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Why Index Funds Are Like Subprime CDOs

359 points by kgwgk 7y ago

Peej255 7y ago
If true what's the hedge? Pension and investments to cash and bonds? Japanese stocks?
- 5822130027 7y ago
  All types of investment in every country is subject to financial repression. You could own gold, but wait ! any gain is taxed as income ( not capital gain ). Carrying it around has stiff penalties. "You invest in how we say you invest" - Uncle Sam.
  - daxorid 7y ago
    Carrying it around has stiff penalties. What are the penalties for carrying bullion?
    - sigstoat 7y ago
      you get tired easily?
  - nradov 7y ago
    Taxes aren't repression.
    - SkyBelow 7y ago
      Unequal taxes seems a valid form of repression. Start with something simple, say taxing people of one race 15% more than another race. That would seem a valid form of repression. Okay, so that rarely happens and is almost always combined with far greater forms of repression. But there are less extreme examples. What about taxing someone more when they have kids, or more when they don't? Sin taxes also seems a way to repress certain behaviors in society by increasing their cost. Why can't the logic apply in other areas of life where tax rates are unequal?
    - turk73 7y ago
      Taxes are involuntarily extracted at gunpoint. Is that not coercive?
- Zhenya 7y ago
  Gold or other hard commodities
- bklyn11201 7y ago
  The hedge to a portfolio full of heavily-indexed stocks would be fairly-valued, non-indexed stocks. Burry had to report his holdings in a 13F filing on August 14: https://www.sec.gov/Archives/edgar/data/1649339/000156761919016689/xslForm13F_X01/form13fInfoTable.xml https://www.sec.gov/Archives/edgar/data/1649339/000156761919... He holds heavily-indexed companies like Disney, Fedex, and Alphabet. He holds a couple of small-cap value companies that aren't likely to be included in more than a couple of small ETFs: Tailored Brands (Mens Warehouse) and Sportsmans Warehouse.
- tardo99 7y ago
  This reminds me of the article someone else posted today about six sigma, where commenters rightly pointed out that the methodology works until companies try to use it to replace actual thinking managers. The hedge is simply to pay attention and make your own decisions. Index funds are great in general, but not when markets get out of whack (bubbles, etc).
groundlogic 7y ago
Not an economist, but it's obvious to anyone used to thinking in terms of systems that index funds can't work after a certain amount of the money poured into the system is managed by index funds. What's the limit - 30% 40%, 50%, 60%? What's the current level in terms of managed capital? (Edit: https://www.cnbc.com/2019/03/19/passive-investing-now-controls-nearly-half-the-us-stock-market.html https://www.cnbc.com/2019/03/19/passive-investing-now-contro... says 45% for US stock-based funds, half a year ago, so maybe like 48% now) I wonder if the endgame is that index funds won't be allowed to trade on the the stock exchanges? I can't imagine how that would be enforced. "Mr/Mrs/Ms Fund manager, you've been trading too close to the index, we'll be forced to terminate your access to the markets"?
- avvt4avaw 7y ago
  You only need the marginal investor to be informed, so it's not clear that you couldn't have a much higher percentage of passive investment (say 90%) and only a small amount of active investors who are providing price discovery. The bigger problem is that most passive investments are not really passive - for example, choosing to invest in a "passive" S&P 500 ETF over a "passive" Russell 2000 ETF is an "active" investment choice (preferring large cap over small cap) so valuation errors and bubbles could develop in segments of the market, even if constituents with an index are all fairly valued relative to one another. These valuation errors could sustain for a long period of time, because it takes much more money to correct a valuation error in a huge market segment than it takes to correct a valuation error in an individual stock.
  - davidw 7y ago
    This lists 3575 stocks among its holdings, which includes both large and small cap stocks: https://investor.vanguard.com/mutual-funds/profile/overview/VTSAX/portfolio-holdings https://investor.vanguard.com/mutual-funds/profile/overview/...
    - avvt4avaw 7y ago
      Sure, which is why I said that _most_ passive investments are not really passive. Vanguard Total Stock Market is pretty passive, as long as you consider your investment universe to be "US stocks". But even in this case the fund only holds stocks (no bonds or real estate) and only US stocks at that (no international or emerging market exposure).
throwaway713 7y ago
Can someone who understands investing well explain what he’s saying in terms that someone who isn’t knowledgeable about this could understand? I kind of think he’s saying that everyone is just shoveling their money into index funds without thinking about it and this leads to incorrectly valued stock that will correct in the form of a crash at some point. Is that sort of the gist of it?
- notyourday 7y ago
  When people invest money into index funds, then the funds must spend all that money buying the shares of the underlying fund companies. So that creates tons of buy orders for the underlying stocks, which creates the buying pressure, which makes the prices rise. As long as more money comes into the index funds the prices of underlying stocks will keep rising. But the higher the prices of the underlying the more money needs to come in to buy them at those prices. What eventually happens is that there's not enough new money coming in for index fund buy orders to maintain the bottom of the underlying prices, which means that the prices start drifting lower, the popular financial press goes nuts, CNBC/FoxBusiness/WallSt Journal/etc blast it in the headlines and the same way goes the other way. People start selling their index funds, which makes the index funds sell the underlying which creates a massive wave of the sell orders creating a downward pressure, which in turn puts brings the indexes lower which makes press go screaming more which causes more people to want to "protect their test egg" by selling the index funds they had.
  - UnFleshedOne 7y ago
    So, a normal decade in the markets?
    - notyourday 7y ago
      A bit more exciting probably since the market is higher now which means that the oscillation will be more impressive. The rest is chicken little - we got into that mess before because neither CDOs nor CDSs were liquid which means that as long as they were not trading banks were able to continue book them at the nominal value and since to trade them one needed to have banks that were on a hook for them to do the trade nothing was moving. That's the biggest issue with those kinds of instruments. Nothing of sort could happen with the index funds because both the derivatives and the underlying are sufficiently liquid, so the drop won't be 100->20 but rather 100->99.9->99.8->99.7->....->20.1->20 which in turn would re-balance everything.
spenczar5 7y ago
He says he's (reluctantly) doing active stock picking. He's a professional investor; I'm just some software engineer with a nest egg, which is 100% in index funds today. What should I be doing, as a schmoe who wants to save money?
- godzillabrennus 7y ago
  Take a look at opportunity zone funds today. You can pull your money out and pay zero capital gain taxes for seven years. Then get a 15% discount on your capital gains at that time. All returns you realize from the fund are capital gains tax free. The benefits end this year.
  - the_watcher 7y ago
    I know a bit about Opportunity Zones (roommate bought property that was subsequently designated one, to his delight), but not about the funds. Do you have any particular recs on where I can read up on them?
    - bklyn11201 7y ago
      This is likely the best first stop for OZ info from a reputable source: https://www.novoco.com/resource-centers/opportunity-zones-resource-center https://www.novoco.com/resource-centers/opportunity-zones-re... The timing restrictions around OZ investments (180 days after cap gains event) make it a bit difficult and will result in lots of bad investments with non-experienced, first-time fund owners. But maybe you have a connection to an OZ that you are familiar with and can rehab a property there. You should get help from a CPA and lawyer, but the basic process would be: 1) Sell stock and now you have cap gains 2) Setup OZ Fund XXX LLC 3) Fund the LLC with your cap gains within 180 days 4) Setup OZ Property YYY LLC 5) Purchase property inside the YYY LLC and fund purchase with XXX LLC 6) Rehab property within 31 months 7) Hold for 10 years a) Pay original cap gains tax bill (minus 15%) in 2026 tax year (negative interest loan from gov) b) Pay zero cap gains on the increase in property value over the 10 years
    - aoeusnth1 7y ago
lukewrites 7y ago
The discussion of this on the Bogleheads forums, a community dedicated to low-cost investing primarily via indexing, provides an interesting counter-point to Burry's opinions: https://www.bogleheads.org/forum/viewtopic.php?f=10&t=289284 https://www.bogleheads.org/forum/viewtopic.php?f=10&t=289284
- 0xcafecafe 7y ago
  This is a good point: Post by ltlurker » Thu Aug 29, 2019 1:24 pm I'm an index investor, like most Bogleheads, and I subscribe to Bloomberg digital so I can read articles such as this and did see this one at lunch (EDT). I'm open to various perspectives especially if there appears to be a rationale behind them. And of course this individual was behind the "big short" so that intrigued me. If I recall correctly, I believe his position is that Index funds tend to favor the largest companies - naturally - as they're mostly market cap weighted. The S&P 500 as we've noted is widely invested in, but the Total Stock Market also has an average weighting that makes it a Large Cap Fund - by Vanguard's standards. Relatively few people directly invest in the Russell 2000 Index or even have those options in their employers' retirement plans. (I have the opportunity to invest in the Completion Index in my retirement plan so that's partway there). I think Burry sees this as an opportunity to look at small cap value, which has been out of favor and not had a good run for some time. I think he must be thinking that a reversion is going to start at some point. None of us can know when, of course. And of course others are looking at the ratio of stock valuations to GDP (apparently one of Warren Buffet's key measures) and believe that there's significance to that, as well.
