Is there an exagerated impact of Tracker funds on Stock Market movements?

grey_gym_sock

Suffolk_lass wrote: »

I have been looking at the area of tracked funds and I now believe a lot of the stock market volatility is caused by an artificial reaction driven by computerised passive tracker funds where the algorithm automatically triggers a sale when the movement of a holding exceeds a certain percentage. And one triggers another, and the reaction goes on. Is my understanding of how they work correct?

that's not right. tracker funds do not buy or sell in response to price changes; they buy or sell in response to money flowing into or out of the tracker fund.

if there is no money flowing into or out of the tracker, it does not need to buy or sell any shares. in order to track its index, the fund will be holding the same % of the shares in every company in its index, e.g. perhaps it holds 0.01% of every company in the index. 0.01% of the biggest companies in the index will be worth a lot more than 0.01% of the smallest companies, so the tracker's holdings in different companies are worth different amounts, but they are all the same percentage. when the prices of companies rise and fall, the values of the holdings will change, but the percentages remain the same.

when more ppl put money into the tracker fund, it uses their cash to increase its % holding in each company. e.g. it might need to buy an extra 0.002% of each company, taking its holding up to 0.012% . if some shares' prices have just been racing upwards, then the cash required to buy that extra 0.002% of their shares will be more than it would have been last week; and if other shares have been falling, it will cost less to buy an extra 0.002% of them. so it is true that trackers put more cash into shares which having been rising, less into shares which have been falling. but they buy the same % of every share. if all trackers have 20% of the market between them, then that leaves 80% of shares for active investors to fight over - and that % is the same for all companies in the index.

similarly, when ppl take money out of a tracker fund, it automatically sells the same percentage of shares in each company. e.g. it might need to sell 0.001% of each company, taking its holding down to 0.011% of each company.

there is another reason (which i haven't mentioned so far) why trackers need to buy or sell: when the composition of the index is changed, i.e. some shares are removed from or added to the index. however, this is relatively rare; e.g. some indexes are updated every 3 months.

tg99

It's often trend following and momentum funds that use such algorithms to try and detect a change in trend which can then cause a wave of selling or buying especially since such models have become more commonplace over the last decade or so. These will often deal in liquid futures contracts especially if the fund is of meaningful size. Good example is when a market falls through a key technical support level which a lot of the trend following funds might be using in their algorithms. This then causes them all to sell at once and can then result in more selling as others stop losses are hit, further technical levels are breached, leveraged traders have to cut exposure due to margin calls etc.

Suffolk_lass

tg99 wrote: »

It's often trend following and momentum funds that use such algorithms to try and detect a change in trend which can then cause a wave of selling or buying especially since such models have become more commonplace over the last decade or so. These will often deal in liquid futures contracts especially if the fund is of meaningful size. Good example is when a market falls through a key technical support level which a lot of the trend following funds might be using in their algorithms. This then causes them all to sell at once and can then result in more selling as others stop losses are hit, further technical levels are breached, leveraged traders have to cut exposure due to margin calls etc.

Thank you for this, the latter part of your explanation is what I think I was trying to allude to in the first post, but attributing it to an automated computer model (demonstrating how little I understand - conscious incompetence, I think!).

The references to liquid futures is an area I know nothing about (yet) - futures I get, liquid futures is one for the glossary for me.

SL

Suffolk_lass

grey_gym_sock wrote: »

that's not right. tracker funds do not buy or sell in response to price changes; they buy or sell in response to money flowing into or out of the tracker fund.

if there is no money flowing into or out of the tracker, it does not need to buy or sell any shares. in order to track its index, the fund will be holding the same % of the shares in every company in its index, e.g. perhaps it holds 0.01% of every company in the index. 0.01% of the biggest companies in the index will be worth a lot more than 0.01% of the smallest companies, so the tracker's holdings in different companies are worth different amounts, but they are all the same percentage. when the prices of companies rise and fall, the values of the holdings will change, but the percentages remain the same.

when more ppl put money into the tracker fund, it uses their cash to increase its % holding in each company. e.g. it might need to buy an extra 0.002% of each company, taking its holding up to 0.012% . if some shares' prices have just been racing upwards, then the cash required to buy that extra 0.002% of their shares will be more than it would have been last week; and if other shares have been falling, it will cost less to buy an extra 0.002% of them. so it is true that trackers put more cash into shares which having been rising, less into shares which have been falling. but they buy the same % of every share. if all trackers have 20% of the market between them, then that leaves 80% of shares for active investors to fight over - and that % is the same for all companies in the index.

similarly, when ppl take money out of a tracker fund, it automatically sells the same percentage of shares in each company. e.g. it might need to sell 0.001% of each company, taking its holding down to 0.011% of each company.

there is another reason (which i haven't mentioned so far) why trackers need to buy or sell: when the composition of the index is changed, i.e. some shares are removed from or added to the index. however, this is relatively rare; e.g. some indexes are updated every 3 months.

Thank you for taking the trouble to explain
SL