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Since the invention of the stock index as a concept in the 1890s by Charles Dow, investors have worked to continually obtain relative outperformance against a comparative benchmark. In doing so, market participants have increasingly sought to capitalize on any opportunity to increase yield and/or decrease risk. Anything offering the prospect of outsmarting markets is afforded a chance. And preference is given to those securities and investment vehicles that possess certain fundamental attributes, key among them liquidity, low transaction costs, low capital requirements, transparency, and flexibility in design. Index-based derivatives made for an almost perfect match, offering participants the occasion to once again endeavor to outmaneuver markets and defy a fundamental law of finance—the relationship between risk and return.
Modern portfolio theory and the efficient frontier, as initially presented in the Journal of Finance by Harry Markowitz in his seminal 1952 work “Portfolio Selection” and built upon throughout the second half of the 20th century, is the foundation for proper portfolio construction and management. Within it, an important correlation exists between risk and return (the risk/return continuum). Risk is directly linked with return, and return directly linked with risk. The more return one desires, the more risk one must take. And conversely, the less risk one desires, the less return one can make. Market participants all too often, whether consciously or not, try to overcome the continuum. As such, portfolios rid themselves of surface risk—those risks that are easily identifiable and diversifiable—but carve a deeper hole insofar as human risk is concerned. Human risk—the blindness of participants thinking markets can be outwitted and certain laws of finance evaded—is omnipresent, and if unchecked, leaves portfolios and the global financial system open to great loss. Human risk takes place at the hands of investing ignorance and finds sustenance in a general lack of humility of participants relative to the randomness and aptitude of the markets themselves. The main reason for the rapid rise in popularity of index-based derivatives is their seamless fit for mitigating surface risk—perfectly satisfying participants’ appetite for peace of mind, while letting far more serious risks go unnoticed. Unfortunately—and potentially very grave for markets and the global financial system—the implementation of index-based derivatives not only conceals human risk but exacerbates it. Derivatives—more specifically, index-based derivatives—owe their popularity to their ability to exaggerate human irrationality. Index-based derivatives take human risk—the same risk that makes it so difficult for participants to buy low and sell high, so difficult for participants to simply own the market portfolio—and conceal it deeper between assets of even the best investment platforms.