  - lotsofpulp 7y ago
    There are fewer publicly listed companies than ever before: https://www.nytimes.com/2018/08/04/business/shrinking-stock-market.html https://www.nytimes.com/2018/08/04/business/shrinking-stock-... >In 2015, for example, the top 200 companies by earnings accounted for all of the profits in the stock market, according to calculations by Kathleen Kahle, a professor of finance at the University of Arizona, and Professor Stulz. In aggregate, the remaining 3,281 publicly listed companies lost money. I'd love to see 2016 to 2019 stats on that, but I think there are structural advantages (proliferation of databases, price transparency) that large corps are enjoying right now with which small companies just can't compete. Technology is obviating many people (and therefore businesses), and allowing the big to get bigger with no marginal cost. Would you bet against the top ten holdings in VTI, which take 1/5th of all investments? https://investor.vanguard.com/etf/profile/portfolio/vti https://investor.vanguard.com/etf/profile/portfolio/vti And also, we know the government will bail out all large entities, especially if many voters are invested in them (which they are due to 401k/pension funds being invested in the very same companies). Who is going to outcompete the few big airlines, telecom providers, FAANG, hotel brands, car rental brands, banks, pharma companies, etc that have national and worldwide reach? I'm sure a few companies here and there might, but by and large, I bet the big players are here to stay (until the whole system breaks down, but then you have bigger problems).
southphillyman 7y ago
Timely article, I was just thinking about this last night...while browsing Vanguard's site looking for index funds to invest in. Everyone blindly putting their money into similar instruments and getting double digit gains nearly every year just seems like it can end catastrophically. I want to do more research on how these passive funds affect the overall market and vice versa.
- lunchables 7y ago
  Aren't most of those double digit gains just from the market rebounding from the 2008 recession?
  - FabHK 7y ago
    Yes, and in particular they would indicate lower future returns for the equity market as a whole, but that has nothing to do with the issue here, namely ETF/index fund vs. non-ETF/index fund.
  - southphillyman 7y ago
    Rebound to inflated values? Reminds me of the housing market in my area now. It's "rebounded" to higher than 2008 levels on the basis of speculation and gentrified neighborhoods being hot. Seems like another bubble. I need to do more research, but I'm curious what the long term viability of these index funds are as more and more people gravitate towards them
    - lunchables 7y ago
      I was thinking more, rebounded to 2008 levels + inflation?
- Kiro 7y ago
  Stupid question but what are you looking for when browsing Vanguard? I thought all the index funds were the same, just following the index.
  - 7y ago
jorblumesea 7y ago
There are ways to get more diversity within indexing itself. eg: small cap index, value index funds. It seems like the bone of contention is that indexes track the entire market based on trading volume, and that is an existential risk given cap weighting. Many now invest in total market indices, which limits the impact of large cap companies. The "cap weighting" problem is a known issue in indexing and this is why you invest in total market, small cap, mid cap indices.
- sigstoat 7y ago
  equal-weight (instead of cap-weighted) funds are also a thing, and perhaps relevant if you want to spread your investment across more of the market: https://www.invesco.com/portal/site/us/ria/etfs/strategies/equal-weight-investing/#tab_tab3 https://www.invesco.com/portal/site/us/ria/etfs/strategies/e...
pwthornton 7y ago
Isn't a big part of the issue with actively managed funds the fees, which usually wipe out any gains above index funds. Wouldn't the market correction be to close the delta in fees between active and passively managed funds to encourage more people to go the active route? A lot of the grousing about passively managed funds come from people who are running actively managed funds that charge huge fees to under perform passive management. By lowering fees, actively managed funds should be able to do a better net and to be able to attract more investors. Any sort of government solution to index funds getting large would basically be protection for these actively managed funds. There are actively managed funds that can beat passive funds, but it's incredibly difficult to do so when you charge a 2% fee.
- whatok 7y ago
  You can't run most active management strategies on anything approaching the average passive fee structure. Additionally, you run into problems with scale. An S&P 500 tracking fund scales extremely well and could add several billion of AUM without having to incur additional expenses. A long only equity fund would probably not be able to do the same without hiring more people, building more infrastructure, etc.
  - pwthornton 7y ago
    I get that the fees can't be comparable, but without passive management, active management fees are unchecked, and they rose a lot over time. I'm willing to agree that it should cost an order of magnitude more for an actively managed fee, but most are beyond that. A lot of this seems like plain greed to me, combined with grift and graft. A lot of workplace plans try to funnel people into actively managed funds that often charge really high fees.
    - whatok 7y ago
      I'm not sure how fees are unchecked. Active management fees have fallen quite a bit over the past 5+ years. A lot of mediocre managers have gone out of business and many more probably will as well. Additionally, new fund launches are near all-time lows.
chad_strategic 7y ago
I have been saying this for years... Passive investing is great. Especially since the S&P 500 has been up for ~10 or years. It's when passive investing becomes panic investing (sell everything).
markbnj 7y ago
Not knowledgeable on these matters, so my money is in index funds. Obviously a lot of other people are in the same category as myself. The article seems to be saying we'd all be better financial citizens if we put our money into actively managed funds, or did our own investing. The latter is out of reach for most people, and with respect to the former it's somewhat puzzling that managed funds can't consistently outperform index funds (https://www.cnbc.com/2019/03/15/active-fund-managers-trail-the-sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html https://www.cnbc.com/2019/03/15/active-fund-managers-trail-t...), and so the managers of those funds in a strict sense don't earn their fees. So what is the average person with a couple bucks to invest supposed to take from this? The market is in peril because not enough money is flowing to people who do a poor job of managing it?
- 6thaccount2 7y ago
  This is my question as well.
- blankaccount 7y ago
  The article is claiming that index funds are an overhyped bubble, so of course they'll out perform actively managed funds that have better liquidity.
  - TimTheTinker 7y ago
    Perhaps they have become that because of their publicity. But when all the financial gurus are recommending investing in traditional securities (stocks and bonds), and millions of people wishing to get a leg up in life obey their advice, doesn't that turn the securities market in general into an "overhyped bubble"? The market behavior and health of any investment, no matter how theoretically sound it is, will be strongly affected by investors' behavior around it. So the fact that index funds are popular (and thus perhaps inflated/overpriced) isn't a knock on the fundamental idea. It's merely an indication of a particular market situation at present.
    - blankaccount 7y ago
ineedasername 7y ago
How can index funds that track the market actually distort the market? In the alternative, wouldn't the same amount of money just be invested in stocks individually? Wouldn't even a small number of active investors jump on distortions and quickly provide more accurate pricing?
yalogin 7y ago
This sounds like good logic. There is one piece of information missing. Did the onset of index funds add more money to the pool? What I mean by that is did people move out of regular stocks into Index funds or did they move out of mutual funds into them? How much is the difference?
amadeuspagel 7y ago
It's a bit self-serving for a hedge fund manager to criticize index funds.
cybersnowflake 7y ago
Accepting that actively managed funds are better than passive index funds is basically acceptance of the classical mentality that there are people who can consistently predict and beat the market and that you can make money by picking the 'right guy'. I assumed most knowledgeable investors abandoned that philosophy in the 80s/90s
- KingMachiavelli 7y ago
