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A critique of the claim that passive investing is a bubble

• talolard 7y ago
  I think this article really misses the point that Burry was making, which is that if the indexs see a sell off they won't find the liquidity in the market to cash out their positions and will drive the market down. This article seems to focus on all of the upsides of indexing, which are all true. However, those upsides don't negate the risk that is being pointed to.
  • sharkbot 7y ago
    Not the author, but I think the article indirectly talks about the liquidity in the markets being far higher than it has been in the past. Further, if there is a stampede for the exits, there still have to be buyers on the other side of the sellers. Those buyers will undoubtably include active managers along with those indexers with different time horizons and/or braver constitutions. Both will likely be rewarded for their patience.
    • ptero 7y ago
      > if there is a stampede for the exits, there still have to be buyers on the other side of the sellers That is a key point in the debate. I do not see that above is necessarily true. Say a price of a low volume stock X is driven down below fundamentals just because index funds have to sell 1% of holdings and cannot find enough buyers for X. While price of X might be irrational fund managers might not be able to act on it because there would be a worry that it may go lower still if selling extends. Could next round get X removed from index? delisted? "The market can stay irrational longer than you can stay solvent" is not an empty worry. My 2c.
  • staticcaucasian 7y ago
    Agreed. Burry seems to be getting a lot of responses but almost none of them seem to have actually listened to what he said (or even read the article). There is real risk from the index-matching synthetic techniques that these funds are using.
  • 0xcafecafe 7y ago
    What if my index fund is actually just buying and holding the underlying stock as opposed to just a price tracking entity? In that case not taker for my fund = no taker for the underlying stock right? Will this not have the liquidity risk that Bury mentions?
    • secabeen 7y ago
      The index fund is holding the underlying stock, largely. The challenge is that if say 5% of their fund holders sell their shares in the fund, the fund has to sell the underlying stock to generate the cash to pay out. Most funds have a rule in their documents that if you are a large fundholder (holding 1% or more of the fund) and you sell, they can hand you stocks directly rather than selling them and giving you cash, but that doesn't work it it's tens of thousands of small fund holders selling.
      • wbl 7y ago
        So? They sell others buy. If I hear there is a squeeze and have cash I'll throw it in: who wouldn't? It's never the case that x٪ of the market can exit at once regardless of how it is owned.
        • joyjoyjoy 7y ago
          "If I hear there is a squeeze and have cash I'll throw it in:" For how many billions will you buy? And why did you not throw it in in 2008? "who wouldn't?" People who are leveraged? "It's never the case that x٪ of the market can exit at once regardless of how it is owned." You may not have heard it. But this is called a stock market crash. One is expected soon. So enjoy the ride and keep your money dry that you can "throw it in"
      • vkou 7y ago
        So? If 5% of all stockholders sell their stock, that's going to cause a downward price movement, too. What is special about an ETF, that makes this situation any worse?
    • C1sc0cat 7y ago
  • davidw 7y ago
    I think that was certainly a more interesting point compared to "who will do price discovery", which seems to be something that would likely find an equilibrium. This article does mention it, but pretty briefly. It'd be interesting to hear from people more familiar with the details of how all this works... perhaps there are some in the initial thread, but I haven't had time to skim it all: https://news.ycombinator.com/item?id=20877700 https://news.ycombinator.com/item?id=20877700
  • human20190310 7y ago
    > ...will drive the market down So what? Let the weak long positions panic and sell at the bottom. Everyone else gets a few years of discount prices to buy. The hardest hit will be those who are leveraged and arguably deserve to get hosed for taking that much risk. If you don’t have to meet a margin call, you can ride out a crisis; if you’ve got cash in reserve, you can profit from it.
    • rocqua 7y ago
      Presuming you are saving for later. Besides a margin call, you might want to exit for, buying a house, going into retirement, covering a period between jobs, or to deal with a medical emergency. Doing that during a crisis hurts. This risk diminishes the value of investments as a safety cushion.
      • human20190310 7y ago
        Index funds aren’t a safety cushion. Vanguard rates it’s own S&P 500 index fund as a 4 out of 5 for risk. [0] [0] https://advisors.vanguard.com/iippdf/pdfs/FS540.pdf https://advisors.vanguard.com/iippdf/pdfs/FS540.pdf
      • throw0101a 7y ago
        > Besides a margin call, you might want to exit for, buying a house, going into retirement, covering a period between jobs, or to deal with a medical emergency. In all of those scenarios you should not be in stocks/equities in the first place. If there is a possibility of needing cash with-in the next 5 years, that money should be in either bonds or term deposits. One's downpayment, first/next few retirement years' income, and emergency fund(s) should not be in equities.
    • gridlockd 7y ago
      After 1989 it took the Nikkei more than a decade to finds its bottom (and then another bottom in 2009) and it hasn't recovered since. How many years of "discount buying" are you planning in?
