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Introduction

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Indices, Index Funds And ETFs

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Abstract

Indices, index funds and exchange-traded funds (ETFs) have become major asset classes in debt, equity, real estate, currency and commodity markets worldwide—and their management, maintenance and use often occurs within the context of human–computer interactions (HCI). As of 2018, there were more indices in the world than the number of exchange-traded companies. The relatively sudden and significant growth of indices, passive/active ETFs and index funds during 1995–2018 (combined with the Internet, increasing volume of cross-border transactions, and improved global settlement/clearing systems) have increased the potential for systemic risk, financial instability and the failure of regulations. The major problem is that more than US$3.5 trillion is invested in indices through ETFs, index funds and equity swaps apparently without regard to the quality and valuation of the underlying companies and commodities. The net effects are that: (i) the companies and commodities in these indices are overvalued and enjoy artificial price support (from these ETFs and index funds); (ii) there is substantial over-investment and “Gambling” in the underlying companies and under-investment in non-listed, micro-cap, small-cap and emerging markets companies, which affects economic growth, development and capital mobility; and (iii) these indices, index funds and ETF and their component companies pose increasing systemic risk and financial instability threats.

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Notes

  1. 1.

    See: Authers, J. (January 22, 2018). “Number Of Stock Indices At 3 Million Dwarfs Tally Of Quoted Companies—Proliferation Reflects Investor Focus On ‘Top-Down’ Analysis Of Markets”. Financial Times (UK). https://www.ft.com/content/9ad80998-fed5-11e7-9650-9c0ad2d7c5b5. According to a survey by the 14-member Index Industry Association, its members publish and calculate 3.28 million indices, of which 3.14 million are for stock markets, but the World Bank notes that there are only 43,192 public companies around the world, and ETFGI notes that there are only about 7,178 ETFs and other exchange-traded products globally. The breakdown of global equity indices is as follows: sector/industry (42.5%), total market cap (14.8%), small cap (13.6%), large cap (10.8%), mid-cap (10.7%), factor/Beta (5.6%), theme/other (1.5%), and environmental/social/governance (0.3%). Geographically, the 2018 statics are: global indices (29%), frontier and emerging markets (14%), and the US (9%).

  2. 2.

    See: Chaparro, F. (March 18, 2017). “There could be a US$3 trillion shift in investing, and it poses a huge problem for mutual funds”. http://pulse.ng/bi/finance/finance-there-could-be-a-3-trillion-shift-in-investing-and-it-poses-a-huge-problem-for-mutual-funds-id6390294.html. This article states that:

    1. (i)

      According to a March 2017 report by Morgan Stanley and Oliver Wyman, ETFs could gain an additional US$2 trillion to US$3 trillion in assets during 2017–2022.

    2. (ii)

      ETFs are deemed to be typically cheaper and more transparent than Mutual Funds, and Mutual Funds have struggled to achieve performance in recent years (in most instances, disclosed calculated fees don’t include non-disclosed “costs” such as re-balancing costs, monitoring costs of both ETF-managers and investors, and ETF-arbitrage costs). Investors moved money from Mutual Funds and into ETFs during 2014–2017 and that has forced Mutual Funds to reduce their fees. ETFs’ market share in the US market alone is likely to increase from 15% to 40–60% during 2017–2027. According to the Morgan Stanley and Oliver Wyman 2017 report, Mutual Funds are now using ETFs to reduce their own costs; and “Asset allocators such as Outsourced Chief Investment Officers (OCIO) and Wealth Managers will account for a large proportion of this incremental demand as they increasingly use ETFs at near zero cost to source Beta exposure, allowing them to focus their resources on high conviction managers or more complex alternative investments. However, looking beyond 2019, the emerging use of passive vehicles as an integral part of an active fund management strategy will be arguably the more significant dynamic. Currently, Mutual Funds have ~$0.5 trillion invested in ETFs, much of which is used for liquidity management. We estimate using ETFs rather than the traditional approach of holding individual stocks offers a cost advantage of 5–8 bps in large and mid-cap equities. As Asset Managers search for ways to deliver performance at lower costs, this may mean that mutual funds will find themselves among the largest investors in ETFs…”.

    3. (iii)

      According to Credit Suisse, the reduction of fees in the mutual fund industry will likely continue. Morgan Stanley estimates that fees charged by active managers could decrease by more than 33% in 2017.

    See: The Economist (August 1, 2015). Roaring ahead—Exchange-traded funds have overtaken hedge funds as an investment vehicle. http://www.economist.com/news/finance-and-economics/21660169-exchange-traded-funds-have-overtaken-hedge-funds-investment-vehicle-roaring?fsrc=rss%7Cfec?fsrc=scn/tw/te/pe/ed/roaringahead

  3. 3.

    On systemic risk/contagion, see: Bahmani-Oskooee and Saha (2016), Naresh et al. (2017), Aloui et al. (2017), Yarovaya et al. (2016), Goswami et al. (2012), Gajardo and Kristjanpoller (2017), Keylock (2018), Kristoufek (2010), Bhuiyan et al. (2017), Ahmad et al. (2018), Zhou and Chen (2016), Curcio et al. (2014), Bhattacharya and O’Hara (2016), Bouri et al. (2017), and Puy (2016).

  4. 4.