  (This is my understanding of the artical with some help from other comments. I probably use some words incorrectly but I think you can get the jist) TLDR: He is't abandoning the current stance that passive > active but rather is discussing the real value of the underlying assets. And he isn't challenging on that stance either. I don't think the artical is out right advocating people to switch their personal investments from a passive index fund to an active one since he & we both know that passive funds tend to do as well or better than active funds after accounting for fees. However, the article (at least how I understood it) is saying total effect of everyone moving their money into ETFs and index funds means that the underlying stocks have an increasing risk of becoming or being overvalued since no one is checking the underlying stocks/companies anymore. As someone just tangentially interested in this topic I've thought of this before in a more tangable way: since every college graduate or hacker news type person knows that index funds are the best then at some point 'everyone' or enough of the population has a stake in index funds that it's likely to be overvalued. The market should/could correct as expected: undervalued companies go unnoticed longer since everyone is passively investing causing actively managed funds to have higher yields (since they can get 'all' of the undervalued companies passive investors miss) and people adjust their holdings accordingly. However, as a few other users stated there a few issues trying to hedge against a buble: 1. Solvency - The market remains 'irrationally' attatched to passive/index funds which means that index funds continue to beat active funds anyway despite their 'real' value/gains being pure speculation. It's difficult convincing people to let you manage their money when your making 4% and the S&P400 is making 8-11% so remaining solvent is an issue. 2. Systemic Risk - Large markets & financial products are intertwined so if index funds are overvalued then it effects the economy & financial institutitions and if it crashes/pops then it sends a shock wave throughout all of them. Finding a hedge that isn't effected by a bubble in one financial product (CDOs, index funds, etc) can be tricky.
graeme 7y ago
Index funds definitely have a free rider problem. Warren Buffett lucidly pointed out that the average performance of active investors will be....the market average. You cannot, by definition, have a majority of investors beating the market. And once you add in fees, index funds produce above average performance, as they have low fees. So far so good. But, the index funds are free riding on the decisions taken by active investors. Active investors do a useful service to the world by moving capital away from inefficient companies and towards efficient companies. If the market gets worse at this capital allocation, we can expect overall lower returns. In other words, there's average market performance but also the factor of efficiency in capital allocation. This is related to but separate from what Burry talked about, I think. His central point seemed to be that valuations were based on very thin trading, and that when money is taken out of index funds, it will be very hard to find sufficient buyers without a large drop in prices. Add in to that complex derivatives etc used in making all the etfs work. That bit is somewhat beyond me though. Anyone got a good analysis of how that may play out?
- sokoloff 7y ago
  > You cannot, by definition, have a majority of investors beating the market. You cannot have a majority of money beating the market. It is mathematically possible for a majority of investors (each relatively small) beat the overall market (albeit unlikely). (I agree with your overall post, but not that line.)
  - graeme 7y ago
    Oh true
- sriram_sun 7y ago
  > But, the index funds are free riding on the decisions taken by active investors. I'm sure there is a pretty clear criteria for making it to the S&P 500 or the Nasdaq 100. Which means it can be coded up. Index funds don't track the investments of other active investors. They track the performance of companies (typically market leaders) based on some transparent and objective criteria. These performances could be tied to a multitude of factors - Founder managed, innovative, market focus, sales & marketing, slave labor, good copycats who knows (or cares?). The point is they've made it to the top of some list and are generating revenue within a system of "acceptable" checks and balances. If the company doesn't meet that criteria, it will be booted off of that list. The bet is always focused on objective criteria. None of that is free riding on active traders.
omarhaneef 7y ago
A lot of people seem to have read this and think that Burry is worried that the indices are weighted by market cap. That is not the issue. The issue is that a large proportion of the index is smaller caps that no one bothers to look at and price properly, and yet massive amounts of money are in ETFs and other contracts that take a position on those smaller, less followed names. So these small names in the large index have been artificially driven up. Sort of like CDOs. You just look at the rating, or the P/E of the 500 stocks in the SP500, but you don't bother to do a deep dive. Were someone to do the deep dive, you would see that they are massively overvalued (and therefore so is the SP500, for instance).
- jpalomaki 7y ago
  If the small cap valuations are totally wrong, shouldn’t some simple measures like P/E show it clearly? Edit: The P/E values on Russel 2000 seem to be almost double compared to S&P 500 [1]. Also some point out that the value is not correct as it leaves out negative earnings which are common among small caps [2]. [1] https://www.wsj.com/market-data/stocks/peyields https://www.wsj.com/market-data/stocks/peyields [2] https://goldco.com/russell-2000s-price-to-earnings-ratio-is-high/ https://goldco.com/russell-2000s-price-to-earnings-ratio-is-...
  - omarhaneef 7y ago
    I think the point is people use the measures that you can clearly see easily (like the P/E), and therefore you don't go down to the level of the stock (oh, temporarily raised earnings, forecast for reduced earnings, and as you point out, negative earnings etc). Note: this is not my argument, but what I understand Burry to be arguing.
motbob 7y ago
So there are two concerns here. One concern is a problem with a certain asset being inflated, in this case S&P 500 stocks, and the money you might lose if you hold those assets and their value goes down to normal. A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caused by a rapid bubble burst may cause a financial crisis. The panic of 2007 (or at least, the liquidity freeze part of it) was not directly caused by devalued assets, but rather the fact that banks relied on those assets having a certain value to do basic, short-term lending, and their confidence in that value was blown away. The second concern is not really a concern for long-term investors. Really, neither is the first. Maybe equity is inflated, but where else are we going to put our money? I think that this article is mostly about risk. If you are not too concerned with risk in your investments (which you should not be if you are more than 10 years before retirement, probably), I think this article doesn't say much about what you should do with your money.
- bob33212 7y ago
  A hedge from this theory would be to buy stocks just outside the SP 500? Something like TSLA. That would be a crazy situation, where the SP 500 is crashing and the rest of the market it taking off
  - motbob 7y ago
    I don't know about that. If a general financial crisis is the concern, stocks outside the S&P 500 would not be spared. What I got from this interview was just a reminder that it makes sense not to get caught up in enthusiasm for a certain asset. And investors (including me) are certainly enthusiastic about the S&P 500 index fund.
  - ChuckMcM 7y ago
    A simpler option is to buy options on the index. You can butterfly the index with calls and puts around your minimum return / maximum loss tolerance.
    - 7y ago
noego 7y ago
I think there are a few good points made by Burry. When comparing across different market segments, today's climate of popular-index-funds can cause bubbles in some segments. For example, everyone and their grandmother invests in the S&P 500, whereas much fewer people are investing in the MSCI EAFE. Because of this, VOO can become over-valued relative to VEA. I agree with this point and have wondered about it myself. I highly encourage everyone to diversify across all market segments, including the S&P 500, mid-cap, small-cap, developed markets and emerging markets. That mitigates the potential S&P-500 bubble that Burry might be warning against. But that said, I don't think it's fair to accuse index funds of causing specific stocks to become over-valued relative to other stocks within the same index. By design, market-weighted index funds maintain the relative prices of different stocks within the same index. Ie, if a whole bunch of people sell their houses tomorrow and invest in the S&P 500, all the stocks in the index will get an equal percentage lift, and pricing ratio of GOOG to MMM will still remain consistent. Note however, that equal-weighted indexes do not have this property. Imagine if the US government decided tomorrow that it was going to invest $10T in the stock market, using equal-weighting. This would translate to ~$20B for every stock in the S&P 500. The biggest stocks like GOOG would see an incremental boost, because $20B is still only ~2% of their market cap. Whereas the smallest stocks in the index would see their share price skyrocket because $20B would more than double their market cap.
commandlinefan 7y ago
> Nobel-approved models of risk that proved to be untrue Makes you wonder how much more of this ends up remaining unquestioned until it’s too late.
jayalpha 7y ago
Horseman Global Unveils New Shorting Philosophy Using ETF Flows As A Catalyst https://www.zerohedge.com/news/2017-04-09/horseman-global-unveils-new-shorting-philosophy-using-etf-flows-catalyst https://www.zerohedge.com/news/2017-04-09/horseman-global-un...
thtthings 7y ago
What i think he is saying is this: If you look at s&p 500 stocks weight for instance, at number 483 is Rollins inc, weight 0.019938%. Do you know this company? But everyone here if you have invested in s&p 500 has invested in this stocks. The way s&p 500 works is it picks stocks based on market cap. Now this company has a very low chance of getting kicked out even if it is a dud as people keep investing in it via ETF's Here lies the opportunity. If you go through every company in s&p 500 you are going to find overvalued and undervalued stocks. One strategy is to pair trade. Take a long/short position. But it is very tough to time as every keeps investing every month. Other strategy is wait for a crash and instead of again investing in these ETF's for small returns pick stocks that got battered for no reason. This has inspired me to actually work a bit, actually looks at balance sheets and pick stocks. Side note, i only own one etf and it is PTF. It has very little stocks and i think focused funds are a better bet.
