The Risk Of An ETF Driven Liquidity Crash

Last week, James Rickards posted an interesting article discussing the risk to the financial markets from the rise in passive indexing. To wit:

“Free riding is one of the oldest problems in economics and in society in general. Simply put, free riding describes a situation where one party takes the benefits of an economic condition without contributing anything to sustain that condition.

This is the problem of ‘active’ versus ‘passive’ investors.

The active investor contributes to markets while trying to make money in them.

A passive investor is a parasite. The passive investor simply buys an index fund, sits back and enjoys the show. Since markets mostly go up, the passive investor mostly makes money but contributes nothing to price discovery.”

Evelyn Cheng highlighted the rise of passive investing as well:

Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets, according to a new report from JPMorgan.

‘While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals,‘ Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan, said in a Tuesday note to clients.

Kolanovic estimates ‘fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago, he said.

‘Derivatives, quant fund flows, central bank policy and political developments have contributed to low market volatility’, Kolanovic said. Moreover, he said, ‘big data strategies are increasingly challenging traditional fundamental investing and will be a catalyst for changes in the years to come.’”