    • lovecg 7y ago
  • mrep 7y ago
    How would they lose liquidity? Authorized participants [0] are always in the market for ETFs. If an ETF share price is crashing out of line with the index it tracks, they will step in and buy shares, swap them with the ETF issuer for the shares of the underlying stock in the index, and sell those shares for an arbitrage profit. Even if one of the underlying stocks becomes illiquid, a big enough price divergence on all of the other liquid stocks would make it profitable to eat the loss or hold the illiquid ones (risky, but remember, there are many authorized participants competing with each other so if there is some way to make an easy arbitrage profit, they will find a way). You'd basically need the entire market to become illiquid. [0]: https://www.investopedia.com/terms/a/authorizedparticipant.asp https://www.investopedia.com/terms/a/authorizedparticipant.a...
    • pjmorris 7y ago
      > basically need the entire market to become illiquid. Which came dramatically close to happening in 2008, see, e.g. [0]. [0] http://pages.stern.nyu.edu/~sternfin/pschnabl/kacperczyk_schnabl.pdf http://pages.stern.nyu.edu/~sternfin/pschnabl/kacperczyk_sch...
    • josu 7y ago
      >You'd basically need the entire market to become illiquid. Yes. It has happened before.
      • asdkfjasl 7y ago
        OK, but in that case is there a distinction between index funds and actively managed funds? Is this a risk that index funds are uniquely exposed to? Also, another thing to keep in mind is that this only affects people who are trying to sell at the bottom. Buy and hold investors care little for liquidity issues during a crash.
        • JumpCrisscross 7y ago
          > in that case is there a distinction between index funds and actively managed funds? Yes. Active managers can choose what to sell based on prevailing market conditions. Index funds must sell across the board. That could involve getting hosed on names in a short-term squeeze. > this only affects people who are trying to sell at the bottom There are lots of index funds. For a broad-market fund, you're probably right--a patient investor can ride out the bloodshed. For leveraged or specialized funds, on the other hand, a rout could permanently impair the portfolio. Equity market collapses, furthermore, have a habit of transmitting into the real economy. A sustained downturn could impair funding conditions, which in turn could affect the fundamental characteristics of a portfolio.
  • ambicapter 7y ago
    This was mentioned in the article > Liquidity is not a huge problem for index funds. But, Ben, what if everyone rushes to the exits all at once? Index funds and ETFs are going to cause a massive crash! > 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.
    • FabHK 7y ago
      > > 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. Yeah, I wanted to highlight that that's not true. Of course there is a market impact, it'll go down. The author might have wanted to say that there is no differential market impact, ie all shares would go down to the same extent (so that there is no impact, say, on capital allocation), but even that is not necessarily true, it clearly depends on the homogeneity (or lack thereof) of the liquidity/elasticity on the other side of those trades.
  • sambe 7y ago
    These sections seem to address the point to me: * "The tail is not wagging the dog" - index funds are a relatively small percentage of total share ownership. * "Benchmark huggers have always been around" - owning ~the index was not started with index funds. * "Active funds literally own the market" - the sum of portfolios of non-index funds ends up having the same profile. * "Price discovery is a cop-out" - relatively small part of the trading volume. * "Liquidity is not a huge problem for index funds" -no market impact to sell (v dubious if you ask me), unlevered. * "Humans matter more than fund structures" - the absence of index funds did not prevent bubbles/crashes. You can disagree with those points (I do with some of them) but that's a large part of the article.
    • bwanab 7y ago
      Right, but consider that the sub-prime mortgage market was a tiny portion of the overall mortgage market in 2007. Derivatives written against sub-prime holdings tipped the balance when the fan was hit. There are tons of derivatives written against the indices, thus indirectly against those funds.
      • AnimalMuppet 7y ago
        No, not against those funds. Pass a royal decree that banishes all index funds from the face of the earth. The tons of derivatives written against the indices remain, unchanged. Those derivatives might be "somewhat in the neighborhood of the funds" or something, but it's not analogous to mortgages.
      • navigatesol 7y ago
        >Derivatives written against sub-prime holdings tipped the balance when the fan was hit There's a bit more nuance to it: those derivatives were a problem because a substantial proportion of them were concentrated in a single, widely-connected, entity (AIG). The derivative market as a whole nets to zero; for every loser there is a winner.
      • turk73 7y ago
        There was the little problem of how sub-prime debt got whitewashed and turned into Aaa rated paper by the ratings agencies. All those sub-prime tranches, had they been correctly rated, would not have had such a magnifying effect. It was because of packaged bonds containing multiple tranches that couldn't be priced at anything but $0. Also, the interest bearing portions of loans were split into different bonds, further complicating matters. There wasn't (and still isn't) a mark-to-market in bonds. Many bonds aren't priced until bought/sold, e.g. illiquid.
