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

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

quote:
“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.”

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

I am no finance expert so the inner-workings of this argument are way above my head. It seems like a fund manager trying to attack passive investments, which has been the "sour grapes" strategy since index funds were invented.

However, the last quoted paragraph, especially the bold part, is what really caught my eye. I always had index funds explained to me as basically being a representation of equities (as in the actual equities). However, and I may be reading this incorrectly, is Burry arguing that these index funds are really active funds trying to mimic actually holding these equities? Do these passive funds really not hold the equities?

If the funds are holding the equities, then I don't see how these are really bubbles. The "bubble" is the increase in money flowing to the market (of index funds, generally), but I don't know what real, direct effects this would have on the price of the equities themselves (which is how the value of the fund would grow). I suppose there could be a secondary effect (more money in any system will cause effects of the sub-parts), but wouldn't that occur wherever this money goes? I'm just saying that the bubble doesn't seem to be a rush of money that is causing the increase itself, it's just that investors are being smarter in how they choose to invest (but this may be the big con that I just don't see properly).