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Tuesday 17 March 2020

The Index Fund Bubble

The global order for investment management firms has changed in the last 5 years. Index investing now more or less accounts for 20-40% of the global capital deployed whether through index funds, ETFs or index-hugging funds. Since an index does not have a cash allocation, there is no buffer when it starts going down. While going up, it feeds into the frenzy and the index constituents get more than their fair share of capital flows. And no one complains. When the tide reverses, the exact opposite happens. Stocks fall because they have fallen a lot. A virtuous cycle turns into a vicious cycle.

This is what we are seeing now. 

The way it possibly ends is when other investors (discretionary/quant/alpha-oriented funds) decide that some factor they are tracking (could be valuations, could be any other metric like volatility, global macro, relative strength, overbought/oversold indicators etc) is now in their comfort zone and start buying. The other possibility is that large investors will get scared of the fall in the indices and full out money thereby starving the passive funds of their fuel.

This is a reason why we are seeing such increased volatility in the global markets.

From a fundamental perspective, earnings are going to be severely hit, supply chains dented (maybe permanently for some, which I have discussed in my previous post). People still are trying to assess how bad things are going to be. 

One thing I am sure. We will now be extrapolating our fears.

No one said investing was easy. Equity gets a risk premium over other asset classes. Yes. A risk premium. Because it is risky!! 

To end let me quote, my friend and fellow VP member @zygo23554:
This virus is God's wrath that brings to the fore fragilities and frailties in your health, relationships and portfolios. 
Fear yourself, not the virus. All it does is show you the mirror so you realize who you truly are. 

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