  • perspective1 7y ago
    Exactly. The article, starting with the title, is pompous and overconfident. Burry made the unanswered point that in a sell-off large index funds will have to dump their smaller holdings at large discounts. We have never had a market crash with passive holdings this large (and consolidated in a small handful of funds)-- we're in unprecedented times. Burry's point is entirely plausible. And although that it wouldn't immediately cause a problem for investors who don't sell (price is not value), the newly discount-price firms may struggle immensely in terms of raising new capital and financing.
    • FabHK 7y ago
      > Burry made the unanswered point that in a sell-off large index funds will have to dump their smaller holdings at large discounts. First, I think he didn't made that point very clearly. Second, why would they be sold at a larger discount than larger holdings? It is all in proportion - they own less and sell less of the smaller holdings. (There are issues conceivable where you have a liquidity mismatch (bonds, real estate), but I haven't seen a solid elaboration of that point. It's the good old "people worry about bond market liquidity" meme that Mark Levine pokes fun at in his Bloomberg Column "Money Stuff".)
      • OJFord 7y ago
        > why would they be sold at a larger discount than larger holdings? It is all in proportion - they own less and sell less of the smaller holdings His argument there AIUI was that the daily volume is not in proportion.
        • FabHK 7y ago
          Fair enough, so going back to a liquidity mismatch. Will be interesting to watch the next market crash.
    • omgwtfbyobbq 7y ago
      The idea that we've never had a market correction with passive holdings at current levels is accurate. It also was an accurate statement in 2008, and it also applies to foreigners and mutual funds now, both of which have increased their holdings of equities over time and both of which have substantially greater holdings than index funds. https://awealthofcommonsense.com/wp-content/uploads/2019/09/Annotation-2019-09-04-220027.jpg https://awealthofcommonsense.com/wp-content/uploads/2019/09/...
  • C1sc0cat 7y ago
    And ignores the current example of the neil woodford equity income fund. This is a smaller example the liquidity problem that Mr Burry was making - it would much worse if a market crash did this to the realy realy big index funds.
  • FabHK 7y ago
    > if the indexs see a sell off they won't find the liquidity in the market to cash out their positions and will drive the market down When investors sell that amount, it doesn't matter whether they hold the underlying assets directly, or via index funds or ETFs, or via actively managed funds. The market will go down. So, which part of the problem is uniquely due to index funds? Burry hasn't made that point very clear. There might be issues with (liquid) index funds that give exposure to inherently less liquid assets, such as bonds or real estate. There might also be issues with index funds that do not hold the assets themselves, but replicate the exposure synthetically by entering a swap with a third party, giving rise to tracking error, counterparts credit risk, etc. However, as I said, Burry hasn't enunciated these concerns very cogently (at least in the extracts quoted by Bloomberg). This article here does nothing to address those concerns.
    • peteradio 7y ago
      Requirement to sell across the board seems to be the unique issue.
      • vkou 7y ago
        They aren't required to sell, unless fund-holders are selling their ETFs. If those fund-holders were owning the stocks directly, instead of ETFs... Those same fund-holders would be... Selling their stocks. Causing the exact same downward price pressures.
        • rocqua 7y ago
          If I sell my ETF, the AP buys it from me, and gets to redeem it for a basket of shares of fixed proportion. Suppose stock X gets 1% in that basket. The issue is if stock X happens to be very illiquid, the APs selling stock X could drive down the price. In a non ETF, managers could decide to relatively slow down the sale of X, to prevent crashing the price. However, in an index fund the mechanism dictates all stocks are sold in the same proportion.
          • 7y ago
  • adventured 7y ago
    Just the fact that the author chose to call Michael Burry's well thought out premise "silly" - tells you most of what you need to know about what is being pitched in the article. I've never seen Burry say anything that qualified as silly, even when a premise of his doesn't play out as dramatically as predicted. Silly is entirely contrary to his personality and analysis, it's attempting to lead the reader and argue via ridicule (where did we see that before?).
  • mcguire 7y ago
    Are you arguing that index investors should not be part of the market at all? A large number of investors leaving the market will see a sell off no matter what vehicle they're in.
  • ptero 7y ago
    This is the way it felt to me, too. The author seems to be cherry picking some incomplete statements from Burry's article and tries to make them sound ridiculous, and sometimes resort to adjectives rather than arguments. I am not a specialist and would love to read an informed analysis and counters to Burry's article. I was hoping that this is what the author tried (as the title suggests), but to me he fell far short of that goal. My 2c.
  • navigatesol 7y ago
    >* if the indexs see a sell off they won't find the liquidity in the market to cash out their positions and will drive the market down.* What is unique about no liquidity during a sell-off driving markets down? It's the definition of a sell-off. The fact there's no liquidity is what drives down the market in every sell-off.
