The benefits of index funds are obvious – you’re guaranteed to match the returns of the index (i.e. the market), minus fees. Of course, that comes with one rarely discussed caveat: market risk.
As easy as it is to say invest passively or buy and hold, you still must sit through the risk, to earn the return. Investors still have trouble in that area. And rightly so. Not everyone is equipped to handle the risk despite the benefits.
But what we’re now seeing is that the line between investment and benchmark is blurring. What once was a yardstick is now a target.
Last month, MSCI announced it would upgrade Pakistan to emerging market status, along with other changes (MSCI releases a quarterly review of all index changes you can find here). The news sent shares in that market soaring, despite the fact it wouldn’t take effect until mid-2017.
As this Bloomberg article points out:
One concern about the spread of index-tracking investments is that they’ll create market distortions, with money moving into or out of shares because of their status in key indexes, instead of anything to do with the securities’ underlying value.
This is nothing new. As I’ve explained before, changes are made to indexes all the time. The big difference now is the huge amount of money chasing these changes. But we should remember, of all things that drive markets in the short term, fundamentals is rarely one of them. Speculation has always played a role in the markets and this is just another form of it.
Anyone who reads the news can learn about index changes days or months in advance and try to take advantage of the potential mispricing opportunities. Theoretically, as more people try to front run the changes, the potential opportunity should diminish. But as long as easy money can be made, people will take advantage of it. So add index changes to the long list of things that impact markets.
But we already knew that. Behavior, sentiment, and, ultimately, fund flows drive prices.
I’ve always believed that the rise of index funds means investor behavior will have a bigger effect on markets (due mostly to the rise of self-directed retirement accounts). It’s more likely that recent performance of an index will have a greater effect on markets as investors pile in or out.
But, it’s conceivable that an index becomes so wildly popular or extremely hated that funds based on it distort prices over longer periods. And if that is the case, then market return, minus fees won’t be enough. Valuations – knowing when to accept or avoid market risk – become just as important.
- Buffett’s Timeless Investing Principles – L. Cunningham
- 1945-2016: Here’s Basically What Happened – M. Housel
- Death of the Risk-Free Rate – Research Affiliates
- The Value of Inactivity in Investing and Other Walks of Life – T. Hanson
- Slow Deciders Make Better Strategists – HBR
- Daniel Kahneman’s Strategy for How to Think Smarter – Wharton
- The Science of Persuasion (pdf) – R. Cialdini
- Machine Money and People Money – T. O’Reilly
- How a Broke Little Island Beat the Hedge Funds – Slate