oli5679 7y ago
I think we aren't close to the margin where indexing is socially harmful. This article elaborates. http://www.philosophicaleconomics.com/2016/05/passive/ http://www.philosophicaleconomics.com/2016/05/passive/
darawk 7y ago
Burry is making a terrible case, and he's fundamentally wrong on basically all counts. > 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. Passive investing is, for the most part, not funging against dollars that would have gone to high quality asset managers. It is removing noise in the form of retail speculation from the market. Asset managers that consistently beat the market (i.e. facilitate price discovery) have no problem raising capital. > “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.” Trading volume != liquidity. They are related, but only indirectly. Liquidity is, for the most part, provided by market makers. Market makers are entities willing to take both sides of orderbook at all (or almost all) times. Most of the time, when you trade a stock, your counter-party is a market maker. Even if nobody is trading, that market maker is still providing liquidity. The liquidity is there, even if no shares are changing hands. Where this gets tricky is that market makers make their money by trading. If there is less volume, they may be willing to provide less liquidity. But it's not at all clear that this is a real problem yet, or that there is any major crisis of liquidity in the markets. The correct way to measure this is not to look at daily volume, but at slippage. How much does the market move when you attempt to buy a large block? I'm not certain, but I don't think this is a major problem for people right now.
atemerev 7y ago
There is no such thing as free money. There are no such things as riskless passive investments that beat the reference market rates (which are close to zero these days). Therefore, index funds carry risk. Therefore, somebody (the bulk of index fund investors) will have to absorb these risks. All of this is nearly obvious.
cm2187 7y ago
The reality is that before ETFs, the largest beta funds were already quasi-replicating the index, trying to beat it by just enough to compensate for the high fees. This low value added funds are simply being replaced by something cheaper, not sure it is such a bad thing.
mcguire 7y ago
The only part that I find interesting or possibly worrying: "Liquidity Risk "“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.”" But other than that the market in index funds dwarfs that in the indexed securities, I haven't the vaguest clue what they (this isn't the first time I have heard this) are worried about.
somberi 7y ago
A useful read that provides a counter view to Mr.Burry's: From The Economist. (1) http://archive.is/2oco0 http://archive.is/2oco0 and (2) https://www.economist.com/finance-and-economics/2018/07/05/the-growth-of-index-investing-has-not-made-markets-less-efficient https://www.economist.com/finance-and-economics/2018/07/05/t... (Unable to archive this) and (3) https://www.economist.com/finance-and-economics/2018/02/08/passive-funds-tracking-an-index-lose-out-when-its-make-up-changes https://www.economist.com/finance-and-economics/2018/02/08/p... (Critical piece to note here is about rebalancing. To quote "Someone who bought all listed American stocks in 1986 and did nothing would by now own less than half the market.")
gooddadmike 7y ago
Ramit Sethi recommends Index. Smart and not sexy way to do investing without loosing.
anonu 7y ago
The thing with predictions in the market is, even if you're the guy who figured out subprime before everyone else, your probability of getting it right the second time is completely independent of the last time.
droithomme 7y ago
I don't know man. Index funds seem to be the safest bet you can make as far as balancing risk and growth. You're betting that the world in general won't collapse over the long term. And if it does any high growth strategy is probably going to collapse with the general world as well so isn't that much safer. What is fascinating is that here is an article claiming that one of the safest bets you can take is the same as one of the biggest most corrupt and deplorable scams of the last 50 years. Now that's interesting because we want to take a look at who wrote that, who published it, and wonder what the heck they are up to peddling this view.
jl2718 7y ago
Is there a fund with low fees that invests according to some reliable accounting metrics of risk and return?
anm89 7y ago
The fervor with which people advocate for ETFs is creepy to me. Ive noticed so many situations where people from all walks of life who don't seem to have put too much thought into the details of how financial markets work, get deeply offended at the idea that the whole world can't collectively park their money in ETFs and collect an absolutely guaranteed 4-7% until the heat death of the universe as if it was some fundamental law of nature. It's not just that they disagree, it's that you seem to be attacking some part of their identity by the mere suggestion.
- jiscariot 7y ago
  I agree...it also has become so commonplace it irks my inner contrarian (having been in ETFs past 20+ years). -Shoeshine boy starts talking stocks--time to exit the market. [1] -Dad starts asking me about bitcoin--time to exit bitcoin position. -Occasionally employed step-sister praising index funds--??? [1] https://archive.fortune.com/magazines/fortune/fortune_archive/1996/04/15/211503/index.htm https://archive.fortune.com/magazines/fortune/fortune_archiv...
nabla9 7y ago
Nothing in the article or in the linked articles, indicates that he is talking about physically replicated passive index funds that replicate few times a year. He is not giving any explanations that would fit to these normal index funds. Ignoring small-cap stocks is kind of side show, because massive index funds can't make much return from small-cap stocks anyway. Even if you create index that includes them, they add only a little ROI. I don't see how index funds can remove price discovery, because they always follow price signals from actively managed funds. There may be market bubble and too much money caching profits but unless actively managed funds start outperforming index funds, they are not doing anything worth investing.
leon1717 7y ago
It wouldn't hurt his reputation throwing such opinions. After bashing down index, he suggested everyone should take a look at some small caps in Japan. That wouldn't hurt either. The point of investing in index is because it saves our time and energy to try to become excellent investors(just maybe). He's selling something, obviously, he's not even trying to lay opinions.
leon1717 7y ago
And of course, he's reading in a lot of feedbacks of his opinions right now. He wins anyway.
dllthomas 7y ago
He seems to use volume traded as a proxy for depth of the market. Is that well supported? I could imagine a stable stock moving no volume because the price didn't move, while everyone is lined up eagerly to make trades an increment out on either side of the current price.
dehrmann 7y ago
Michael Burry made his money on the tech and housing bubble busting. The main difference here is that in both, retail investors got the idea that they could get rich quick and bought into asset bubbles. But index funds aren't an asset bubble--people buy them instead of stocks, then the fund buys the stocks on investors' behalves. In aggregate, capital inflows look mostly the same. His points about liquidity of small cap stocks and price discovery are interesting, though; it's just fundamentally different from what he's been good at spotting. The trigger also isn't as obvious as home prices declining 50%. The S&P 500 dropped 15% in December 2018, and this wasn't an issue.
fallingfrog 7y ago
I eagerly await the bursting of this new bubble of hubris and stupidity as capitalism continues its self-cannibalistic path to destruction. Believe me when I say that there’s nothing I enjoy more than watching rich people lose all their money.
- fallingfrog 7y ago
  Oh I should probably not post in the wee hours of the morning
heyflyguy 7y ago
When I read these articles, I always begin to question if I am a passive or active investor. I strongly believe in keeping a diverse portfolio, mainly because I am keenly aware of my own ignorance as it relates to understanding complex stock moves and changes. Warren Buffet encourages novices to invest in index funds, since they outperform individual picks. Understanding asset value and free cash flow changed my life and my entire investment thesis about 10 years ago. Developing my own version of "Rich Dad, Poor Dad" I now seek to buy or build assets that make a return to me. Some return cash, others good feelings or emotions. I find that my financial situation is far more stable this way, I am semi-insulated from group-think (markets); and I look at re-applying net proceeds on a regular basis. That is a fun activity, using cash from one investment to build a new investment that will hopefully also return cash and build an asset. It takes precious little to do this, and the most fun of all has been teaching my daughter how to make money. At 8 she looks at apartments, hot dog stands, and many small businesses as an opportunity to "make cash". We now have interesting conversations in the car about what it would take to start "X" business.
donglebix 7y ago
Found this sort of relevant PDF which makes interesting reading - https://www.esrb.europa.eu/pub/pdf/asc/esrb.asc190617_9_canetfscontributesystemicrisk~983ea11870.en.pdf https://www.esrb.europa.eu/pub/pdf/asc/esrb.asc190617_9_cane...

