
A critique of the claim that passive investing is a bubble - sharkbot
https://awealthofcommonsense.com/2019/09/debunking-the-silly-passive-is-a-bubble-myth/
======
talolard
I think this article really misses the point that Burry was making, which is
that if the indexs see a sell off they won't find the liquidity in the market
to cash out their positions and will drive the market down.

This article seems to focus on all of the upsides of indexing, which are all
true. However, those upsides don't negate the risk that is being pointed to.

~~~
sambe
These sections seem to address the point to me:

* "The tail is not wagging the dog" \- index funds are a relatively small percentage of total share ownership.

* "Benchmark huggers have always been around" \- owning ~the index was not started with index funds.

* "Active funds literally own the market" \- the sum of portfolios of non-index funds ends up having the same profile.

* "Price discovery is a cop-out" \- relatively small part of the trading volume.

* "Liquidity is not a huge problem for index funds" -no market impact to sell (v dubious if you ask me), unlevered.

* "Humans matter more than fund structures" \- the absence of index funds did not prevent bubbles/crashes.

You can disagree with those points (I do with some of them) but that's a large
part of the article.

~~~
dcolkitt
> "Liquidity is not a huge problem for index funds" -no market impact to sell
> (v dubious if you ask me), unlevered.

If you're talking about index mutual funds, then the author is just plain
wrong. Any open-ended fund offering daily liquidity will trade, and therefore
produce market impact, to meet its daily redemptions.

If you're only talking about ETFs, then this is technically correct. Besides
the occasional index re-constitution, unlevered index ETFs don't do any
trading. However it's definitely not true that there's no market impact. As
the fund grows (or shrinks) the shares just don't magically appear in the
portfolio. Somebody has to go out and buy (or sell) those shares, and like any
trading volume, that creates market impact.

The mechanism that ETFs actually use is something called "Authorized
Participants" (or APs for short). Basically market makers have the right to
create or redeem shares in the ETF. To create new shares, they go out and buy
all the stocks in the index, then hand a basket over to the ETF fund manager,
who then hands back new shares of the equivalent value. And to destroy shares,
the AP hand over shares in the ETF, and the fund manager hands back a basket
of shares from the index.

If there's high demand for investors to own the ETF, that'll push up the ETF's
stock price. As the price rises relative to the index value, APs will detect
an arbitrage opportunity. They'll go out and buy the basket of stocks in the
index at a cheaper price, then create new ETF shares at the richer price, and
pocket the difference. Vice versa if there's demand from investors to exit the
ETF.

The mechanism keeps the ETF price closely pegged to the index, because the
further out of line it gets the more arbitrageur activity pushes it back in
line. While also flexibly satisfying investors' specific demand for the ETF at
any given time. Basically it delegates the role of trading from the fund
manager, who usually doesn't have any special expertise in trading, to highly
specialized trading firms and market makers.

However, as you can clearly see, market impact most definitely exists. If a
flurry of investors rush to enter or exit an ETF, then a huge amount of
trading has to be done to create or redeem the shares. Just because the APs
create this trading impact, instead of the fund itself, is a distinction
without a difference. The underlying stocks in the index _are_ subject to
market impact.

~~~
navigatesol
> _If a flurry of investors rush to enter or exit an ETF, then a huge amount
> of trading has to be done to create or redeem the shares. Just because the
> APs create this trading impact, instead of the fund itself, is a distinction
> without a difference. The underlying stocks in the index are subject to
> market impact._

But the trading isn't the cause of the market impact, it's the _redemptions
that occur_ first, and force the trading. There had to have been economic or
financial reasons for those redemptions to occur. The fact that when everyone
tries to sell at one, there's aren't enough buyers is a story of the ages.
That ETFs will suffer the same consequences in a run is hardly unique to them
as financial assets.

~~~
smogcutter
Right? I don’t see what the fuss is about. If the argument boils down to
“price and liquidity will drop in a sell-off”, well that’s basically a law of
nature. I don’t see why index funds are a special case.

------
lacker
I believe index funds are a good investment strategy, but at the same time we
shouldn’t get defensive when people criticize them, and call a thoughtful
critique “silly”. In fact I would like to hear _more_ intelligent criticism of
index funds, and thoughts around preparing for a hypothetical world in which
index funds were overrated, not less.

How might we notice that index funds were becoming overrated? Perhaps the rise
of hedge funds which consistently outperformed index funds? Is that happening?

What should we do if index funds became overrated? Move our money into a
medium-size number of stocks, like 30 of them, to essentially do our own index
selection? Or moving out of stocks entirely?

