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Uncertainty, not ETFs, spurring on market volatility

People have wondered if the markets would get increasingly volatile if more investors switched to passive index investing. If more and more investors were buying and selling the same stocks at the same time and there were fewer price setters (active investors) to fight with one another over price, then maybe prices would rise and fall more often and with more amplitude.

Buy-and-hold index investing assumes that markets are efficient enough that you can't reliably beat it over the long term. So why try? Why not just buy the market and earn the market return while paying lower fees? This would be opposed to active investors, who in aggregate, also earn the market return except they pay higher fees since the cost of active management and execution is higher than passive investing.

This simple logic, coupled with decades of academic studies indicating that there is virtually no way to reliably predict which active managers will beat the market next, has led to a growth in index investing. Most of that growth is through exchange-traded funds (ETFs) as opposed to index mutual funds.

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Concurrently, there has been an increase in overall market volatility. The number of 'All or Nothing' days on the S&P 500 – days when 400 or more of the 500 stocks in the index are all positive or negative – numbered 27 for the entirety of the 1990s. This year alone there have been more all or nothing days (35 so far) on the S&P 500 than those 10 years put together. So to say that market volatility has increased would be an understatement.

This simple correlation between the increase in index investing and the increase in market volatility has prompted some to question if there is also causation between the two. Is the reason there are more days when most of the stocks in an index all point in the same direction because more people are holding all 500 stocks indiscriminately?

Nope. While indexing is certainly on the increase, the assets in ETFs are dwarfed by assets in mutual funds. According to a report from Frank Hracs, chief economist at Credo Consulting, ETF assets in Canada are running at less than 10 per cent of mutual fund assets (and we've seen similar market volatility in Canada). Also, let's not forget the dollars invested in individual stocks, hedge funds, and institutional funds like pensions. There just isn't the scale required to demonstrate a causal link. Richard Keary of Global ETF Advisors LLC concurs, indicating that the search for causation between ETFs and market volatility is simply a witch hunt.

So, what is the cause of the market volatility? Uncertainty. The U.S. government has never had it's credit rating downgraded before. Greece is on the precipice of defaulting and the worry of a euro zone debt contagion that could spread and bring the banking system to a grinding halt would only serve to exacerbate a potential global recession. The magnitude of these problems, and the uncertainty with how to deal with them has investors around the world scrambling to figure out heads from tails, which has led to more peaks and valleys on a day-to-day basis in the markets.

How long will this heightened volatility last? Unfortunately, there is uncertainty to that answer, too.

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About the Author
Personal Finance columnist

Preet Banerjee is a consultant to the financial services industry. You can follow him on twitter at  @PreetBanerjee. You can find his conflict of interest disclosure on his website. More

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