  • bradshaw1965 7y ago
    It's important to distinguish market cap based indexes and other asset class indexes. Small and micro-caps are notoriously hard to trade but mega-caps typically have much higher liquidity. There is a much higher chance of a micro-cap passive fund having a liquidity problem then a market cap index fund.
  • imtringued 7y ago
    That is fundamentally how markets work. If everyone sells and no one buys then prices are going down. Whether you are using an active or passive fund or pick stocks yourself doesn't matter.
  • solotronics 7y ago
    I wonder what the breakdown is within the index ETFs on what money is in 401ks, Roth, institutional investor, etc. If a big portiton of it is retirement accounts those aren't moving much anyways.
    • MandieD 7y ago
      Except for all the near-retirees who freak out as they see their balances rapidly shrinking - and sell. Like my parents did in 2008/9, and I didn't think to caution them not to. Ugggg...
  • vkou 7y ago
    Umm, if there's a stock market crash, triggering investors to panic-sell their shares, what difference does it make that I'm selling off my Vanguard ETF, or my personal, non-ETF stock holdings? I'm still driving the price down, causing other holdouts to sell off, driving the price further down. It's the definition of a market crash.
  • throw0101a 7y ago
    Why would they need to cash out their positions? Indexes seem to actually have inflows during bear markets. See Point 2: * https://www.etfstrategy.com/three-reasons-why-indexing-and-etfs-wont-cause-the-next-market-crash-10448/ https://www.etfstrategy.com/three-reasons-why-indexing-and-e... See also Vanguard's (biased) opinion: * https://www.vanguardcanada.ca/individual/articles/education-commentary/markets-and-economy/market-downturns.htm https://www.vanguardcanada.ca/individual/articles/education-... The people using index funds generally don't think about their portfolios—which is the whole point of them. It's probably the cocaine-fueled traders that are causing all the ruckus.
• lacker 7y ago
  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 more intelligent criticism of index funds, and thoughts around preparing for a hypothetical world in which index funds were overrated, not less. How might we notice that index funds were becoming overrated? Perhaps the rise of hedge funds which consistently outperformed index funds? Is that happening? 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? Thinking about questions like this without attacking criticism as “silly” is IMO a better way to minimize risk.
  • jackcosgrove 7y ago
    I found an inconsistency in the article. > We’re just seeing a shift from closet indexing to ETFs and other index funds en masse now that investors have wisened up. So active managers are copying the indexes. > Index fund investors are simply buying what the active investors have laid out for them. But indexes buy what the active managers pick. The author appears to be confused as to who is the tail and who is the dog. Maybe this is resolved by saying some active managers do price discovery, but most are just copycats. It's not clear though. For the record I think index funds are still the best choice for a retail investor, and the article is mostly true. Namely > Many of the worries about indexing really boil down to career risk in the asset management space. Some of the arguments seem to be hasty and not well presented though.
    • FabHK 7y ago
      No inconsistency. > > We’re just seeing a shift from closet indexing to ETFs and other index funds en masse now that investors have wisened up. Some active managers used to (clandestinely more or less) copy the indexes, but investors move away from active managers into passive funds. The prices are determined on the margin, by the remaining active investors. That's all consistent. > index funds are still the best choice for a retail investor Yes, index funds or index-linked ETFs. Agreed.
  • 7y ago
• awillen 7y ago
  As I read it, the word bubble in the Burry interview was really just used for clickbait purposes - his argument wasn't so much that index funds are overvalued, it was that there's opportunity in small caps because they're underrepresented in index funds, and everyone else is investing in index funds.
  • kjs3 7y ago
    I don't think so (although bubble is clearly a loaded term). As I understand it, the other part of Burry's argument is that the passive funds distort the market such that if there's a rush for the door there wouldn't be sufficient liquidity to prevent a crash.
  • mrfredward 7y ago
    The Bloomberg article mixed Bury's words and the author's words quite a bit, and I'm beginning to wonder if the whole reason we're having this discussion is because some important nuance was lost. It's hard to see why Mom and Pop buy and hold index investors should care about the liquidity risk Bury talks about...market cap weighted funds will be fine in the long run because the ratio of each underlying stock to a fund share will be constant through the temporary price fluctuations...so no money is lost if the price crashes and then comes back to the same sport shortly after. Perhaps there are other market participants who are leveraged and would find themselves insolvent if indexes cause a liquidity problem? I just don't see how the fund investors themselves would be hurt if underlying stock prices went out of whack for an afternoon.
