Indexing is screwing up a lot of things. This is not news. Equity investors focused on bottom-up, fundamental analysis have been complaining for years about how hard it is to make money. They complain about valuations being too high and out of whack with reality. They complain about how the market goes up every day. They complain about how things don’t make any sense. The stock market has entered Bizarro World, and nobody really knows why, but they suspect that this is all somehow related to indexing, which, as a strategy, has attracted trillions of dollars in assets under management.
That assessment is correct. And there is precedent for all of this. If you go back 10 years to the commodities bull market of the late 2000s, you may recall that people began to believe that raw materials were an asset class with entirely different characteristics than equities and fixed income, and one that is less correlated, providing diversification benefits to any portfolio. And so people began to invest in commodity index swaps, swap agreements that gave exposure to a broad basket of commodity prices. Since investors typically only bet the price would go up with these agreements, the proliferation of these index swaps put upward pressure on the price of commodities.
Guess what happened next? Commodity prices began to levitate, all at the same time, and people who had worked in the commodity markets for years suddenly could not figure out what was going on. I had conversations with those people back then and they assured me that corn was going back to $2 and wheat was going back to $6, which were the levels that would prevail under normal supply-and-demand fundamentals rather than $7 and $9, respectively, at the time. I said, “No, you don’t understand,” this is the new paradigm — macro demand for commodities is here to stay.
As you can imagine, there was as much hate and discontent about commodity index swaps back then as there is about exchange-traded funds today. There were congressional hearings and people testified that commodity index swaps facilitated hoarding of commodities by those who were not end-users, raising prices for everyone else. Such speculation should not be allowed in commodities markets, they argued.
In the end, a bear market did what the government couldn’t. Commodities topped out in March of 2008 and plunged almost 60 percent in a matter of a few months based on the Goldman Sachs Commodity Index as the inflows into commodity index swaps became outflows. Commodities prices never recovered, and remain at a fraction of their previous levels.
Many have questioned the wisdom of treating commodities as an asset class. After all, wheat is different from gold, which is different from oil. Well, what about equities? Are equities an asset class?
That may seem a silly question to ask. Equities have been considered an asset class for decades, and index funds have been around for a lot longer than commodity index swaps. But hear me out.
ExxonMobil Corp. is different from Google’s parent, Alphabet Inc., which is different from Wal-Mart Stores Inc. These businesses have nothing to do with one another, except that they are all C corps, and that their shares are publicly traded on an exchange. But you can’t find three more different businesses. So why buy them all at the same time, through an index?
The answer is that they are all U.S. companies and are all affected by the same macro factors, such as politics or the U.S. economy, but you could have made similar statements about the commodity markets. The idea of commodity indexing has been mostly discredited, but it’s interesting that only commodity indexing was discredited, not all indexing.
A lot has been written about the distortions caused by purchasing a basket of stocks indiscriminately. In the old days, if you bought an S&P 500 Index fund you could say that you were diversified. But can the same be said now when so many people are buying the same fund? Active managers have been praying for an unwind of the index fund trade, but if what happened in commodities is any guide, it would probably mean a hurricane-force bear market. As we saw with commodity indexes, flows can go out as well as in. The idea of large-scale redemptions seems too terrible to contemplate, but it could happen.
There is a reason fads come and go in the capital markets. Someone devises a strategy, the strategy works, promoters promote the strategy, the strategy gets large enough to cause distortions — then the strategy unwinds, and people spend the next few decades reflecting on how dumb it was while looking for the next fad. Is indexing simply a fad? I don’t know the answer, and time will tell. Certainly it is large enough to cause distortions now, and history shows that the exit is always much smaller than the entrance.
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