The Solution Is

It appears that the wild swings in heavily shorted stocks, most recently for AMC movie theaters, is causing instabilities in the market that threaten the stability of index funds.

The solution to this is fairly straightforward, first and most importantly, enact a transaction tax for all financial transfers to increase the friction, and hence reduce the speculation.

It might also be a good idea to ban Payment for Flow Order, which is a Bernie Madoff inspired "Innovation" which is little more than an excuse for front running, where a broker executes their trades before those of their customers for their own personal profit.

Speculation is a cost we pay for investment, an evil that we tolerate in order to encourage investment.

A tax of between 10 and 50 basis points (⅒% — ½%) tax per transaction. 

Even if it does not generate as much revenue as its supporters predict, it will produce a very real public good:

Index funds are supposed to cut out the human-driven craziness that periodically infects markets, but the recent meme-stock fever proved the $11 trillion industry is far from immune.

The remarkable surge in shares of AMC Entertainment Holdings Inc. and a handful of other stocks is showing up in multiple exchange-traded funds, skewing portfolios, altering risk profiles and exerting outsized influence on prices.

Take the $68 billion iShares Russell 2000 ETF (ticker IWM). In the past week through Thursday, AMC powered 70% of the product’s advance. The stock was responsible for less than a 10th of the fund’s return in the previous week.

It’s a timely reminder that even diversified funds on autopilot remain subject to the whims and eccentricities that frequently lash markets out of nowhere.

………

“For index investing, the appeal is that human decision-making, human emotions are taken out of it,” said Tom Essaye, a former Merrill Lynch trader who founded “the Sevens Report” newsletter. “That works all well and good until a stock that is supposed to be 50 basis points of the fund now becomes 6%.”

This is going to destroy us all.