A critique of the claim that passive investing is a bubble

I think this article really misses the point that Burry was making, which is that if the indexs see a sell off they won&#x27;t find the liquidity in the market to cash out their positions and will drive the market down.<p>This article seems to focus on all of the upsides of indexing, which are all true. However, those upsides don&#x27;t negate the risk that is being pointed to.

I believe index funds are a good investment strategy, but at the same time we shouldn’t get defensive when people criticize them, and call a thoughtful critique “silly”. In fact I would like to hear <i>more</i> intelligent criticism of index funds, and thoughts around preparing for a hypothetical world in which index funds were overrated, not less.<p>How might we notice that index funds were becoming overrated? Perhaps the rise of hedge funds which consistently outperformed index funds? Is that happening?<p>What should we do if index funds became overrated? Move our money into a medium-size number of stocks, like 30 of them, to essentially do our own index selection? Or moving out of stocks entirely?<p>Thinking about questions like this without attacking criticism as “silly” is IMO a better way to minimize risk.

The &quot;this time is different&quot; crowd rides again.<p>Burry highlighted two simple truths of financial markets: people will buy shit they don&#x27;t understand, and people who make financial products will try to earn a liquidity premium by transforming something illiquid to something liquid (which always blows up).<p>Most people (who I have met) who own passives have no idea what they are buying but are sure that buying passives makes them very smart. This blows up every time.<p>I also don&#x27;t think Burry was making some bombastic claim about 100% of ETFs causing the end of civilisation. He was making a limited, reasonable claim about trends in markets. Yes, he generalised but, in my estimation, he has earned that right.<p>Simply, going from 0 to $300m+ earns you that right. Very few people have achieved that. Very few people have done it in the way he did (taking real risk). The views of a triggered financial adviser leeching off his clients don&#x27;t hold as much weight (and shows all the self-awareness of a financial adviser to write a post implying they should).

One question I have about Burry&#x27;s comments that isn&#x27;t (directly) addressed in this article relates to Burry&#x27;s observation that trading volumes are remarkably low relative to the value of assets pegged to the equities being traded. For example, he remarks that over half of the S&amp;P 500 stocks trade under $150 million daily, despite trillions of dollars in assets globally indexed to those stocks. (And he notes that almost half of Russel 2000 stocks trade at less than $1 million during the day.)<p>My question is, does this imply that there&#x27;s substantially more synthetic indexing (without ownership of the underlying securities) than we realize? If there are trillions in indexed assets where the funds owned the majority of the index components, wouldn&#x27;t average daily inflows lead to higher trading volumes than we&#x27;re seeing? Or are the market makers such a huge portion of the market that they act as a massive collective buffer causing very few shares to actually be traded?

As I read it, the word bubble in the Burry interview was really just used for clickbait purposes - his argument wasn&#x27;t so much that index funds are overvalued, it was that there&#x27;s opportunity in small caps because they&#x27;re underrepresented in index funds, and everyone else is investing in index funds.

&gt; <i>Yes, index investors are free riders, but this is the way most markets work. We don’t go to the grocery store to bid on prices of oranges against one another to set an equilibrium. The market does that for us.</i><p>Actually, our behavior does shape the price of oranges. If we go to the store and they&#x27;re less expensive, then we are more likely to buy them. The analogy breaks down because he&#x27;s comparing indexes and oranges, not stock indexes and food indexes. Imagine if 14% of people went to the grocery, picked up a sack of pre-selected items that were best sellers last week -- all in the name of efficiency and reducing overhead. That would be quite weird indeed, and some people would point out that if enough people did this it would create market inefficiencies and potentially cause a glut or crash of certain food prices.

