
Why Index Funds Are Like Subprime CDOs - kgwgk
https://www.bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos
======
markbnj
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...](https://www.cnbc.com/2019/03/15/active-fund-managers-trail-the-
sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html)), 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?

~~~
ptero
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.

That is the gist of it I think.

~~~
dfabulich
That doesn't answer markbnj's question. You elaborate why the passive market
is in peril (because in the event of a sell-off, the ETFs will be forced to
sell a bunch of low-volume stocks, crashing them), but that's just explaining
in detail that the market is in peril because not enough money is flowing to
people who do a poor job of managing it.

But, granting that Burry is right and you're interpreting him correctly, what
is the average person with a couple bucks to invest supposed to do instead of
passive investments?

Surely we can't recommend actively managed funds, funds that don't even earn
back their fees. And, if not passive investing, and not actively managed
funds, then…what, exactly?

~~~
jackcosgrove
Dollar cost average purchases of index funds, and slowly draw down your shares
in retirement. Maybe rebalance every year or so as you get older. In other
words, don't panic or try to time the market. Those are purely speculative and
usually pro-cyclic movements that just introduce noise into price discovery.
After all, when there's a market crash, did millions of machines in factories
fall apart, or millions of workers in offices forget how to do their jobs?
It's just a psychological overreaction.

As to institutionalizing this stability, it would be nice if index funds
offered fund choices that prohibited selling or trading for one, two, three
decades. Since you as the investor would be adding information to the market
("I'm not an index fund band-wagoner, I understand buy-and-hold and I will
practice what I preach") you would be rewarded with better returns in exchange
for signaling your intentions and acting as a cushion when everyone else is
panicking.

~~~
bb88
> After all, when there's a market crash, did millions of machines in
> factories fall apart...

In 2008, the crash happened because suddenly Wyle E. Coyote realized there was
gravity when he ran off the cliff. Mortgages were actually defaulting on a
very high rate, but people put blindfolds on and didn't want to see. It wasn't
just a "psychological overreaction" but real fear and panic as those same
investors were trying to squeeze through the same exit door as everyone else.

There is still some reasonable fear in 2019 that large financial institutions
will choose to make money at the expense of the economy.

~~~
lonelappde
If you were invested in the broader market, and didn't move your whole
portfolio in our out of cash in 1 year,the 2008 worldwide economic collapse
was barely a blip in long term performance.

~~~
bb88
So you're point is exactly what again? It's okay for banks to manipulate the
markets because in the end it all averages out?

------
lukewrites
The discussion of this on the Bogleheads forums, a community dedicated to low-
cost investing primarily via indexing, provides an interesting counter-point
to Burry's opinions:
[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=289284](https://www.bogleheads.org/forum/viewtopic.php?f=10&t=289284)

~~~
piker
> a community dedicated to low-cost investing primarily via indexing

Right or wrong, that must be one boring place.

[Re: downvotes, The post was just intended to convey that the thesis of "put
your money in the lowest cost index funds using an allocation formulatically
dictated by modern portfolio theory, and don't touch it for the next 35 years"
would be unlikely to provide much fresh content.]

~~~
beat
A community consisting of people patting each other on the back for being so
much more clever than everyone else is rarely boring to the participants.

The fact that this explains a majority of self-selecting communities is purely
coincidental, of course.

~~~
greenshackle2
Including Hacker News, no doubt.

~~~
beat
NO SHIT.

------
motbob
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.

~~~
bob33212
A hedge from this theory would be to buy stocks just outside the SP 500?
Something like TSLA. That would be a crazy situation, where the SP 500 is
crashing and the rest of the market it taking off

~~~
ChuckMcM
A simpler option is to buy options on the index. You can butterfly the index
with calls and puts around your minimum return / maximum loss tolerance.

~~~
onaraft
Which requires a margin trading account, a non-trivial amount of trading
experience, a non-trivial amount of capital, constant management, and is
highly leveraged. The risk profile is totally different.

------
pwthornton
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.

~~~
whatok
You can't run most active management strategies on anything approaching the
average passive fee structure. Additionally, you run into problems with scale.
An S&P 500 tracking fund scales extremely well and could add several billion
of AUM without having to incur additional expenses. A long only equity fund
would probably not be able to do the same without hiring more people, building
more infrastructure, etc.

~~~
pwthornton
I get that the fees can't be comparable, but without passive management,
active management fees are unchecked, and they rose a lot over time.

I'm willing to agree that it should cost an order of magnitude more for an
actively managed fee, but most are beyond that.

A lot of this seems like plain greed to me, combined with grift and graft. A
lot of workplace plans try to funnel people into actively managed funds that
often charge really high fees.

~~~
whatok
I'm not sure how fees are unchecked. Active management fees have fallen quite
a bit over the past 5+ years. A lot of mediocre managers have gone out of
business and many more probably will as well. Additionally, new fund launches
are near all-time lows.

