Why index funds are herding mechanisms?

The underperforming active industry has less incentive to innovate because the other side of the performance fee is zero management fee

If you thought passive index funds are low risk, think again. Index funds are herding mechanisms that create more risk than perceived by the average investor. The deafening noise about the move to passive is setting us all up for a market failure. Even if active investing is inefficient, index fund herding is a tragedy of commons that needs collective awakening to iron out.

Herding in the index funds industry

Investment management can be interpreted as a bustling marketplace filled with vendors selling various goods. Active investors carefully analyse 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. 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 overall market performance rather than seek out specific opportunities.

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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.

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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’s stock price goes up not because of iPhone sales but because there is more inflow into Index funds, which are overweighted on Apple.

This collective behavior that is disconnected from reality is called herding.

The flock of birds also resonate in a recent 2020 paper, “ETFs and Systemic Risks”, published by the CFA Research Institute. In it, Maureen O’Hara and Ayan Bhattacharya explain how index products have become the main force influencing markets. 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 percent 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 volatility and induce positive serial correlations between these volatilities. Another example of how passive can go wrong is when monetary policy change can have a big impact on stock markets, and BOJ could end up owning more than 40 percent of Nikkei as the non-BOJ ETF holders can see a herding event as they rush for the exit door.

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Index funds industry herding by design

Index funds were designed to be popular. Popularity is a necessary ingredient for herding, e.g. FAANG. They are well covered by NEWS. Indexes give 80 percent of their weight to 20 percent of these large 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.

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.

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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 investing, 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 overpricing.

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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 return, 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 cannot 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.

The impending market failure

Animals often herd to reduce risk and increase their chance 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 chance of detecting predators increases. 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 behavior that enhances their overall survival.

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The recovery that never happens

What works for animals in numbers though 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.

Thus, the 'passive' argument is not always be against 'active'. The argument of 'passive' is with itself. How good it is at doing what it does? Can it make more return by reducing concentration? Can it more fairly represent 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 trillion of passive investing, you cannot blame the 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 cannot 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.