    • laminarflow 7y ago
      I agree with your views, but anecdotally, my worry is about how many of those Mom and Pop investors bought the index funds specifically because the index funds have recently performed well; and of that faction, how much of the capital allocated to index funds was pulled from other sources, causing those sources to fall in value? The data would also support that on a dollar-weighted basis, most index fund investors are not really buying-and-holding: "Turnover rates for two of the most popular ETFs are higher than 3500%(!), an average holding period of about a week. That is dozens of times greater than the trading liquidity of even its most liquid constituents" http://www.grantspub.com/files/presentations/Grant's%20Conference_Oct%204%202016_Steven%20Bregman_Final[2].pdf http://www.grantspub.com/files/presentations/Grant's%20Confe...
• derivagral 7y ago
  The dig at "Active Management" feels like it detracts from the article, but I guess they're playing a bit to the audience. 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'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 %'s.
  • wbl 7y ago
    No they don't. Let's suppose we have A Corp and B Corp both 50٪ of the total market and A Corps price and hence market cap falls by 50٪, making it 33٪ of the total market. The holdings of a fund haven't changed but the exposure still equals the market.
    • gzu 7y ago
      He is saying when people exit and index sells all their stocks equal to current market cap rankings that the opposite side of trade buy demand for all those won’t be equal. Bad stocks may go down further than solid companies. A shift in value vs growth preferences caused by the downturn itself could be the cause of that. The entire index and all holdings would then HAVE to readjust for this discrepancy and lead to more forced selling of bad stocks and buying of solid companies creating more liquidity crisis.
• gzu 7y ago
  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.
• frgtpsswrdlame 7y ago
  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. Also he jumps around Burry's arguments by focusing on liquidity and in AAPL and FB. Burry'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're market-cap weighted, this would have a cyclical component, more passive purchases -> higher market cap -> higher weighting in passive indices -> more passive purchases. This would result in another cyclical component where that cycle causes: passive fund outperformance -> increased investing in passive funds -> passive fund outperformance. Then in an event where people start liquidating there is no one there to purchase those stocks and they've been dramatically overvalued anyways so their price gets crushed. This is specifically why Burry likes small cap active. If you pay attention to finance discussion on this board then you'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 'rational' price discoverers. >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. Imagine doing this but replacing 'index funds' with mortgage CDOs. Look I'm not even saying Burry is right but the absolute inability of the finance commentariat to actually address what he's saying is giving him more credence.
  • gzu 7y ago
    I believe this is related to the rise in buybacks where price fundamentals no longer matter, only goal for companies is to get the largest market cap as possible ignoring long term risks in order to attract an increasing flow of passive money being poured into the markets.
• TomGullen 7y ago
  If an index selloff could cause a drop in underlying stock price, wouldn't we see this effect when stocks are relegated from various indexes? Does this effect exist?
  • C1sc0cat 7y ago
    Yes and hedgefunds play this game for example M&S getting dumped from the FTSE 100
  • adambyrtek 7y ago
    This effect does exist, but changes to indexes are public, so this information is mostly included in the price already.
• kolbe 7y ago
  Reminder: "index funds" are also managed by humans. For example, all stocks in the S&P 500 are chosen by Standard & Poors. Stocks are added and removed as they see fit based on various criteria such as profitability, float, market cap, &c. The only things that I can see that truly differentiate S&P from other active managers are that they (a) have very little skin in the game. (b) they get to make decisions about what other people have to do with their money (c) they tend to recommend more stocks with less turnover than typical active managers (d) they tell the public ahead of time what will be bought or sold, so traders get to buy/sell ahead of time (e) their actions are relatively predictable, thanks to a long history of sticking to their stated goals.
  • gzu 7y ago
    The S&P 500 is basically a group of largest established 500 market cap stocks traded in the US proportioned to market cap. There is no active management determining price and weights here.
    • Aunche 7y ago
      I don't think so. Otherwise Uber and Snap would both be in the S&P 500.
      • FabHK 7y ago
        There are certain criteria, see [1] or [2] for a summary. They need to be publicly traded for sufficient time, have sufficient free float, be profitable, etc. See [3] for example on why Tesla isn't. [1] https://us.spindices.com/documents/methodologies/methodology-sp-us-indices.pdf https://us.spindices.com/documents/methodologies/methodology... [2] https://en.m.wikipedia.org/wiki/S%26P_500_Index#Selection_criteria https://en.m.wikipedia.org/wiki/S%26P_500_Index#Selection_cr... [3] https://seekingalpha.com/article/4088016-will-tesla-join-s-and-p-500 https://seekingalpha.com/article/4088016-will-tesla-join-s-a...
        • kolbe 7y ago
          Yep. So, you don't just own the top 500 stocks by market cap. You own a set of stocks that resemble that idea, but are in fact still choices made by S&P. Also notice that stocks don't immediately get dropped when they fall below that criteria; there's a buffer for how bad they have to get to be dropped. Additionally, the rules governing these choices are free to change at any time. For example, whether stocks with split voting shares should qualify is still a discussion. Let's also not forget Hacker News's favorite law: Goodhart's Law. The S&P has performed wonderfully well when it was observed as an index. But now that it's a target, the world will change around it.
