June 25, 2024

# Unravelling the Birth of Market Bubbles

Tuesday, 28 May 2024, 11:14 am

Every day, ‘Ponzi funds’ inflate asset prices by around $500m, leading to a rampant misallocation of as much as £344bn over the past five years, according to a fresh study.

The study, by Harvard Business School and Capital Fund Management, reveals that actively managed funds, which possess a tiny fraction of stocks in their holdings, are responsible for this surge. They augment the prices of stocks beyond their fair value, resulting in an unnatural rise in performance that entices new clients.

This surge of newcomers, pursuing the inflated returns, triggers a feedback loop and an eventual wealth shift towards early fund investors. This artificially boosted performance eventually collapses when the price pressure recedes.

This surge of fresh investors can both predict bubbles in exchange-traded funds (ETFs), and also account for market crashes.

The study observes, “Investors’ propensity to weigh recent returns more heavily implies even brief-lived price pressure can exert influence.”

By the estimation of the authors since 2019, ETFs have reallocated nearly $440bn (£344bn) due to this feedback loop. The authors Philippe van der Beck, Jean-Philippe Bouchaud, and Dario Villamaina, opined that the causes underlying the feedback loop bear relevance “more generally” to other markets, including the $300bn (£235bn) commodities futures market.

The authors concluded, “The participants’ inability to tell apart fund returns arising from fundamental factors and those arising from price impact bears serious repercussions for asset markets.”

Just to clarify, Ponzi schemes are a type of investment fraud where early investors are paid profits with the money put in by newer investors. This helps maintain the illusion of returns as long as there’s continued addition of new funds.

Typically, an economic bubble isn’t considered a Ponzi scheme, as it doesn’t depend on a central entity misrepresenting the investment scheme.

Further Reading

Think you can beat the market? Most active managers can’t

Frequently Asked Questions

What exactly is a Ponzi scheme?

A Ponzi scheme is a type of fraudulent investment strategy wherein the returns of initial investors are paid using the funds provided by recent investors. This creates an illusion of profit, while in reality, it’s a circular movement of money from new to old investors without actual earnings.

How is an economic bubble formed?

An economic bubble emerges when the prices of assets inflate drastically beyond their intrinsic value. Usually, this is driven by exaggerated expectations of future growth, speculation, or a sharp upsurge in demand. The bubble inevitably bursts when the prices revert back to their true value, leading to a rapid downfall.

What implications does an economic bubble have on the market?

The burst of an economic bubble often leads to a market recession or crash, as was the case in the 2008 housing market bubble. Investors often suffer heavy losses, and it can disrupt the overall economic growth. It also poses serious implications for regulatory bodies as it reflects underlying issues in monitoring and control.