Index Fund Risk in 2025

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Happy Sunday.

We've all heard the debates about index trackers taking over the market. Critics love to talk about how they make markets less efficient, but here's something that doesn't get enough attention – they might actually be making markets riskier. When investors feel good about the market, they pour money into index funds. These funds then have to buy all their stocks in fixed proportions – they don't get to pick and choose. So the more a stock is owned by index funds, the more it's going to move in sync with all the other stocks in those indexes.

A personal ask: give today’s sponsor a “click” so I can keep ranting about index funds and drink good coffee (at the same time)

The Mechanics of Modern Index Fund Risk

1: The Correlated Trading Engine

The foundation of modern market risk begins with how passive funds operate:

• Passive funds execute trades automatically based on index composition and fund flows

• When investors add $1 billion to S&P 500 funds, this triggers proportional purchases across all 500+ companies, regardless of their individual characteristics

• Example: A tech company and a consumer staples company move in sync despite having completely different business models

• This creates artificial price linkages between fundamentally unrelated companies

• The effect compounds as more assets shift to passive vehicles

2: The Liquidity Mirage

During a "crisis," there is a mismatch between perceived and actual market liquidity. ETF trading happens on two levels, like a trading card market:

Secondary Market:

• Most trading is between investors, like collectors swapping cards

Primary Market:

Large institutions can create/redeem ETF shares by exchanging the actual stocks, like trading a complete set for a sealed box

During market stress, this structure reveals key patterns:

• ETFs often lead price discovery, showing market sentiment faster than underlying stocks becausde more eyes/volume tend to be on ETF’s during market “crisis” time

• Prices can briefly disconnect from the ETF's asset value as the market gets swamped with volume it normally doesn’t see creating slight inefficiencies

The COVID crisis highlighted these dynamics:

• High trading volumes across both ETFs and underlying markets

• Some fixed-income ETFs traded at discounts to NAV

• Market structure proved resilient despite extreme conditions

• Circuit breakers and other market mechanisms help prevent cascading effects

Large financial institutions maintain efficient pricing by arbitraging any significant disconnects.

3: The Systematic Risk Shift

Market structure has fundamentally changed:

• Undiversifiable market risk has increased 20%+ since 1980

• Company-specific factors (idiosyncratic risk) have less impact on stock prices

• Market-wide movements dominate individual stock performance

• Traditional diversification benefits are reduced

• Portfolio risk management needs to adapt to this new reality

• Beta (market sensitivity) becomes more important than stock selection

Implications to consider (seriously)

• Traditional risk models may underestimate systematic risk

• Market stress events could be more severe and frequent as concentration risk eats it’s own tail

• Need for new approaches to portfolio construction (can ai solve this and how does that affect lebrons legacy?)

• Importance of understanding and managing market beta exposure

• Potential regulatory concerns about market stability
  
  
  

Stay curious 🙂 

- John

Note: This article explores academic research findings and is for educational and entertainment purposes only. Nothing in this piece constitutes personalized financial advice. Always conduct your own research and consult qualified professionals for investment decisions.