Does this guy not see the contradictions in his own argument? He simultaneously believes that active funds are doing a fine job of price discovery AND that managers at active funds who deviate too much from their (passive) benchmark are likely to be fired.<p>Also he jumps around Burry&#x27;s arguments by focusing on liquidity and in AAPL and FB. Burry&#x27;s whole point is about less liquid components at the bottom of indices which are getting dragged upward by a lack of price discovery and inclusion in widespread passive funds. Since they&#x27;re market-cap weighted, this would have a cyclical component, more passive purchases -&gt; higher market cap -&gt; higher weighting in passive indices -&gt; more passive purchases. This would result in another cyclical component where that cycle causes: passive fund outperformance -&gt; increased investing in passive funds -&gt; passive fund outperformance.<p>Then in an event where people start liquidating there is no one there to purchase those stocks and they&#x27;ve been dramatically overvalued anyways so their price gets crushed. This is specifically why Burry likes small cap active.<p>If you pay attention to finance discussion on this board then you&#x27;ve definitely heard the phrase: “The market can stay irrational longer than you can stay solvent.” The argument here is that irrationality has persisted long enough to crush most &#x27;rational&#x27; price discoverers.<p>&gt;Do you know what didn’t cause the Great Depression or Japan stock market crash or 1987 crash or 1973-74 bear market? Index funds. Index funds also weren’t around for the South Sea bubble in the 1700s. Do you know what did cause these bubbles and subsequent crashes? Human nature.<p>Imagine doing this but replacing &#x27;index funds&#x27; with mortgage CDOs.<p>Look I&#x27;m not even saying Burry is right but the absolute inability of the finance commentariat to actually address what he&#x27;s saying is giving him more credence.

&gt; When an index fund investor sells, they’re technically selling their holdings in direct proportion to their weighting in the index. So there is literally no market impact.<p>Correct me if I’m wrong but isn’t there a well known price premium for stocks included in major index funds? As I understand it, the most popular indexes target a few companies, thus index funds that track them funnel a disproportionate volume of demand to those companies causing a price premium.<p>It’s stands to reason that if a sudden outflow of money from index funds occurred, that price premium would swing the equal and opposite direction.

I just looked at the prospectus for one index ETF I own [1]. It actually has a lot of wiggle room. 10% of assets can be invested in things that aren&#x27;t in the index. The 90% that&#x27;s guaranteed to be invested in index assets is also not guaranteed to be exactly weighted by market cap. The fund is not even required to own every asset in the index.<p>I don&#x27;t know what other ETFs have in their prospectuses, but this wiggle room seems like it could mitigate some of the concerns about crashes due to low liquidity in thinly traded stocks.<p>[1] <a href="http:&#x2F;&#x2F;hosted.rightprospectus.com&#x2F;ETF&#x2F;Fund.aspx?dt=P&amp;cu=808524102" rel="nofollow">http:&#x2F;&#x2F;hosted.rightprospectus.com&#x2F;ETF&#x2F;Fund.aspx?dt=P&amp;cu=8085...</a>

Reminder: &quot;index funds&quot; are also managed by humans. For example, all stocks in the S&amp;P 500 are chosen by Standard &amp; Poors. Stocks are added and removed as they see fit based on various criteria such as profitability, float, market cap, &amp;c. The only things that I can see that truly differentiate S&amp;P from other active managers are that they<p>(a) have very little skin in the game.<p>(b) they get to make decisions about what other people have to do with their money<p>(c) they tend to recommend more stocks with less turnover than typical active managers<p>(d) they tell the public ahead of time what will be bought or sold, so traders get to buy&#x2F;sell ahead of time<p>(e) their actions are relatively predictable, thanks to a long history of sticking to their stated goals.

I&#x27;m a little confused about the point about index funds being a small percentage of assets, when there are constantly articles like &quot;Passive investing automatically tracking indexes now controls nearly half the US stock market.&quot; <a href="https:&#x2F;&#x2F;www.cnbc.com&#x2F;2019&#x2F;03&#x2F;19&#x2F;passive-investing-now-controls-nearly-half-the-us-stock-market.html" rel="nofollow">https:&#x2F;&#x2F;www.cnbc.com&#x2F;2019&#x2F;03&#x2F;19&#x2F;passive-investing-now-contro...</a><p>His graph shows an arrow pointed at the small sliver on ETFs, but that isn&#x27;t necessarily the same as passive investing which would include a lot of mutual funds.

&quot;When an index fund investor sells, they’re technically selling their holdings in direct proportion to their weighting in the index. So there is literally no market impact.&quot;<p>Have to take the rest of the article with several grains of salt after reading this. Even if the index was spread against all stocks it would have an impact. It implies that you can only move money around the market, not take it out of the market altogether.