------
groundlogic
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.

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...](https://www.cnbc.com/2019/03/19/passive-investing-now-controls-
nearly-half-the-us-stock-market.html) 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"?

~~~
avvt4avaw
You only need the marginal investor to be informed, so it's not clear that you
couldn't have a much higher percentage of passive investment (say 90%) and
only a small amount of active investors who are providing price discovery.

The bigger problem is that most passive investments are not really passive -
for example, choosing to invest in a "passive" S&P 500 ETF over a "passive"
Russell 2000 ETF is an "active" investment choice (preferring large cap over
small cap) so valuation errors and bubbles could develop in segments of the
market, even if constituents with an index are all fairly valued relative to
one another. These valuation errors could sustain for a long period of time,
because it takes much more money to correct a valuation error in a huge market
segment than it takes to correct a valuation error in an individual stock.

~~~
davidw
This lists 3575 stocks among its holdings, which includes both large and small
cap stocks:

[https://investor.vanguard.com/mutual-
funds/profile/overview/...](https://investor.vanguard.com/mutual-
funds/profile/overview/VTSAX/portfolio-holdings)

~~~
avvt4avaw
Sure, which is why I said that _most_ passive investments are not really
passive. Vanguard Total Stock Market is pretty passive, as long as you
consider your investment universe to be "US stocks".

But even in this case the fund only holds stocks (no bonds or real estate) and
only US stocks at that (no international or emerging market exposure).

------
throwaway713
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?

~~~
kybernetikos
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.

~~~
davidw
> 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 start to make more money than before.

This makes sense to me - I would see returns to active investors increasing
gradually, as there are fewer of them. At which point, more people take their
passive investments and give them to the active investors. At some point you
maybe reach some sort of equilibrium.

Why would it not be a well-functioning feedback loop like this?

> 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.

Also, worth noting that it's _beneficial for the market_ , not necessarily
(and probably not likely) for the individual investor, who will pay higher
fees and may underperform the market.

~~~
kybernetikos
> Also, worth noting that it's beneficial for the market, not necessarily (and
> probably not likely) for the individual investor, who will pay higher fees
> and may underperform the market.

Excellent point. Indeed, I believe the academic view is that due to decreasing
returns to scale, funds flow in and out of active funds, with an equilibrium
only when any alpha (performance above the norm) is entirely swallowed by
fees.

------
spenczar5
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?

~~~
dcolkitt
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.

~~~
fragsworth
> 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.

But that's not true, because suppose if 99.9% of investors are buying ETFs and
only 0.1% are actively managing, there won't be enough funds to bring all
these panic dislocated stocks back up for many, many years.

~~~
cbanek
> But that's not true, because suppose if 99.9% of investors are buying ETFs
> and only 0.1% are actively managing, there won't be enough funds to bring
> all these panic dislocated stocks back up for many, many years.

The price change of a stock doesn't always depend on how often a stock is
bought. For example, when earnings hit, a stock can easily move 10%. That's
not because there was a certain amount of people buying at every price between
what it was and +10%. This can happen because earnings are better, and many
people base price of an earnings multiple. When new knowledge is put into the
system, there's a new price.

If everyone who is trading a stock agrees on a price, that is the price. If
people don't agree, it is generally the highest price someone is willing to
sell it for (and find a buyer), or the lowest someone is willing to buy it for
(and find a seller). If that disconnects a lot, you get a high bid/ask spread,
and possibly no shares trade (lack of liquidity). It might only take a few
shares or be a very short time to move a stock a lot.

------
darawk
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.

------
graeme
Index funds definitely have a free rider problem.

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?

~~~
sokoloff
> You cannot, by definition, have a majority of investors beating the market.

You cannot have a majority of _money_ beating the market. It is mathematically
possible for a majority of _investors_ (each relatively small) beat the
overall market (albeit unlikely).

(I agree with your overall post, but not that line.)

~~~
graeme
Oh true

------
anm89
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.

~~~
jiscariot
I agree...it also has become so commonplace it irks my inner contrarian
(having been in ETFs past 20+ years).

-Shoeshine boy starts talking stocks--time to exit the market. [1]

-Dad starts asking me about bitcoin--time to exit bitcoin position.

-Occasionally employed step-sister praising index funds--???

[1]
[https://archive.fortune.com/magazines/fortune/fortune_archiv...](https://archive.fortune.com/magazines/fortune/fortune_archive/1996/04/15/211503/index.htm)

------
mcguire
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.