    On financial instability, see: Al-Khazali and Mirzaei (2017), Financial Stability Board (2011), U.S. Senate (October 2011), Kosev and Williams (2011), Ivanov and Lenkey (2014), Aldridge (2014, 2016), Linnertova (2015), Chen and Li (2014), Wang et al. (2016), Lobão and Pereira (2017), Charles et al. (2017), Prasanna and Menon (2013), Stošić et al. (2015), Ferreira et al. (2018), Gil-Alana et al. (2013), Rizvi and Arshad (2017), Ahmad et al. (2018), Abu-Alkheil et al. (2017), Singh et al. (2018), Donders et al. (2017), Nagayev et al. (2016), Chacko et al. (2016), Xu and Yin (2017), Chiu and Tsai (2017), Marszk and Lechman (2018), Dannhauser (2017), Lechman and Marszk (2015), and Deev and Linnertová (2014).

  5. 5.

    See: Duarte et al. (2010), Chen et al. (2017), Lee et al. (2017), Tsionas and Michaelides (2017), Bonanno et al. (2004), Harré and Bossomaier (2009), Kenett et al. (2012), Sornette (2003), and Keylock (2018).

  6. 6.

    See: Ozer and Ertokatli (2010), Sasikumar and Kamaiah (2014), Aldridge (2016), Broman (2016), Kaiser et al. (2018), Badshah et al. (2018), Wisniewski (2016), Jouini (2013), Abu-Alkheil et al. (2017), Vortelinos et al. (2018), Christou et al. (2017), Li et al. (2016), Li and Peng (2017), Ho and Huang (2015), Tang and Xu (2013), and Abhyankar et al. (1997).

  7. 7.

    See: Chen et al. (2010), Oztekin et al. (2016), Schellhorn (2011), Wang et al. (2012), Feuerriegel and Gordon (2018), and Chiang et al. (2016).

  8. 8.

    See: Avellaneda and Zhang (2010), Preis et al. (2011), and Lahmiri (2018).

  9. 9.

    See: White (2007), and Levell (2015).

  10. 10.

    See: Malagrino et al. (2018), Chen and Hao (2017), Cao et al. (2013), Anbalagan and Maheswari (2015), Ng et al. (2014), Arnoldi (2016), Shahzad et al. (2018), Chen et al. (2010), Nwogugu (2013), Martyn et al. (2012), Steel et al. (2007), Jacob et al. (2013), Cheng et al. (2010), Lee et al. (2006), Yu and Huarng (2008, 2010), and Roy and Sarkar (2011).

  11. 11.

    See: Wang et al. (2016), Reigneron et al. (2011), Nobi et al. (2014), Shi et al. (2016), Gong et al. (2016), Sandoval (2014), Shapira et al. (2009), Haluszczynski et al. (2017), Kwon and Yang (2008), and Gao et al. (2018).

  12. 12.

    See the AI and decision models in Castro and Parsons (2014), Domshlak et al. (2011), Grishina et al. (2017), Nadendla et al. (Oct. 2016), Song et al. (2017), Rekik et al. (2014), Correia et al., eds. (2014), and Marwala (2013).

  13. 13.

    Moore, S. (Aug 29, 2014). How Securities Lending Makes Some ETFs Free. https://www.forbes.com/sites/simonmoore/2014/08/29/securities-lending-makes-some-etfs-free/#66fd4f673d6f. This article stated in part: “The amount of securities lending profits that ETF sponsors pass onto ETF investors varies, but appears to be increasing. Blackrock was the subject of a lawsuit contesting their return of securities lending fees to investors, that case was dismissed last year. As of the start of this year Blackrock (the owner of iShares) returns 70%–75% of securities lending revenue to investors. Vanguard returns 100% of securities lending proceeds to investors after their costs. As Dave Nadig of ETF.com argues the difference isn’t just in the revenue/profit split which is calculated in a slightly different way by the different firms, it’s also in the policies for lending, Blackrock appears to lend more broadly, hence increasing potential lending returns, but also raising the risk level slightly, whereas Vanguard may be more selective in identifying lending opportunities with greater profitability.”

    See: Blocher and Whaley (May 2016).

  14. 14.

    See: Christie and Schultz (1994), Khwaja and Mian (2005), Jiang et al. (2013), Aggarwal and Wu (2003), Lin (2017), Allen et al. (2006), and The Economist (Jan. 15, 1998).

  15. 15.

    See: Arnoldi (2016), Lee et al. (2013), Lin (2017), Cao et al. (2016), and Jiang et al. (2013).

  16. 16.

    See: Brennan, T. (Jan 26, 2011). Cramer: Case-Schiller Not a Good Index for Housing. CNBC. http://www.cnbc.com/id/41274473. This article stated in part: “The Case-Shiller index measures only 20 U.S. markets. It’s nowhere near as representative as people make it out to be. Cramer thinks the Federal Housing Finance Agency’s index is far better. Its numbers are calculated by ZIP code, using the purchase prices of houses that back mortgages that have been sold to, or guaranteed by Fannie Mae or Freddie Mac. As Cramer said, ‘It’s a super-granular housing report based on a much larger data set than the 20 cities of the Case-Shiller.’ And what did the FHFA index say about home prices just yesterday? That they were unchanged from October to November on a seasonally adjusted basis… .The bottom line here is that investors should forget the negative press reports and the Case-Shiller index, and focus instead on the FHFA, the NAR and even the housing stocks for an accurate picture of what’s going on.”

    See Ro, S. (March 29, 2012). S&P: We Know The Case-Shiller Home Price Index Has Problems But There’s Nothing We Can Do About It. http://www.businessinsider.com/sp-blitzer-case-shiller-home-price-index-2012-3

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Nwogugu, M.I.C. (2018). Introduction. In: Indices, Index Funds And ETFs. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-137-44701-2_1

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