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-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?
I will try to interpret, but obviously it is just my interpretation (and personally I mostly agree with many theses Burry gave). First, he does not really talk about being a "good citizen" or not. His points are for "greedy citizens" who, in his view, should be worried (about his pocketbook) if he is heavily invested in passive index funds.
This is due to his "bigger and bigger crowds, same exits" analogy: individuals easily move through doors at will; but if a crowd rushes out through the same door, injuries happen.
His premise is that many stocks that index funds invest in have low liquidity (small door): half of stocks in SP500 trades less than $150M a day. This is tiny (he quotes total market cap of indices of $150 trillion). What happens if there is a small, but synchronized outflow for any reason? If customers ask for 1% of index funds to be sold, index funds have to sell 1% of their holdings in the exact ratios defined by the index, including stocks with low trading volumes. Which is a problem, as there may be no one to sell them to, so prices of those stocks may crash and create a big panic causing additional sales of index funds bringing down bigger chunks of the market.
Imagine there was a cookie market made up of two types of cookies, tasty and meh. An active investor in cookies would spend time determining which cookies are likely tasty and which are meh. They would pay more for the tastier cookies so they can savor the flavor and less for the meh ones they can binge eat in the shower when no one is home.... A passive investor comes along and says, I don't want to do all this research, I'll just assume the market was able to price these accordingly and buy any cookie at the market price. At the beginning, it is great. They just sit back and buy baskets of cookies, some tasty, some meh... but they always pay the higher price for tasty and lower price for meh, so it is fair. Over time, more people start buying baskets of cookies rather than spending time/money figuring out what to pay for them. At some point, no one is left to figure out which cookies are tasty vs meh, so the price of all cookies converge to a single price. Cookie manufactures notice this and figure might as well just make meh cookies as no one can tell the difference until after they buy them... and then we are stuck in a world with meh cookies. With some critical mass of active cookie investors, prices could be set fairly for all cookies. Too many active investors, and there is a drain on the system as there is likely a lot of duplicated work among the investors ( each one has to have a research team, back office cookie trading systems, etc, etc ). Too little and prices become less accurate.
> 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 evidence shows that most of us suck at investing. Further, I think Burry's critique is more limited:
> One reason he likes small-cap value stocks: they tend to be under-represented in passive funds.
IMHO, the problem he's stating is that people are focusing on large-cap companies. Basically the S&P500. And the S&P500 index funds probably do hold most of the passively invested money. But to solve this (small- vs large-cap focus), the solution is not to throw away passive investing, but to change the focus.
For example, instead of buying Vanguard's S&P500 fund (VOO), to buy their Total Market fund (VTI) which uses the CRSP U.S. Total Market Index:
It's just that the S&P (and DOW) have more name recognition.
But generally speaking, these decisions are micro-optimizations. Just put away a little every month and re-invest and dividends, and over the long-term you'll do well.
The point of the article for me is that all of this capital in one place is bad for contagion, and there’s no backstop to even small fluctuations downward / sell-offs that will end up zeroing out the wealth of most index investors. In that way it resembles all the capital in CDOs - but this time instead of being held by banks that can get bailed out it’s being held by individuals. Woof.
Bottom line - they look low risk until they’re absolutely not low risk because of these properties.
As an average investor I’d say diversify is still a good strategy. Don’t just do US Market index funds. Global stocks, bonds, and other small-cap stock collections might help hedge risk of large-caps going bust. Most passive-style funds also have these options. Not an active investor. Just a dude playing a dude disguised as another dude. This is not investment advice.
There is an interesting idea when index funds are taken to an extreme in that if no one is manually playing the market or managing investments then everything is invested in at the same or similar rates. Index funds need active traders to trade and set pricing within the market.
My analogy would be if we are all buying tickets to the big game and sit in the stands until it's over, there's no one to yell and shout and drive the energy of the crown or possibly no one to even compete on the field therefore why are we even showing up?
It's definitely the extreme - active trading isn't going away any time soon but fears of a only a limited group playing the market and managing or controlling stock prices for their gain isn't 100% unrealistic.
The more interesting question is, if there is an index fund crash, will the actively managed funds benefit from it, or crash right alongside the index funds? How much are actively managed funds contaminated by stocks that are in index funds? (That probably depends on the type; a small-cap or emerging markets managed fund will probably be mostly clean of the indexed stocks, but a managed large-cap is probably full of them.)
