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Index funds and index-based ETF’s have become increasingly popular, primarily because of their ease of purchase and low management fees. While these products are definitely useful for many investment applications, they may be responsible for some of the increased volatility that we have been seeing in the stock market. But at the same time, they may improve the profit opportunities for fundamentally oriented investors, particularly turnaround investors.
These index-based products make it very easy for investors to move quickly in and out of the market as a whole or in and out of certain sectors or asset classes. Because of this ease of entry and exit, many investors such as hedge funds are using index ETF’s to try to time the market--a very poor use of these products in our opinion.
Whenever there are net purchases or sales of an index fund, the fund must buy or sell (as the case may) the underlying securities. As the movements in and out of these funds become more rapid, the funds’ large scale purchases and sales of the underlying securities can lead to more volatility in the markets. The effect of index fund trading may have only a modest influence in market sectors dominated by actively traded stocks with large market capitalizations, such as the S&P 500 stocks. But in other, less liquid sectors, the effect can be more profound. For example, trading in ETF’s in the small cap stock and high yield bond sectors has increased significantly over the last year or so. In these sectors, where there is normally less activity in the underlying securities, the transactions from the ETF’s can move prices quite sharply.
The good news from the increasing use of index products is that it creates more inefficiencies in stocks and other securities that either aren’t in the index or represent a very small percentage of the index. And inefficiency--in an otherwise pretty efficient market--often leads to superior gain potential. Turnaround stocks often fall in this category. Many turnaround stocks have been dropped from their previous index when the stock fell in price. This adds to the inefficiency--and profit potential--in turnaround stocks.