• cryptica 7y ago
  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'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't need to be efficient in order to derive profits.
• CzarnyZiutek 7y ago
  financial engineering :facepalm:
• pbreit 7y ago
  That is a very confusing headline.
• crb002 7y ago
  I don't buy the liquidity argument. Their mere existence creates liquidity. Two sides to every trade. Index fund "sell offs" will likely go to buyers of the same index fund shares but at a lower price. 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't suffer from a liquidity issue.
  • turk73 7y ago
    That is only true in a liquid market. I remember plenty of times in 2008 when some stocks went "no bid" and the price plummeted until circuit breakers cut in. Some very blue chip companies got hammered hard back then. That's the whole concept of why stock traders need to beware the "crowded exit"--if everyone is trying to sell a the same time, the little guy is going to be holding the bag and can't get a fill on his order. Coincidentally, this is when high frequency trading became lucrative.
• masgbox 7y ago
  yes!
• hogFeast 7y ago
  The "this time is different" crowd rides again. Burry highlighted two simple truths of financial markets: people will buy shit they don'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). 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. I also don'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. 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't hold as much weight (and shows all the self-awareness of a financial adviser to write a post implying they should).
  • thanatropism 7y ago
    I hate this kind of smart-ass top-level "ITT" comment that paints an entire discussion happening besides it with broad strokes. If only one person does this I can call him names and downvote him. If there are two camps and both camps do this, people tribalize and everything goes meta. Then no further actual discussion can take place.
    • hogFeast 7y ago
      If you think it is "smart-ass", you don't understand what I am saying (or, more probably, what Burry is saying). There are no "camps" here. The OP is trying to create a tribe (passive investors are cultish, so this is a very odd comment...I will assume an honest mistake) but that makes no sense on this topic (unless you are selling something, which he is). The meta of my point is: people try this discussion over and over, it is always wrong, some things in finance are universal (because they have been happening for literally three hundred years). What you appear to have missed is the part where I said: Burry is not making a "bombastic claim" about what will happen 100% of the time. In my experience, most people think this is what investing is about (the OP is certainly an example). It isn't. I am not making a bombastic claim. The observation is, again, that: you have a lot of unsophisticated buyers and some non-zero amount of these products are about liquidity transformation. You can have a debate about this all you want but it isn't interesting or engaging to anyone but people who are unsophisticated (not 100% true in this case, Asness is a notable exception but he was an academic and it is mostly academics who take an interest). My interest is limited to the fact that: it is astonishing how often this happens, and equally astonishing how fervently people will deny that it is happening again (although they are usually new converts).
• PaulHoule 7y ago
  I think someday we will think that index funds were pernicious but we don't understand entirely why yet. If you believe, for instance, that there is an "S&P 500" bubble then there is difficulty turning that into an investable thesis. The S&P 500 is about 80% of the valuation of the stock market. If the S&P 500 pops, then relatively the other 20% of the market will go up, but how much can it go up? 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&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.
• gnicholas 7y ago
  > 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. Actually, our behavior does shape the price of oranges. If we go to the store and they're less expensive, then we are more likely to buy them. The analogy breaks down because he'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.
  • IshKebab 7y ago
    People more or less do do that. I've often searched for something on Amazon and bought the most popular result.
    • gnicholas 7y ago
      Sure, but do you buy a bundle of goods this way? That’s the analog of index investing.
      • thekyle 7y ago
        What's the difference between going and buying 10 top goods individually and buying a bundle that contains those same 10 top goods.
        • yifanl 7y ago
          Nothing, but the analogy would be buying the Amazon top-seller of every product category. It doesn't make sense, you aren't going to use any of those products, you don't even care what most of them are.
      • IshKebab 7y ago
        Sure, when I buy a crate of wine, or a box of chocolates. Stretching the analogy somewhat but I think the point still stands that it doesn't require the entire market to actively invest to keep everything priced very close to the same price they would be if index funds didn't exist.
• dkarl 7y ago
  As others have noted, there's a lot here that isn't relevant to Burry's argument, but this seems like the key rebuttal to me: 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 don't have the knowledge to evaluate this statement, but to me, it undermines Burry's point that passive investing distorts prices. And this bit that he quotes from someone else expands on the point: 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. As I understand it, Burry'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 "true" 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 "escape" from the index funds to actively managed funds, because index funds will always approximate the aggregate opinion of the actively managed funds. This accords with my naive idea of how index funds work, but I don't know if they actually do work that way, so I can't evaluate the soundness of either argument.