Well the argument, if I correctly understand, is that the less liquid stocks in index funds are getting pumped up because investor demand for passive stocks is outweighing active price discovery. This would exhibit a cyclical pattern where as passive outperformed, more investors switch over which continues to pump bad stocks and so on. Then in a downturn, even if you hold, as investors get scared and pull their cash out of the index fund, those less liquid stocks will get hammered by the double factor of their being already overvalued and also thinly traded, dragging passive performance way down.
Not saying I agree but, if he's right it makes complete sense that passive would outperform active right now, just that in the next downturn it would dramatically underperform.
The market is in peril because there are too few actors setting value based on the merits of the company instead of betting on other investors' behavior.
You want to help? Pull some, not all but some assets out of index funds and put them into individual companies you understand and believe have long term profitability. Sell those assets when you think they're overvalued by the market.
Trading less often is correlated with better performance (you are not an HFT)
There is some responsibility you have. Your money isn't going to just magically work for you, you have some obligation to research and understand what you are investing in. When nobody does it, the market is in trouble.
I think his point is that most index funds are weighted towards large caps and ignore small ones. With more and more money pouring in, it creates an inflation in value there whereas the small caps get ignored. That is the most logical interpretation I can draw out of his statement (although I am a 100% index investor myself).
It’s all fine to say that active funds can’t outperform index funds... but if it’s a bubble and it crashes, then people in active funds will be having a field day while the people who bet it all on index funds will be left behind like the people who leveraged their 3 homes to buy 5 more during the “real estate always and consistently goes up” days of pre 2008.
The problem with bubbles is that everyone’s a winner and every indicator is confirming the everlasting increase.. on the way up.
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.
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.
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.
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?
Most folks here are focusing on Burry's comments regarding price-discovery. However there is another huge point: Liquidity risk. To understand his point, you have to know the gory details of how an ETF operates.
First: When you buy a ETF share for the S&P 500 (iShares, Vanguard etc), the share is not backed by all 500 S&P components. Virtually all the large-number component ETFs are using a sampling of shares to match the underlying index. (They would be buried by transaction fees otherwise.) The subsampling of the index is reasonably well-understood math, but relies on an assumption: That the buying and selling each component share will not be greatly affected by the ETF purchase or sale.
[Edit: I may be out of date - Some ETFs are full samples. Nevertheless, the bigger point that the ETF purchase/sale does not much affect the price stands.]
Second: The ETF uses a very clear process to keep the price of the ETF in equilibrium with the index it represents. Large players are allowed to go to the ETF adminstrator (say iShares) and turn in a bunch of the ETF shares, and iShares will transfer back the underlying components. So if the ETF price ever gets too cheap relative to the index, the big players will redeem the ETF share, and then sell the underlying shares they received, which results in a quick, nearly guaranteed profit.
Conversely, if the ETF price goes above the index, a large player will bring a basket of the underlying component shares to iShares, and iShares will give them corresponding ETF shares. So they buy the components cheap, sell the expensive ETF, again making a quick profit.
Now to what Burry is saying: Several components of the big indices are thinly traded compared to the amount of money in the index funds. In a large index drop, there will be disproportionate downward moves in those thinly traded shares: As large players will be redeeming the ETFs for underlying shares and then sell, these thinly traded stocks will drop further than you'd predict from the index. This will cause the index to drop further, which will cause more ETF shares to be redeemed, perpetuating the cycle.
I think his point should be better known than it currently is: The current wisdom that "you can't lose money in the stock market long-term" is reminiscent of "you can't lose money buying a house."
I think the contrast is between active and passive funds.
If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets.
A passive fund adds money into the system, but it doesn't add any intelligence - it relies on the intelligence of the current market participants.
As more and more money switches from active to passive, we have more and more money relying on less and less intelligence. This means that the market is becoming less and less efficient, and prices are deviating more and more from where they should be.
Passive investors are essentially leeching returns off the work of the active investors.
This article suggests that the effect will be ultimately catastrophic, where I suspect that it'll just result in money slowly swinging back the other way as active funds take advantage of the situation to start to make more money than before. That's pretty much what the article says he's doing.
Other replies were good. But I'll add my two cents.
Index investors are basically free riders off the information and research generated by active investors. Indexing basically works pretty well because the market's efficient.
