, and of course fast-trading programs compound the risks of more flash crashes. A trade war could get out of hand. All worth considering.
I found JPMorgan's alert most interesting for what it didn't mention, the ultimate market driver: earnings. The outlook for earnings wasn't impacted by flash crashes or sudden hair-raising drops in the past nor will it be by market gyrations in the future.
Again, earnings trump all else and their future will not be driven by market-related events. Good thing.
David Vomund is an Incline Village-based fee-only money manager. Information is found at http://www.VomundInvestments.com or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial advisor before purchasing any security.