Are Index Funds Herding Mechanisms?

If you thought your passive Index Funds are low risk, think again. Index funds are herding mechanisms that create more risk than what a street investor perceives. The deafening noise about the move to passive is setting us all up for a market failure. Even if Active is inefficient, Index Fund herding is a tragedy of commons that needs collective awakening to iron out.

I - Herding in the Index Funds Industry

The Bustling Marketplace

Investment management can be interpreted as a bustling marketplace filled with vendors selling various goods. Active investors are akin to vendors who actively search for undervalued items, negotiate prices, and engage in strategic buying and selling.

Active investors, like astute vendors, carefully analyze the market, identify opportunities, and use their expertise to find hidden gems or bargains. They may explore different stalls, interact with different sellers, and gather information to make informed decisions. Their actions contribute to the discovery and exploitation of market inefficiencies.

On the other hand, passive investors are like customers who prefer a more hands-off approach. They trust that the market as a whole determines fair prices and trends. These customers opt to visit well-established stalls, follow the crowds, and make purchases based on the popularity and reputation of the items. They aim to capture the overall market performance rather than seek out specific opportunities.

The interplay between active and passive investors in the market mirrors the dynamics between vigilant vendors and passive customers in the marketplace. The active investors actively engage in researching and trading to discover inefficiencies and create a more efficient market. Meanwhile, passive investors rely on collective wisdom and broad market trends to guide their investment decisions.

Similar to how the marketplace functions harmoniously with the presence of both active vendors and passive customers, the financial market thrives when active and passive investors coexist. The active investors play a role in uncovering opportunities and driving market efficiency, while the passive investors contribute to overall stability by aligning with the broader market sentiment. This dynamic interaction ensures the continuous functioning and evolution of the market.

The story of passive risk began in 1980 when Grossman and Stiglitz explained how information symmetry happens in the context of its asymmetry, there is no efficiency without inefficiency, or in simple terms there is no passive industry without active. The idea of active investment managers removing inefficiency to create an efficient world or active managers generating more inefficiency for making passive more relevant is an information polarity, without which markets can’t function. Information polarity is the needed complexity for the market to function perpetually.

Flock of birds

Now imagine a flock of birds flying in the sky. Each bird has its knowledge and perception of the environment. However, when they notice one bird changing direction, they tend to follow suit and move in the same direction. This behavior occurs because the birds believe that the collective movement of the group indicates the presence of valuable information or a potential threat. Now, if you replace stocks with Index funds, which own most of the underlying market, the peculiar nature of stocks will not drive the markets anymore but the direction of the index funds. Wherever the fund goes, the market will follow.

This is what Froot, Scharfstein, and Stein explained in 1992 in their paper, "Herd on the Street: Informational Inefficiencies in a Market with Short-Term Speculation”. They described how in financial markets when index products (such as exchange-traded funds or index funds) dominate and information spreads slowly, market participants find it more profitable to align their actions with the overall market trend rather than relying solely on their individual information. A world where Apple prices go up not because of iPhone sales but because there is more inflow into the Index funds, which are overweighted on Apple. This collective behavior that is disconnected from reality is called herding.

The flock of birds also resonates in a recent 2020 paper, ETFs and systematic risks, published by the CFA Research Institute, Ayan Bhattacharya, Maureen O’Hara explains how index products have become the main force influencing markets. The systematic factor has become the primary driver of not only index prices but also the prices of all related assets. This poses a problem because the price of an asset becomes less indicative of its unique characteristics and more influenced by overall market trends. As a result, traders can more easily adopt speculative strategies based on following the crowd. This herd-like behavior turns potential weaknesses into broader risks, as issues in one market can quickly spread to other markets. The convenience of ETFs makes it easier to spread these shocks when markets experience disruptions.

The Japanese Case Study

The Bank of Japan (BOJ) is a classic example of passive gone wrong. BOJ is a top-10 shareholder of 40% of listed Nikkei companies. Charoenwong, Morck, and Wiwattanakantang (2019) found that the BOJ’s purchases of ETFs increased stock prices. Hanaeda and Serita (2017) found that larger holdings of ETFs increase market volatilities and induce more positive serial correlations between these volatilities. Another example of how passive can go wrong is when monetary policy changes can have a big impact on stock markets, and BOJ could end up owning more than 40% of Nikkei as the non-BOJ ETF holders can see a herding event as they rush for the exit door.

II - Index Funds Industry Herding by Design 

Index Fund Popularity

Index funds were designed to be popular. Popularity is a necessary ingredient for herding. Most sizeable stocks and generally the most popular e.g. FANG. They are well covered by NEWS. Indexes give 80% of their weight to 20% of these large sizes of popular components. 

Anchoring and confirmation bias

When something is visible, it naturally anchors and creates representative bias. If Index is overweighting a certain set of stocks, they must be good. Indexes make it easier for investors to allay doubts about what they are holding. Or in other words make it irrelevant for investors to question the Index construction, if it is already beating everything. If something is ahead in the game, it must be good. Performance blinds the investors and makes it a self-fulfilling prophecy.