An index investor just comes in and just pays whatever the current market price is and allocates in proportion to whatever current market valuations are. He doesn't even need to know anything about the underlying companies. "Microsoft? Never heard of it. But the market says it's worth 3.8% of all major American stocks, so I'll put 3.8% of my money in it"
Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.
And the reason it does work is because the active managers compete so fiercely with each other. They end up showing all their cards to the market. And all the information they have, and the research and the analysis winds up reflected in the publicly available stock prices. In effect active investors pay their managers big fat salaries to analyze stocks, and passive investors get nearly all the benefits without any of the costs.
I'll try. Price discovery means finding out the value of a stock by people bidding to sell and buy it. Historically, beating the stock market is hard to do, so one strategy is to just go along for the ride, buy a little of everything. This is what ETFs do. You're not bidding your guess of the value a company should have, you are just saying "hey, I'll pay what that other guy is willing to pay". Now, thats not a problem necessarily, but if the majority of people are not placing their own bids, and everyone is just saying I'll take what the market rate is, then the price of a stock isn't really tied to anything. This is the world we are in today. ETFs have become so massive, some of them are starting to be the majority shareholder of the companies in their portfolio. Now let's say our dear leader really tanks the economy and everyone rushes to sell their ETFs. The companies most effected by whatever policy fuckup are not the only ones that go down, the whole market will go down. Scary stuff.
The more sophisticated part of the argument is that indexes require overexposure to thinly traded stocks and that in a market sell off the assets linked to the index would see outflows, which require selling the underlying(s), which would cause a material price hit in illiquid stocks, which could cause a partial feedback effect as the index would then slip more.
If one believes this to be true, one necessarily believes that illiquid index constituents are overvalued today relative to their actual enterprise value and will, at some point in the future, be sharply undervalued as a large number of computers controlling trillions of dollars attempts to implement a for loop shoveling money at you.
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.
Someone that knows more than me: how is a correction going to happen on index funds?
Retail investors are told to shovel money in and keep it there. Who's going to be selling to pop the bubble? Do investment banks have a lot of index funds and their derivatives bought? Does there have to me some major re-allocation within the fund that causes investors to sell?
If a single stock is valued incorrectly, how is that going to bring down the entire index?
I can explain the analogy at least, though I think there's a serious flaw in his reasoning.
CDOs are collections of mortgages with rules about how they pay out. During the last bubble they were sold (and rated by supposedly respectable third-party arbiters) as among the safer investments available. This was because the CDO had a safety feature where a certain percentage of the mortgages were expected to default, and so you didn't need all top-quality mortgages, lousy ones were okay, too. Thus the sudden availability of "NINJA" (No Income, No Job, no Assets) loans, which were completely inexplicable to basically everyone. No one would have lent their own money to poor credit risks, but the CDOs would buy that loan and stick in in their security in a heartbeat. The problem came that once the expected maximum level of default was breached, the CDO started paying out very little or nothing, and the value fell to near zero.
So his analogy is that the same thing will happen to index funds, which invest on the principle that you don't need to pick top-quality stocks, that you just buy all of them. As far as it goes, there is a significant similarity with CDOs. As an index investor, I don't try to find my own good stocks, I don't even need someone skilled in stock picking. I'm relying to an extent on financial engineering and the rest of the market to make sure that I'm not grossly overpaying for the lousy companies that are in the index. He notes that there is a huge multiple on many of the stocks, such as the 266 that have less than $150 million in daily trades, but represent trillions held by index funds. Trading is the "price discovery" mechanism of the market, and lightly traded stocks are subject to all kinds of manipulations and volatility, to be sure.
But there are several places where I think he's making a major stretch with this argument. First, the CDOs were sliced into "tranches", so when you bought a CDO you didn't get the underlying assets, just the right to a payment stream. The index fund sticks very close to the current market value of its assets; you get what you would have gotten if you just bought all 500 stocks individually, without any financial magic. For instance, on a $10K investment the Vanguard S&P fund trails its index by about $100 over 10 years. There's no daylight for shenanigans there, so I think the financial engineering argument is categorically false.
