Ponzi Funds Paper by van der Beck, Bouchaud, and Villamaina

New Ponzi Finance Paper Explains the Collapse of ARKK and is Bad News for Index Funds

Ponzi Funds Paper by van der Beck, Bouchaud, and Villamaina Has a Dire Message for Index Funds

Events are moving rapidly. The current state of understanding regarding index funds’ effects on stock prices, valuations, and trading activity is accelerating. When we created Passive Parabellum last year to monitor the effects of indexing on capital markets, our goal was to keep our readers informed of these developments in a readable format that simplified the academic jargon and esoteric mathematics that appears in these papers.

Our friend Mike Green, recently highlighted a new academic paper entitled Ponzi Funds.

This paper delves into Cathie Wood’s ARKK ETF and proves that her performance had nothing to do with superior stock-picking skills or the profitability of the underlying companies owned by the fund. Very simply, the fund’s price rose and the companies it owned outperformed because a lot of money flowed into the ARKK ETF. These flows actually drove huge returns, which then became self-reinforcing, because even more money gravitated to ARKK as investors were enticed by its superior past performance. It was a self-reinforcing cycle or, if you prefer, what George Soros calls reflexivity.

The authors write in the paper:

“During this period, the thematic ETF’s positions were 20 times larger than the daily dollar volume in those securities. This implies that whenever the thematic ETF received a 1% inflow on a certain day and proportionally rescaled its positions, it bought 20% of the daily volume in the underlying stocks. Because its portfolio was heavily concentrated in these individual securities and it received over 200% inflows, a large portion of its portfolio return was driven by its own price impact.”

So Cathie’s fund became so large, whenever money flowed in to her fund she was buying so much of the daily volume of her names that the money flowing into ARKK was actually the source of her huge returns as it pushed her names higher!

While the authors of the Ponzi Finance paper were focused on ARKK specifically, these dynamics are also present in S&P 500 index funds but they act on a much larger scale. Due to the dominance of index funds, the stock market is increasingly inelastic, meaning that a dollar invested in the market will increase stock prices at least $5 and probably as much as $17. Therefore, it is the hundreds of billions of dollars flowing into index funds each year that creates their superior performance. The great returns have nothing to do with the profitability of the companies in the S&P 500, like Amazon or Apple. In fact, the iPhone-maker has recently suffered flatlining sales and profits yet its stock price has continued skyward, because of the stock’s large weighting in the S&P 500:

Much like Cathie Woods ARKK imploded as investors withdrew their money, the same will happen to the passive Ponzi scheme once index funds experience sustained net outflows for the first time in their history.

The Passive Endgame approaches.

Read the Ponzi Funds Paper by van der Beck, Bouchaud, and Villamaina here.

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