It doesn&#x27;t seem silly at all. I agree with Michael Burry; I think passive investing is a bubble -- by definition. If you spent $10 million to make a cafe in your small hometown, you would never get that money back for the obvious reason that you could simply never sell that much coffee. The fundamentals aren&#x27;t there.<p>So if you invest in &quot;all coffee shops&quot; or &quot;all shops in my hometown&quot;, you&#x27;re not looking at fundamentals, you&#x27;re investing to invest. And, by definition, (assuming all shops are priced correctly) you&#x27;re artificially inflating.<p>If someone invests across a group of stocks, it&#x27;s because &quot;the market always goes up over time.&quot; And if enough people believe that then it can be true for a very, very long period. But eventually it becomes your $10 million coffee shop. It&#x27;s a bubble. And even a bubble that lasts decades will eventually pop.

Meta: I read articles like this, and some of the 5+ paragraph comments on this site, and it makes a ton of sense to me why people are downright afraid of the work required to learn how the economy works at a low level. It&#x27;s crazy how often probabilities are presented as fact.<p>My mother-in-law works for the state doing financial investing, and I&#x27;ve seen some of the functions and constant values she&#x27;s had to memorize to get her degrees. Constants that are based on models that are often decades old. It&#x27;s all ultimately a form of forecasting based on models, but it&#x27;s treated as gospel of how it will all occur.<p>Perhaps that&#x27;s why it works at all - everyone&#x27;s using the same models, and they behave in a set pattern (established by schooling and &quot;how it&#x27;s always been done&quot;) based off those models, which makes the models accurate.

The dig at &quot;Active Management&quot; feels like it detracts from the article, but I guess they&#x27;re playing a bit to the audience.<p>What I found a little more concerning is their glossing over of the liquidity risks. If everyone wants to sell an index, then at some point that index needs to liquidate shares (proportionally). Those shares won&#x27;t have uniform demand, which is going to cause both price fluctuations (drops) which affect the value of the index. The fun part here too is that this can play some havoc with market-cap weighted indexes, which now need to adjust their holding %&#x27;s.

It depends on whether and to what degree indexes are affecting price discovery:<p>If prices are being set predominantly by active investors who are truly buying and selling <i>based on bottom-up, security-level research</i>, then the percentage of assets that happens to be invested in passive funds is not that important, because price discovery would be working exactly as you and I would hope.<p>But if prices are being set predominantly by (a) active investors who are <i>chasing indexes because they don&#x27;t have a choice</i>, (b) active managers who are <i>being forced to sell positions</i> to cope with a high rate of redemptions (from investors who plow that capital back into passive strategies), and (c) traders who grasp this dynamic and shrewdly exploit it for as long as possible; then price discovery might not be working as we would hope. Prices would no longer be reflecting perceived risk; they would be reflecting the (temporary) influence of this once-in-history dynamical process.<p>Burry makes a compelling case, I think, that the latter is a more accurate description of the current state of financial markets than the former, and that this state of affairs can only persist so long as capital continues to flow from active to passive strategies at such high rates. Globally, assets under management are not infinite, so capital cannot flow indefinitely from active to passive strategies: Sooner or letter, this dynamical process must exhaust itself.

His point about the increase in volume leading to price discovery is laughable. More algos than ever are trading with each other on the subsecond scale but that means nothing for long term equity values. With the rise of index tracking there are fewer than ever investors actively positioning themselves against a standard indexed allocation by picking good and selling bad stocks. Indexing is riding the boat buying everything in equal components due to market cap weight.

IMO the real issue is amount of cash available for investment and the lack of investable assets[1].<p>If i were king for a day I&#x27;d legislate a low bar that required the equities to be listed so that both the insiders cannot be barred from liquidity and so that the investing public can access those parts of the economy.<p>[1]: <a href="https:&#x2F;&#x2F;personal.vanguard.com&#x2F;pdf&#x2F;ISGPCA.pdf" rel="nofollow">https:&#x2F;&#x2F;personal.vanguard.com&#x2F;pdf&#x2F;ISGPCA.pdf</a>

At some point, someone (or a collective) needs to make a decision about how capital is allocated among different firms.<p>Traditional money managers may not be the right way to do that, but we should be clear that decisions are still being made somehow.<p>I guess it&#x27;s not the investors plowing money into the first index fund they find. And it&#x27;s not the index fund, because they don&#x27;t do a lot of management.<p>So I guess it&#x27;s a handful of hedge funds that set prices?