It also doesn't bother me that the stocks are thinly traded relative to the assets, because one of the big advantages of passive investing is that you're not trading all the time. Again looking at Vanguard, they turn over less than 4% of the stocks in a given year. But that's what you should do if you don't want to get killed by trading fees. Buy and hold and all that. For there to be a problem you'd have to see that those stocks were getting volatile, or that the index funds were constantly buying at a disadvantage. It is true that there is a certain amount of trying to beat the index funds to the punch; kind of hard to keep from telegraphing your investment choices when they're literally written into the name of the fund and you need to buy for a half-billion dollar fund. But these are tiny in magnitude. If anything, things are much more efficient and rapid then they were before computers took on most of the trading.
Finally you get to the thing I worry he has a point. If 100% of the money was passive, there would be huge opportunities to exploit. There's no law that says passive investing is going to be better than active. It's been true so long that maybe it's taken as gospel when it shouldn't be. Nothing is forever, and anyone who argues "it's different this time" is probably wrong, eventually. But there's still a ton of money out there in active funds, hedge funds, pensions, etc. If they saw a good opportunity, they would take it. There's too much money to be made by sharp-eyed investors to let the market as a whole get to the point where bad stocks and good stocks are treated the same.
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?
The thing is even if Burry is right (and that's a big if), it doesn't mean that you as an individual investor with a long time-horizon should do anything different.
Burry's argument is that many of the underlying stocks inside the index have a lot less liquidity than the index funds and securities themselves. E.g. if a lot of capital quickly exits the index funds, then some of the single-name stocks may be overwhelmed by the liquidity. That would result in their prices becoming severely dislocated relative to their true value.
But if you're just buying-and-holding that doesn't matter. If the stocks in your portfolio become temporarily dislocated, who cares? Dislocations by definition correct themselves over time. If some stock falls 50% because of panic selling, without anything having to do with the underlying company, it will eventually return to the correct price. And much sooner than the decades long timeline that you're saving for.
That doesn't mean that Burry's thesis is irrelevant to everyone. In particular if you're an institution that offers liquidity to your clients it may be very relevant. Or if you're a bank, hedge fund, or insurance company that's subject to mark-to-market capital ratios or margin calls.
If stocks become very dislocated, your investors may panic and redeem their money. Or your regulator may say you have insufficient capital and have to liquidate. That's very bad, because you'll be forced to sell at fire-sale prices. However, that's not relevant to individual investors, because nobody can force you to sell out just because your portfolio goes down.
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.
In my view there are two take-aways from this: 1. Diversify, but 2. not too much.
1. Even among index funds, maintain some diversification. Don't put all in US large caps (S&P 500), but also some international and some small caps (Russel 2000).
He is saying that given how much money is invested via index funds now, there are opportunities in assets that are not (or insufficiently) represented in index funds. (This is hard, though, and the standard advice to refrain from trying and placing your bets on index funds instead remains valid, I think, particularly for mature markets in which you don't have an edge.)
The second take-away is at a tension with the first:
2. Avoid ETFs that handle illiquid assets (real estate, bonds, etc.) or create synthetic exposure using swaps and derivatives.
For big, liquid assets, the ETF or index fund can just take the investor money and go buy the assets. Then the value of the fund is approximately the value of its constituent assets, sort of by definition, and that value is relatively easy to realise (that is, if you want your money back, you get it - they'll have to sell some of the assets, but they're liquid, and that won't influence price too much).
For smaller or more exotic assets, a fund might not buy them outright, but contract with a third party (an investment bank, typically), and give the bank the money, with the bank promising that it will return the value of the asset. So, it's "like" holding the asset, except that you get the credit risk of the bank - there's a risk the bank might not be able to uphold its promise. And this is most likely to happen when everyone runs for the exit.
> 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.
> ... 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.
So, an ETF promising to deliver the value of an index can generally do it, and there was no big failure so far, but scenarios are conceivable where it cannot deliver.
The best passive way to approach your situation, is probably what you already know: gradually keep investing passively with the savings from your income. Over the long haul that has a reasonably high probability of turning out well with very little intervention on your part as a non-professional.
