Is passive investing a bubble?

Absolutely not. Before I tell you why not, skip to response number 5. Then, if you want to know more, come back and read the whole thing.

Earlier this year, in an email interview with Bloomberg News, Michael Burry wrote that he thought index funds were a pricing bubble, just like CDOs in the early 2000s. As a fund manager, Michael Burry shorted the CDO market in 2007. In hindsight, a brilliant play. Having spent the last three days reading articles written about his comments, I have become frustrated with the conspicuous absence of clear thinking and direct quotes. So, without further introduction, here are Burry’s words, copied from *Bloomberg.com:

“Central banks and Basel III have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in interest rates anymore. And now passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies—these do not require the security-level analysis that is required for true price discovery.

“This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.

“The dirty secret of passive index funds—whether open-end, closed-end, or ETF—is the distribution of daily dollar value traded among the securities within the indexes they mimic.

“In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those—456 stocks—traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different—the index contains the world’s largest stocks, but still, 266 stocks—over half—traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.

“This structured asset play is the same story again and again—so easy to sell, such a self-fulfilling prophecy as the technical machinery kicks in. All those money managers market lower fees for indexed, passive products, but they are not fools—they make up for it in scale.

“Potentially making it worse will be the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day. This fundamental concept is the same one that resulted in the market meltdowns in 2008. However, I just don’t know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be.”

*Accessed 10/11/19. https://www.bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos

In summary, Burry makes 4 claims:

1. That price discovery has been removed by a passive approach,
2. That liquidity in underlying stocks does not support the dollars invested through index funds,
3. That the industry is capitalizing on available technology for profit, despite the potential danger to the retail investor (you), and
4. That passive funds use derivatives to match index prices and manage daily fund flows.

These claims, if true, would indeed amount to a pricing bubble.

What follows are my responses and a conclusion.

Response number 1. Price discovery might be eliminated at a passive investing market share of 100%, but anything less renders this claim untrue. It takes only a few independent traders per stock making daily judgements on new information to price that information into the market. In an imaginary world where none of those traders are actively seeking new information and betting on it, the market might be inefficient (prices might not reflect all available information). However, to reach that imaginary world, 100% of global stock market assets would have to be invested through passive funds. This is not currently the case. We are not even close; and frankly, I think we will never get there.

Response number 2. The specific liquidity risk pointed out by Burry is both uninformed and illogical. It is true that if a mutual fund is in a state of net redemptions from their investors, they have to liquidate underlying assets to fund the redeemed shares. It is also true that if the sell-off overwhelms the trading volume of each of those underlying stocks it could impact each of their prices. Burry claims that, with the amount of assets tied up in index funds, a mass exodus from passive will more than overwhelm the trading volume and push down the share price of many perfectly legitimate stocks—an irrational market crash. My counterclaim is that the move away from passive would have to be a shift on a global scale over the course of one trading day in order to have such a tragic impact. That sell-off could conceivably occur over the course of a week at the shortest. Legally, mutual funds can take up to seven days to fund redeemed shares. Further, the move to passive investing has come as the result of the information revolution and cultural change of the past half-century. What are the chances that foundation will disappear in one single day? It is so highly unlikely as to render this whole scenario impossible.

Response number 3. Burry is right about one thing: the majority of this industry exists to make money, not to deliver market returns to their clients. This results in a lot of words and promises being marketed without increasing returns efficiently or doing the best for clients. As an example, common passive strategies tend to allocate whole portfolios according to market capitalization. This fails to take advantage of the size premium or the value premium, and heavily weights portfolios toward large US growth stocks. Yet companies supplying these cap-weighted products claim an academic basis for their strategies, simply because they do not employ active trading—pretty clever. Burry’s criticism of the Wall Street indexing approach is well-earned.

As an aside, it seems to me that Michael Burry is wholly dedicated to his clients. That is refreshing.

Response number 4. Burry’s fourth claim is theoretically true. Index funds could use derivatives, such as futures or calls and puts, to track their chosen index more closely. At this point, I have not been able to obtain data for the whole industry. But as far as I can tell, major index funds allocate less than 5% to derivatives.

The passive funds that we advise our clients to own are not index funds. They are factor funds—academically structured to obtain market returns, not to track an index. That eliminates the need for calls and puts.

Response number 5. What is a bubble, anyway? A bubble is an overpricing of securities or assets in a market. So-called because, eventually, they pop and the whole market responds with a crash. This is a theory, of course. Because if everyone really knew that these assets were so severely overpriced, they would sell off to adjust the price down, which is exactly what happens when bubbles pop. Bubbles are not a counterexample of the Efficient Market Hypothesis; they are an example of it. The very moment new information is available, it gets priced into the market. The very moment that a security or asset is surely known to be worth less than its current price, it gets sold—and not a moment sooner. Professor Eugene Fama has long said that it is impossible to predict or identify bubbles. Yes, the market crashes every few years, and you need to make sure you are prepared for that. But no matter what we think they are, or who thinks we are facing one, bubble fear-mongering should not affect your portfolio decisions.

When Michael Burry shorted CDOs in 2007, he had come to a personal conclusion that the mortgage industry would eventually crash. He made a bet and stuck with it. That bet paid off.

As for Cornerstone Wealth Partners, we do not gamble with our clients’ money.

There may come a day when the public loses its infatuation with passive investing. At that time, I will stand for what I know is right, just as I do now.

Own Equities. Diversify Globally. Rebalance.

Remain Disciplined. Live Life on Purpose.

Simon Joshua is a licensed investment advisor representative at Cornerstone Wealth Partners in Michigan. He has structured his practice around investor coaching and committed himself to leading communities in establishing a legacy of fulfillment.