Passive global funds, algos might have magnified stock crash: Emkay study

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 algorithm-driven strategies might have exacerbated the recent stock market crash.

Nearly two-third of the $4.6 billion (Rs 34,000 crore) of net selling in Indian equities by foreign portfolio investors (FPIs) from February 19 till now has come from passive funds, estimates a report by Emkay Global Financial Services.

This is based on a study of about 200 exchange-traded funds (ETFs), with combined assets under management of $1.5 trillion that have an average India allocation of nine per cent. In this period, these ETFs saw outflow of $25 billion, the brokerage said.

ETFs make up roughly $38 bn (Rs 2.8 trillion) of the passive money coming into India. Of this, India-dedicated ETFs managed assets of a little over $10 bn (Rs 74,000 crore) as of end-December 2019.

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 stocks in the same proportion as the weight of these in the index. This means these funds are supposed to perform in line with their benchmarks, except for a small difference known as the tracking error.

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

Both index funds and ETFs have seen significant inflow in developed markets over the past few years. The recent selloff, therefore, has also been led by these. 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 sell orders of 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,” explains U R Bhat, 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, he added. “These funds can go on a selling spree when stop-losses are triggered.”

Algorithmic trading, where a computer automatically executes trades based on pre-programmed instructions, was introduced in India in 2009. It now contributes to about two-fifth of exchange volumes. This figure is over 80 per cent of volumes in developed markets such as America.

“Algo and programmed trading work on momentum, which gets accentuated on both sides, in a rising market as well as during steep falls. This has been reflected in market movement over the past few days,” said Navneet Munot, chief investment officer at SBI Mutual Fund.

A programme could be created to sell shares that have broken below a specified trading range, which can lead to execution of big sell orders in a falling market. And, when sellers vastly outnumber buyers, this 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 and chief executive at uTrade Solutions, algo traders in India have made money in the past week or two owing to the volatility. They trade between the bid and ask spreads, making money via arbitrage and market-making functions.

“They 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 — they are operated by the framework provided by humans,” clarified Nandwani.

The US Federal Reserve’s decision on Sunday to cut interest rates there to nearly zero and launch a $700-bn quantitative easing programme, failed to cheer global stock markets. Asian and European markets tumbled by 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.