359 points by kgwgk 7y ago

Peej255 7y ago

If true what's the hedge? Pension and investments to cash and bonds? Japanese stocks?

5822130027 7y ago
All types of investment in every country is subject to financial repression. You could own gold, but wait ! any gain is taxed as income ( not capital gain ). Carrying it around has stiff penalties. "You invest in how we say you invest" - Uncle Sam.
- daxorid 7y ago
  Carrying it around has stiff penalties. What are the penalties for carrying bullion?
  - sigstoat 7y ago
    you get tired easily?
- nradov 7y ago
  Taxes aren't repression.
  - SkyBelow 7y ago
    Unequal taxes seems a valid form of repression. Start with something simple, say taxing people of one race 15% more than another race. That would seem a valid form of repression. Okay, so that rarely happens and is almost always combined with far greater forms of repression. But there are less extreme examples. What about taxing someone more when they have kids, or more when they don't? Sin taxes also seems a way to repress certain behaviors in society by increasing their cost. Why can't the logic apply in other areas of life where tax rates are unequal?
  - turk73 7y ago
    Taxes are involuntarily extracted at gunpoint. Is that not coercive?
Zhenya 7y ago
Gold or other hard commodities
bklyn11201 7y ago
The hedge to a portfolio full of heavily-indexed stocks would be fairly-valued, non-indexed stocks. Burry had to report his holdings in a 13F filing on August 14: https://www.sec.gov/Archives/edgar/data/1649339/000156761919016689/xslForm13F_X01/form13fInfoTable.xml https://www.sec.gov/Archives/edgar/data/1649339/000156761919... He holds heavily-indexed companies like Disney, Fedex, and Alphabet. He holds a couple of small-cap value companies that aren't likely to be included in more than a couple of small ETFs: Tailored Brands (Mens Warehouse) and Sportsmans Warehouse.
tardo99 7y ago
This reminds me of the article someone else posted today about six sigma, where commenters rightly pointed out that the methodology works until companies try to use it to replace actual thinking managers. The hedge is simply to pay attention and make your own decisions. Index funds are great in general, but not when markets get out of whack (bubbles, etc).

groundlogic 7y ago

Not an economist, but it's obvious to anyone used to thinking in terms of systems that index funds can't work after a certain amount of the money poured into the system is managed by index funds. What's the limit - 30% 40%, 50%, 60%? What's the current level in terms of managed capital? (Edit: https://www.cnbc.com/2019/03/19/passive-investing-now-controls-nearly-half-the-us-stock-market.html https://www.cnbc.com/2019/03/19/passive-investing-now-contro... says 45% for US stock-based funds, half a year ago, so maybe like 48% now) I wonder if the endgame is that index funds won't be allowed to trade on the the stock exchanges? I can't imagine how that would be enforced. "Mr/Mrs/Ms Fund manager, you've been trading too close to the index, we'll be forced to terminate your access to the markets"?

avvt4avaw 7y ago
You only need the marginal investor to be informed, so it's not clear that you couldn't have a much higher percentage of passive investment (say 90%) and only a small amount of active investors who are providing price discovery. The bigger problem is that most passive investments are not really passive - for example, choosing to invest in a "passive" S&P 500 ETF over a "passive" Russell 2000 ETF is an "active" investment choice (preferring large cap over small cap) so valuation errors and bubbles could develop in segments of the market, even if constituents with an index are all fairly valued relative to one another. These valuation errors could sustain for a long period of time, because it takes much more money to correct a valuation error in a huge market segment than it takes to correct a valuation error in an individual stock.
- davidw 7y ago
  This lists 3575 stocks among its holdings, which includes both large and small cap stocks: https://investor.vanguard.com/mutual-funds/profile/overview/VTSAX/portfolio-holdings https://investor.vanguard.com/mutual-funds/profile/overview/...
  - avvt4avaw 7y ago
    Sure, which is why I said that _most_ passive investments are not really passive. Vanguard Total Stock Market is pretty passive, as long as you consider your investment universe to be "US stocks". But even in this case the fund only holds stocks (no bonds or real estate) and only US stocks at that (no international or emerging market exposure).

throwaway713 7y ago

Can someone who understands investing well explain what he’s saying in terms that someone who isn’t knowledgeable about this could understand? I kind of think he’s saying that everyone is just shoveling their money into index funds without thinking about it and this leads to incorrectly valued stock that will correct in the form of a crash at some point. Is that sort of the gist of it?

notyourday 7y ago
When people invest money into index funds, then the funds must spend all that money buying the shares of the underlying fund companies. So that creates tons of buy orders for the underlying stocks, which creates the buying pressure, which makes the prices rise. As long as more money comes into the index funds the prices of underlying stocks will keep rising. But the higher the prices of the underlying the more money needs to come in to buy them at those prices. What eventually happens is that there's not enough new money coming in for index fund buy orders to maintain the bottom of the underlying prices, which means that the prices start drifting lower, the popular financial press goes nuts, CNBC/FoxBusiness/WallSt Journal/etc blast it in the headlines and the same way goes the other way. People start selling their index funds, which makes the index funds sell the underlying which creates a massive wave of the sell orders creating a downward pressure, which in turn puts brings the indexes lower which makes press go screaming more which causes more people to want to "protect their test egg" by selling the index funds they had.
- UnFleshedOne 7y ago
  So, a normal decade in the markets?
  - notyourday 7y ago
    A bit more exciting probably since the market is higher now which means that the oscillation will be more impressive. The rest is chicken little - we got into that mess before because neither CDOs nor CDSs were liquid which means that as long as they were not trading banks were able to continue book them at the nominal value and since to trade them one needed to have banks that were on a hook for them to do the trade nothing was moving. That's the biggest issue with those kinds of instruments. Nothing of sort could happen with the index funds because both the derivatives and the underlying are sufficiently liquid, so the drop won't be 100->20 but rather 100->99.9->99.8->99.7->....->20.1->20 which in turn would re-balance everything.

spenczar5 7y ago

He says he's (reluctantly) doing active stock picking. He's a professional investor; I'm just some software engineer with a nest egg, which is 100% in index funds today. What should I be doing, as a schmoe who wants to save money?

godzillabrennus 7y ago
Take a look at opportunity zone funds today. You can pull your money out and pay zero capital gain taxes for seven years. Then get a 15% discount on your capital gains at that time. All returns you realize from the fund are capital gains tax free. The benefits end this year.
- the_watcher 7y ago
  I know a bit about Opportunity Zones (roommate bought property that was subsequently designated one, to his delight), but not about the funds. Do you have any particular recs on where I can read up on them?
  - bklyn11201 7y ago
    This is likely the best first stop for OZ info from a reputable source: https://www.novoco.com/resource-centers/opportunity-zones-resource-center https://www.novoco.com/resource-centers/opportunity-zones-re... The timing restrictions around OZ investments (180 days after cap gains event) make it a bit difficult and will result in lots of bad investments with non-experienced, first-time fund owners. But maybe you have a connection to an OZ that you are familiar with and can rehab a property there. You should get help from a CPA and lawyer, but the basic process would be: 1) Sell stock and now you have cap gains 2) Setup OZ Fund XXX LLC 3) Fund the LLC with your cap gains within 180 days 4) Setup OZ Property YYY LLC 5) Purchase property inside the YYY LLC and fund purchase with XXX LLC 6) Rehab property within 31 months 7) Hold for 10 years a) Pay original cap gains tax bill (minus 15%) in 2026 tax year (negative interest loan from gov) b) Pay zero cap gains on the increase in property value over the 10 years
  - aoeusnth1 7y ago

lukewrites 7y ago

The discussion of this on the Bogleheads forums, a community dedicated to low-cost investing primarily via indexing, provides an interesting counter-point to Burry's opinions: https://www.bogleheads.org/forum/viewtopic.php?f=10&t=289284 https://www.bogleheads.org/forum/viewtopic.php?f=10&t=289284

