ETFs have become the new worry of investors obsessed with hunting for the next big derivative explosion. ZeroHedge has said they are “ETF = Synthetic CDO. Soooo complicated,” and FT Alphaville posted a research piece this past weekend highlighting how many investors may not have access to the underlying in the event of a run on an ETF.
Today FT Alphaville followed up on that with an even larger reason to worry, the combination of indexing and ETFs.
Citing a paper from NYU’s Jeffrey Wurgler, they point out that indexing creates correlations in stocks included on the index, which allows those stocks to not reflect their underlying fundamentals.
From Jeffrey Wurgler, cited at FT Alphaville (emphasis theirs);
The net flows into index-linked products are both large and not perfectly correlated with other investors’ trades. Indexers and index-product users are by definition pursuing different strategies from those of the more active investor. They are less interested in keeping close track of the relative valuations of index and non-index shares. Some are index arbitrageurs or basis traders who care only about price parity between index derivatives and the underlying stock portfolio. The upshot is that over time, the index members can slowly drift away from the rest of the market, a phenomenon I will call “detachment.”
What we found most interesting was when this indexing collides with ETFs to create a potential bubble problem. Essentially, investors are buying into the index with ease and creating an environment where money coming in impacts returns in a disproportionate manner. Wurgler says this may be one of the underlying causes of the flash crash.
So, essentially, indexing makes it bad. ETFs multiply that further, through an ease in investment, and the final result could be a threatening investment position for the little guy trying to hold an ETF.