If you're talking about index mutual funds, then the author is just plain wrong. Any open-ended fund offering daily liquidity will trade, and therefore produce market impact, to meet its daily redemptions.

If you're only talking about ETFs, then this is technically correct. Besides the occasional index re-constitution, unlevered index ETFs don't do any trading. However it's definitely not true that there's no market impact. As the fund grows (or shrinks) the shares just don't magically appear in the portfolio. Somebody has to go out and buy (or sell) those shares, and like any trading volume, that creates market impact.

The mechanism that ETFs actually use is something called "Authorized Participants" (or APs for short). Basically market makers have the right to create or redeem shares in the ETF. To create new shares, they go out and buy all the stocks in the index, then hand a basket over to the ETF fund manager, who then hands back new shares of the equivalent value. And to destroy shares, the AP hand over shares in the ETF, and the fund manager hands back a basket of shares from the index.

If there's high demand for investors to own the ETF, that'll push up the ETF's stock price. As the price rises relative to the index value, APs will detect an arbitrage opportunity. They'll go out and buy the basket of stocks in the index at a cheaper price, then create new ETF shares at the richer price, and pocket the difference. Vice versa if there's demand from investors to exit the ETF.

The mechanism keeps the ETF price closely pegged to the index, because the further out of line it gets the more arbitrageur activity pushes it back in line. While also flexibly satisfying investors' specific demand for the ETF at any given time. Basically it delegates the role of trading from the fund manager, who usually doesn't have any special expertise in trading, to highly specialized trading firms and market makers.

However, as you can clearly see, market impact most definitely exists. If a flurry of investors rush to enter or exit an ETF, then a huge amount of trading has to be done to create or redeem the shares. Just because the APs create this trading impact, instead of the fund itself, is a distinction without a difference. The underlying stocks in the index are subject to market impact.

There is already a very well known liquidity problem with index funds that track S&P500. Since stocks come and go from this list, index fund managers need to be very careful about how they buy and share these stocks so as not to greatly effect their prices, and cost the fund too much money.

So index funds already have a pretty big effect in markets. I suspect some of the stretegies used for these events will be similar to how managers mitigate short term mass enters and exits in a fund.

My bigger suspicion in general with index fund mass selling though, is that while they are meant to track the market over the mid to long term, they are actually priced seperate from the market, and this seperate pricing means that if there’s a mass sell off, then fund share prices fall, and others have incentive to buy them at a discount. Eventually both index and benchmark prices reach equilibrium. Maybe there’s total havoc in the market in the meantime, but this mechanism will mitigate it to some degree.

But the trading isn't the cause of the market impact, it's the redemptions that occur first, and force the trading. There had to have been economic or financial reasons for those redemptions to occur. The fact that when everyone tries to sell at one, there's aren't enough buyers is a story of the ages. That ETFs will suffer the same consequences in a run is hardly unique to them as financial assets.

I think they claim is that their is a lot of "dumb money" holding indexed products that are likely to sell all at once when things turn south. By the structure of these funds, their will be large selling pressure on the underlying stocks and a good chunk of them don't have the liquidity to support that pressure. That doesn't mean their will be a metldown, just that prices will tank very hard and a lot of people will lose a lot of money + the economic effects that has I don't understand.

I was hoping the original article would tear that reasoning down, and while it did touch on various mechanisms it didn't give a cohesive thesis as to why that is wrong.

There is no evidence for this. During the 2000-2002 and 2008-2009 index funds actually saw higher inflows:

* https://www.etfstrategy.com/three-reasons-why-indexing-and-e...

Perhaps there will be greater correlation between names in a downturn, but then again, factor-based investing might offset some of that.

Derivatives written against sub-prime holdings tipped the balance when the fan was hit. There are tons of derivatives written against the indices, thus indirectly against those funds.

Those derivatives might be "somewhat in the neighborhood of the funds" or something, but it's not analogous to mortgages.

There's a bit more nuance to it: those derivatives were a problem because a substantial proportion of them were concentrated in a single, widely-connected, entity (AIG).

The derivative market as a whole nets to zero; for every loser there is a winner.

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.

(John Maynard Keynes, General Theory, Chapter 12, page 142 in the Google Book edition)

Imagine if you'd invested in the Russel 3000 index, which aims at tracking the entire US stock market. If the ETF manager transferred the securities as you exited you'd now have to manually sell 3000 securities across many markets. The ETF has tools and processes for this, you don't. You pay them a fee for the convenience of not having to deal with the underlying assets.

Another example would be something like the iShares gold or iShares silver ETF. They hold precious metals in a secure vault on your behalf, for a fee. You probably don't want a delivery from an armored truck every time you exit the ETF! :)

https://www.investopedia.com/terms/r/redemption-mechanism.as...