Thinking about questions like this without attacking criticism as “silly” is
IMO a better way to minimize risk.

~~~
jackcosgrove
I found an inconsistency in the article.

> We’re just seeing a shift from closet indexing to ETFs and other index funds
> en masse now that investors have wisened up.

So active managers are copying the indexes.

> Index fund investors are simply buying what the active investors have laid
> out for them.

But indexes buy what the active managers pick.

The author appears to be confused as to who is the tail and who is the dog.
Maybe this is resolved by saying _some_ active managers do price discovery,
but most are just copycats. It's not clear though.

For the record I think index funds are still the best choice for a retail
investor, and the article is mostly true. Namely

> Many of the worries about indexing really boil down to career risk in the
> asset management space.

Some of the arguments seem to be hasty and not well presented though.

~~~
FabHK
No inconsistency.

> > We’re just seeing a shift from closet indexing to ETFs and other index
> funds en masse now that investors have wisened up.

Some active managers used to (clandestinely more or less) copy the indexes,
but investors move away from active managers into passive funds.

The prices are determined on the margin, by the remaining active investors.
That's all consistent.

> index funds are still the best choice for a retail investor

Yes, index funds or index-linked ETFs. Agreed.

------
hogFeast
The "this time is different" crowd rides again.

Burry highlighted two simple truths of financial markets: people will buy shit
they don't understand, and people who make financial products will try to earn
a liquidity premium by transforming something illiquid to something liquid
(which always blows up).

Most people (who I have met) who own passives have no idea what they are
buying but are sure that buying passives makes them very smart. This blows up
every time.

I also don't think Burry was making some bombastic claim about 100% of ETFs
causing the end of civilisation. He was making a limited, reasonable claim
about trends in markets. Yes, he generalised but, in my estimation, he has
earned that right.

Simply, going from 0 to $300m+ earns you that right. Very few people have
achieved that. Very few people have done it in the way he did (taking real
risk). The views of a triggered financial adviser leeching off his clients
don't hold as much weight (and shows all the self-awareness of a financial
adviser to write a post implying they should).

~~~
thanatropism
I hate this kind of smart-ass top-level "ITT" comment that paints an entire
discussion happening besides it with broad strokes.

If only one person does this I can call him names and downvote him. If there
are two camps and both camps do this, people tribalize and everything goes
meta. Then no further actual discussion can take place.

~~~
hogFeast
If you think it is "smart-ass", you don't understand what I am saying (or,
more probably, what Burry is saying).

There are no "camps" here. The OP is trying to create a tribe (passive
investors are cultish, so this is a very odd comment...I will assume an honest
mistake) but that makes no sense on this topic (unless you are selling
something, which he is).

The meta of my point is: people try this discussion over and over, it is
always wrong, some things in finance are universal (because they have been
happening for literally three hundred years).

What you appear to have missed is the part where I said: Burry is not making a
"bombastic claim" about what will happen 100% of the time. In my experience,
most people think this is what investing is about (the OP is certainly an
example). It isn't. I am not making a bombastic claim.

The observation is, again, that: you have a lot of unsophisticated buyers and
some non-zero amount of these products are about liquidity transformation. You
can have a debate about this all you want but it isn't interesting or engaging
to anyone but people who are unsophisticated (not 100% true in this case,
Asness is a notable exception but he was an academic and it is mostly
academics who take an interest).

My interest is limited to the fact that: it is astonishing how often this
happens, and equally astonishing how fervently people will deny that it is
happening again (although they are usually new converts).

~~~
AlanYx
Thanks for this -- your comment above about "transforming something illiquid
to something liquid" and dcolkitt's post above explaining the possible
consequences when indexed ETFs are substantially more liquid than many of the
underlying securities really helped me understand the crux of Burry's
argument. Are you aware of any academics that are studying this issue or
modeling the risks?

~~~
hogFeast
Well, I suppose the literature around the liquidity premium relates to this
topic. But liquidity is fairly simple (and drives the market cycle): liquidity
is worthless in booms, and very valuable in busts.

But something to note here too: most measures of historical returns do not
look at liquidity either. I am in the UK, and I know there is research (I
can't find it atm) showing that before 1970s, trading costs were significant.
Historical returns rarely reflect that. Nor do they reflect the fact that most
people before 1970 probably couldn't own any asset other than govt bonds (or
that most banks were forced to own them too).

So I would say the issues with indexes are two-fold. First, they will fail if
they are built on illiquid securities (recent example here is also Neil
Woodford's implosion). Second, they are often predicated on historical returns
that are, in any non-academic/practical sense, fictional.

Another reply is Horizon Kinetics...apart from GMO, they are the only
investment manager whose letters I actually read. And on ETFs, they have
written a lot.

------
AlanYx
One question I have about Burry's comments that isn't (directly) addressed in
this article relates to Burry's observation that trading volumes are
remarkably low relative to the value of assets pegged to the equities being
traded. For example, he remarks that over half of the S&P 500 stocks trade
under $150 million daily, despite trillions of dollars in assets globally
indexed to those stocks. (And he notes that almost half of Russel 2000 stocks
trade at less than $1 million during the day.)

