Index providers must adapt to regime change in financial markets

Markets becoming increasingly volatile with more Robinhood investors

Tom Eckett

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The rise of retail investors and meme stocks since the pandemic is having a dramatic impact on the sleepy world of indexing and as a result, index providers must be prepared to adapt to the market environment that surrounds them.

Earlier this month, WallStreetBets-inspired traders were back in action, driving the share price of AMC to over 3,000% gains so far this year.

AMC’s surge showed up in a number of exchange-traded funds with the company’s weighting in the SoFi Social 50 ETF (SFYF) ballooning to 23.5% while the Invesco Dynamic Leisure and Entertainment ETF (PEJ) saw it jump to an 18% weighting.

Meanwhile, BlackRock’s US momentum ETFs, the iShares Edge MSCI USA Momentum Factor UCITS ETF (IUMF) and its US counterpart, fell victim to the scheduled dates of its semi-annual rebalances.

By only rebalancing in May, IUMF has missed the swing to cyclical stocks which took place last November following the Pfizer vaccine news, however, the ETF has now shifted to financials, in particular, leaving the strategy open to questions about whether the rebalance was too little too late.

The issues with both the rise of meme stock trading and momentum ETFs highlights the potential risk with adopting infrequent scheduled rebalance dates.

Is a semi-annual rebalance sufficient? The answer very much depends on the area of the market the index is exposed to.

Ifthe FTSE 100rebalanced quarterly this would pass on unnecessary costs to the end of investor, however, in markets where stocks have the potential to move quickly and severely, index providers must look at the rules they are applying.

As one industry source told ETF Stream: “Financial markets have entirely changed and rules should be fit for purpose in this new environment.”

So what options do index providers have? One potential solution is to increase the number of scheduled rebalance dates in more volatile areas of the market.

This paid dividends for PEJ – an ETF that rebalances quarterly – which had an 18% weighting to AMC on 2 June before rebalancing on 3 June and removing the stock entirely as it no longer fit the requirements of the rules.

While PEJ benefitted from “impeccable timings” as CFRA Research noted, this was more down to luck rather than any other metric at work.

Do index providers need to be regulated?

Another approach could be toimplement certain thresholdsso if a stock increases above a certain weighting in an index, it triggers an automatic rebalance in the ETF.

Plenty for index providers to consider over the coming months, however, the industry needs to adapt quickly if it is to stay up to speed with the increasingly volatile nature of certain markets.

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