Research Articles

Foregoing Due Diligence

The following is an abstract. Here is a link to the full article: Foregoing Due Diligence.

This article focuses on decision-making trends in the context of security selection and asset allocation that may have significant implications for investors. In particular, there has been tremendous growth in broad market index investing and automated rebalancing strategies. This translates into little to no due diligence regarding the price paid (valuation) or asset quality. This behavior parallels those that led up to the credit crisis.

During the housing bubble, investors at least demanded AAA (well, BBB) stamps to skip due diligence. With index and robo strategies, due diligence is again being set aside as investors are placing their trust in efficient markets. In recent years, this has worked well for those employing this strategy. While I cannot say when, I expect this fad to come to an abrupt and chaotic halt when the music finally stops.

To be fair, index products such as exchange-traded funds (ETFs) can be great tools and help many investors (just like collateralized debt obligations or CDOs). However, there is a significant liquidity mismatch between the trading volume of some index products and that of their underlying securities. While index buyers and sellers are close to equilibrium, there may be no problem. However, if an imbalance develops and liquidity spills over into the underlying markets, then we may see significant volatility as the tail starts wagging the dog.