Michael Burry, hedge fund manager of The Big Short fame, recently warned of a “passive investing bubble“. He is concerned that the recent influx of people investing passively in index funds will come crashing down in spectacular fashion, similar to the fallout from subprime collateralised debt obligations in 2008.
There is no doubt his words carry weight and, considering the millions of dollars he made by ‘shorting’ the housing market in 2008, I’m inclined to listen to what he has to say.
There has been a concern for nearly 20 years now that the performance of indexers is unnaturally bolstering the performance of the indexes and the stocks within them.
Index investing puts the focus on the companies with the largest market caps, leaving the mid, small and micro-cap companies unnoticed.
What does an index fund do?
An index fund tracks a specific index, for example, a FTSE 100 fund tracks the top 100 UK stocks in the London Stock Exchange (LSE). A FTSE 250 fund tracks the next biggest 250 stocks in the LSE and so on. Exchange-traded funds (ETFs), are a popular example of index/tracker funds.
The goal of index funds is not to beat the market, but to match its performance. This is why they are considered a long-term investment vehicle. Ten years is recommended, because the stock market tends to go up over a longer period, but it fluctuates along the way and a short-term investment may not reap the rewards.
Passive investing in funds is appealing because it is a simple investment to understand, it saves the investor money in fees that are usually lower than for actively managed funds, it’s usually a tax-efficient option, and trading costs are cheaper than for equity investing.
Michael Burry’s warning
There has been a rapid increase in passive investing in recent years and Burry’s concern is that it will all come tumbling down.
In a recent Bloomberg News interview Burry said: “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.”
Here he refers to the fact that many of the stocks traded, even in the best-known indices containing the largest stocks, are low volume, with low liquidity.
The worry is that the prices of these less-traded equities are being influenced by the billions of dollars flowing into them from funds. If passive investors suddenly sell their funds (including institutional investors and pension funds), the stocks linked to them will be badly affected and their prices rapidly decline. Many investors’ decisions are made by algorithms that will automatically sell stocks if they fall a certain percentage. There’s little to no human involvement. Stop losses are set at comparable levels so should some big event (US/China trade war, Brexit, a global crisis) cause a market decline, it could trigger a sell-off. Once large investors start selling, others will follow suit and the price will plummet.
Until I read this interview, I thought favourably toward index funds and could see their appeal to the novice investor. However, with the increasing volatility of world markets and ominous words from such an observant individual I would think twice about choosing to invest in one today. Burry says he likes small-cap value stocks because they tend to be under-represented in passive funds.