------
omarhaneef
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).

~~~
jpalomaki
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].

[1] [https://www.wsj.com/market-
data/stocks/peyields](https://www.wsj.com/market-data/stocks/peyields) [2]
[https://goldco.com/russell-2000s-price-to-earnings-ratio-
is-...](https://goldco.com/russell-2000s-price-to-earnings-ratio-is-high/)

~~~
omarhaneef
I think the point is people use the measures that you can clearly see easily
(like the P/E), and therefore you don't go down to the level of the stock (oh,
temporarily raised earnings, forecast for reduced earnings, and as you point
out, negative earnings etc).

Note: this is not my argument, but what I understand Burry to be arguing.

------
heyflyguy
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.

------
noego
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.

------
leon1717
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.

------
thtthings
What i think he is saying is this:

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
A useful read that provides a counter view to Mr.Burry's:

From The Economist.

(1) [http://archive.is/2oco0](http://archive.is/2oco0)

and

(2) [https://www.economist.com/finance-and-
economics/2018/07/05/t...](https://www.economist.com/finance-and-
economics/2018/07/05/the-growth-of-index-investing-has-not-made-markets-less-
efficient) (Unable to archive this)

and

(3) [https://www.economist.com/finance-and-
economics/2018/02/08/p...](https://www.economist.com/finance-and-
economics/2018/02/08/passive-funds-tracking-an-index-lose-out-when-its-make-
up-changes) (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
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?

------
cm2187
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.

------
dehrmann
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.

------
nabla9
Nothing in the article or in the linked articles, indicates that he is talking
about physically replicated passive index funds that replicate few times a
year. He is not giving any explanations that would fit to these normal index
funds.

Ignoring small-cap stocks is kind of side show, because massive index funds
can't make much return from small-cap stocks anyway. Even if you create index
that includes them, they add only a little ROI.

I don't see how index funds can remove price discovery, because they always
follow price signals from actively managed funds.

There may be market bubble and too much money caching profits but unless
actively managed funds start outperforming index funds, they are not doing
anything worth investing.

------
droithomme
I don't know man. Index funds seem to be the safest bet you can make as far as
balancing risk and growth. You're betting that the world in general won't
collapse over the long term. And if it does any high growth strategy is
probably going to collapse with the general world as well so isn't that much
safer.

What is fascinating is that here is an article claiming that one of the safest
bets you can take is the same as one of the biggest most corrupt and
deplorable scams of the last 50 years. Now that's interesting because we want
to take a look at who wrote that, who published it, and wonder what the heck
they are up to peddling this view.

------
Peej255
If true what's the hedge? Pension and investments to cash and bonds? Japanese
stocks?

~~~
5822130027
All types of investment in every country is subject to financial repression.

You could own gold, but wait ! any gain is taxed as income ( not capital gain
). Carrying it around has stiff penalties.

"You invest in how we say you invest" \- Uncle Sam.

~~~
nradov
Taxes aren't repression.

~~~
SkyBelow
Unequal taxes seems a valid form of repression.

Start with something simple, say taxing people of one race 15% more than
another race. That would seem a valid form of repression.

Okay, so that rarely happens and is almost always combined with far greater
forms of repression. But there are less extreme examples. What about taxing
someone more when they have kids, or more when they don't?

Sin taxes also seems a way to repress certain behaviors in society by
increasing their cost. Why can't the logic apply in other areas of life where
tax rates are unequal?

------
anonu
The thing with predictions in the market is, even if you're the guy who
figured out subprime before everyone else, your probability of getting it
right the second time is completely independent of the last time.

------
jorblumesea
There are ways to get more diversity within indexing itself. eg: small cap
index, value index funds. It seems like the bone of contention is that indexes
track the entire market based on trading volume, and that is an existential
risk given cap weighting. Many now invest in total market indices, which
limits the impact of large cap companies. The "cap weighting" problem is a
known issue in indexing and this is why you invest in total market, small cap,
mid cap indices.

~~~
sigstoat
equal-weight (instead of cap-weighted) funds are also a thing, and perhaps
relevant if you want to spread your investment across more of the market:

[https://www.invesco.com/portal/site/us/ria/etfs/strategies/e...](https://www.invesco.com/portal/site/us/ria/etfs/strategies/equal-
weight-investing/#tab_tab3)

------
southphillyman
Timely article, I was just thinking about this last night...while browsing
Vanguard's site looking for index funds to invest in. Everyone blindly putting
their money into similar instruments and getting double digit gains nearly
every year just seems like it can end catastrophically. I want to do more
research on how these passive funds affect the overall market and vice versa.

~~~
lunchables
Aren't most of those double digit gains just from the market rebounding from
the 2008 recession?

