Indexation: an accident waiting to happen?

Written by: Richard Willsher Posted: 26/03/2018

index illoThe explosive growth in exchange-traded funds has highlighted the investment opportunities offered by tracking indices. But some experts are concerned that a dangerous bubble might be forming

Go back 10 years and the only people who’d have heard of exchange-traded funds (ETFs) would be those who really knew their investing onions.

That’s not the case these days. With the rise of robo-advisers and passive investing, today an increasing number of investors are familiar with what ETFs do – in many cases, simply tracking an index of one kind or another.Right now, ETFs represent a relatively small proportion of global assets under management (AUM). 

In its report last year, Global Asset Management 2017: The Innovator’s Advantage, The Boston Consulting Group calculated the total value of global AUM in 2016 at just over US$69trn. This includes all actively managed funds and passive ones such as ETFs and trackers. 

In January this year, specialist ETF and exchange-traded products (ETP) consultancy ETFGI calculated that assets invested in ETPs listed globally reached a new high of $4.83trn during 2017 – a mere seven per cent of the total.

What’s significant about this number, however, is that it represents a 36 per cent increase on a year earlier. Globally, ETFGI reckons that there are now in excess of 5,300 ETPs traded across different markets. And it’s a trend that looks set to continue.

Moody’s Investors Service has calculated that by 2024, passive investments in the US, including ETFs and other indexed funds, will overtake actively managed ones. What’s more, even within actively managed portfolios, investment managers may also employ ETFs to provide their investors with exposure to certain assets. This could be to the largest listed companies through one of the major indices or, say, emerging market stocks via an index such as MSCI’s Emerging Market Index. 

Tradition and innovation

The indices, and the companies that construct and maintain them – such as S&P, FTSE or MSCI – wield huge influence over the investments we make. The S&P 500, for instance, is the world’s most followed single stock market index, with $7.5trn of AUM benchmarked to it. S&P also offers an extensive range of other indices. 

MSCI reports that $10trn of AUM is benchmarked to its family of indices. FTSE Russell, part of the London Stock Exchange Group, also reports that $10trn is benchmarked to its products. 

However, this isn’t the whole story. There is now a growing number of businesses that compile indices – 191 separate firms, according to a database maintained by ETFGI. Some are familiar names in the finance world – Bloomberg, Markit or STOXX. Others are stock exchanges around the world and banks such as Deutsche Bank, Credit Suisse or Citigroup. 

Then there are those that are relatively new, but which are making their names as providers of specialist indices – including ScientificBeta, Solactive and Horizon Kinetics. The more you look, the more it becomes clear just how diverse the index universe is becoming. 

Frankfurt-based Solactive’s founder and CEO Steffen Scheuble says: “We believe that globally there are 20 indices that are very hard to replace due to their branding power. Everything beyond that is our market – and in this space, we believe that the competition will increase significantly.” 

The key is choosing an area of specialisation and developing the programming tools to gather real-time market information to formulate a credible basket index whose story will appeal to investors. For example, while the S&P 500, the Dow Jones Industrial Average, the FTSE 100 and others are stock market indices, Bloomberg specialises in bond market indices. 

Solactive is an index provider and calculation agent for more than 260 ETFs globally and accounts for around five per cent of all ETFs. Its indices include, among others, commodity-related ones such as its London Gold Price and its Silver Futures indices. 

It also compiles indices that track futures and derivative instruments. These are themselves constructed on the back of the price movements and outlooks of underlying assets such as bonds, equities or commodities traded in various markets.

Another approach to indices is so-called ‘thematics’ investing. This involves selecting particular stocks from the wider market and constructing an index upon them, excluding all others. This gives the investor exposure to specific themes. 

STOXX, for example, offers its iSTOXX FactSet Ageing Population Index. This tracks firms from around the world that target their goods and services to older people, such as healthcare firms, insurance companies and goods companies. 

From the same family, the iSTOXX Global Women Leadership Select 30 Index ‘systematically selects stocks from the STOXX Global 1800 Index that have a relatively high proportion of women at board level, while maximising overall dividend yield and minimising overall volatility of the derived index’. 