My question is, does this imply that there's substantially more synthetic
indexing (without ownership of the underlying securities) than we realize? If
there are trillions in indexed assets where the funds owned the majority of
the index components, wouldn't average daily inflows lead to higher trading
volumes than we're seeing? Or are the market makers such a huge portion of the
market that they act as a massive collective buffer causing very few shares to
actually be traded?

~~~
travisoneill1
As the manager of the ETF you could allow it to float freely in which case it
could trade at a premium or discount to NAV. But it wouldn't move too far
because this would attract arbitrageurs who would trade the ETF against the
individual stocks and bring it back in line. This would result in volume in
the individual stocks. Another way you could do this is hold a pile of units
in reserve and actively sell into the market when the ETF trades at a premium
and buy when it trades at a discount. This approach would not result in any
volume in the individual stocks (except for re-balancing from time to time). I
think what he is saying is that ETF's use the latter approach. Of course this
could also be done in an totally synthetic manner, but I don't think that
index funds do this. It would be messy.

~~~
nickles
> As the manager of the ETF you could allow it to float freely in which case
> it could trade at a premium or discount to NAV.

ETFs are securities that trade freely. They may be open ended or closed ended,
but the price of both is determined independent of NAV.

> But it wouldn't move too far because this would attract arbitrageurs who
> would trade the ETF against the individual stocks and bring it back in line.

This is the _creation /redemption mechanism_ and is actually responsible for
keeping the market cap of open ended ETFs in line with the NAV. Closed ended
funds don't have such a mechanism, so the cap may diverge from the NAV.

> Another way you could do this is hold a pile of units in reserve and
> actively sell into the market when the ETF trades at a premium and buy when
> it trades at a discount. This approach would not result in any volume in the
> individual stocks (except for re-balancing from time to time).

This defeats the tax advantages of the ETF structure. Instead of having the
manager buy and sell names, APs (authorized particpants) do the trading,
hedging with units of the ETF. They then do an in-kind exchange with the fund
manager at the end of the day. If the AP has net purchased the underlying
basket, they will exchange the basket for shares of the ETF ( _creation_ ). If
the AP is net short the basket, they will exchange their offsetting ETFs for
the underlying basket ( _redemption_ ). This should affect the volume of the
constituents.

Some ETFs do not require creation and redemption to be done with the full
basket of index members. These tend to be based on names that trade less
frequently. In this case the manager allows a subset of the index to be
exchanged. In this case, the creation/redemption mechanism will not
necessarily affect the volumes of all members of the index. Note that this can
could cause tracking error.

Managers will rebalance when the index the fund is based on changes. For
example, bond ETFs generally rebalance once a month. Market cap weighted ETFs
(as opposed to, for example, equal weighted ETFs) are easier for managers as
well, because the fund doesn't need active rebalancing.

------
awillen
As I read it, the word bubble in the Burry interview was really just used for
clickbait purposes - his argument wasn't so much that index funds are
overvalued, it was that there's opportunity in small caps because they're
underrepresented in index funds, and everyone else is investing in index
funds.

~~~
mrfredward
The Bloomberg article mixed Bury's words and the author's words quite a bit,
and I'm beginning to wonder if the whole reason we're having this discussion
is because some important nuance was lost.

It's hard to see why Mom and Pop buy and hold index investors should care
about the liquidity risk Bury talks about...market cap weighted funds will be
fine in the long run because the ratio of each underlying stock to a fund
share will be constant through the temporary price fluctuations...so no money
is lost if the price crashes and then comes back to the same sport shortly
after.

Perhaps there are other market participants who are leveraged and would find
themselves insolvent if indexes cause a liquidity problem? I just don't see
how the fund investors themselves would be hurt if underlying stock prices
went out of whack for an afternoon.

~~~
laminarflow
I agree with your views, but anecdotally, my worry is about how many of those
Mom and Pop investors bought the index funds _specifically because_ the index
funds have recently performed well; and of that faction, how much of the
capital allocated to index funds was pulled from other sources, causing those
sources to fall in value?

The data would also support that on a dollar-weighted basis, most index fund
investors are not really buying-and-holding:

"Turnover rates for two of the most popular ETFs are higher than 3500%(!), an
average holding period of about a week. That is dozens of times greater than
the trading liquidity of even its most liquid constituents"

[http://www.grantspub.com/files/presentations/Grant's%20Confe...](http://www.grantspub.com/files/presentations/Grant's%20Conference_Oct%204%202016_Steven%20Bregman_Final\[2\].pdf)

------
gnicholas
> _Yes, index investors are free riders, but this is the way most markets
> work. We don’t go to the grocery store to bid on prices of oranges against
> one another to set an equilibrium. The market does that for us._

Actually, our behavior does shape the price of oranges. If we go to the store
and they're less expensive, then we are more likely to buy them. The analogy
breaks down because he's comparing indexes and oranges, not stock indexes and
food indexes. Imagine if 14% of people went to the grocery, picked up a sack
of pre-selected items that were best sellers last week -- all in the name of
efficiency and reducing overhead. That would be quite weird indeed, and some
people would point out that if enough people did this it would create market
inefficiencies and potentially cause a glut or crash of certain food prices.

~~~
maerF0x0
We bid on a basket of groceries by choosing a store to shop at though. The
price of oranges is mostly immaterial when compared to the greater pricing of
the collection of goods purchased in a single trip. This is why loss leaders
make sense. They entice you in w/ a distorted price and then recoup the loss
across your basket.