A few large eggs in one basket

The popularity and the bias increase the herding and hence the concentration so much so that the basket is full of a few large eggs and hundreds of small eggs. If one egg breaks, you have lost a major value of the basket.

Newspaper of tomorrow

The real reason an Index returns are overwhelmingly consistent in outperformance is that an Index is an ex-post construction. The weight is allocated to a component as it is ahead of the race, not before. There is no anticipation in an Index creation. It’s like taking the newspaper of tomorrow, striking out the losers, shortlisting the winners and overweighting them, inflating paper value into inflated actual value, and keeping the world of investors happy because they see an increase in value and have thrown caution to the wind.

Active Manager’s Underperformance

Out of the 26 billionaires listed in Bloomberg Markets, 13 are from fintech, trading, and hedge funds. Active may have overall sagged in performance and may not beat the market but the few who do, do it significantly. The majority of Active managers who don’t beat the market are forced to herd, buying similar popular components. Most managers are invested at market tops and underinvested in market bottoms because they herd. No active manager can foresee the winners of tomorrow today and even if they could, they have to also anticipate when the train will stop. Stock-specific exit and entry anticipation is an improbable game to master by doing similar things. And when active managers keep tracking the market and herding together as a group, they strengthen the popularity of Index funds and hence create more herding.

The fee predicament

The underperforming active industry has less incentive to innovate because the other side of the performance fee is zero management fee. Why would someone innovate if the investors pay for underperformance? If the investors stop paying the fees to their active manager or advisor till he outperforms, the active industry overnight will turn a leaf. 

The free lunch

Unlike Active, the Index fund Passive industry hides under the near zero fee veil. Why would investors ask questions, if they are getting it for free? Investors don’t understand that there is no free lunch. And what seems free is concentrated, risky, and inflated.

Investors are poor in maths

The reality of our poor maths education is another reason why investors don’t understand the risk of our current Index funds. Owen A. Lamont and Richard H. Thaler, in their paper “Can the Market Add and Subtract?”, illustrate this lack of investors' capability as a group to efficiently price assets owing to investor irrationality and limited attention. They find evidence of significant mispricing i.e. under or over-pricing.

Value underperforms Growth

Value’s popularity is married to human overconfidence to be able to pick stocks. Value investing may have an opportunity to deliver absolute returns, but it does not have the statistical character to deliver outperformance to beat Growth over a decade-long investing rolling period. And even if Value beats Growth in some time windows, it can not do it consistently. We need a secular bear market to better understand Value outperformance. Barring periods of Momentum Crashes, Growth beats Value and hence the growth-biased index funds are always ahead of value and hence Index funds stay ahead in the game of performance.

Fear of Missing out (FOMO)

What do you think will happen, if growth-biased index funds keep beating value-biased index funds? Herding happens because Index Funds create FOMO. Herding feeds on FOMO, which fuels the rush towards passive.

Your neighbour can make you herd

If your neighbour is going passive, what do you think you will do? You will start going passive too. The stock market community, whether online or offline, can foster a sense of belonging and camaraderie among investors. Engaging in discussions about the latest news, sharing insights, and seeking validation from like-minded individuals can contribute to addiction. The social aspect of discussing stock market news is appealing and creates herding.

III - The Impending Market Failure

Herding in Animals

Animals often form herds as a strategy to reduce their risk and increase their chances of survival. By staying together in a group, they can benefit from several advantages that help them avoid or minimize potential risks. Here are some ways animals avoid risk by herding. Predator detection: Herds enhance the collective vigilance of animals. With more individuals on the lookout, the chances of detecting predators increase. Dilution effect: In a large herd, the risk of an individual being targeted by a predator decreases. Confusion effect: Herding can create confusion and make it difficult for predators to focus on a single target. Selfish herd theory: This theory suggests that individuals within a herd position themselves in a way that maximizes their safety. Social cohesion: Animals in herds often develop social bonds and cooperative behaviors that enhance their overall survival. 

The recovery that never happens

Because our lizard brains are animal instincts are impulsive. What works for animals in numbers, works against us in stock market investments. We don’t understand how our Index funds are herding us, creating a rush for that disco door on the cliff that opens outside. When you rush up to a cliff, rushing thoughtlessly into something, you are going to fall off the cliff. We have seen this before with the recovery of the Tokyo Stock Exchange which made its high on December 29, 1989. The high remains unreachable for more than 30 years. There are many more examples. The Great Depression took 25 years to recover. The Y2K peak took 12 years to recover in the U.S. 

Conclusion

The Passive argument can not always be against the Active. The argument of Passive is with itself. How good it is at doing what it does? Can it make more returns by reducing concentration? Can it be a more fair representation of the market and not be an amplification mechanism that pulls in naive investors who think Index funds are the safest bet? If you allow an 1871 biased method to herd $50 T of passive investing, you can not blame S&P 500. The Index happens to be the biggest Passive instrument of all time because its historical legacy got it here. But no legacy can be permanent, if it can not question its real value creation for the society. Today’s Index funds are herding mechanisms and ripe for disruption because the Rich Get Richer is not a mathematical certainty.