I find it grimly amusing that the posters here expressing variations on the &quot;this is fine&quot; position are making the exact arguments that market boosters were making before&#x2F;during the mortgage finance crisis in 2007&#x2F;2008.<p>The problem with those arguments is the fact that what turns a recession into a depression is demand strikes: when the people with cash lose faith in the integrity of the market, they just take their money off the table and go home. Arbitrage and market correction dynamics cease to function.<p>The fact that depressions can be caused by collapses in demand as well as in supply was the key insight of Keynes et al. in the 1930&#x27;s, which is why he argued that the government must have the power to regulate markets and the authority to step in and become the buyer of last resort in the face of an incipient depression.<p>Keynes&#x27; insight was conveniently forgotten by the early 2000&#x27;s, regulation was resisted, the shadow market grew out of bounds, bailouts and stimulus met political resistance, and the rest is history.<p>How short the time span of memory is.

Now my main concern with index funds I hold (broad market&#x2F;large cap) is that I definitely have exposure to businesses (e.g. fossil fuels) that I don&#x27;t actually want to be invested in.<p>Anyone have suggestions on the best sustainable ETFs out there?

I think this idea of an index fund bubble makes a lot of sense in terms of metrics like economic efficiency. Investors are paying more money to buy stocks which provide less economic value per dollar invested... but low productivity and economic inefficiency doesn&#x27;t mean low profits. Indexed companies often have monopolies in their fields and can derive profits from rent seeking activities and lobbying for beneficial regulations so they don&#x27;t need to be efficient in order to derive profits.

I believe what’s missing from the recent analyses of beta&#x2F;index investing is that alpha continues to lag when in theory stock pickers should be able to find more mispriced assets. Although volatility around earnings (which serve as valuation reset) has generally increased. Unprecedented bull market and 3&#x2F;4 of investable wealth now pooling into passives funds simply cannot be overcome. What it does provide is significantly asymmetrical opportunities shorting single stocks.

Wasn&#x27;t the housing bubble driven in part by a form of passive investing, namely bundling mortgages (one of the &quot;safest private investments&quot;)?<p>Economic systems are feedback loops. If something is the best investment that causes it to become a bad investment in proportion to how rapidly people realize it&#x27;s a good investment.

In these times I&#x27;m looking at more conservative &quot;passive investments&quot; such as interest bearing accounts, FDIC insured. With Twitter posts resulting in large swings in the market, I declare &quot;market manipulation&quot; by those with large numbers of followers.

For those interested in this topic, Horizon Kinetics&#x27; 2016 presentation &quot;Indexation: Capitalist Tool&quot; is a fascinating read, as it points out some baffling structural mismatches between indexes and their underlying securities beyond just liquidity (which was the main focus of Burry&#x27;s analysis).<p><a href="http:&#x2F;&#x2F;www.grantspub.com&#x2F;files&#x2F;presentations&#x2F;Grant&#x27;s%20Conference_Oct%204%202016_Steven%20Bregman_Final[2].pdf" rel="nofollow">http:&#x2F;&#x2F;www.grantspub.com&#x2F;files&#x2F;presentations&#x2F;Grant&#x27;s%20Confe...</a><p><i>Edit</i> Some highlights:<p>&gt; Does an asset allocation program or roboadvisor tool seeking foreign market exposure know that 6 of the top 10 holdings of the iShares MSCI Spain Index get 70% or more of their revenues from outside of Spain? That a purchase of the ETF is, essentially, investing outside Spain? The same holds true for emerging markets ETFs.<p>&gt; the business demand of ETF organizers for liquid stocks has only increased, with the influx of funds directed into the same limited population of liquid stocks. ExxonMobil is one of the most liquid. Ergo, it will be found almost anywhere one can imagine that it can be placed. It’s Growth, It’s Value, Its’ a Bird, It’s a Plane...<p>&gt; Would an active manager of a low-risk strategy be permitted the risk of a near-50% weighting in financials? ... These largest-in-class ETFs can legitimately be characterized as low volatility, since of late the financial sector has not been volatile. And the high weighting enables the ETF to attain its advertised low Beta.