~~~
gnicholas
> * We bid on a basket of groceries by choosing a store to shop at though*

I'm not sure I agree with this. Most grocery stores stock the same food, so
it's not as if going to Lucky instead of Safeway shapes what you can/will get.
You're right that if you go for particular sale items, you're more likely to
get those. But does that have a basket-level impact? I'm not sure it does.
Also, consider that when you go to a grocery store, you probably purchase
about .05% of the items they sell. It's not like we go to Safeway and buy most
of the things they sell there.

------
frgtpsswrdlame
Does this guy not see the contradictions in his own argument? He
simultaneously believes that active funds are doing a fine job of price
discovery AND that managers at active funds who deviate too much from their
(passive) benchmark are likely to be fired.

Also he jumps around Burry's arguments by focusing on liquidity and in AAPL
and FB. Burry's whole point is about less liquid components at the bottom of
indices which are getting dragged upward by a lack of price discovery and
inclusion in widespread passive funds. Since they're market-cap weighted, this
would have a cyclical component, more passive purchases -> higher market cap
-> higher weighting in passive indices -> more passive purchases. This would
result in another cyclical component where that cycle causes: passive fund
outperformance -> increased investing in passive funds -> passive fund
outperformance.

Then in an event where people start liquidating there is no one there to
purchase those stocks and they've been dramatically overvalued anyways so
their price gets crushed. This is specifically why Burry likes small cap
active.

If you pay attention to finance discussion on this board then you've
definitely heard the phrase: “The market can stay irrational longer than you
can stay solvent.” The argument here is that irrationality has persisted long
enough to crush most 'rational' price discoverers.

>Do you know what didn’t cause the Great Depression or Japan stock market
crash or 1987 crash or 1973-74 bear market? Index funds. Index funds also
weren’t around for the South Sea bubble in the 1700s. Do you know what did
cause these bubbles and subsequent crashes? Human nature.

Imagine doing this but replacing 'index funds' with mortgage CDOs.

Look I'm not even saying Burry is right but the absolute inability of the
finance commentariat to actually address what he's saying is giving him more
credence.

~~~
gzu
I believe this is related to the rise in buybacks where price fundamentals no
longer matter, only goal for companies is to get the largest market cap as
possible ignoring long term risks in order to attract an increasing flow of
passive money being poured into the markets.

------
newshorts
> When an index fund investor sells, they’re technically selling their
> holdings in direct proportion to their weighting in the index. So there is
> literally no market impact.

Correct me if I’m wrong but isn’t there a well known price premium for stocks
included in major index funds? As I understand it, the most popular indexes
target a few companies, thus index funds that track them funnel a
disproportionate volume of demand to those companies causing a price premium.

It’s stands to reason that if a sudden outflow of money from index funds
occurred, that price premium would swing the equal and opposite direction.

~~~
AlanSE
I've asked this question before and consistently failed to get a clear answer
- why is there any deviation between index fund weighting and market cap?

To some extent, I'm sure the definition of a "public" company comes into play.
Not all stocks are traded in all exchanges, so you could include stocks only
listed on one exchange.

Then there's the practice of many index funds picking the top N stocks by
market cap. This seems like a backwards practice to me. The small cap stocks
should be limited in weight by... their small market cap.

Then there are other hairy factors. Even out of the stocks in an index, it
seems that weight does not correspond to capitalization. The reason seems to
be some historical drivel. While I can understand that is the way it is, I
fail to understand why it should be that way.

Why should an equities index fund be anything other than public companies
proportional to their size? If people prefer large cap or small cap, then
those variations should be offered as special boutique products. But it seems
that we have it backwards, where the default offering is based on arbitrary
non-proportional weights, and with a cutoff restricting it to large cap.

~~~
id
>The small cap stocks should be limited in weight by... their small market
cap.

A lot of index funds include small caps nowadays. Not all of them because it's
more difficult to track 4000 versus 500 stocks. Also the more popular indexes
have usually been around for a long time and have fewer constituents.

>it seems that weight does not correspond to capitalization

Pretty much all index funds invest in the public float and it makes sense:

[https://en.wikipedia.org/wiki/Public_float](https://en.wikipedia.org/wiki/Public_float)

~~~
AlanSE
The public float sounds legit. I wouldn't argue with that, in fact, it's
probably the technically accurate metric.

Where I was coming from was...

