FEEDBACK LOOP: Big Funds, Little Stocks

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What happens when a big fund invests in little stocks and a wave of new dollars come in? The fund has to buy all those little stocks, driving the price up, and boosting performance at the fund. And because many investors wrongly rely on past performance to predict future results, seeing that performance entices more of them to invest in the fund, perpetuating the distortion. Jason Zweig explains in The Wall Street Journal, writing:

What your exchange-traded fund owns is important. Who else owns your ETF might be even more important.

That’s because a fund’s returns often don’t depend merely on the behavior of the investments it buys, but also on the behavior of the investors who buy the fund.

Hot money—a sudden influx of cash from people trying to get rich quick—can overheat an ETF and create what new research calls “self-inflated returns.” The result, sooner or later, is self-inflicted losses. Fortunately, you can protect yourself with some common sense.

What are self-inflated returns?

They start when a fund generates a burst of high performance. Maybe an “active” ETF run by stock pickers buys a few big winners. Or maybe a passive fund that holds everything in a benchmark tracking one market segment has gotten hot.

In either case, people notice. They buy the fund in droves, pouring in hundreds of millions or even billions of dollars. The ETF’s managers take that cash and pump it into the stocks the fund already owns.

If those stocks are small and thinly traded, the fund’s own buying will drive their prices up. That will raise its return again, attracting even more money from performance-chasers, pushing the prices of the fund’s stocks even higher and drawing in another blast of hot money.

A new study—by Philippe van der Beck, a finance professor at Harvard Business School, and Jean-Philippe Bouchaud and Dario Villamaina of Capital Fund Management, a Paris-based investment firm—looks at how this cycle feeds on itself.

As the researchers put it, “Investors chase their own impact.”

The study hasn’t yet been published in a peer-reviewed journal, but I think the findings are solid.

Over the years, many portfolio managers have told me that large inflows at a fund that concentrates on smaller, less-liquid stocks can drive prices up if the fund’s buying constitutes much of the typical daily volume in those stocks.

Action Line: Don’t get caught in an index fund feedback loop. Work with an advisor who will craft a portfolio of individual securities to meet your needs. When you’re ready, I’m here. In the meantime, please click here to subscribe to my free monthly Survive & Thrive letter.