I’m a big fan of ye olde passively-traded exchange-traded fund (I’ve spoken about this plenty of times, but mostly here).

As is Mr Buffett (see here).

However.

I feel it’s important to point out a cautionary tale. Mainly because: all things in moderation. And when things are not in moderation, it can all go horribly wrong.

Lessons from the Argentine Default of 2001/2002

First off, you should have a listen to this lecture that Felix Salmon gave at the LSE a few weeks ago. And for some of the background to Argentina’s Sovereign Debt saga, here’s an earlier post: “Cry For Yourselves – You Vultures” says Argentina.

The background:

1. By the late 90s, Argentina had borrowed a lot of money.
2. Actually, it was borrowing money to repay borrowed money – which can be standard (it’s what we mean by “rolling” one’s debt) – but not when the new borrowings are at much higher rates of interest and not when you’re replacing old long-term debt with new short-term debt hoping against hope that something will happen in the interim that would let you repay it.
3. Everyone knew that the Argentine debt levels were unsustainable.
4. The IMF, the World Bank, and even the bankers on Wall Street were saying “You know you really should just default a little bit now in order to avoid defaulting a lot more later…”
5. Yes, that unsustainable.

The real question: why were investors continuing to lend them money knowing all of this?

The truth is, much of the problem came from the IMF and the World Bank continuing to lend to Argentina after poor credit ratings drove up their interest repayments. But at least some of the answer was the work of passively-traded emerging-market-bond-index tracker funds.

Before I get there, a reminder of how an index tracker fund works:

1. The product provider looks at an index that it’s going to track, like the S&P 500.
2. It says things like “So 2% of the index is Apple shares, 1.7% is Mobil-Exxon… etc”
3. It then says to investors “We’re going to track this index by collecting your money and investing 2% of it in Apple shares, 1.7% in Mobil-Exxon…etc.”
4. And: “We’ll get the trading algorithms to check that we’re in line with the index at the end of each day/week/quarter – at which point, the computer will shuffle around the investments to get it as close to the underlying composition of the S&P 500 index as possible.”
5. Because: “We’re in this game to minimise cost (by minimising transactions) and minimise tracking error (by minimising the amount of deviation between the fund and the index). Those two things are generally going to be in conflict. But we’ve got great algorithms, so give us your money!”
6. Also: “We’ll almost certainly be cheaper than active investment managers.”
7. And finally: “The probability is that we’ll beat them at least 50% of the time before fees.”

So because index-tracker funds are, by their nature, passive – it means that no thought is given to any awkwardness in the underlying index. Which is normally fine – because most companies/bonds are small relative to the total index, and you can generally trust that the active guys and the institutional investors are busy watching on the sidelines for market distortions, and that they’ll trade to correct the mis-pricing #efficientmarkethypothesis

But whatever the EMH fans might like to believe, this is not always the case.

If you look at the Emerging Market Bond Index in 1999, you’ll notice that Argentine debt made up a significant chunk of the index:

When money flowed into passive funds that were tracking the Emerging Market Bond Index, some of it had to go into Argentine debt.

And the more Argentina borrowed, the larger the proportion of the index it took up, and the more money that needed to flow into Argentine debt in order for the passive funds to keep in line with the index.

In a curious burst of crazy, the borrower was being lent more money because it had already borrowed so much of it.

And then the inevitable happened, and we had the largest sovereign bond default in human history.

What That Means For Passive Index Tracker Investment

Given the wrong set of circumstances, passive funds run the risk of blindly creating a feedback loop of over-investment.

And when you think about it, that makes sense:

1. If a significant stock is over-priced due to high demand
2. Then passive index-trackers are going to magnify that demand by trying to buy enough of the stock to reflect the higher price in their index composition.
3. Higher demand → higher prices.
4. Higher prices → even higher passive index-tracker demand in order to rebalance the portfolio again.
5. And so on until existing holders of the stock decide that the stock is over-priced enough that they’d be crazy not to sell.
6. At which point, supply starts to match demand, slowing down the price increase.

This process is less of a concern when:

1. Passive investment funds are small relative to the total investment in the market; and/or
2. When there are no large single components (stocks/bonds/etc) in the index.

But it’s something to think about when the market has significant passive index funds and/or the universe of stock options (or bonds, etc) is small…

What to do about it

The type of passive fund that I’m talking about mainly refers to those that use market price or market capitalisation as the metric for re-balancing.

But there are also passive funds that are designed to overweight securities that are “underpriced” and underweight securities that are “overpriced”*.
*How they determine that is a completely separate question. And also, how effective they are – because if you’re facing off against large passive funds that don’t care about over/under-pricing, then what’s the basis for assuming that the market will correct itself?

So there are (contrarian?) ways to counter the risk that the passive funds will self-create their own investment bubbles.

But I’d say that the really important thing to do is pay attention.

Having a passive investment doesn’t mean that you get to sit passively by and watch it do whatever. You have to look at it regularly, with or without a financial advisor, and ask yourself “But does this really make sense?” And if it looks too good to be true, or some things in the index look over-invested, consider whether greed is making you crazy, and whether the market is crazy, and possibly adjust your investment choice.

As a final point, I just want to say that pausing to think about what the market is doing does not mean that you’re trying to “time the market” or “speculate”. What you’re actually doing is acknowledging that markets tend to be efficient when it doesn’t matter, and wildly inefficient when it really counts.

It’s why Mr Buffett, for all his preach of passive investing, is a long-term active investor.

I think it’s the investing equivalent of “working smart, not hard”: passive in general, active when you need to be.

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.