0xcafecafe 7y ago
This is a good point: Post by ltlurker » Thu Aug 29, 2019 1:24 pm I'm an index investor, like most Bogleheads, and I subscribe to Bloomberg digital so I can read articles such as this and did see this one at lunch (EDT). I'm open to various perspectives especially if there appears to be a rationale behind them. And of course this individual was behind the "big short" so that intrigued me. If I recall correctly, I believe his position is that Index funds tend to favor the largest companies - naturally - as they're mostly market cap weighted. The S&P 500 as we've noted is widely invested in, but the Total Stock Market also has an average weighting that makes it a Large Cap Fund - by Vanguard's standards. Relatively few people directly invest in the Russell 2000 Index or even have those options in their employers' retirement plans. (I have the opportunity to invest in the Completion Index in my retirement plan so that's partway there). I think Burry sees this as an opportunity to look at small cap value, which has been out of favor and not had a good run for some time. I think he must be thinking that a reversion is going to start at some point. None of us can know when, of course. And of course others are looking at the ratio of stock valuations to GDP (apparently one of Warren Buffet's key measures) and believe that there's significance to that, as well.
- lotsofpulp 7y ago
  There are fewer publicly listed companies than ever before: https://www.nytimes.com/2018/08/04/business/shrinking-stock-market.html https://www.nytimes.com/2018/08/04/business/shrinking-stock-... >In 2015, for example, the top 200 companies by earnings accounted for all of the profits in the stock market, according to calculations by Kathleen Kahle, a professor of finance at the University of Arizona, and Professor Stulz. In aggregate, the remaining 3,281 publicly listed companies lost money. I'd love to see 2016 to 2019 stats on that, but I think there are structural advantages (proliferation of databases, price transparency) that large corps are enjoying right now with which small companies just can't compete. Technology is obviating many people (and therefore businesses), and allowing the big to get bigger with no marginal cost. Would you bet against the top ten holdings in VTI, which take 1/5th of all investments? https://investor.vanguard.com/etf/profile/portfolio/vti https://investor.vanguard.com/etf/profile/portfolio/vti And also, we know the government will bail out all large entities, especially if many voters are invested in them (which they are due to 401k/pension funds being invested in the very same companies). Who is going to outcompete the few big airlines, telecom providers, FAANG, hotel brands, car rental brands, banks, pharma companies, etc that have national and worldwide reach? I'm sure a few companies here and there might, but by and large, I bet the big players are here to stay (until the whole system breaks down, but then you have bigger problems).

southphillyman 7y ago

Timely article, I was just thinking about this last night...while browsing Vanguard's site looking for index funds to invest in. Everyone blindly putting their money into similar instruments and getting double digit gains nearly every year just seems like it can end catastrophically. I want to do more research on how these passive funds affect the overall market and vice versa.

lunchables 7y ago
Aren't most of those double digit gains just from the market rebounding from the 2008 recession?
- FabHK 7y ago
  Yes, and in particular they would indicate lower future returns for the equity market as a whole, but that has nothing to do with the issue here, namely ETF/index fund vs. non-ETF/index fund.
- southphillyman 7y ago
  Rebound to inflated values? Reminds me of the housing market in my area now. It's "rebounded" to higher than 2008 levels on the basis of speculation and gentrified neighborhoods being hot. Seems like another bubble. I need to do more research, but I'm curious what the long term viability of these index funds are as more and more people gravitate towards them
  - lunchables 7y ago
    I was thinking more, rebounded to 2008 levels + inflation?
Kiro 7y ago
Stupid question but what are you looking for when browsing Vanguard? I thought all the index funds were the same, just following the index.
- 7y ago

jorblumesea 7y ago

There are ways to get more diversity within indexing itself. eg: small cap index, value index funds. It seems like the bone of contention is that indexes track the entire market based on trading volume, and that is an existential risk given cap weighting. Many now invest in total market indices, which limits the impact of large cap companies. The "cap weighting" problem is a known issue in indexing and this is why you invest in total market, small cap, mid cap indices.

sigstoat 7y ago
equal-weight (instead of cap-weighted) funds are also a thing, and perhaps relevant if you want to spread your investment across more of the market: https://www.invesco.com/portal/site/us/ria/etfs/strategies/equal-weight-investing/#tab_tab3 https://www.invesco.com/portal/site/us/ria/etfs/strategies/e...

pwthornton 7y ago

Isn't a big part of the issue with actively managed funds the fees, which usually wipe out any gains above index funds. Wouldn't the market correction be to close the delta in fees between active and passively managed funds to encourage more people to go the active route? A lot of the grousing about passively managed funds come from people who are running actively managed funds that charge huge fees to under perform passive management. By lowering fees, actively managed funds should be able to do a better net and to be able to attract more investors. Any sort of government solution to index funds getting large would basically be protection for these actively managed funds. There are actively managed funds that can beat passive funds, but it's incredibly difficult to do so when you charge a 2% fee.

whatok 7y ago
You can't run most active management strategies on anything approaching the average passive fee structure. Additionally, you run into problems with scale. An S&P 500 tracking fund scales extremely well and could add several billion of AUM without having to incur additional expenses. A long only equity fund would probably not be able to do the same without hiring more people, building more infrastructure, etc.
- pwthornton 7y ago
  I get that the fees can't be comparable, but without passive management, active management fees are unchecked, and they rose a lot over time. I'm willing to agree that it should cost an order of magnitude more for an actively managed fee, but most are beyond that. A lot of this seems like plain greed to me, combined with grift and graft. A lot of workplace plans try to funnel people into actively managed funds that often charge really high fees.
  - whatok 7y ago
    I'm not sure how fees are unchecked. Active management fees have fallen quite a bit over the past 5+ years. A lot of mediocre managers have gone out of business and many more probably will as well. Additionally, new fund launches are near all-time lows.

chad_strategic 7y ago

I have been saying this for years... Passive investing is great. Especially since the S&P 500 has been up for ~10 or years. It's when passive investing becomes panic investing (sell everything).

markbnj 7y ago

Not knowledgeable on these matters, so my money is in index funds. Obviously a lot of other people are in the same category as myself. The article seems to be saying we'd all be better financial citizens if we put our money into actively managed funds, or did our own investing. The latter is out of reach for most people, and with respect to the former it's somewhat puzzling that managed funds can't consistently outperform index funds (https://www.cnbc.com/2019/03/15/active-fund-managers-trail-the-sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html https://www.cnbc.com/2019/03/15/active-fund-managers-trail-t...), and so the managers of those funds in a strict sense don't earn their fees. So what is the average person with a couple bucks to invest supposed to take from this? The market is in peril because not enough money is flowing to people who do a poor job of managing it?

6thaccount2 7y ago
This is my question as well.
blankaccount 7y ago
The article is claiming that index funds are an overhyped bubble, so of course they'll out perform actively managed funds that have better liquidity.
- TimTheTinker 7y ago
  Perhaps they have become that because of their publicity. But when all the financial gurus are recommending investing in traditional securities (stocks and bonds), and millions of people wishing to get a leg up in life obey their advice, doesn't that turn the securities market in general into an "overhyped bubble"? The market behavior and health of any investment, no matter how theoretically sound it is, will be strongly affected by investors' behavior around it. So the fact that index funds are popular (and thus perhaps inflated/overpriced) isn't a knock on the fundamental idea. It's merely an indication of a particular market situation at present.
  - blankaccount 7y ago

ineedasername 7y ago

How can index funds that track the market actually distort the market? In the alternative, wouldn't the same amount of money just be invested in stocks individually? Wouldn't even a small number of active investors jump on distortions and quickly provide more accurate pricing?

yalogin 7y ago

This sounds like good logic. There is one piece of information missing. Did the onset of index funds add more money to the pool? What I mean by that is did people move out of regular stocks into Index funds or did they move out of mutual funds into them? How much is the difference?

amadeuspagel 7y ago

It's a bit self-serving for a hedge fund manager to criticize index funds.

cybersnowflake 7y ago

Accepting that actively managed funds are better than passive index funds is basically acceptance of the classical mentality that there are people who can consistently predict and beat the market and that you can make money by picking the 'right guy'. I assumed most knowledgeable investors abandoned that philosophy in the 80s/90s

