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SlowFlowPro
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Michael Burry calls passive investments/index funds a bubble
Compares them to CDOs in 2008

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).


Delacroix
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Member since Oct 2008
3864 posts

re: Michael Burry calls passive investments/index funds a bubble
TLDR: Fund manager doesn't like when people don't let him manage their money


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Y.A. Tittle
Winthrop Fan
Member since Sep 2003
74621 posts

re: Michael Burry calls passive investments/index funds a bubble
quote:

Compares them to CDOs in 2008



That was a pretty small niche investment vehicle by comparison, no?


LSURussian
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re: Michael Burry calls passive investments/index funds a bubble
I read what Burry said a day or so ago several times. I still don't understand why the passive investment vehicles are a bubble.

I can understand the idea that the stock market is a bubble which translates to any pooled stock investment fund being a part of that bubble.

But how those passive funds can be identified as THE bubble is beyond my comprehension.


SlowFlowPro
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Member since Jan 2004
366954 posts

re: Michael Burry calls passive investments/index funds a bubble
quote:

I can understand the idea that the stock market is a bubble which translates to any pooled stock investment fund being a part of that bubble.

Exactly.

quote:

But how those passive funds can be identified as THE bubble is beyond my comprehension.

Yeah I don't get it. It seems like he's implying there is an active management component hidden with buzzwords like "derivative".

It doesn't make any sense to me, which is why I came here to get some education on it. If you don't understand it, then I feel better b/c that means I'm not crazy.


LSURussian
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re: Michael Burry calls passive investments/index funds a bubble
quote:

b/c that means I'm not crazy.
Only on this one issue....


SlowFlowPro
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re: Michael Burry calls passive investments/index funds a bubble
quote:

That was a pretty small niche investment vehicle by comparison, no?

The problem was in the exposure because they kept adding layers that added exponential exposure with each layer. The actual money in that sector wasn't amazing, but they kept creating derivatives on top of derivatives, with each layer creating, effectively, insurance on all the underlying obligations, drastically increasing exposure if they ever game due. They could get all sorts of insane return/fees on this, but it was all built on the assumption that the CDOs would never really come due (because mortgages were seen as impervious and literally 0 risk).


SlowFlowPro
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re: Michael Burry calls passive investments/index funds a bubble
quote:

Only on this one issue....


it's a start


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LSUtoOmaha
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re: Michael Burry calls passive investments/index funds a bubble
Maybe he simply means that people have no real regard for what they are buying?


Y.A. Tittle
Winthrop Fan
Member since Sep 2003
74621 posts

re: Michael Burry calls passive investments/index funds a bubble
quote:

The problem was in the exposure because they kept adding layers that added exponential exposure with each layer. The actual money in that sector wasn't amazing, but they kept creating derivatives on top of derivatives, with each layer creating, effectively, insurance on all the underlying obligations, drastically increasing exposure if they ever game due. They could get all sorts of insane return/fees on this, but it was all built on the assumption that the CDOs would never really come due (because mortgages were seen as impervious and literally 0 risk).


I didn't mean to suggest that didn't make it a legitimate "problem", just that I don't see any way to say we might currently be dealing with any sort of comparable "bubble." T

hat being said, I would be lying if I said I completely understand all that he's talking about either. Just seems like a much different scenario if we are talking about a vehicle that pretty much everyone who has an investment of any kind likely has some sort of direct stake in.


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SlowFlowPro
Stanford Fan
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Member since Jan 2004
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re: Michael Burry calls passive investments/index funds a bubble
quote:

Maybe he simply means that people have no real regard for what they are buying?

naw


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lsu13lsu
Member since Jan 2008
6871 posts

re: Michael Burry calls passive investments/index funds a bubble
The average person doesn't realize that an S&P 500 mutual fund/ETF doesn't really own the underlying stock. There isn't enough stock to go around because of how many funds/etfs there are that want to match the S&P 500 etc. What these funds/etfs own is derivatives of said stock that "mimic" the stock.

So tons and tons of derivatives on top of derivatives have been created to "mimic" stocks and are owned by "Passive" investors unknowingly.

That is what Burry is discussing.
This post was edited on 9/6 at 10:47 am


Ace Midnight
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Between sanity and madness
Member since Dec 2006
69015 posts

re: Michael Burry calls passive investments/index funds a bubble
quote:

I am no finance expert


Me, either.

However, it is a transparent attack on the concept of index funds, particularly passive ones. He wants us to draw the conclusion that passive indexes, which use a cold, calculating computer algorithm is somehow less factoring in "price discovery" than a human fund manager who is doing exactly the same thing, albeit with different tools.