There is also nothing wrong with adjusting the ratio of cash vs equities that you're accumulating (eg the share of your income going into the market vs going into cash in a span of time). It's the exact same safety vs risk lever that is commonly utilized in adjusting equities vs bonds as you get older. Some will call it market timing, it is not, as you are not attempting to time a top or bottom. With recession alarms going off in most global economic data, increasing your conservative posture is nothing more than being modestly prudent (and it doesn't have to be an extreme adjustment; if 100% of your net savings is going into the market now, changing that to 75/25 or 50/50 with cash, is entirely reasonable). Even Warren Buffett has turned hardcore conservative with this market, he's buying nothing and sitting on a $122b record pile of cash that is very much annoying him (by his own admission). The reason for his behavior, beyond the obvious blaring economic data, is that the valuations are terrible vs the growth we're seeing (both macro economy and corporate earnings); right now investors are paying a steep premium in most cases for the value they're getting. Buffett doesn't like the price he's paying for the value he's getting, so he has gone into bunker mode, as he has done prominently several times in the past. The simple, non-professional approach to that move, is to just make a reasonable adjustment to how much cash you're accumulating (which can obviously later be deployed if an opportunity presents; in the meantime you're likely to see a very modest inflation debasement to the fiat).
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.
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?
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.
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.
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).
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].
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.
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.
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.
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.
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?
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.
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.
[+] [-] markbnj|6 years ago|reply
[+] [-] ptero|6 years ago|reply
This is due to his "bigger and bigger crowds, same exits" analogy: individuals easily move through doors at will; but if a crowd rushes out through the same door, injuries happen.
His premise is that many stocks that index funds invest in have low liquidity (small door): half of stocks in SP500 trades less than $150M a day. This is tiny (he quotes total market cap of indices of $150 trillion). What happens if there is a small, but synchronized outflow for any reason? If customers ask for 1% of index funds to be sold, index funds have to sell 1% of their holdings in the exact ratios defined by the index, including stocks with low trading volumes. Which is a problem, as there may be no one to sell them to, so prices of those stocks may crash and create a big panic causing additional sales of index funds bringing down bigger chunks of the market.
That is the gist of it I think.
[+] [-] drelihan|6 years ago|reply
[+] [-] throw0101a|6 years ago|reply
The evidence shows that most of us suck at investing. Further, I think Burry's critique is more limited:
> One reason he likes small-cap value stocks: they tend to be under-represented in passive funds.
IMHO, the problem he's stating is that people are focusing on large-cap companies. Basically the S&P500. And the S&P500 index funds probably do hold most of the passively invested money. But to solve this (small- vs large-cap focus), the solution is not to throw away passive investing, but to change the focus.
For example, instead of buying Vanguard's S&P500 fund (VOO), to buy their Total Market fund (VTI) which uses the CRSP U.S. Total Market Index:
* https://en.wikipedia.org/wiki/Center_for_Research_in_Securit...
Or perhaps a fund that uses the the Russell 3000 or Wilshire 5000.
* https://en.wikipedia.org/wiki/Russell_3000_Index
* https://en.wikipedia.org/wiki/Wilshire_5000
It's just that the S&P (and DOW) have more name recognition.
But generally speaking, these decisions are micro-optimizations. Just put away a little every month and re-invest and dividends, and over the long-term you'll do well.
[+] [-] sailfast|6 years ago|reply
Bottom line - they look low risk until they’re absolutely not low risk because of these properties.
As an average investor I’d say diversify is still a good strategy. Don’t just do US Market index funds. Global stocks, bonds, and other small-cap stock collections might help hedge risk of large-caps going bust. Most passive-style funds also have these options. Not an active investor. Just a dude playing a dude disguised as another dude. This is not investment advice.
[+] [-] blankaccount|6 years ago|reply
[+] [-] charwalker|6 years ago|reply
My analogy would be if we are all buying tickets to the big game and sit in the stands until it's over, there's no one to yell and shout and drive the energy of the crown or possibly no one to even compete on the field therefore why are we even showing up?
It's definitely the extreme - active trading isn't going away any time soon but fears of a only a limited group playing the market and managing or controlling stock prices for their gain isn't 100% unrealistic.
[+] [-] unknown|6 years ago|reply
[deleted]
[+] [-] beat|6 years ago|reply
[+] [-] frgtpsswrdlame|6 years ago|reply
Not saying I agree but, if he's right it makes complete sense that passive would outperform active right now, just that in the next downturn it would dramatically underperform.
[+] [-] colechristensen|6 years ago|reply
You want to help? Pull some, not all but some assets out of index funds and put them into individual companies you understand and believe have long term profitability. Sell those assets when you think they're overvalued by the market.
