Passive global funds, algos may have magnified market crash

ETFs are similar to index funds, except that these may be bought and sold on the exchanges. They're preferred by institutional investors

The sell-off from passive global funds and algo-driven strategies may have exacerbated the market crash witnessed in the past few sessions.
 
Nearly two-thirds of the $4.6 billion of net selling in Indian equities by foreign portfolio investors (FPIs) from February 19 till now came from passive funds, estimates a report by Emkay Global Financial Services.
 
The estimates are based on the study of about 200 exchange traded funds (ETFs) with assets under management of $1.5 trillion that have an average India allocation of 9 per cent. During this period, these ETFs saw outflows of $25 billion, the brokerage said.
 
Index funds and ETFs have seen significant inflows in developed markets over the past few years. The recent selloff, therefore, has also been led by these funds. Global funds such as BlackRock, Templeton, and Fidelity could have 10-30 per cent of their investment routed through passive strategies, reckon experts.
 
“The selling can be exacerbated as ETFs simply execute the sell orders by the underlying investors. They cannot take a call on repurchasing shares at lower levels when valuations are attractive, or sell stock X to buy Y or hold/deploy cash as is the case with active funds,” said UR Bhat, director, director at Dalton Capital Advisors. “The stampede to make an exit with no regard to price or valuation and the lack of buyers can push prices down further.”
 
Selling by hedge funds with algo-based stop losses (orders to sell when the price drops to a pre-specified level) could have got triggered in this market as well, added Bhat: “These funds can go on a selling spree when the stop losses are triggered”
 
Algorithmic trading, where a computer automatically executes trades based on pre-programmed instructions, was introduced in India in 2009 and contributes to about two-fifths of exchange volumes. It forms more than 80 per cent of volumes in developed markets such as the US.
 
“Algo and programmed trading works on momentum, which gets accentuated on both sides, in a rising market as well as during steep falls. This has been reflected in the market movement in the last few days,” said Navneet Munot, CIO, SBI MF. 
 
A programme could be created to sell shares that have broken below a certain trading range, which can lead to the execution of big sell orders in a falling market. And when sellers vastly outnumber buyers, it can lead to a situation where the prices continue to slide till a buyer is willing to execute a trade.
 
According to Kunal Nandwani, founder & CEO at uTrade Solutions, algo traders in India have made money in the past week or two owing to the volatility. Such traders trade between the bid and ask spreads and make money via arbitrage and market-making functions.
 
“Algos have, in some instances, led to market crashes in the past due to poor implementations of algorithms. Algos, by themselves, however, do not drag the markets down as they are operated by the framework provided by humans,” clarified Nandwani.
 
The Fed’s move to cut interest rates to near-zero on Sunday and launch a $700 billion quantitative easing programme, failed to cheer global markets, as Asian and European markets tumbled 2.5-9 per cent on Monday.
 
“The rising share of passive funds globally surely leads to higher volatility, but also could open up opportunities when selling happens without regard to underlying bottom-up fundamentals,” observed the Emkay note.
 
A passive portfolio management aims to mimic the investment holdings of a particular index. Index funds, for instance, are a type of mutual fund with a portfolio constructed to match or track the components of an index such as the Nifty 50. They purchase the stocks in the same proportion as the weight of the stocks in the index. This means these funds are supposed to perform in line with that of their benchmarks, except for a small difference known as the tracking error.
 
ETFs are similar to index funds, except that they can be bought and sold on the exchanges and are preferred by institutional investors.