[https://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average](https://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average)

> The value of the Dow is not a weighted arithmetic mean[5] and does not
> represent its component companies' market capitalization, but rather the sum
> of the price of one share of stock for each component company. The sum is
> corrected by a factor which changes whenever one of the component stocks has
> a stock split or stock dividend, so as to generate a consistent value for
> the index.[6]. It is not an accurate representation of the US market or
> total market.[7][8][9]

It mentions "consistent value", but that's over time. You can be
misrepresented in weightings but still consistent over time.

Basing the weightings on the stock price sounds royally stupid... if I'm even
reading that correctly. But maybe this insanity is just the DOW?

It's also the first one I grab for, because it's the first one that media
reports on.

------
modeless
I just looked at the prospectus for one index ETF I own [1]. It actually has a
lot of wiggle room. 10% of assets can be invested in things that aren't in the
index. The 90% that's guaranteed to be invested in index assets is also not
guaranteed to be exactly weighted by market cap. The fund is not even required
to own every asset in the index.

I don't know what other ETFs have in their prospectuses, but this wiggle room
seems like it could mitigate some of the concerns about crashes due to low
liquidity in thinly traded stocks.

[1]
[http://hosted.rightprospectus.com/ETF/Fund.aspx?dt=P&cu=8085...](http://hosted.rightprospectus.com/ETF/Fund.aspx?dt=P&cu=808524102)

------
kolbe
Reminder: "index funds" are also managed by humans. For example, all stocks in
the S&P 500 are chosen by Standard & Poors. Stocks are added and removed as
they see fit based on various criteria such as profitability, float, market
cap, &c. The only things that I can see that truly differentiate S&P from
other active managers are that they

(a) have very little skin in the game.

(b) they get to make decisions about what other people have to do with their
money

(c) they tend to recommend more stocks with less turnover than typical active
managers

(d) they tell the public ahead of time what will be bought or sold, so traders
get to buy/sell ahead of time

(e) their actions are relatively predictable, thanks to a long history of
sticking to their stated goals.

~~~
gzu
The S&P 500 is basically a group of largest established 500 market cap stocks
traded in the US proportioned to market cap. There is no active management
determining price and weights here.

~~~
Aunche
I don't think so. Otherwise Uber and Snap would both be in the S&P 500.

~~~
FabHK
There are certain criteria, see [1] or [2] for a summary. They need to be
publicly traded for sufficient time, have sufficient free float, be
profitable, etc.

See [3] for example on why Tesla isn't.

[1]
[https://us.spindices.com/documents/methodologies/methodology...](https://us.spindices.com/documents/methodologies/methodology-
sp-us-indices.pdf)

[2]
[https://en.m.wikipedia.org/wiki/S%26P_500_Index#Selection_cr...](https://en.m.wikipedia.org/wiki/S%26P_500_Index#Selection_criteria)

[3] [https://seekingalpha.com/article/4088016-will-tesla-join-
s-a...](https://seekingalpha.com/article/4088016-will-tesla-join-s-and-p-500)

~~~
kolbe
Yep. So, you don't just own the top 500 stocks by market cap. You own a set of
stocks that resemble that idea, but are in fact still choices made by S&P.
Also notice that stocks don't immediately get dropped when they fall below
that criteria; there's a buffer for how bad they have to get to be dropped.
Additionally, the rules governing these choices are free to change at any
time. For example, whether stocks with split voting shares should qualify is
still a discussion.

Let's also not forget Hacker News's favorite law: Goodhart's Law. The S&P has
performed wonderfully well when it was observed as an index. But now that it's
a target, the world will change around it.

~~~
gzu
It’s a huge stretch to say the S&P 500 isn’t the current top 500 stocks by
market cap just because they don’t include several recent IPOs and have
discretion to exclude stocks based on potential stock manipulation. These are
very rare cases that have little affect on the overall index. In time (not
instantly) they add large established companies. Proportions are always
weighted directly to market cap percentage. They’re not weighing some stocks
higher than others like how an active manager would allocate.

Agree “beating the index” is quite a joke since that is the benchmark for fund
performance and so much money is passive invested now. Matching the index
performance is saying “our fund equities have appreciated on equal basis to
how all others have”.

------
sct202
I'm a little confused about the point about index funds being a small
percentage of assets, when there are constantly articles like "Passive
investing automatically tracking indexes now controls nearly half the US stock
market." [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)

His graph shows an arrow pointed at the small sliver on ETFs, but that isn't
necessarily the same as passive investing which would include a lot of mutual
funds.

------
dumbfounder
"When an index fund investor sells, they’re technically selling their holdings
in direct proportion to their weighting in the index. So there is literally no
market impact."

Have to take the rest of the article with several grains of salt after reading
this. Even if the index was spread against all stocks it would have an impact.
It implies that you can only move money around the market, not take it out of
the market altogether.

------
david927
It doesn't seem silly at all. I agree with Michael Burry; I think passive
investing is a bubble -- by definition. If you spent $10 million to make a
cafe in your small hometown, you would never get that money back for the
obvious reason that you could simply never sell that much coffee. The
fundamentals aren't there.

So if you invest in "all coffee shops" or "all shops in my hometown", you're
not looking at fundamentals, you're investing to invest. And, by definition,
(assuming all shops are priced correctly) you're artificially inflating.

If someone invests across a group of stocks, it's because "the market always
goes up over time." And if enough people believe that then it can be true for
a very, very long period. But eventually it becomes your $10 million coffee
shop. It's a bubble. And even a bubble that lasts decades will eventually pop.

