Financial Innovation and Unintended Consequences

Financial Innovation Can Have Unintended Consequences

I recently read Contrarian Investment Strategies: The Psychological Edge, a fantastic book by David Dreman. Dreman is the founder and chairman of Dreman Value Management LLC, a firm which manages approximatlely $5B for individuals and institutions and a Forbes columnist since 1979. Dreman's investment approach is "contrarian value"—he looks for companies trading at low price-to-earnings, price-to-book, and/or price-to-cash flow ratios.

The book is broken down into five sections: (I) Investor Psychology & Behavioral Finance; (II) Efficient Market Hypothesis and Its Flaws; (III) Economic Forecasting; (IV) Market Overreactions; and (V) Challenges and Opportunities in the Future.

In Section II of the book, Dreman spends quite a bit of time critiquing one of the leading investment theories over the past several decades: the Efficient Market Hypothesis (EMH). In a nutshell, EMH is based on the premise that the market is always efficient and that any new data (i.e., earnings surprises, mergers and acquisitions, corporate scandals, etc.) are immediately and correctly reflected in the prices of stocks. And since prices always reflect the "true" value of companies, EMH suggests there is no sense in trying to beat the market—you should simply own the index.

Dreman identifies several flaws in the EMH, including the use of beta (or volatility) as the only measure of risk in a portfolio. He goes on to talk about how bubbles and panics shouldn't occur if the market is truly efficient in pricing in new information. As part of the bubble discussion, Dreman reflects on how the 1987 crash was at least partially caused by the advent of equity index and portfolio insurance futures (used in conjunction with high levels of leverage). Both of these new financial instruments were supposed to provide increased liquidity and protect investors from downside risk. Instead, liquidity dried up as investors piled into short positions in the futures market, and the equity indices sold off to remain aligned with the futures. 

I immediately saw parallels in today's markets with the explosive growth in exchange-traded funds (ETFs). ETFs are seeing enormous inflows of capital as investors look to make bidirectional bets on sectors, countries, currencies, and other asset classes. It seems like every week we hear about new ETFs and new features of these funds. But what if these funds, which are supposed to add liquidity to the market by allowing investors to get in and out of baskets of securities quickly, actually end up hurting market liquidity? What if, as we saw in 1987, the tail wags the dog? 

Let's take a hypothetical example: suppose you were invested in a health care ETF because you wanted exposure to the pharmaceutical and biotechnology sectors. One day, you see a headline that one of the largest holdings in that ETF has significant accounting irregularities and its CPA firm has resigned. That stock is indicated down 50 percent in the premarket. But guess what else is down? The health care ETF you own. And if enough people are selling that health care ETF, the other companies in that ETF could fall dramatically simply because the sum of the value of the companies in the index needs to remain in line with the index it's tracking. As we saw in 1987, this could result in a very dangerous self-fulfilling spiral as selling begets selling.

We have since glimpses of this type of action in the past few years during the Flash Crash and earlier in 2015 when the Dow Jones Industrial Average dropped nearly 1,100 points in minutes. Both of these events were blamed primarily on high-frequency trading and algorithmic trading, but there hasn't been much definitive evidence presented. I am not suggesting that ETFs are good or bad. I am simply highlighting the fact that sometimes financial innovation leads to unintended consequences.



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