Recently the renowned investor Michael Burry who previously won big by betting against CDOs in the GFC has raised concerns and described a possible ‘bubble’ in the world of passive investing. This is the great Index Fund Bubble.
“People always ask me what is going on in the markets, It is simple. Greatest Speculative Bubble of All Time in All Things. By two orders of magnitude. #FlyingPigs360.”Michael Burry
Burry’s argument centers around the massive recent inflows into the passive investing space.
“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,”Michael Burry index fund theory
We can see in the graph below how popular these options have become. He brings forth the idea that these massive inflows are distorting stock prices, which he believes is creating a bubble that will eventually burst.
The idea behind this is that by buying index funds we are buying and supporting the price of the companies without any consideration of the underlying fundamentals.
Additionally, he believes that the stocks on the lower end of the scale have also been largely inflated and that due to the small volumes of these companies, any run on the stocks will cause a collapse of the price.
The first point on price discovery, in-effect is correct and brings up an interesting concept of passive versus active management. In the current market I have previously talked about the huge success of passive investments and how they have continuously outperformed active funds. However, in a world where passive funds completely dominate the market this would open an opportunity for active investors. In this scenario growing companies’ prices would not reflect their underlying earnings and profitability.
Price Discovery and the Active Investor
In this case an active investor could easily pick these companies on an earnings basis and earn huge returns as the market hasn’t accounted for the underlying earnings of the business. In this scenario active managed funds would outperform passively managed funds. And as such they would become more popular until the opportunity again reverses.
In the event that these indices become overbought and start to bubble this would be easily reflected as a raise in the average PE of the indices. The current index PE gives me no concern for this being the current situation. Another consideration is that in effect a bubble effect created by index fund would be happening in real-time and creating opportunities that could be exploited by active managers and in-turn arbitraging the opportunity and regulating the market.
Another consideration is that on the baseline these headlines seem to give the idea that investors should ditch passive funds and go to active. Not only does this go against the current research of passive outperforming active but it also would still leave investors vulnerable if there was actually a crash. Remember ETFs are a trust that own the underlying assets, they trade at almost exactly their NAV due to their open-ended structure. This means that in the case that there is a bubble that bursts the prices of the actual companies would burst not just passive investments, but for everyone.
The prices of all those companies would be impacted, meaning all investors would feel the impact, not just Passive Investors.
The Next Big Crash…Again
Another thing to consider is that every year some big famous investor is calling the next big crash. Sure, one day one of them will be right. But until that time history has shown that good financial markets will continue to make excellent returns.
The Run on Small Cap Companies
Burry’s main point is that a large sell-off event could create a run on the small market cap stocks which have too low of a liquidity to facilitate this. In such a case the ETF would have to unload large amounts of low-volume stocks. In this situation it is important to remember that these stocks are at the bottom end of the fund and receive the least proportion of the NAV. In many ETFs the fine print states that many of these bottom companies won’t even be brought. This is because the small proportion and impact they would have on returns means it isn’t worth the extra cost and effort of including them.
Let’s Break down the Maths:
Let’s take the VAS ETF for our example, VAS consists of 298 companies even though the ETF aims to replicate the returns of the ASX 300. The smallest company VAS currently holds is Amaysim. The proportion allocated to AYS is 0.00568%. The current NAV is 4.8B. So, VAS currently holds approximately $270K in Amaysim. This isn’t that much. And in the event of a run on the ETF a proportion of this would be able to be removed without issue, the average turnover of AYS is 62K so a large proportion of VAS holdings would be able to be removed in a run on the ETF.
However, there are many index ETFs, and as their NAVs grow so will their holdings in these smaller companies. However, there is always a buyer at the right price. So, in effect even if there is a run on the index funds that crashes the prices of these smaller cap companies, they will still be able to unload their holdings at the right price. Which to active investors will create great buying opportunities until the price is bid back up to a reasonable level.
And even if the index funds do realize a lose on these small companies it is important to remember that they are only a very small proportion of their holdings which means a capital lose on them really won’t make a difference to investor returns. History has also shown that Authorized Participants will also continuously work efficiently in the case of all market conditions including downturns.
Summary on The Index Fund Bubble
To summarise all this information every single year a large famous investor says the world is going to end. One day they will be right. But until that day the market will keep making investors large returns.
It is possible that index funds could distort the price discovery of companies. However, in the extreme case that this creates a bubble that bursts, everyone will be affected. This is because everyone is exposed to these major companies. So, there is no point not holding index funds to try and avoid this unlikely event. On his second point investors will always be able to offload companies at the right price. And even if the fund makes a loss on their microcap companies the loss will be a very small proportion of the investors returns.
In our opinion, The best thing to do is to stick to the contemporary research and the proven track record of these funds. Here’s another great resource on Burry’s bubble.
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