And yes, if there’s an area of the investment world that’s riven with market jargon and technical terminology, index investing is up with the leaders. The term ‘smart beta index’ is used to describe indices such as these that aim to provide investors with lower risks and better returns by cleverly selecting index components.

The future of indexation, believes Steve Berkley, Global Head of Indices at Bloomberg, may lie in the hands of data providers. He cites Bloomberg’s ability to draw on its massive information bank and computing power.

“Where once banks played a much greater role in providing index information to their clients, now firms like ours are democratising the index data and sharing data with a much larger range of people,” he says. “They’ll be able to create customised indices by accessing historical data by themselves. 

“In the past, it was only the most advanced organisations that were able to manipulate data and come up with different types on analyses. We’re working towards enabling smart people, with good ideas to play, to come up with new investment products.”

Bubble trouble?

However, while the rapid growth of ETPs is grabbing the limelight, below the surface, the success of index investment may contain the ingredients for self-harm. Leaving aside the question of whether investors fully understand the risks of investing in some of the more esoteric index-related products, market concentration risk could become significant. 

For example, investors in an S&P 500 tracker fund or ETF would invest in, among others, Alphabet (Google), Amazon, Apple, Facebook and Microsoft – the world’s five largest companies by capitalisation. Investors in other funds of the world’s largest businesses would also do so. As might those investing in specialist indices of major technology stocks.

And those investing in so-called ‘momentum’ funds, which invest in companies that are basically going great guns and which fund managers think will continue to do so.

Add such drivers together, quite apart from actual company performance and news flow, and it’s easy to see that prices for certain chosen stocks could become hugely inflated. No surprise then that on 27 October last year, CNBC reported that these five stocks had gained close on $900bn in the previous year. 

Moreover, the news channel reported, these stocks had been the top contributors to the S&P 500’s 15 per cent gain in 2017.

But what will happen when confidence ebbs? How will it be when the algorithms that both shape and follow global trading and investment patterns determine that upside limits have been reached? What’s to stop selling activity accelerating as rapidly as buying had previously done?

At least there’s some good news for ETF investors. As these trade on exchanges in the same way as individual stocks, they are liquid. Investors smart enough to feel a cold draught on their portfolios can sell quickly. Those investing in mutual funds with daily reporting or hedge funds with lock-in periods may well not be so fortunate – so too Johnny-come-lately investors and institutions that pick up on trends too late in the day.

In summary then, index investing enables investors to easily buy exposure to markets, specific sectors, asset types and trends. ETPs are attractive because they’re easy to buy and sell and because they involve minimal human intervention. They’re low cost as compared with other active and passive funds. But they’re not immune to market forces. And their exponential growth feeds off of the markets they help to drive higher. 

The growth of regulation and increased transparency will almost certainly continue to drive investors away from high-cost traditional investment managers and towards ETPs in the coming months and years. However, in July last year, the UK’s financial industry regulator, the Financial Conduct Authority, decided against taking immediate action on ETFs, but intends to keep a ‘very close watch’ on them. 

But then, some regulators do have a history of chasing after horses that have long-since bolted.


It used to be so simple. Index tracking, for most people, meant investing in a fund that tracked,say, the 100 leading shares listed on the London Stock Exchange – the FTSE 100. Or maybe the largest companies in the US, the S&P 500. Today, there’s a huge range of trackers to choose from. Here are just some of them:
Bond/fixed income An index that follows the prices of selected bonds issued by governments, municipalities, corporates, mortgage-backed securities and other debt instruments.
Commodities These indices track the price of commodities – such as gold, silver, oil and natural gas.
Equities The traditional index tracker that follows a range of shares quoted on a particular stock market.
Leveraged index Using derivatives and a lending multiple, leverage is used to increase the return available from investing in an underlying index.
Shorting an index Because index tracking ETFs are quoted on public markets, they can be bought, sold, borrowed or shorted as any other stock. An ETF that’s expected to fall in value is borrowed from, say, an institution, and sold. It’s then bought back at a lower price and returned to the lender of the ETF, minus a borrowing fee. The profit is retained by the shorting investor.


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