Wall Street
Wall Street in New York City. Photo by Alex Proimos via Wikimedia Commons

By Jon Morris

Stock market indexes have become so popular that there are now more indexed securities than stocks traded in the United States.

An index fund is simply a mutual fund or new exchange traded fund that tracks groups of investments. Whether it is indexing by country, company size, or industry, investors have flocked to indexed securities in remarkable numbers. The most popular index is the S&P 500, where a quarter of the world’s market capitalization is held.

Why is index investing becoming so popular now? A few factors come into play, including a prolonged bull market (when stocks are increasing in value) and falling fees. Indexing has benefits, such as allowing people to invest in assets they could not own easily before, but also perils, including heightened systematic risk.

Indexing has had times of popularity before. Charles Dow invented the Dow Jones Industrial Average in the late 1890s as a popular way to track, back then, just 12 companies. Standard and Poor’s traces its origins to tracking the United States railroad boom in the 1860s. John Bogle, the founder of Vanguard, widely popularized the use of index investing. He created the first mutual fund that tracks the S&P 500, The Vanguard 500, and then later Vanguard’s popularized ETF tracking the S&P 500 as well. Vanguard does this with cheaper fees than other investment products out there and thus, revolutionized the investment industry and spawned the “indexing investment” phenomenon that we see today.

Indexing has evolved to take on a much more simplified life. To invest in the S&P 500, instead of investing in all 500 stocks and annually updating the newly added or subtracted companies, investors take a simpler approach: just buy an ETF that invests in the S&P 500 for you. Probably the most important reason indexing has taken off today is that before ETFs, tracking indexes was incredibly expensive, but after the invention of ETFs, indexing became incredibly easy and cheap.

Jon Morris

There is no doubt that index investing has helped the retail investor. The complex process of picking and choosing investments today with an enormous amount of information at one’s fingertips can be overwhelming. These indexed investment products (specifically the products tracking the S&P 500) provide a popular way of capturing the 500 largest companies primarily in the U.S., and the index has had an impressive proven track record.

ETFs have also given the individual investor the ability to own assets they wouldn’t have otherwise have access to. These assets could range from a collection of municipal bonds or foreign stocks, to more complicated products like leveraged “gold” products or derivative assets. They also allow individuals to diversify their portfolio better and easier than ever before.

But ETFs can come with drawbacks.

Andrew Lo, professor of finance at MIT, touches upon the indexing revolution in a podcast with the Financial Times. “When we start getting those outcomes (outcomes of negative returns) in a synchronous fashion, we will start herding and can affect markets in a dramatic fashion”. He goes on to explain that the interconnectedness of index funds heightens systematic risk. While conventional wisdom holds that diversification is key to eliminating risks, diversifying only gets rid of asset specific risk – not systematic risk. Systematic risk played a big role in the Financial Crisis of 2008.

Another drawback is that there have been rises in leveraged ETFs, which are so complicated that people may invest in them and not necessarily understand the consequences. These are products that state they are “3x leveraged” and carry some title stating what asset they are supposedly tracking. Investments placed in these products carry substantial amount of risk that many investors simply do not understand.

For instance as explained in this Wall Street Journal article “Direxion Daily Junior Gold Miners Bull 3X ETF” may lead investors to naturally assume their money is tied to a product tracking junior gold miners, but in fact, this ETF isn’t tracking junior gold miners alone. Instead Direxion uses complex derivative “swaps” with banks to triple its leverage, so every $1 you invest Direxion gives $3 to another ETF called the VanEck Vectors Junior Gold Miners ETF. And if that ETF becomes enormously funded, they are forced to invest beyond their objective and instead of just holding “junior” or small gold-mining stocks, they begin to hold much larger gold-mining stocks. So for an investor who thinks gold miners’ profits will rise and invests in the 3X leveraged ETF, they may be rudely surprised to realize that the ETF may go down, even if gold miners’ profits actually did go up. How can this be? The ETF may have had to rollover its swap, rebalance its holdings, or for other reasons.

The grand point here is when individual investors think they can make a quick buck in gold by investing in a leveraged ETF; they should realize there are grander forces at work than merely the price of gold or gold miners.

This extension of credit through swaps is outright dangerous and can go unnoticed by the individual investor because they didn’t take out a line of credit, but contributed to the general rise of credit by investing in an investment that in itself is leveraged (by taking out credit through the complex derivatives).

Human behavior doesn’t change — but this new extension of credit does.

Jon Morris is an undergraduate studying finance at San Diego State University.