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The Fragility of Stock Markets: It's not always as straightforward as it seems

What triggered the so-called Black Monday? Portfolio insurance was quickly identified as a scapegoat. This was a new and popular technique at the time to protect portfolios from further losses in falling markets. For this purpose, futures were sold during downward movements. The chain of suspicion went like this: the stock market falls, the portfolio insurer sells an index future, the future price falls because of the sell orders, the falling futures are seen by investors as a warning signal, who then sell their shares. The stock market keeps falling and it starts all over again in a iterative loop. Portfolio insurance had spread rapidly. They came out of nowhere and within just two years made up the lion's share in futures trading. In addition, the orders were not placed individually, but mostly bundled.

This explanation sounds conclusive. However, in the course of an investigation, the US Securities and Exchange Commission put this into perspective as follows: According to the SEC, portfolio insurance was not the sole root of the crash, but a "significant factor" that made a dark day even darker.

The big unknown, however, was the extent. It is not clear to what extent the changes in futures prices had affected the stock market. Since Black Monday, the SEC has been aware of the potential consequences of unintended consequences of news in the stock market - like other market watchers. The financial media couldn't get enough of scary stories about derivatives, especially when held by fund managers. (A few years ago while visiting a financial news format, I heard an "expert" who deserves these quotation marks say the following: The redemption of shares in the PIMCO Total Return bond fund would lead to a bond crash because the fund uses its derivatives dump. I'm still waiting for that crash.)

New dangers from the great indexing trend? 

Over the past few years, the scrutiny of futures and options has shifted to the general trend in the market to index investments. Exchange Traded Funds (ETFs) made the start. They came into focus because of their trading mechanism. These mechanisms have repeatedly failed. In some cases the price of ETFs collapsed abruptly, during the correction in August 2015, numerous ETFs were suspended from trading, and some had pricing problems days afterwards. That terrified investors. The basis for inferring ETFs as the real culprits of the market volatility, according to the motto: “Bad security brings market instability”, was even thinner than the connection between futures trading and a stock crash in 1987. For the “Flash Crash “From 2010, for example, when the problems with ETFs were initially identified as the main culprit, there were a multitude of causes, as it later turned out.

The focus of market observers and journalists is now on the subject of indexing. Many active fund managers (those who are fueling the indexation trend through frequent underperformance of their products) have been only too happy to take up the unpleasant feelings of many investors and observers and develop the theory that increasing investments in market capitalization-weighted indices are causing "bubbles". On the other hand, stocks that are not included in such indices would be forgotten. If the bubble burst, according to many fund managers, disappointed index investors would exit their index funds and force the index funds to sell stocks, which would turn the downward spiral of popular index heavyweights even further, which in turn would lead to further redemptions, and so on. In short - it would be Black Monday of 1987 in slow motion.

There is now another potential scapegoat. Only recently the crossfire shifted towards Strategic Beta ETFs. Rob Arnott of Research Affiliate, one of the ardent proponents of this approach, co-authored an article entitled "How Can Smart Beta Go Badly Wrong?" In this article, Arnott took the discussion of an index bubble a step further and thought out loud whether the boom in Strategic Beta ETFs - strategies that exploit factors such as value, momentum or low volatility - had gone too far: Has the academic discovery of these "anomalies" prepares the ground for their own destruction as new money drives stock prices to the point where the bubble bursts?

“We see a reasonable likelihood of a smart beta crash as a result of the rapidly increasing popularity of factor tilt strategies,” Arnott writes. (It's ironic, by the way, that Arnott of all people is raising these concerns. Given the data Arnott is presenting, I'm less convinced of his thesis. But that's a different topic.) Suffice it to say, Strategic Beta is also a topic made it onto the list of potential threats to the stock market.

The moral of the story: 

1) It is difficult to distinguish the effects of new financial instruments on the stock market from other causes of a crash. However, it stands to reason that there is always more than one reason for an abrupt correction. The bursting of a bubble is usually preceded by irrational optimism on the part of investors.

2) However, the fears about the dispruptive mode of action of new instruments or techniques are based on a certain truth content.

3) There is an even greater cause for concern today than it was in the past. In addition to exchange-traded derivatives, there is a huge market for bespoke derivatives, plus ETFs, plus the rise of other forms of indexing, plus the emergence of high-frequency trading. But to construct a horror story from these points would be presumptuous.

We don't know if any of these will prove to be destabilizing for the markets. But we can't rule it out either. In no case should the list of possible sources of danger be understood as a general warning against equity investments. Many investors have long-term commitments. Rather, this article is aimed at the wise. Many characteristics of the stock market have changed in recent years. So you shouldn't be surprised if interference flares up again and again. Not more but also not less.

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