FFS, ETFs are actually traded. So, if you're buying, selling or holding those, you have the price in real time.

If anything, when you buy an actively managed fund, you're basically buying the fund manager. If you buy a passive index fund, you're effectively "buying" a proxy for that index. With an ETF you're effectively "buying" the index.

The crux of the valid part of his argument is that these low volume, low value stocks have a much wider variability in valuation than the index or ETF might suggest. Certainly, that's true, but that's also true of the index. If they're all wrong, the index was worthless. If an individual stock here or there is wrong (low), it should be balanced out by one that is likewise wrong the other way (high).

At least that's my amateurish take on it.

I mean, if he's right, then index funds, generally are inferior to individual stocks and that is legitimately crazy for 99% of investors.


Ace Midnight
LSU Fan
Between sanity and madness
Member since Dec 2006
69015 posts

re: Michael Burry calls passive investments/index funds a bubble
quote:

I can understand the idea that the stock market is a bubble which translates to any pooled stock investment fund being a part of that bubble.


Yes - insofar as equities are inherently "bubblish", then it is a bubble. Index funds aren't all that new any more and this is the first time I've seen them targeted as a bubble, derivatives or not.

The housing "derivative" bubble was very easy to explain - the risk was not priced correctly (because folks were being granted mortgages they could not afford, regardless of risk, but everyone pretended that wasn't happening). It was easy to see. But, it was dismissed because of the emotional "security" of both mortgages and the protection government grants banks.

"Too big to fail." If he's right about this issue, then the "stock market" is too big to fail. You pays your money and you takes your chances. Still way better than 1929 from a risk/return standpoint.


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SlowFlowPro
Stanford Fan
Simple Solutions to Complex Probs
Member since Jan 2004
366954 posts

re: Michael Burry calls passive investments/index funds a bubble
quote:

The average person doesn't realize that an S&P 500 mutual fund/ETF doesn't really own the underlying stock. There isn't enough stock to go around because of how many funds/etfs there are that want to match the S&P 500 etc. What these funds/etfs own is derivatives of said stock that "mimic" the stock.

This makes sense and is a direct answer to my questions in OP.


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LSURussian
LSU Fan
Member since Feb 2005
116180 posts
 Online 

re: Michael Burry calls passive investments/index funds a bubble
quote:

an S&P 500 mutual fund/ETF doesn't really own the underlying stock. There isn't enough stock to go around because of how many funds/etfs there are that want to match the S&P 500 etc. What these funds/etfs own is derivatives of said stock that "mimic" the stock.
This is the first time I've heard that argument. Do you have a link explaining more about it? I'd like to learn more about it. Thanks.


KamaCausey_LSU
Member since Apr 2013
6341 posts

re: Michael Burry calls passive investments/index funds a bubble
So he's saying that the index funds can't accurately track the volume of it's lower volume stocks? And that when the bottom falls out low volume stocks will pop the index fund "bubble"?


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gpburdell
Georgia Tech Fan
ATL
Member since Jun 2015
550 posts

re: Michael Burry calls passive investments/index funds a bubble
quote:

If anything, when you buy an actively managed fund, you're basically buying the fund manager. If you buy a passive index fund, you're effectively "buying" a proxy for that index. With an ETF you're effectively "buying" the index.


When you buy a mutual fund, you are buying it at net asset value (NAV) which is determined at the end of the trading day. When you buy an ETF you are buying above or below the NAV which is called a premium or discount. This premium or discount from the NAV can be significant on ETFs with low volume.


lsu13lsu
Member since Jan 2008
6871 posts

re: Michael Burry calls passive investments/index funds a bubble
quote:

This is the first time I've heard that argument. Do you have a link explaining more about it? I'd like to learn more about it. Thanks.


I don't have a link. Burry discusses funds using them. Nearly all prospectus I have read state they may use securities that mimic the stock when stock isn't available and show futures and options in their annual report.


Ole War Skule
LSU Fan
North Shore
Member since Sep 2003
3034 posts

re: Michael Burry calls passive investments/index funds a bubble
quote:

The average person doesn't realize that an S&P 500 mutual fund/ETF doesn't really own the underlying stock. There isn't enough stock to go around because of how many funds/etfs there are that want to match the S&P 500 etc. What these funds/etfs own is derivatives of said stock that "mimic" the stock.



Please explain this. Everything I'm reading says that the ETF buys and owns the stocks.

"An ETF is a type of fund. It owns assets (bonds, stocks, gold bars, etc.) and divides ownership of itself into shares that are held by shareholders. The details of the structure (such as a corporation or trust) will vary by country, and even within one country there may be multiple possible structures.[7] The shareholders indirectly own the assets of the fund."


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