So you know how I sometimes get concerned about feedback loops when it comes to passive investing?

Here’s an email I was writing to the Slate Money team, involving a sudden realisation and swift embarrassment:

Hi Felix, Jordan and Cathy (although Cathy was away for the episode that I’m writing about)

In the “Worse Than Marxism” edition, Felix asked how much of the market would need to be passive before passive investing would start to affect stock prices – and his suggestion was that the number needed to be north of 99%.

Now I think that Felix was talking about stock prices in general – but my mind went down a different track, and now I have a somewhat-related question.

First, some background: my understanding of passively-traded index funds is that the funds have to rebalance periodically in order to track the index. And this would be done with algorithms that are pre-set to rebalance the portfolios on a regular basis in order to minimise tracking error. 

With that in mind, my question is: what is the risk of feedback loops here (which could impact the stock prices – especially when we’re talking about companies that are significant in the index)?

Here’s my example: Apple shares, because Apple sits in the DJIA, and it’s one of the largest components of the S&P500. Let’s say that there is news in the market about a potential tax fine that throws the momentum algorithms into a spin, and the Apple share price falls. At that point, when the index tracking funds come to rebalance, they’re going to be selling off Apple shares, which further lowers the price of Apple shares, because they’re selling them…

*stares off into space*

Oh hang on. 

*lightbulb*

Um – the index fund won’t need rebalancing. Because the value of the Apple shares in the fund will have come down. So nothing would need to be rebalanced.

*draws table*

And if you wanted to track the above, you’d get exactly the same movement in the fund only as long as you keep the same number of units before and after the price dip:

Dammit. MATH MUCH.

*returns to drawing board in huff*

I’m leaving the older post up as a mark of my shame.

And happily continuing to recommend passively-traded funds as well sensible*.
*However. I don’t think that this means passive money can’t create a bit of a bubble. For example, if you’re investing in an index that contains assets which are a bit bubbly (like a fancy tech stock), then any new inflows into the passive index tracker fund will have to throw more money into the bubbly stock than into the less expensive shares. And if you have large amounts of money flowing into passive index trackers because those seem so cool and hip right now, then the fund runs the risk of exacerbating the bubble by over-weighting the expensive bubble-stock. But that’s more of a bubble in the stock market than anything else – which was always risk regardless.

PS: sorry if that all had too much jargon. For a less jargon-filled explanation of passive investing, check out “Exchange-Traded Funds: Where I Would Put My Savings Today”

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.