Trading less often is correlated with better performance (you are not an HFT)
There is some responsibility you have. Your money isn't going to just magically work for you, you have some obligation to research and understand what you are investing in. When nobody does it, the market is in trouble.
[+] [-] 0xcafecafe|6 years ago|reply
[+] [-] nabdab|6 years ago|reply
The problem with bubbles is that everyone’s a winner and every indicator is confirming the everlasting increase.. on the way up.
[+] [-] 6thaccount2|6 years ago|reply
[+] [-] lukewrites|6 years ago|reply
[+] [-] motbob|6 years ago|reply
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.
[+] [-] pwthornton|6 years ago|reply
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.
[+] [-] groundlogic|6 years ago|reply
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-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"?
[+] [-] throwaway713|6 years ago|reply
[+] [-] jpmattia|6 years ago|reply
First: When you buy a ETF share for the S&P 500 (iShares, Vanguard etc), the share is not backed by all 500 S&P components. Virtually all the large-number component ETFs are using a sampling of shares to match the underlying index. (They would be buried by transaction fees otherwise.) The subsampling of the index is reasonably well-understood math, but relies on an assumption: That the buying and selling each component share will not be greatly affected by the ETF purchase or sale.
[Edit: I may be out of date - Some ETFs are full samples. Nevertheless, the bigger point that the ETF purchase/sale does not much affect the price stands.]
Second: The ETF uses a very clear process to keep the price of the ETF in equilibrium with the index it represents. Large players are allowed to go to the ETF adminstrator (say iShares) and turn in a bunch of the ETF shares, and iShares will transfer back the underlying components. So if the ETF price ever gets too cheap relative to the index, the big players will redeem the ETF share, and then sell the underlying shares they received, which results in a quick, nearly guaranteed profit.
Conversely, if the ETF price goes above the index, a large player will bring a basket of the underlying component shares to iShares, and iShares will give them corresponding ETF shares. So they buy the components cheap, sell the expensive ETF, again making a quick profit.
Now to what Burry is saying: Several components of the big indices are thinly traded compared to the amount of money in the index funds. In a large index drop, there will be disproportionate downward moves in those thinly traded shares: As large players will be redeeming the ETFs for underlying shares and then sell, these thinly traded stocks will drop further than you'd predict from the index. This will cause the index to drop further, which will cause more ETF shares to be redeemed, perpetuating the cycle.
I think his point should be better known than it currently is: The current wisdom that "you can't lose money in the stock market long-term" is reminiscent of "you can't lose money buying a house."
[+] [-] kybernetikos|6 years ago|reply
If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets.
A passive fund adds money into the system, but it doesn't add any intelligence - it relies on the intelligence of the current market participants.
As more and more money switches from active to passive, we have more and more money relying on less and less intelligence. This means that the market is becoming less and less efficient, and prices are deviating more and more from where they should be.
Passive investors are essentially leeching returns off the work of the active investors.
This article suggests that the effect will be ultimately catastrophic, where I suspect that it'll just result in money slowly swinging back the other way as active funds take advantage of the situation to start to make more money than before. That's pretty much what the article says he's doing.
[+] [-] dcolkitt|6 years ago|reply
Index investors are basically free riders off the information and research generated by active investors. Indexing basically works pretty well because the market's efficient.
An index investor just comes in and just pays whatever the current market price is and allocates in proportion to whatever current market valuations are. He doesn't even need to know anything about the underlying companies. "Microsoft? Never heard of it. But the market says it's worth 3.8% of all major American stocks, so I'll put 3.8% of my money in it"
Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.
And the reason it does work is because the active managers compete so fiercely with each other. They end up showing all their cards to the market. And all the information they have, and the research and the analysis winds up reflected in the publicly available stock prices. In effect active investors pay their managers big fat salaries to analyze stocks, and passive investors get nearly all the benefits without any of the costs.
[+] [-] tjpaudio|6 years ago|reply
[+] [-] patio11|6 years ago|reply
If one believes this to be true, one necessarily believes that illiquid index constituents are overvalued today relative to their actual enterprise value and will, at some point in the future, be sharply undervalued as a large number of computers controlling trillions of dollars attempts to implement a for loop shoveling money at you.
[+] [-] notyourday|6 years ago|reply
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.
