When index funds make the market riskier

So many things have been said about the rise of index trackers. The detractors of index funds typically focus on how these funds make markets less efficient, but have they considered that they also make markets riskier?

It is intuitively clear to most investors that if index trackers gain a larger share of the market, stocks will start to move more in line with each other. If investors are becoming more bullish about a market, they pour more money into index trackers. These vehicles then invest that money in a range of stocks in fixed ratios. Hence, the larger the ownership of a stock by index trackers, the higher its correlation should be with other stocks tracked by these funds.

You can see the change in the average correlation between two stocks in the US in the chart below as calculated in a new study. Since the late 1990s, the average correlation has significantly increased.

Average correlation between two US stocks

Source: Fang et al. (2024)

This increase in stock correlation coincided with the rise of index trackers in the US.

Average correlation between two US stocks and index tracker market share

Source: Fang et al. (2024)

But is it more than just correlation? The authors of the study looked at all the stocks in the US and calculated how much o the company was owned by ETFs and index trackers. They found that a 9% increase in the ownership of the company from index trackers increased the correlation with other stocks by about 10% and the beta to the stock market by about 6%. Hence, if the market drops by 20%, stocks that have 9 percentage points higher ownership by index trackers experience a share price decline of 21.2% rather than the 20% drop for the average stock.

If you ask me, that is not really a big deal because if the market drops by 20% I have bigger problems than to complain about a drop of 21.2% rather than 20%.

However, this increased downside risk for stocks more frequently owned by index trackers comes from the increase in correlation between the stock and market overall. And as I just wrote, this correlation increases by about 10% relative to a market with no index trackers.

But here comes the true problem. The market risk overall is driven essentially by the covariance of all stocks in the market with each other. If there was only one stock that dropped 21.2% when the market drops 20% that’s not a problem. But when all (or most) stocks in the market are heavily owned by index trackers, each of these stocks drops by 21.2%, which means that the market overall drops by 21.2%, not 20% as in a world without index trackers. Got it?

Since the late 1990s, index trackers have gone from basically zero market share to c.20% market share in the US according to the ICI Fact Book. And that is probably heavily understated because many of the largest index tracking portfolios are separated accounts of institutional investors like pensions funds and endowments with no public reporting.

But if we take the 20% number at face value, it means that compared to the late 1990s, the volatility of the US stock market has increased by 22.5%. So instead of a 20% drawdown in the late 1990s and early 2000s, the market would now drop by about 24.5%. Now remember that when tech stocks collapsed in the early 2000s, the US stock market dropped by some 40% in two years. In today’s world with lots of index funds in the market that would translate to a roughly 50% drop.

And here comes my question to investors and regulators alike: Has anyone ever considered this potential downside to markets? How will regulators react when one day, the market drops by a large amount and the key driver were highly correlated trades by index trackers? What do you think will happen then?