Three reasons why indexing and ETFs won't cause the next market crash
05 June 2019 | Topical insights
Commentary by Jim Rowley, Vanguard head of active/passive portfolio research.
After a decade-long bull run in stocks, recent market volatility has made investors increasingly edgy. Amid interest rate uncertainty, heightened trade tensions and confusion around Brexit, many market commentators see abounding reasons for an imminent and sharp market downturn. And some even cite the growth of indexing strategies as a potential trigger of the next bear market.
In our view, the surging popularity of index tracker funds and exchange-traded funds (ETFs) represents one of the most positive and profound developments for investors over the last 40 years. This growth has also made them an obvious scapegoat for some on which to pin the responsibility for market corrections. However, that is no reason to lay the blame for market weakness at their door. In fact, this argument is symptomatic of a misunderstanding about how markets and indexing actually work.
We make no claim to have the inside track on the timing or the cause of the next market downturn. But index investing is unlikely to be the source. Here are three reasons why.
1. No link between indexing growth and bear markets
First of all, crashes, volatility and bear markets have been around for much longer than index funds. Perhaps the most notorious stock market crash in history, in 1929, occurred more than 40 years before the first index fund was launched in the mid-1970s. The Great Crash of ’29, like almost all other major market downturns since then, was caused by a combination of a negative catalyst – this can be a macroeconomic shock, major catastrophe or speculative bubble, for example – and the resulting investor panic that drives the market down sharply.
More recently, the 2000-2002 dot-com bubble and the Great Financial Crisis of 2008-2009 both corroborate that no discernible relationship exists between the expansion of index investing and bear markets. Throughout this time, assets in index-linked funds and ETFs increased as a proportion of equity market capitalisation. Meanwhile, the market continued to ebb and flow in an apparently uncorrelated way.
This should not come as a shock to investors. Not only do index funds make up a small segment of the assets of the overall market, but they make up an even smaller segment of trading volume. For example, trading volume related to the portfolio management of US equity indexing strategies, which is by far the biggest asset class among indexed strategies, makes up below 5 per cent of overall US stock exchange trading volume.1
2. Investors do not desert index funds during volatility
A common argument made against index funds and ETFs is that index investors will all rush for the exits at the first sign of a market downturn, liquidating their investments and pulling markets down still further. However, this claim is tenuous, and this is the second reason supporting index investing.
During the bear markets of 2000-02 and 2008-09, investors didn’t sell their holdings of index funds. Quite the opposite, in fact – index-linked investments actually saw significant inflows. One could even reasonably argue that investors regarded these ready-made portfolios as havens during unpredictable times exactly because they typically come at a low cost and are well diversified. But more likely than this is that the growth of indexing during this period represented more of a structural trend. Over time, increasing numbers of long-term, buy-and-hold investors are choosing index funds and ETFs.
3. ETFs not a driver of market volatility
As the popularity of index investing has grown, many investors have opted to pursue indexing strategies using one investment fund structure in particular — exchange traded funds. This brings us to the third reason. Over the last 20 years, the ETF market has boomed, but some market commentators claim that ETFs are predominantly being used for speculative trading and are creating price volatility.
However, as is the case with index mutual funds, ETFs make up a small part of the overall market - around 13 per cent of global investment assets in 2017, according to Morningstar. And owing to the way ETF trading is structured, the majority of trades do not directly impact the price of the underlying investments. Because of this, ETFs are unlikely to contribute to price swings. Vanguard research has indicated that for every €1 in daily equity ETF trading volume on exchanges, less than 25 cents resulted in primary market transactions. In other words, more than 75 per cent of ETF trading did not lead to the purchase or sale of the ETF’s underlying investments.
The success of indexing
Fearmongering about bear markets and volatility entirely overlooks the benefits that investors have derived from the rise of indexing and ETFs. Index-linked funds are an understandable and accessible way for investors to increase their chances of achieving better investment outcomes.
A single trade can now give investors access to a portfolio that is broadly diversified and low cost. These two features alone can significantly improve investment returns and they are central to our investment philosophy at Vanguard.
Volatility was part of investing life long before the invention of index funds and ETFs, and markets will continue to experience bouts of turbulence. But index investing will most likely not be the source of this volatility.
1James J. Rowley, Jr., CFA; Inna Zorina, CFA; Carol Zhu, 2019. A drop in the bucket: Indexing’s share of U.S. trading activity. Valley Forge, Pa.: The Vanguard Group.
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