AMC and Tesla are Examples of the Possible Dangers of Passive Index Funds

Posted on 06/06/2021

As institutional investors such as college endowments, pensions, and sovereign wealth funds seek to invest in passive index funds, or create their own indices based on traditional benchmarks, new volatility risks can arise in their equity portfolios. Over the past 30 years, index investing has risen in popularity as it is low-cost, many times outperformed active management, and takes the human-decision making and bias out of stock selection.

One of the biggest risks to passive indexed portfolios in listed equities is that they are set. Investors have no control over the individual holdings in the portfolio. Once the rules are set, the game is played.

High price-to-earnings ratio stocks like Tesla Inc. and meme stocks like AMC Entertainment Holdings Inc. are included in major U.S. indices and exchange-traded funds. The Reddit-fueled army of investors have driven AMC’s stock price to insane highs vs. the company’s actual fundamental valuations. AMC struggled financially even before the COVID-19 pandemic.

By getting indexed these stocks market valuations benefit from passive investors re-allocating. These ETFs or index strategies must blindly buy these stocks. This is changing the risk profile of these ETFs and exerting outsized influence on the price of these securities. iShares Russell 2000 ETF (ticker IWM), which oversees US$ 68 billion in assets, had AMC influence 70% of the ETF’s advances in the past week through that Thursday.

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