~~~
southphillyman
Rebound to inflated values? Reminds me of the housing market in my area now.
It's "rebounded" to higher than 2008 levels on the basis of speculation and
gentrified neighborhoods being hot. Seems like another bubble. I need to do
more research, but I'm curious what the long term viability of these index
funds are as more and more people gravitate towards them

~~~
lunchables
I was thinking more, rebounded to 2008 levels + inflation?

------
donglebix
Found this sort of relevant PDF which makes interesting reading -
[https://www.esrb.europa.eu/pub/pdf/asc/esrb.asc190617_9_cane...](https://www.esrb.europa.eu/pub/pdf/asc/esrb.asc190617_9_canetfscontributesystemicrisk~983ea11870.en.pdf)

------
atemerev
There is no such thing as free money. There are no such things as riskless
passive investments that beat the reference market rates (which are close to
zero these days). Therefore, index funds carry risk. Therefore, somebody (the
bulk of index fund investors) will have to absorb these risks. All of this is
nearly obvious.

------
jayalpha
Horseman Global Unveils New Shorting Philosophy Using ETF Flows As A Catalyst

[https://www.zerohedge.com/news/2017-04-09/horseman-global-
un...](https://www.zerohedge.com/news/2017-04-09/horseman-global-unveils-new-
shorting-philosophy-using-etf-flows-catalyst)

------
dllthomas
He seems to use volume traded as a proxy for depth of the market. Is that well
supported? I could imagine a stable stock moving no volume because the price
didn't move, while everyone is lined up eagerly to make trades an increment
out on either side of the current price.

------
oli5679
I think we aren't close to the margin where indexing is socially harmful. This
article elaborates.

[http://www.philosophicaleconomics.com/2016/05/passive/](http://www.philosophicaleconomics.com/2016/05/passive/)

------
yalogin
This sounds like good logic.

There is one piece of information missing. Did the onset of index funds add
more money to the pool? What I mean by that is did people move out of regular
stocks into Index funds or did they move out of mutual funds into them? How
much is the difference?

------
chad_strategic
I have been saying this for years...

Passive investing is great. Especially since the S&P 500 has been up for ~10
or years.

It's when passive investing becomes panic investing (sell everything).

------
commandlinefan
> Nobel-approved models of risk that proved to be untrue

Makes you wonder how much more of this ends up remaining unquestioned until
it’s too late.

------
jl2718
Is there a fund with low fees that invests according to some reliable
accounting metrics of risk and return?

------
leon1717
And of course, he's reading in a lot of feedbacks of his opinions right now.
He wins anyway.

------
gooddadmike
Ramit Sethi recommends Index. Smart and not sexy way to do investing without
loosing.

------
amadeuspagel
It's a bit self-serving for a hedge fund manager to criticize index funds.

------
fallingfrog
I eagerly await the bursting of this new bubble of hubris and stupidity as
capitalism continues its self-cannibalistic path to destruction. Believe me
when I say that there’s nothing I enjoy more than watching rich people lose
all their money.

~~~
fallingfrog
Oh I should probably not post in the wee hours of the morning

------
cybersnowflake
Accepting that actively managed funds are better than passive index funds is
basically acceptance of the classical mentality that there are people who can
consistently predict and beat the market and that you can make money by
picking the 'right guy'.

I assumed most knowledgeable investors abandoned that philosophy in the
80s/90s

~~~
KingMachiavelli
(This is my understanding of the artical with some help from other comments. I
probably use some words incorrectly but I think you can get the jist)

TLDR: He is't abandoning the current stance that passive > active but rather
is discussing the real value of the underlying assets.

And he isn't challenging on that stance either. I don't think the artical is
out right advocating people to switch their personal investments from a
passive index fund to an active one since he & we both know that passive funds
tend to do as well or better than active funds after accounting for fees.

However, the article (at least how I understood it) is saying total effect of
everyone moving their money into ETFs and index funds means that the
underlying stocks have an increasing risk of becoming or being overvalued
since no one is checking the underlying stocks/companies anymore. As someone
just tangentially interested in this topic I've thought of this before in a
more tangable way: since every college graduate or hacker news type person
knows that index funds are the best then at some point 'everyone' or enough of
the population has a stake in index funds that it's likely to be overvalued.

The market should/could correct as expected: undervalued companies go
unnoticed longer since everyone is passively investing causing actively
managed funds to have higher yields (since they can get 'all' of the
undervalued companies passive investors miss) and people adjust their holdings
accordingly. However, as a few other users stated there a few issues trying to
hedge against a buble:

1\. Solvency - The market remains 'irrationally' attatched to passive/index
funds which means that index funds continue to beat active funds anyway
despite their 'real' value/gains being pure speculation. It's difficult
convincing people to let you manage their money when your making 4% and the
S&P400 is making 8-11% so remaining solvent is an issue.

2\. Systemic Risk - Large markets & financial products are intertwined so if
index funds are overvalued then it effects the economy & financial
institutitions and if it crashes/pops then it sends a shock wave throughout
all of them. Finding a hedge that isn't effected by a bubble in one financial
product (CDOs, index funds, etc) can be tricky.

