Will Index Funds Become Our Riskiest Investments?

Dr. Michael Burry is a name well-known across the financial sector and for good reason. He is quite the hedge fund savant and has time and time again identified market bubbles right before they pop. Many identify him as the hedge fund manager of Scion Asset Management and as a very reputable investor. Even more of you may know him as “that guy” in the popular movie, The Big Short.

Burry’s hedge fund commands well over an impressive $300 million in assets under management today and boasts extraordinary returns throughout and especially during recessions. Michael Burry began his superstar career making a fortune shorting overvalued tech companies during the dot-com bubble in 2001. Once again in 2005, Burry began betting against the market purchasing credit default swaps profiting once subprime mortgages began to collapse in the housing crisis in 2008. Each time, Burry has predicted huge bubbles in the market and took swift action to profit immensely.

Michael Burry’s newest money prediction?

His next big warning from late 2019 is of the looming index fund and passive investing bubble. This is worrisome to most especially with Burry’s almost omniscient track record of foreseeing market highs. In fact, most investors have a large portion of their portfolios within index or passive funds. The all too common money advice these days seems to always be telling us to invest in index funds for safe and close to guaranteed long term returns.

According to the Federal Reserve Bank of Boston, in 2009, active funds had almost 300% more assets under management compared to passive funds. A decade later in August of 2019, passively managed funds tracking US equity indexes overcame actively managed funds in total assets under management.

Since then, more and more money has been flowing out of actively managed funds straight into index funds. During the last few years, the general public has started losing faith in fund managers trying to beat the market. The belief that index funds beat out active investing has been beaten into so many people’s minds that it has morphed into something more like common sense.

This huge trend towards passive investing is exactly what Burry sees as another dangerous bubble. His two main takeaways are that passive investing leaves no room for price discovery and a huge liquidity problem.

No Room for Price Discovery with Passive Investing

Burry believes the trillions of dollars injected into index funds or passive investments is warping prices in the market. The fundamentals like DCF’s or simple valuation analysis are no longer being recognized by the market which is destroying price discovery.

In a 2019 interview with Bloomberg, Burry states, “This is very much like the bubble in synthetic asset-backed CDO’s 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.” In essence, Burry is arguing that the longer this goes on the worse the crash will be in the future.

Passive Investing Causing Liquidity Issues

The second argument towards the downfall of index funds is that sometime in the future, the same wave of funds flowing into passive funds will reverse and that escape will create massive liquidity problems within the market.

One of the various popular indexes that many invest into is the S&P 500 which is a collection of the most notable 500 large cap companies listed on US stock exchanges. In Burry’s analysis, he has seen that more than half of those 500 companies included in the S&P 500 have a trading volume of less than $150 million on an average day.

Compared to the trillions of dollars currently invested into index funds, this has the potential to create huge price drops in many huge US companies in the case of a liquidity crisis. Burry likens this scenario to the analogy of a movie theater being packed while the emergency exits are the same size as always.

What does this mean for index funds or passive investors?

The biggest question is whether or not we are actually in danger of any sort of bubble in relation to passive funds. We can either continue believing in the consistent returns of index funds or liquidate all our investments and run for the hills. First, let’s do some thinking before we make our choice.

If we break down what an index fund is, we can see that it is really just a big list of stocks you can invest in pretty easily these days. For example, one of the most common passive funds is an S&P500 index fund. As of the day of writing this article, you could spend $129 to buy FXAIX and own a small percentage of the entirety of the top 500 publicly traded stocks on the US stock exchanges.This is a great choice for many investors since you can immediately diversify your investments with much lower fees compared to actively managed funds. These funds aren’t just limited to the S&P and can be structured around almost everything you can imagine from foreign stocks to the entire US equities market.

On top of being able to diversify, these index funds have also beat actively managed funds in almost every long term scenario. In fact, Warren Buffet recently won a million dollar bet with the top performing hedge fund managers that they couldn’t produce better returns than a simple S&P 500 index fund over 10 years.

The hedge fund managers that lost were mostly ivy league graduates with the brightest minds in economics and finance. If they couldn’t beat the market I have little hope in doing better myself.

With evidence like this, passive investing has seen a huge rise in popularity during the last few years with mainstream financial advice finally seeing the advantages of lower fees, simple diversification, and consistent profitability.

According to Michael Burry, the popularity in index investing is arbitrarily driving up the prices of the stocks included in these indexes and causing this disconnect with the actual value of the underlying companies. Yet does this actually hold true? If a stock is included within an index, will the price of the stock automagically increase?

Inclusion of stocks to indexes

In order to answer this, we can take a look at the historical data. Let’s take a look both at stocks that have been added to an index to see whether they increase in price and stocks that have been removed from an index to see if that causes their stock price to drop.

When a stock is added to an index, it is first announced to the public before index fund managers automatically add the company into their funds. This gives individual investors and speculators the chance to purchase the stock before it gets added to the index to profit once the huge capital of index funds pour in.

Yet when this phenomenon was actually researched by the National Bureau of Economic Research, it was found that although stocks generally see a slight increase in price after the announcement that it’s going to be added to an index, once the stock is actually added to an index, the price quickly returns to normal. The demand tends to slow down after the inclusion to the index and the price drops where it then returns to a new equilibrium. The long term research proves that the addition of a stock to an index has no lasting or permanent effects on its price and shows no superior performance or demand. The opposite was also found true with stocks that are dropped from an index in which they saw no price drops or long term lasting effects.

Index Fund Functionalities

The results of this research may also be explained away by the function of most indexes such as the S&P 500. In order for a company to join or be included in the index, they must first have a history of strong performance, brand recognition, and market cap to even be considered.

Additionally, the assets managed by index funds are all weighted towards the largest companies with the majority of volume. In reality, the largest stocks within the index see the majority of capital invested into them. If we look at this another way, the smallest stocks within the index experience the least amount of money from index investing.

Once again, looking at the S&P 500, we see that the top 10 companies make up more than a fifth of the overall market cap of the index. This means the overwhelming majority of capital in index funds is actually invested into the larger cap companies which see much larger trading volume on average. Michael Burry’s concern for the liquidity crisis may not be as large of a concern as many might make it out to be. If in the future there is a huge selloff of index funds, outside investors may just see that as an excellent opportunity to buy low which would in effect drive the prices back up to equilibrium.

These index funds and passive funds are really just a way for investors to put their money on the average performance of the market instead of specific companies. As long as the US market continues to grow and perform well, total market funds will see strong performance as well. If foreign markets continue to grow then foreign market funds will also grow.

Despite what Burry predicts, Index or passive investing might not be a bubble. In 2008, people falsely believed that housing prices could only go up and many times were leveraging their money far beyond what they could afford. That led to disastrous results when housing prices momentarily stopped rising as many were not liquid enough to hold their investments. On the other hand, the majority of capital in passive investing is not leveraged and is aimed for long term growth. Regardless of the many similarities between past market bubbles, index funds might just prevail.

This article is for informational purposes; only not all information will be accurate. This should not be considered Financial or Legal Advice. Consult a financial professional before making any significant financial decisions.

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