KingMachiavelli 7y ago
(This is my understanding of the artical with some help from other comments. I probably use some words incorrectly but I think you can get the jist) TLDR: He is't abandoning the current stance that passive > active but rather is discussing the real value of the underlying assets. And he isn't challenging on that stance either. I don't think the artical is out right advocating people to switch their personal investments from a passive index fund to an active one since he & we both know that passive funds tend to do as well or better than active funds after accounting for fees. However, the article (at least how I understood it) is saying total effect of everyone moving their money into ETFs and index funds means that the underlying stocks have an increasing risk of becoming or being overvalued since no one is checking the underlying stocks/companies anymore. As someone just tangentially interested in this topic I've thought of this before in a more tangable way: since every college graduate or hacker news type person knows that index funds are the best then at some point 'everyone' or enough of the population has a stake in index funds that it's likely to be overvalued. The market should/could correct as expected: undervalued companies go unnoticed longer since everyone is passively investing causing actively managed funds to have higher yields (since they can get 'all' of the undervalued companies passive investors miss) and people adjust their holdings accordingly. However, as a few other users stated there a few issues trying to hedge against a buble: 1. Solvency - The market remains 'irrationally' attatched to passive/index funds which means that index funds continue to beat active funds anyway despite their 'real' value/gains being pure speculation. It's difficult convincing people to let you manage their money when your making 4% and the S&P400 is making 8-11% so remaining solvent is an issue. 2. Systemic Risk - Large markets & financial products are intertwined so if index funds are overvalued then it effects the economy & financial institutitions and if it crashes/pops then it sends a shock wave throughout all of them. Finding a hedge that isn't effected by a bubble in one financial product (CDOs, index funds, etc) can be tricky.

graeme 7y ago

Index funds definitely have a free rider problem. Warren Buffett lucidly pointed out that the average performance of active investors will be....the market average. You cannot, by definition, have a majority of investors beating the market. And once you add in fees, index funds produce above average performance, as they have low fees. So far so good. But, the index funds are free riding on the decisions taken by active investors. Active investors do a useful service to the world by moving capital away from inefficient companies and towards efficient companies. If the market gets worse at this capital allocation, we can expect overall lower returns. In other words, there's average market performance but also the factor of efficiency in capital allocation. This is related to but separate from what Burry talked about, I think. His central point seemed to be that valuations were based on very thin trading, and that when money is taken out of index funds, it will be very hard to find sufficient buyers without a large drop in prices. Add in to that complex derivatives etc used in making all the etfs work. That bit is somewhat beyond me though. Anyone got a good analysis of how that may play out?

sokoloff 7y ago
> You cannot, by definition, have a majority of investors beating the market. You cannot have a majority of money beating the market. It is mathematically possible for a majority of investors (each relatively small) beat the overall market (albeit unlikely). (I agree with your overall post, but not that line.)
- graeme 7y ago
  Oh true
sriram_sun 7y ago
> But, the index funds are free riding on the decisions taken by active investors. I'm sure there is a pretty clear criteria for making it to the S&P 500 or the Nasdaq 100. Which means it can be coded up. Index funds don't track the investments of other active investors. They track the performance of companies (typically market leaders) based on some transparent and objective criteria. These performances could be tied to a multitude of factors - Founder managed, innovative, market focus, sales & marketing, slave labor, good copycats who knows (or cares?). The point is they've made it to the top of some list and are generating revenue within a system of "acceptable" checks and balances. If the company doesn't meet that criteria, it will be booted off of that list. The bet is always focused on objective criteria. None of that is free riding on active traders.

omarhaneef 7y ago

A lot of people seem to have read this and think that Burry is worried that the indices are weighted by market cap. That is not the issue. The issue is that a large proportion of the index is smaller caps that no one bothers to look at and price properly, and yet massive amounts of money are in ETFs and other contracts that take a position on those smaller, less followed names. So these small names in the large index have been artificially driven up. Sort of like CDOs. You just look at the rating, or the P/E of the 500 stocks in the SP500, but you don't bother to do a deep dive. Were someone to do the deep dive, you would see that they are massively overvalued (and therefore so is the SP500, for instance).

jpalomaki 7y ago
If the small cap valuations are totally wrong, shouldn’t some simple measures like P/E show it clearly? Edit: The P/E values on Russel 2000 seem to be almost double compared to S&P 500 [1]. Also some point out that the value is not correct as it leaves out negative earnings which are common among small caps [2]. [1] https://www.wsj.com/market-data/stocks/peyields https://www.wsj.com/market-data/stocks/peyields [2] https://goldco.com/russell-2000s-price-to-earnings-ratio-is-high/ https://goldco.com/russell-2000s-price-to-earnings-ratio-is-...
- omarhaneef 7y ago
  I think the point is people use the measures that you can clearly see easily (like the P/E), and therefore you don't go down to the level of the stock (oh, temporarily raised earnings, forecast for reduced earnings, and as you point out, negative earnings etc). Note: this is not my argument, but what I understand Burry to be arguing.

motbob 7y ago

So there are two concerns here. One concern is a problem with a certain asset being inflated, in this case S&P 500 stocks, and the money you might lose if you hold those assets and their value goes down to normal. A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caused by a rapid bubble burst may cause a financial crisis. The panic of 2007 (or at least, the liquidity freeze part of it) was not directly caused by devalued assets, but rather the fact that banks relied on those assets having a certain value to do basic, short-term lending, and their confidence in that value was blown away. The second concern is not really a concern for long-term investors. Really, neither is the first. Maybe equity is inflated, but where else are we going to put our money? I think that this article is mostly about risk. If you are not too concerned with risk in your investments (which you should not be if you are more than 10 years before retirement, probably), I think this article doesn't say much about what you should do with your money.

bob33212 7y ago
A hedge from this theory would be to buy stocks just outside the SP 500? Something like TSLA. That would be a crazy situation, where the SP 500 is crashing and the rest of the market it taking off
- motbob 7y ago
  I don't know about that. If a general financial crisis is the concern, stocks outside the S&P 500 would not be spared. What I got from this interview was just a reminder that it makes sense not to get caught up in enthusiasm for a certain asset. And investors (including me) are certainly enthusiastic about the S&P 500 index fund.
- ChuckMcM 7y ago
  A simpler option is to buy options on the index. You can butterfly the index with calls and puts around your minimum return / maximum loss tolerance.
  - 7y ago

noego 7y ago

I think there are a few good points made by Burry. When comparing across different market segments, today's climate of popular-index-funds can cause bubbles in some segments. For example, everyone and their grandmother invests in the S&P 500, whereas much fewer people are investing in the MSCI EAFE. Because of this, VOO can become over-valued relative to VEA. I agree with this point and have wondered about it myself. I highly encourage everyone to diversify across all market segments, including the S&P 500, mid-cap, small-cap, developed markets and emerging markets. That mitigates the potential S&P-500 bubble that Burry might be warning against. But that said, I don't think it's fair to accuse index funds of causing specific stocks to become over-valued relative to other stocks within the same index. By design, market-weighted index funds maintain the relative prices of different stocks within the same index. Ie, if a whole bunch of people sell their houses tomorrow and invest in the S&P 500, all the stocks in the index will get an equal percentage lift, and pricing ratio of GOOG to MMM will still remain consistent. Note however, that equal-weighted indexes do not have this property. Imagine if the US government decided tomorrow that it was going to invest $10T in the stock market, using equal-weighting. This would translate to ~$20B for every stock in the S&P 500. The biggest stocks like GOOG would see an incremental boost, because $20B is still only ~2% of their market cap. Whereas the smallest stocks in the index would see their share price skyrocket because $20B would more than double their market cap.

commandlinefan 7y ago

> Nobel-approved models of risk that proved to be untrue Makes you wonder how much more of this ends up remaining unquestioned until it’s too late.

jayalpha 7y ago

Horseman Global Unveils New Shorting Philosophy Using ETF Flows As A Catalyst https://www.zerohedge.com/news/2017-04-09/horseman-global-unveils-new-shorting-philosophy-using-etf-flows-catalyst https://www.zerohedge.com/news/2017-04-09/horseman-global-un...

thtthings 7y ago

What i think he is saying is this: If you look at s&p 500 stocks weight for instance, at number 483 is Rollins inc, weight 0.019938%. Do you know this company? But everyone here if you have invested in s&p 500 has invested in this stocks. The way s&p 500 works is it picks stocks based on market cap. Now this company has a very low chance of getting kicked out even if it is a dud as people keep investing in it via ETF's Here lies the opportunity. If you go through every company in s&p 500 you are going to find overvalued and undervalued stocks. One strategy is to pair trade. Take a long/short position. But it is very tough to time as every keeps investing every month. Other strategy is wait for a crash and instead of again investing in these ETF's for small returns pick stocks that got battered for no reason. This has inspired me to actually work a bit, actually looks at balance sheets and pick stocks. Side note, i only own one etf and it is PTF. It has very little stocks and i think focused funds are a better bet.