[+] [-] 0xDEFC0DE|6 years ago|reply
Retail investors are told to shovel money in and keep it there. Who's going to be selling to pop the bubble? Do investment banks have a lot of index funds and their derivatives bought? Does there have to me some major re-allocation within the fund that causes investors to sell?
If a single stock is valued incorrectly, how is that going to bring down the entire index?
[+] [-] Peej255|6 years ago|reply
[+] [-] wnissen|6 years ago|reply
CDOs are collections of mortgages with rules about how they pay out. During the last bubble they were sold (and rated by supposedly respectable third-party arbiters) as among the safer investments available. This was because the CDO had a safety feature where a certain percentage of the mortgages were expected to default, and so you didn't need all top-quality mortgages, lousy ones were okay, too. Thus the sudden availability of "NINJA" (No Income, No Job, no Assets) loans, which were completely inexplicable to basically everyone. No one would have lent their own money to poor credit risks, but the CDOs would buy that loan and stick in in their security in a heartbeat. The problem came that once the expected maximum level of default was breached, the CDO started paying out very little or nothing, and the value fell to near zero.
So his analogy is that the same thing will happen to index funds, which invest on the principle that you don't need to pick top-quality stocks, that you just buy all of them. As far as it goes, there is a significant similarity with CDOs. As an index investor, I don't try to find my own good stocks, I don't even need someone skilled in stock picking. I'm relying to an extent on financial engineering and the rest of the market to make sure that I'm not grossly overpaying for the lousy companies that are in the index. He notes that there is a huge multiple on many of the stocks, such as the 266 that have less than $150 million in daily trades, but represent trillions held by index funds. Trading is the "price discovery" mechanism of the market, and lightly traded stocks are subject to all kinds of manipulations and volatility, to be sure.
But there are several places where I think he's making a major stretch with this argument. First, the CDOs were sliced into "tranches", so when you bought a CDO you didn't get the underlying assets, just the right to a payment stream. The index fund sticks very close to the current market value of its assets; you get what you would have gotten if you just bought all 500 stocks individually, without any financial magic. For instance, on a $10K investment the Vanguard S&P fund trails its index by about $100 over 10 years. There's no daylight for shenanigans there, so I think the financial engineering argument is categorically false.
It also doesn't bother me that the stocks are thinly traded relative to the assets, because one of the big advantages of passive investing is that you're not trading all the time. Again looking at Vanguard, they turn over less than 4% of the stocks in a given year. But that's what you should do if you don't want to get killed by trading fees. Buy and hold and all that. For there to be a problem you'd have to see that those stocks were getting volatile, or that the index funds were constantly buying at a disadvantage. It is true that there is a certain amount of trying to beat the index funds to the punch; kind of hard to keep from telegraphing your investment choices when they're literally written into the name of the fund and you need to buy for a half-billion dollar fund. But these are tiny in magnitude. If anything, things are much more efficient and rapid then they were before computers took on most of the trading.
Finally you get to the thing I worry he has a point. If 100% of the money was passive, there would be huge opportunities to exploit. There's no law that says passive investing is going to be better than active. It's been true so long that maybe it's taken as gospel when it shouldn't be. Nothing is forever, and anyone who argues "it's different this time" is probably wrong, eventually. But there's still a ton of money out there in active funds, hedge funds, pensions, etc. If they saw a good opportunity, they would take it. There's too much money to be made by sharp-eyed investors to let the market as a whole get to the point where bad stocks and good stocks are treated the same.
https://investor.vanguard.com/mutual-funds/profile/portfolio...
[+] [-] spenczar5|6 years ago|reply
[+] [-] dcolkitt|6 years ago|reply
Burry's argument is that many of the underlying stocks inside the index have a lot less liquidity than the index funds and securities themselves. E.g. if a lot of capital quickly exits the index funds, then some of the single-name stocks may be overwhelmed by the liquidity. That would result in their prices becoming severely dislocated relative to their true value.
But if you're just buying-and-holding that doesn't matter. If the stocks in your portfolio become temporarily dislocated, who cares? Dislocations by definition correct themselves over time. If some stock falls 50% because of panic selling, without anything having to do with the underlying company, it will eventually return to the correct price. And much sooner than the decades long timeline that you're saving for.