~~~
8ytecoder
There are always active investors who could take advantage of this valuation
mismatch and bet for/against specific companies that they think are
undervalued/overvalued and make money. Eventually this valuation mismatch
would show up in their P/L statement and balance sheet. Passive investing
freeloads on active investors - in a sense. That's all it is and I for one
think it's great.

------
falcolas
Meta: I read articles like this, and some of the 5+ paragraph comments on this
site, and it makes a ton of sense to me why people are downright afraid of the
work required to learn how the economy works at a low level. It's crazy how
often probabilities are presented as fact.

My mother-in-law works for the state doing financial investing, and I've seen
some of the functions and constant values she's had to memorize to get her
degrees. Constants that are based on models that are often decades old. It's
all ultimately a form of forecasting based on models, but it's treated as
gospel of how it will all occur.

Perhaps that's why it works at all - everyone's using the same models, and
they behave in a set pattern (established by schooling and "how it's always
been done") based off those models, which makes the models accurate.

------
derivagral
The dig at "Active Management" feels like it detracts from the article, but I
guess they're playing a bit to the audience.

What I found a little more concerning is their glossing over of the liquidity
risks. If everyone wants to sell an index, then at some point that index needs
to liquidate shares (proportionally). Those shares won't have uniform demand,
which is going to cause both price fluctuations (drops) which affect the value
of the index. The fun part here too is that this can play some havoc with
market-cap weighted indexes, which now need to adjust their holding %'s.

~~~
wbl
No they don't. Let's suppose we have A Corp and B Corp both 50٪ of the total
market and A Corps price and hence market cap falls by 50٪, making it 33٪ of
the total market. The holdings of a fund haven't changed but the exposure
still equals the market.

~~~
gzu
He is saying when people exit and index sells all their stocks equal to
current market cap rankings that the opposite side of trade buy demand for all
those won’t be equal. Bad stocks may go down further than solid companies. A
shift in value vs growth preferences caused by the downturn itself could be
the cause of that. The entire index and all holdings would then HAVE to
readjust for this discrepancy and lead to more forced selling of bad stocks
and buying of solid companies creating more liquidity crisis.

------
cs702
It depends on whether and to what degree indexes are affecting price
discovery:

If prices are being set predominantly by active investors who are truly buying
and selling _based on bottom-up, security-level research_ , then the
percentage of assets that happens to be invested in passive funds is not that
important, because price discovery would be working exactly as you and I would
hope.

But if prices are being set predominantly by (a) active investors who are
_chasing indexes because they don 't have a choice_, (b) active managers who
are _being forced to sell positions_ to cope with a high rate of redemptions
(from investors who plow that capital back into passive strategies), and (c)
traders who grasp this dynamic and shrewdly exploit it for as long as
possible; then price discovery might not be working as we would hope. Prices
would no longer be reflecting perceived risk; they would be reflecting the
(temporary) influence of this once-in-history dynamical process.

Burry makes a compelling case, I think, that the latter is a more accurate
description of the current state of financial markets than the former, and
that this state of affairs can only persist so long as capital continues to
flow from active to passive strategies at such high rates. Globally, assets
under management are not infinite, so capital cannot flow indefinitely from
active to passive strategies: Sooner or letter, this dynamical process must
exhaust itself.

~~~
qaq
And there would be hedge funds that would try to exploit this eventually
pushing things back into balance

------
gzu
His point about the increase in volume leading to price discovery is
laughable. More algos than ever are trading with each other on the subsecond
scale but that means nothing for long term equity values. With the rise of
index tracking there are fewer than ever investors actively positioning
themselves against a standard indexed allocation by picking good and selling
bad stocks. Indexing is riding the boat buying everything in equal components
due to market cap weight.

------
maerF0x0
IMO the real issue is amount of cash available for investment and the lack of
investable assets[1].

If i were king for a day I'd legislate a low bar that required the equities to
be listed so that both the insiders cannot be barred from liquidity and so
that the investing public can access those parts of the economy.

[1]:
[https://personal.vanguard.com/pdf/ISGPCA.pdf](https://personal.vanguard.com/pdf/ISGPCA.pdf)

------
jeffdavis
At some point, someone (or a collective) needs to make a decision about how
capital is allocated among different firms.

Traditional money managers may not be the right way to do that, but we should
be clear that decisions are still being made somehow.

I guess it's not the investors plowing money into the first index fund they
find. And it's not the index fund, because they don't do a lot of management.

So I guess it's a handful of hedge funds that set prices?