  • christophilus 7y ago
    > Index fund investors are simply buying what the active investors have laid out for them. That works until it doesn't. If passive becomes big enough, the indices themselves will be the ones steering the ship. The active managers won't be significant enough to sway the indices. I heard this analogy on a podcast (I think it was Invest Like the Best): Indices are like a drunk person, and active managers are like the sober friend guiding the drunk home. But if the drunk becomes 10x the size of the sober friend, the friend is no longer strong enough to be a guide. If passive funds get big enough to dwarf active management, they eventually will be the ones steering the market, and active investors will be noise at that point. In that scenario, I'm not sure what happens, but it seems that indexing would become more like a Ponsi scheme.
• newshorts 7y ago
  > 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. 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. 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.
  • tobylane 7y ago
    >isn’t there a well known price premium for stocks included in major index funds? Maybe the premium is for being in the index, which the index fund dutifully reacts to. There are only 100 places in the FTSE100 so it is seen as significant. The current news about a major UK high street retailer is that it dropped out of this index, implying it's the beginning of its end. https://www.google.com/search?q=marks+and+spencers&tbm=nws https://www.google.com/search?q=marks+and+spencers&tbm=nws
  • AlanSE 7y ago
    I've asked this question before and consistently failed to get a clear answer - why is there any deviation between index fund weighting and market cap? To some extent, I'm sure the definition of a "public" company comes into play. Not all stocks are traded in all exchanges, so you could include stocks only listed on one exchange. Then there's the practice of many index funds picking the top N stocks by market cap. This seems like a backwards practice to me. The small cap stocks should be limited in weight by... their small market cap. Then there are other hairy factors. Even out of the stocks in an index, it seems that weight does not correspond to capitalization. The reason seems to be some historical drivel. While I can understand that is the way it is, I fail to understand why it should be that way. Why should an equities index fund be anything other than public companies proportional to their size? If people prefer large cap or small cap, then those variations should be offered as special boutique products. But it seems that we have it backwards, where the default offering is based on arbitrary non-proportional weights, and with a cutoff restricting it to large cap.
• maerF0x0 7y ago
  IMO the real issue is amount of cash available for investment and the lack of investable assets[1]. If i were king for a day I'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. [1]: https://personal.vanguard.com/pdf/ISGPCA.pdf https://personal.vanguard.com/pdf/ISGPCA.pdf
• deleted 7y ago
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• david927 7y ago
  It doesn'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't there. So if you invest in "all coffee shops" or "all shops in my hometown", you're not looking at fundamentals, you're investing to invest. And, by definition, (assuming all shops are priced correctly) you're artificially inflating. If someone invests across a group of stocks, it's because "the market always goes up over time." 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's a bubble. And even a bubble that lasts decades will eventually pop.
  • 8ytecoder 7y ago
    There are always active investors who could take advantage of this valuation mismatch and bet for/against specific companies that they think are undervalued/overvalued and make money. Eventually this valuation mismatch would show up in their P/L statement and balance sheet. Passive investing freeloads on active investors - in a sense. That's all it is and I for one think it's great.
  • gdubs 7y ago
    Investing in a whole sector isn’t any less of an investment. You still have to believe in coffee as something that will return in the long time. You’re just trading risk for softer returns than if you were to take a gamble on one specific shop.
• bitxbit 7y ago
  I believe what’s missing from the recent analyses of beta/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 3/4 of investable wealth now pooling into passives funds simply cannot be overcome. What it does provide is significantly asymmetrical opportunities shorting single stocks.
• sct202 7y ago
  I'm a little confused about the point about index funds being a small percentage of assets, when there are constantly articles like "Passive investing automatically tracking indexes now controls nearly half the US stock market." 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... His graph shows an arrow pointed at the small sliver on ETFs, but that isn't necessarily the same as passive investing which would include a lot of mutual funds.
• hsnewman 7y ago
  In these times I'm looking at more conservative "passive investments" such as interest bearing accounts, FDIC insured. With Twitter posts resulting in large swings in the market, I declare "market manipulation" by those with large numbers of followers.
• dumbfounder 7y ago
  "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." 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.
• AlanYx 7y ago
  One question I have about Burry's comments that isn't (directly) addressed in this article relates to Burry'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&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.) My question is, does this imply that there'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't average daily inflows lead to higher trading volumes than we'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?
  • sokoloff 7y ago
    > (And he notes that almost half of Russel 2000 stocks trade at less than $1 million during the day.) He notes that 456 (a little under a quarter) of the Russell 2000 trade less than $1MM/day: "“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." S&P index funds have an annual turnover of around 2-4% of AUM typically, so the transaction need to track closely is perhaps not as high as one might think.