That doesn't mean that Burry's thesis is irrelevant to everyone. In particular if you're an institution that offers liquidity to your clients it may be very relevant. Or if you're a bank, hedge fund, or insurance company that's subject to mark-to-market capital ratios or margin calls.
If stocks become very dislocated, your investors may panic and redeem their money. Or your regulator may say you have insufficient capital and have to liquidate. That's very bad, because you'll be forced to sell at fire-sale prices. However, that's not relevant to individual investors, because nobody can force you to sell out just because your portfolio goes down.
[+] [-] godzillabrennus|6 years ago|reply
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.
[+] [-] Ididntdothis|6 years ago|reply
[+] [-] FabHK|6 years ago|reply
1. Even among index funds, maintain some diversification. Don't put all in US large caps (S&P 500), but also some international and some small caps (Russel 2000).
He is saying that given how much money is invested via index funds now, there are opportunities in assets that are not (or insufficiently) represented in index funds. (This is hard, though, and the standard advice to refrain from trying and placing your bets on index funds instead remains valid, I think, particularly for mature markets in which you don't have an edge.)
The second take-away is at a tension with the first:
2. Avoid ETFs that handle illiquid assets (real estate, bonds, etc.) or create synthetic exposure using swaps and derivatives.
For big, liquid assets, the ETF or index fund can just take the investor money and go buy the assets. Then the value of the fund is approximately the value of its constituent assets, sort of by definition, and that value is relatively easy to realise (that is, if you want your money back, you get it - they'll have to sell some of the assets, but they're liquid, and that won't influence price too much).
For smaller or more exotic assets, a fund might not buy them outright, but contract with a third party (an investment bank, typically), and give the bank the money, with the bank promising that it will return the value of the asset. So, it's "like" holding the asset, except that you get the credit risk of the bank - there's a risk the bank might not be able to uphold its promise. And this is most likely to happen when everyone runs for the exit.
> 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.
> ... 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.
So, an ETF promising to deliver the value of an index can generally do it, and there was no big failure so far, but scenarios are conceivable where it cannot deliver.
[+] [-] adventured|6 years ago|reply
There is also nothing wrong with adjusting the ratio of cash vs equities that you're accumulating (eg the share of your income going into the market vs going into cash in a span of time). It's the exact same safety vs risk lever that is commonly utilized in adjusting equities vs bonds as you get older. Some will call it market timing, it is not, as you are not attempting to time a top or bottom. With recession alarms going off in most global economic data, increasing your conservative posture is nothing more than being modestly prudent (and it doesn't have to be an extreme adjustment; if 100% of your net savings is going into the market now, changing that to 75/25 or 50/50 with cash, is entirely reasonable). Even Warren Buffett has turned hardcore conservative with this market, he's buying nothing and sitting on a $122b record pile of cash that is very much annoying him (by his own admission). The reason for his behavior, beyond the obvious blaring economic data, is that the valuations are terrible vs the growth we're seeing (both macro economy and corporate earnings); right now investors are paying a steep premium in most cases for the value they're getting. Buffett doesn't like the price he's paying for the value he's getting, so he has gone into bunker mode, as he has done prominently several times in the past. The simple, non-professional approach to that move, is to just make a reasonable adjustment to how much cash you're accumulating (which can obviously later be deployed if an opportunity presents; in the meantime you're likely to see a very modest inflation debasement to the fiat).
[+] [-] unknown|6 years ago|reply
[deleted]
[+] [-] chad_strategic|6 years ago|reply
:)
[+] [-] darawk|6 years ago|reply
> 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.
[+] [-] graeme|6 years ago|reply
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?
[+] [-] anm89|6 years ago|reply
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.
[+] [-] mcguire|6 years ago|reply
"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.
[+] [-] omarhaneef|6 years ago|reply
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|6 years ago|reply
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 [2] https://goldco.com/russell-2000s-price-to-earnings-ratio-is-...
[+] [-] heyflyguy|6 years ago|reply
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.
[+] [-] noego|6 years ago|reply
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.
[+] [-] leon1717|6 years ago|reply
[+] [-] thtthings|6 years ago|reply
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.
[+] [-] somberi|6 years ago|reply
From The Economist.
(1) http://archive.is/2oco0
and
(2) 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/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.")
[+] [-] ineedasername|6 years ago|reply
[+] [-] cm2187|6 years ago|reply
[+] [-] dehrmann|6 years ago|reply
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.