Benchmarks — threat to the system?
Nature doesn’t just hate a vacuum, it’s not keen on concentration either. By co-ordinating our investment and economic activity around market indices, are we creating a huge too-big-to-fail problem?
In April 1831, an accident occurred that forced the British army to change its procedures. The event was unforeseeable, though hindsight makes its causes — and its simple solution — seem obvious.
A company of soldiers marched on to the Broughton Suspension Bridge, which began to vibrate in unison with their step. As more troops marched on, the vibrations became more pronounced. Rather than becoming alarmed, the soldiers enjoyed the swaying, even playfully exacerbating it. But as the first troops reached the far side, a bolt snapped, causing the bridge to collapse.
This catastrophic engineering failure was catalysed by lockstep marching. As the Manchester Guardian put it: “If the same, or a much larger number of persons, had passed over in a crowd, and without observing any regular step, in all probability the accident would not have happened, because the tread of one person would have counteracted the vibration arising from that of another.”
I fear we may be marching merrily towards a similar collapse, albeit a financial one. The risk stems from the widespread use of benchmarks, which are synchronising investors’ actions. This is most obvious in passive investing, whose perpetual growth is encouraged despite its unknown consequences.
To succeed, index tracking calls upon the wisdom of crowds — a convincing theory described well in James Surowiecki’s eponymous book. But proponents of this theory (Mr Surowiecki included) warn of “error correlation”. In short, crowds are collectively good at gauging the number of sweets in a jar, as long as each member is left alone to guess; a guess that is too high tends to even out another that is too low. But if one loudmouth shouts that he thinks there are 500 sweets, then many will anchor their estimates on 500, even if there are only half that number in the jar. The crowd’s answer then detaches from reality.
And so it is with passive. When the market consisted solely of individual investors making their own mistakes, it made sense for a few to take a smart, cheap ride by aping the average. But it is no longer just a few. A study from the Stern School of Business showed that trackers made up around 2 per cent of the US mutual fund market in the mid-1980s, but by 2009 it was closer to 20 per cent.
That by itself is not worrying. It becomes a concern when combined with the proportion of the market that is now “closet tracking” the loud-mouthed benchmark. Closet trackers are the equivalent of civilians on the bridge, whose steps unwittingly converge with and then amplify those of the soldiers. Thirty years ago, around 97 per cent of that market consisted of free agents, all making their own unrelated decisions. Now around half is in trackers or closet trackers. Then add in the swarm of hedge funds and high-frequency traders that aim for nothing but quick gains from the predictable rump of passive money. That leaves us with a disconcertingly large proportion of the market that is marching in lockstep.
The US is the epicentre of concern. Its exchange traded fund industry is more advanced and its deep liquidity appeals to short-term traders. It is also the largest component of the world index, making it a natural winner from globalisation among index-aware international investors. Such investors are not concerned by fundamentals: witness US equities’ current popularity, despite a long-term valuation only exceeded at previous historic market peaks.
It cannot go on forever. Markets are often irrational in the short term, but eventually reality bites. This could be gradual, but given the blind marching of so many investors, a Black-Monday-sized flash crash — as the bolt finally snaps — is a real and growing possibility.
If this happens soon, that may give us all useful pause for thought as to the consequences of a passive-dominated market. If left unchecked, a technical crash from higher levels could spill over into the real economy. In the case of the Broughton Bridge collapse, the army’s preventive response was regulatory change. All troops were subsequently ordered to break step when crossing a bridge — a remedy that has proved as effective as it is simple. Post-crash hindsight may demand that more investors break step too.
Unfortunately, gauging the probability of a technical market event is difficult, and trying to time it impossible. Regardless, I worry for the blindfolded investor holding an overvalued asset purely because it is in an index: it will not take much for its value to be swept away.
I wrote this note for the FT back in 2013. Clearly I was early at best (if you’re not-right-yet for long enough, at some point you have to admit you’re just plain wrong).
Am I wrong with this one? I’ve got to say it still rings true. But let’s hope I am. Another decade’s worth of heavy index buying means that, if I’m right, the fall out from these levels would be messy. Fingers crossed…