oli5679 7y ago

I think we aren't close to the margin where indexing is socially harmful. This article elaborates. http://www.philosophicaleconomics.com/2016/05/passive/ http://www.philosophicaleconomics.com/2016/05/passive/

darawk 7y ago

Burry is making a terrible case, and he's fundamentally wrong on basically all counts. > 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. Passive investing is, for the most part, not funging against dollars that would have gone to high quality asset managers. It is removing noise in the form of retail speculation from the market. Asset managers that consistently beat the market (i.e. facilitate price discovery) have no problem raising capital. > “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.” Trading volume != liquidity. They are related, but only indirectly. Liquidity is, for the most part, provided by market makers. Market makers are entities willing to take both sides of orderbook at all (or almost all) times. Most of the time, when you trade a stock, your counter-party is a market maker. Even if nobody is trading, that market maker is still providing liquidity. The liquidity is there, even if no shares are changing hands. Where this gets tricky is that market makers make their money by trading. If there is less volume, they may be willing to provide less liquidity. But it's not at all clear that this is a real problem yet, or that there is any major crisis of liquidity in the markets. The correct way to measure this is not to look at daily volume, but at slippage. How much does the market move when you attempt to buy a large block? I'm not certain, but I don't think this is a major problem for people right now.

atemerev 7y ago

There is no such thing as free money. There are no such things as riskless passive investments that beat the reference market rates (which are close to zero these days). Therefore, index funds carry risk. Therefore, somebody (the bulk of index fund investors) will have to absorb these risks. All of this is nearly obvious.

cm2187 7y ago

The reality is that before ETFs, the largest beta funds were already quasi-replicating the index, trying to beat it by just enough to compensate for the high fees. This low value added funds are simply being replaced by something cheaper, not sure it is such a bad thing.

mcguire 7y ago

The only part that I find interesting or possibly worrying: "Liquidity Risk "“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.”" But other than that the market in index funds dwarfs that in the indexed securities, I haven't the vaguest clue what they (this isn't the first time I have heard this) are worried about.

somberi 7y ago

A useful read that provides a counter view to Mr.Burry's: From The Economist. (1) http://archive.is/2oco0 http://archive.is/2oco0 and (2) https://www.economist.com/finance-and-economics/2018/07/05/the-growth-of-index-investing-has-not-made-markets-less-efficient https://www.economist.com/finance-and-economics/2018/07/05/t... (Unable to archive this) and (3) https://www.economist.com/finance-and-economics/2018/02/08/passive-funds-tracking-an-index-lose-out-when-its-make-up-changes https://www.economist.com/finance-and-economics/2018/02/08/p... (Critical piece to note here is about rebalancing. To quote "Someone who bought all listed American stocks in 1986 and did nothing would by now own less than half the market.")

gooddadmike 7y ago

Ramit Sethi recommends Index. Smart and not sexy way to do investing without loosing.

anonu 7y ago

The thing with predictions in the market is, even if you're the guy who figured out subprime before everyone else, your probability of getting it right the second time is completely independent of the last time.

droithomme 7y ago

I don't know man. Index funds seem to be the safest bet you can make as far as balancing risk and growth. You're betting that the world in general won't collapse over the long term. And if it does any high growth strategy is probably going to collapse with the general world as well so isn't that much safer. What is fascinating is that here is an article claiming that one of the safest bets you can take is the same as one of the biggest most corrupt and deplorable scams of the last 50 years. Now that's interesting because we want to take a look at who wrote that, who published it, and wonder what the heck they are up to peddling this view.

jl2718 7y ago

Is there a fund with low fees that invests according to some reliable accounting metrics of risk and return?

anm89 7y ago

The fervor with which people advocate for ETFs is creepy to me. Ive noticed so many situations where people from all walks of life who don't seem to have put too much thought into the details of how financial markets work, get deeply offended at the idea that the whole world can't collectively park their money in ETFs and collect an absolutely guaranteed 4-7% until the heat death of the universe as if it was some fundamental law of nature. It's not just that they disagree, it's that you seem to be attacking some part of their identity by the mere suggestion.

jiscariot 7y ago
I agree...it also has become so commonplace it irks my inner contrarian (having been in ETFs past 20+ years). -Shoeshine boy starts talking stocks--time to exit the market. [1] -Dad starts asking me about bitcoin--time to exit bitcoin position. -Occasionally employed step-sister praising index funds--??? [1] https://archive.fortune.com/magazines/fortune/fortune_archive/1996/04/15/211503/index.htm https://archive.fortune.com/magazines/fortune/fortune_archiv...

nabla9 7y ago

Nothing in the article or in the linked articles, indicates that he is talking about physically replicated passive index funds that replicate few times a year. He is not giving any explanations that would fit to these normal index funds. Ignoring small-cap stocks is kind of side show, because massive index funds can't make much return from small-cap stocks anyway. Even if you create index that includes them, they add only a little ROI. I don't see how index funds can remove price discovery, because they always follow price signals from actively managed funds. There may be market bubble and too much money caching profits but unless actively managed funds start outperforming index funds, they are not doing anything worth investing.

leon1717 7y ago

It wouldn't hurt his reputation throwing such opinions. After bashing down index, he suggested everyone should take a look at some small caps in Japan. That wouldn't hurt either. The point of investing in index is because it saves our time and energy to try to become excellent investors(just maybe). He's selling something, obviously, he's not even trying to lay opinions.

leon1717 7y ago

And of course, he's reading in a lot of feedbacks of his opinions right now. He wins anyway.

dllthomas 7y ago

He seems to use volume traded as a proxy for depth of the market. Is that well supported? I could imagine a stable stock moving no volume because the price didn't move, while everyone is lined up eagerly to make trades an increment out on either side of the current price.

dehrmann 7y ago

Michael Burry made his money on the tech and housing bubble busting. The main difference here is that in both, retail investors got the idea that they could get rich quick and bought into asset bubbles. But index funds aren't an asset bubble--people buy them instead of stocks, then the fund buys the stocks on investors' behalves. In aggregate, capital inflows look mostly the same. His points about liquidity of small cap stocks and price discovery are interesting, though; it's just fundamentally different from what he's been good at spotting. The trigger also isn't as obvious as home prices declining 50%. The S&P 500 dropped 15% in December 2018, and this wasn't an issue.

fallingfrog 7y ago

I eagerly await the bursting of this new bubble of hubris and stupidity as capitalism continues its self-cannibalistic path to destruction. Believe me when I say that there’s nothing I enjoy more than watching rich people lose all their money.

fallingfrog 7y ago
Oh I should probably not post in the wee hours of the morning

heyflyguy 7y ago

When I read these articles, I always begin to question if I am a passive or active investor. I strongly believe in keeping a diverse portfolio, mainly because I am keenly aware of my own ignorance as it relates to understanding complex stock moves and changes. Warren Buffet encourages novices to invest in index funds, since they outperform individual picks. Understanding asset value and free cash flow changed my life and my entire investment thesis about 10 years ago. Developing my own version of "Rich Dad, Poor Dad" I now seek to buy or build assets that make a return to me. Some return cash, others good feelings or emotions. I find that my financial situation is far more stable this way, I am semi-insulated from group-think (markets); and I look at re-applying net proceeds on a regular basis. That is a fun activity, using cash from one investment to build a new investment that will hopefully also return cash and build an asset. It takes precious little to do this, and the most fun of all has been teaching my daughter how to make money. At 8 she looks at apartments, hot dog stands, and many small businesses as an opportunity to "make cash". We now have interesting conversations in the car about what it would take to start "X" business.

donglebix 7y ago

Found this sort of relevant PDF which makes interesting reading - https://www.esrb.europa.eu/pub/pdf/asc/esrb.asc190617_9_canetfscontributesystemicrisk~983ea11870.en.pdf https://www.esrb.europa.eu/pub/pdf/asc/esrb.asc190617_9_cane...