As volatility in the stock market grows, a handful of experts are raising an alarm about the rise of index ETFs and mutual funds, which has never accounted for this much of the market before.
They warn that the unprecedented amount of index ETFs trading in the market — index ETFs accounted for nearly 30 percent of the trading in the U.S. equities market last summer — could magnify, or even cause, flash crashes.
In turn, that may put individual investors, who are increasingly invested in index funds, more at risk. And many may not realize how exposed they are to the risks of a relatively small group of stocks held in the major indexes, said experts.
Tim McCarthy, a former president of San Francisco-based Charles Schwab and Japan's Nikko Asset Management, has been a longtime proponent of index investing. But he now advises that investors diversify their investment styles as well as their asset classes.
He suggested investors move 25 percent to 50 percent of their equity portfolios into actively managed absolute return funds, preferably those with a 10-year track record and a relatively small amount of assets of between $1 billion to $2 billion. (Research has shown over the years that active managers stand their best chance of success before their assets under management grows too high.
As always, he said, investors should look for low fees.
A stock bubble in index funds
He said he has grown increasingly uneasy about the risks based on the hypergrowth of index funds, and the price difference between stocks outside and inside index funds.
From 2007 through 2014, index domestic equity mutual funds and ETFs received $1 trillion in net new cash and reinvested dividends, according to the Washington, D.C.-based Investment Company Institute. In contrast, actively managed domestic equity mutual funds experienced a net outflow of $659 billion, including reinvested dividends, from 2007 to 2014.
Meanwhile, the price of the underlying equities in index funds is rising, though no one is sure exactly why. Research by S&P Capital IQ, as of Dec. 31, found stocks that were in the Russell 2000 were trading at a 50 percent premium to stocks that were not, up from 12 percent in 2006. The statistics are based on median price-to-book ratio.
That kind of price difference is seen by some as a kind of canary in the coal mine, indicating that there is a bubble in the stocks of companies held in index funds — and that their prices could come down further and faster than other stocks in a downturn. In turn, that could put pressure on the share prices of the index mutual funds and ETFs themselves.
"It's complicated, but it could be a very big problem," said David Pope, managing director of quantamental research at S&P Capital IQ. He and colleague Frank Zhao studied the liquidity in the market for the S&P 500 last summer and identified the 10 stocks that had the biggest difference in liquidity at that time, compared with the index. They included ExxonMobil, Berkshire Hathaway, Johnson & Johnson, Microsoft, General Electric, Wells Fargo, Procter & Gamble, JPMorgan Chase, Pfizer and PepsiCo.
Read more: Watch out for this $1 trillion stock bubbl
They warn that the unprecedented amount of index ETFs trading in the market — index ETFs accounted for nearly 30 percent of the trading in the U.S. equities market last summer — could magnify, or even cause, flash crashes.
In turn, that may put individual investors, who are increasingly invested in index funds, more at risk. And many may not realize how exposed they are to the risks of a relatively small group of stocks held in the major indexes, said experts.
Tim McCarthy, a former president of San Francisco-based Charles Schwab and Japan's Nikko Asset Management, has been a longtime proponent of index investing. But he now advises that investors diversify their investment styles as well as their asset classes.
He suggested investors move 25 percent to 50 percent of their equity portfolios into actively managed absolute return funds, preferably those with a 10-year track record and a relatively small amount of assets of between $1 billion to $2 billion. (Research has shown over the years that active managers stand their best chance of success before their assets under management grows too high.
As always, he said, investors should look for low fees.
A stock bubble in index funds
He said he has grown increasingly uneasy about the risks based on the hypergrowth of index funds, and the price difference between stocks outside and inside index funds.
From 2007 through 2014, index domestic equity mutual funds and ETFs received $1 trillion in net new cash and reinvested dividends, according to the Washington, D.C.-based Investment Company Institute. In contrast, actively managed domestic equity mutual funds experienced a net outflow of $659 billion, including reinvested dividends, from 2007 to 2014.
Meanwhile, the price of the underlying equities in index funds is rising, though no one is sure exactly why. Research by S&P Capital IQ, as of Dec. 31, found stocks that were in the Russell 2000 were trading at a 50 percent premium to stocks that were not, up from 12 percent in 2006. The statistics are based on median price-to-book ratio.
That kind of price difference is seen by some as a kind of canary in the coal mine, indicating that there is a bubble in the stocks of companies held in index funds — and that their prices could come down further and faster than other stocks in a downturn. In turn, that could put pressure on the share prices of the index mutual funds and ETFs themselves.
"It's complicated, but it could be a very big problem," said David Pope, managing director of quantamental research at S&P Capital IQ. He and colleague Frank Zhao studied the liquidity in the market for the S&P 500 last summer and identified the 10 stocks that had the biggest difference in liquidity at that time, compared with the index. They included ExxonMobil, Berkshire Hathaway, Johnson & Johnson, Microsoft, General Electric, Wells Fargo, Procter & Gamble, JPMorgan Chase, Pfizer and PepsiCo.
Read more: Watch out for this $1 trillion stock bubbl