  • omarhaneef 7y ago
    I assumed he was talking about the futures market. The SP500 and Mini-SP500 contracts. The volumes are high -- I don't know if they're in the trillions (depending on how you count them) -- but they're high. That would constitute "synthetic indexing" in the sense you are talking about.
  • travisoneill1 7y ago
    As the manager of the ETF you could allow it to float freely in which case it could trade at a premium or discount to NAV. But it wouldn't move too far because this would attract arbitrageurs who would trade the ETF against the individual stocks and bring it back in line. This would result in volume in the individual stocks. Another way you could do this is hold a pile of units in reserve and actively sell into the market when the ETF trades at a premium and buy when it trades at a discount. This approach would not result in any volume in the individual stocks (except for re-balancing from time to time). I think what he is saying is that ETF's use the latter approach. Of course this could also be done in an totally synthetic manner, but I don't think that index funds do this. It would be messy.
• api 7y ago
  Wasn't the housing bubble driven in part by a form of passive investing, namely bundling mortgages (one of the "safest private investments")? 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's a good investment.
• deleted 7y ago
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• jeffdavis 7y ago
  At some point, someone (or a collective) needs to make a decision about how capital is allocated among different firms. Traditional money managers may not be the right way to do that, but we should be clear that decisions are still being made somehow. I guess it's not the investors plowing money into the first index fund they find. And it's not the index fund, because they don't do a lot of management. So I guess it's a handful of hedge funds that set prices?
  • Excel_Wizard 7y ago
    Index funds do not contribute to the process of price discovery. As long as a certain fraction of trades are performed by active investors, price discovery will continue to be accurate. Currently, active traders dominate, making up the majority of trades. This fraction could be much smaller than it currently is and still be OK.
    • jeffdavis 7y ago
      There are still people discovering prices, and they are still getting paid somehow, probably by first-mover advantage. Are we sure that the right model is to just watch these first-movers and do what they do?
• tempsy 7y ago
  Now my main concern with index funds I hold (broad market/large cap) is that I definitely have exposure to businesses (e.g. fossil fuels) that I don't actually want to be invested in. Anyone have suggestions on the best sustainable ETFs out there?
  • deleted 7y ago
    [deleted]
• blacksqr 7y ago
  I find it grimly amusing that the posters here expressing variations on the "this is fine" position are making the exact arguments that market boosters were making before/during the mortgage finance crisis in 2007/2008. 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. 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'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. Keynes' insight was conveniently forgotten by the early 2000's, regulation was resisted, the shadow market grew out of bounds, bailouts and stimulus met political resistance, and the rest is history. How short the time span of memory is.
• cs702 7y ago
  It depends on whether and to what degree indexes are affecting price discovery: If prices are being set predominantly by active investors who are truly buying and selling based on bottom-up, security-level research, 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. But if prices are being set predominantly by (a) active investors who are chasing indexes because they don't have a choice, (b) active managers who are being forced to sell positions 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. 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.
  • qaq 7y ago
    And there would be hedge funds that would try to exploit this eventually pushing things back into balance
• modeless 7y ago
  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't in the index. The 90% that'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. I don'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. [1] http://hosted.rightprospectus.com/ETF/Fund.aspx?dt=P&cu=808524102 http://hosted.rightprospectus.com/ETF/Fund.aspx?dt=P&cu=8085...
• tjpaudio 7y ago
  "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" This is a straight out false statement. Who is this guy again? Oh yea, he has his hands in passive investment big time.
• gridlockd 7y ago
  Back in 2007 you could've made a similar chart to show that CDOs are a small amount of the market. What's unclear is the impact that ETFs have on prices. This "debunking" doesn't address the point about low volume. Let's suppose most of those non-ETFs owners are buy and hold investors that bought in a long time ago and wouldn't buy anywhere near today's prices. That would mean ETF holders, especially those who joined late, could still be responsible for a disproportionate share of today's prices. If the market shows signs of weakness, these people need to get out, especially if they bought on leverage.
• laminarflow 7y ago
  For those interested in this topic, Horizon Kinetics' 2016 presentation "Indexation: Capitalist Tool" 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's analysis). http://www.grantspub.com/files/presentations/Grant's%20Conference_Oct%204%202016_Steven%20Bregman_Final[2].pdf http://www.grantspub.com/files/presentations/Grant's%20Confe... Edit Some highlights: > 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. > 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... > 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.
• falcolas 7y ago
  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's crazy how often probabilities are presented as fact. My mother-in-law works for the state doing financial investing, and I've seen some of the functions and constant values she's had to memorize to get her degrees. Constants that are based on models that are often decades old. It's all ultimately a form of forecasting based on models, but it's treated as gospel of how it will all occur. Perhaps that's why it works at all - everyone's using the same models, and they behave in a set pattern (established by schooling and "how it's always been done") based off those models, which makes the models accurate.