~~~
Excel_Wizard
Index funds do not contribute to the process of price discovery.

As long as a certain fraction of trades are performed by active investors,
price discovery will continue to be accurate. Currently, active traders
dominate, making up the majority of trades. This fraction could be much
smaller than it currently is and still be OK.

~~~
jeffdavis
There are still people discovering prices, and they are still getting paid
somehow, probably by first-mover advantage.

Are we sure that the right model is to just watch these first-movers and do
what they do?

------
blacksqr
I find it grimly amusing that the posters here expressing variations on the
"this is fine" position are making the exact arguments that market boosters
were making before/during the mortgage finance crisis in 2007/2008.

The problem with those arguments is the fact that what turns a recession into
a depression is demand strikes: when the people with cash lose faith in the
integrity of the market, they just take their money off the table and go home.
Arbitrage and market correction dynamics cease to function.

The fact that depressions can be caused by collapses in demand as well as in
supply was the key insight of Keynes et al. in the 1930's, which is why he
argued that the government must have the power to regulate markets and the
authority to step in and become the buyer of last resort in the face of an
incipient depression.

Keynes' insight was conveniently forgotten by the early 2000's, regulation was
resisted, the shadow market grew out of bounds, bailouts and stimulus met
political resistance, and the rest is history.

How short the time span of memory is.

------
tempsy
Now my main concern with index funds I hold (broad market/large cap) is that I
definitely have exposure to businesses (e.g. fossil fuels) that I don't
actually want to be invested in.

Anyone have suggestions on the best sustainable ETFs out there?

------
cryptica
I think this idea of an index fund bubble makes a lot of sense in terms of
metrics like economic efficiency. Investors are paying more money to buy
stocks which provide less economic value per dollar invested... but low
productivity and economic inefficiency doesn't mean low profits. Indexed
companies often have monopolies in their fields and can derive profits from
rent seeking activities and lobbying for beneficial regulations so they don't
need to be efficient in order to derive profits.

------
bitxbit
I believe what’s missing from the recent analyses of beta/index investing is
that alpha continues to lag when in theory stock pickers should be able to
find more mispriced assets. Although volatility around earnings (which serve
as valuation reset) has generally increased. Unprecedented bull market and 3/4
of investable wealth now pooling into passives funds simply cannot be
overcome. What it does provide is significantly asymmetrical opportunities
shorting single stocks.

------
api
Wasn't the housing bubble driven in part by a form of passive investing,
namely bundling mortgages (one of the "safest private investments")?

Economic systems are feedback loops. If something is the best investment that
causes it to become a bad investment in proportion to how rapidly people
realize it's a good investment.

------
hsnewman
In these times I'm looking at more conservative "passive investments" such as
interest bearing accounts, FDIC insured. With Twitter posts resulting in large
swings in the market, I declare "market manipulation" by those with large
numbers of followers.

------
laminarflow
For those interested in this topic, Horizon Kinetics' 2016 presentation
"Indexation: Capitalist Tool" is a fascinating read, as it points out some
baffling structural mismatches between indexes and their underlying securities
beyond just liquidity (which was the main focus of Burry's analysis).

[http://www.grantspub.com/files/presentations/Grant's%20Confe...](http://www.grantspub.com/files/presentations/Grant's%20Conference_Oct%204%202016_Steven%20Bregman_Final\[2\].pdf)

 _Edit_ Some highlights:

> Does an asset allocation program or roboadvisor tool seeking foreign market
> exposure know that 6 of the top 10 holdings of the iShares MSCI Spain Index
> get 70% or more of their revenues from outside of Spain? That a purchase of
> the ETF is, essentially, investing outside Spain? The same holds true for
> emerging markets ETFs.

> the business demand of ETF organizers for liquid stocks has only increased,
> with the influx of funds directed into the same limited population of liquid
> stocks. ExxonMobil is one of the most liquid. Ergo, it will be found almost
> anywhere one can imagine that it can be placed. It’s Growth, It’s Value,
> Its’ a Bird, It’s a Plane...

> Would an active manager of a low-risk strategy be permitted the risk of a
> near-50% weighting in financials? ... These largest-in-class ETFs can
> legitimately be characterized as low volatility, since of late the financial
> sector has not been volatile. And the high weighting enables the ETF to
> attain its advertised low Beta.

------
TomGullen
If an index selloff could cause a drop in underlying stock price, wouldn't we
see this effect when stocks are relegated from various indexes? Does this
effect exist?

~~~
adambyrtek
This effect does exist, but changes to indexes are public, so this information
is mostly included in the price already.

