Avoiding Hidden Index Risks

September 01, 2011

Picking an index tracker implies an active choice about the downside risks you’re incurring.

If you haven’t already read it, I recommend you take a look at Andrew Clark’s fascinating article on the possible losses to be expected by investors tracking stock and commodity indices.

Clark makes three key points, in my opinion.

First, the actual losses that might be expected from a portfolio of stocks or commodities are larger than classical finance theory predicts. Classical theory, including the Capital Asset Pricing Model (CAPM), which is the basis of most textbooks on investment and finance, is based upon an assumption of returns from stocks being normally distributed.

In practice, this doesn’t work. Clark reminds us that the actual expected loss from a portfolio is much higher, particularly when measured over short time periods. Markets crash more often than most textbooks would suggest.

Second, Clark suggests that we should combine his measure of “expected shortfall” with our own individual level of loss aversion to assess how much risk we can really take. We know from behavioural finance theory that people tend to be more sensitive to losses than to gains, often accepting a lower expected return over time in order to avoid an interim shortfall.

If we’re not fully aware of our own sensitivity to loss, and of the fact that markets can drop by a lot more than we’re anticipating, we’re likely to end up bailing out of our investment at the worst possible moment: selling, rather than buying, in March 2009, for example. We probably all know the sensation of “never again” after having been taken on too bumpy a ride.

Using leverage makes it even more likely that we’re going to panic and get out at the wrong time. Clark also questions the suitability of commodities as an asset class for loss-sensitive investors, given the very large downside risks they incur.

Finally, Clark reminds us that certain index variants can amplify potential losses. Autocorrelation in capitalisation-weighted indices—the tendency of all stocks to move together at the same time—may be higher than for other index types, he says, and can land investors with much bigger moves than they had foreseen.

This is something I wrote about in my last blog. There’s been a steady increase in internal index correlations for some of the most widely-followed equity indices, something that seems to reflect the steady increase in stock market investment via ETFs and other tracker funds (that’s my opinion, though others disagree).

Do ETF investors buying an S&P 500 index tracker, for example, understand that they are exposing themselves to a potential risk from the index methodology itself (as opposed to randomly selecting a portfolio of the index constituents and equal-weighting them, for example)? Or that this index-related risk, that of implied internal correlations between stocks, has been rising steadily?

Clark argues that index providers need to do more to highlight such risks, and it’s hard to disagree.

But what are the implications of Clark’s article for those investing by index (or ETF) across asset classes? First, that you may lose more than you might imagine, and you should reassess your capacity for losses and your investment time horizon in the light of this. Second, you need to diversify more than you might think. Third, you should examine closely the index methodology your tracker is using, and consider both alternative weighting schemes and less popular index variants.

In other words, there’s no way to remain passive about your investment portfolio, even if you’re using index funds.


This blog first appeared on our sister website, IndexUniverse.eu.

 

 

 

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