If an index selloff could cause a drop in underlying stock price, wouldn&#x27;t we see this effect when stocks are relegated from various indexes? Does this effect exist?

Back in 2007 you could&#x27;ve made a similar chart to show that CDOs are a small amount of the market.<p>What&#x27;s unclear is the impact that ETFs have on prices. This &quot;debunking&quot; doesn&#x27;t address the point about low volume.<p>Let&#x27;s suppose most of those non-ETFs owners are buy and hold investors that bought in a long time ago and wouldn&#x27;t buy anywhere near today&#x27;s prices.<p>That would mean ETF holders, especially those who joined late, could still be responsible for a disproportionate share of today&#x27;s prices. If the market shows signs of weakness, these people need to get out, especially if they bought on leverage.

As others have noted, there&#x27;s a lot here that isn&#x27;t relevant to Burry&#x27;s argument, but this seems like the key rebuttal to me:<p><i>Active funds literally own the market. When you buy an index fund of the total stock market, you are literally buying the stock market in proportion to the shares held by all active investors. If you sum up the collective holdings of active managers, what you basically get is a market-cap-weighted index. Index fund investors are simply buying what the active investors have laid out for them.</i><p>I don&#x27;t have the knowledge to evaluate this statement, but to me, it undermines Burry&#x27;s point that passive investing distorts prices.<p>And this bit that he quotes from someone else expands on the point:<p><i>The use of price signals by those who played no role in setting them may be capitalism’s most important feature. That most of us and most of our dollars don’t have to pick stocks, or to price air conditioners, is a great benefit and taking advantage of it makes us honest smart capitalists, not commissars.</i><p>As I understand it, Burry&#x27;s argument is that index funds distort prices because capital is being allocated in an automated and uniform way, instead of being allocated according to the expertise of a diverse, success-weighted group of investors who are motivated to make intelligent and informed decisions. At some point the difference between the index-fund-driven prices and the &quot;true&quot; prices according to informed opinion will become obvious, and investors will attempt to flee index funds, popping the bubble. The rebuttal in this argument is that active investors are still controlling the market because index funds mirror their activity. We will never reach a state where people will rush to &quot;escape&quot; from the index funds to actively managed funds, because index funds will always approximate the aggregate opinion of the actively managed funds.<p>This accords with my naive idea of how index funds work, but I don&#x27;t know if they actually <i>do</i> work that way, so I can&#x27;t evaluate the soundness of either argument.

I don&#x27;t buy the liquidity argument. Their mere existence creates liquidity. Two sides to every trade. Index fund &quot;sell offs&quot; will likely go to buyers of the same index fund shares but at a lower price.<p>Apple alone has $50 billion in cash that will flow into Vanguard if index funds hit a 50% plunge. Same with Buffet. Index funds may be bubble priced, but they don&#x27;t suffer from a liquidity issue.

&quot;When an index fund investor sells, they’re technically selling their holdings in direct proportion to their weighting in the index. So there is literally no market impact&quot;<p>This is a straight out false statement. Who is this guy again? Oh yea, he has his hands in passive investment big time.

That is a very confusing headline.

yes!

I think someday we will think that index funds were pernicious but we don&#x27;t understand entirely why yet.<p>If you believe, for instance, that there is an &quot;S&amp;P 500&quot; bubble then there is difficulty turning that into an investable thesis. The S&amp;P 500 is about 80% of the valuation of the stock market. If the S&amp;P 500 pops, then relatively the other 20% of the market will go up, but how much can it go up?<p>The most harmful effect we know now of the passive funds is that they have a strong incentive (when they vote their shares) to discourage competition. If they own both AT&amp;T and Verizon they would rather both of these be profitable at the expense of consumers rather than work hard to gain market share for one or the other.