------
gridlockd
Back in 2007 you could've made a similar chart to show that CDOs are a small
amount of the market.

What's unclear is the impact that ETFs have on prices. This "debunking"
doesn't address the point about low volume.

Let's suppose most of those non-ETFs owners are buy and hold investors that
bought in a long time ago and wouldn't buy anywhere near today's prices.

That would mean ETF holders, especially those who joined late, could still be
responsible for a disproportionate share of today's prices. If the market
shows signs of weakness, these people need to get out, especially if they
bought on leverage.

------
dkarl
As others have noted, there's a lot here that isn't relevant to Burry's
argument, but this seems like the key rebuttal to me:

 _Active funds literally own the market. When you buy an index fund of the
total stock market, you are literally buying the stock market in proportion to
the shares held by all active investors. If you sum up the collective holdings
of active managers, what you basically get is a market-cap-weighted index.
Index fund investors are simply buying what the active investors have laid out
for them._

I don't have the knowledge to evaluate this statement, but to me, it
undermines Burry's point that passive investing distorts prices.

And this bit that he quotes from someone else expands on the point:

 _The use of price signals by those who played no role in setting them may be
capitalism’s most important feature. That most of us and most of our dollars
don’t have to pick stocks, or to price air conditioners, is a great benefit
and taking advantage of it makes us honest smart capitalists, not commissars._

As I understand it, Burry's argument is that index funds distort prices
because capital is being allocated in an automated and uniform way, instead of
being allocated according to the expertise of a diverse, success-weighted
group of investors who are motivated to make intelligent and informed
decisions. At some point the difference between the index-fund-driven prices
and the "true" prices according to informed opinion will become obvious, and
investors will attempt to flee index funds, popping the bubble. The rebuttal
in this argument is that active investors are still controlling the market
because index funds mirror their activity. We will never reach a state where
people will rush to "escape" from the index funds to actively managed funds,
because index funds will always approximate the aggregate opinion of the
actively managed funds.

This accords with my naive idea of how index funds work, but I don't know if
they actually _do_ work that way, so I can't evaluate the soundness of either
argument.

~~~
christophilus
> Index fund investors are simply buying what the active investors have laid
> out for them.

That works until it doesn't. If passive becomes big enough, the indices
themselves will be the ones steering the ship. The active managers won't be
significant enough to sway the indices.

I heard this analogy on a podcast (I think it was Invest Like the Best):
Indices are like a drunk person, and active managers are like the sober friend
guiding the drunk home. But if the drunk becomes 10x the size of the sober
friend, the friend is no longer strong enough to be a guide.

If passive funds get big enough to dwarf active management, they eventually
will be the ones steering the market, and active investors will be noise at
that point. In that scenario, I'm not sure what happens, but it seems that
indexing would become more like a Ponsi scheme.

~~~
dkarl
As I understand it, the index funds aren't drunk and aimless, forced in a
certain direction as a side effect of the trades of active investors. They are
intentionally and methodically following the active investors.

~~~
yborg
Or the underlying companies that are traded.

This "evil zombie index fund" trope seems to imply that index managers just
continue to blindly buy the stocks in the index regardless of events, falsely
inflating the value of companies. If a company is unable to generate cashflow
from its underlying business, this will quickly become evident because it will
be unable to pay its creditors and employees. It could take advantage of its
"inflated value" by issuing shares to generate cash, but this would then
obviously begin diluting the stock and cause the price to fall, the "zombie
indexes" wouldn't simply continue to price it at a constant value. I.e. price
discovery will happen, just perhaps not as quickly as an active analyst
monitoring the stock would do it.

------
crb002
I don't buy the liquidity argument. Their mere existence creates liquidity.
Two sides to every trade. Index fund "sell offs" will likely go to buyers of
the same index fund shares but at a lower price.

Apple alone has $50 billion in cash that will flow into Vanguard if index
funds hit a 50% plunge. Same with Buffet. Index funds may be bubble priced,
but they don't suffer from a liquidity issue.

------
tjpaudio
"When an index fund investor sells, they’re technically selling their holdings
in direct proportion to their weighting in the index. So there is literally no
market impact"

This is a straight out false statement. Who is this guy again? Oh yea, he has
his hands in passive investment big time.

------
pbreit
That is a very confusing headline.

------
masgbox
yes!

------
PaulHoule
I think someday we will think that index funds were pernicious but we don't
understand entirely why yet.

If you believe, for instance, that there is an "S&P 500" bubble then there is
difficulty turning that into an investable thesis. The S&P 500 is about 80% of
the valuation of the stock market. If the S&P 500 pops, then relatively the
other 20% of the market will go up, but how much can it go up?

The most harmful effect we know now of the passive funds is that they have a
strong incentive (when they vote their shares) to discourage competition. If
they own both AT&T and Verizon they would rather both of these be profitable
at the expense of consumers rather than work hard to gain market share for one
or the other.

