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Why Index Funds Are Like Subprime CDOs (bloomberg.com)
359 points by kgwgk on Sept 4, 2019 | hide | past | favorite | 317 comments

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...), 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?

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.

Burry's point is not that a lot of indexed stocks are relatively illiquid and thus index funds would have a hard time getting out of them in a serious downturn.

His point is that the index funds don't own the stocks at all; they trade derivatives like futures and CDO's that mimic the movement of the stocks in leveraged fashion, and the more people who dump their money into index funds without doing their own research, the more leveraged the funds become.

He's warning that in the next serious downturn, over-leverage may cause cascading collapse of index funds and the economy with them, like it did in the mortgage finance crisis.

> His point is that the index funds don't own the stocks at all

This is misleading, I think. Depends on the fund. Some seek to match the benchmark through a certain exposure to derivatives and synthetic things. Others hold the stocks in proportion.

The vanguard funds I'm invested in don't have much synthetics - they own the stocks

As far as I'm aware they also have flexibility in when they sell or buy stocks, so they don't need to buy them the second you move money in etc.

IWM, the largest of the Russel 2K ETFs with $38B cap has exactly 0.14% in cash/derivatives ($53.7M)


> His point is that the index funds don't own the stocks at all

What? Where did you see that? Not only do the index ETF issuers own the stock but I believe they are legally obligated to do so.

"Potentially making it worse will be the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day. This fundamental concept is the same one that resulted in the market meltdowns in 2008."

The keyword there is "help". They use derivatives to handle the daily fund flows. They should be a tiny percentage of the whole fund value.

You only find out who's swimming naked when the tide goes out.

Burry's point is, whatever the percentage of leverage, it's reaching levels that are dangerous for the larger economy.

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?

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.

> 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.

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.

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?

> 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.

Panic is quite literally a psychological overreaction.

So if only people had acted rationally while they were losing billions of money, things would have been okay?

I think the only thing one should always do is actively update one knowledge and be ready to adjust strategy accordingly.

No strategy/advice last forever

There is no such thing as passive investing per se.

So instead of recommending fund, it's better to recommend them to learn of the fundamentals of investing instead.

And isn't the fundamental truth of investing: optimize returns based on your tolerance for risk? For the vast majority of the population, the optimal way to get the highest returns with the lowest risk is to put the money into either the S&P 500 or a total market index.

Every study has shown that people do not get rewarded appropriately for the risk they take on when they move away from diversification.

The fundamental as in you should know how anything generate value, what is index actually is, how the index work, why the index being recommended, how the stock market work, etc.

Maybe we are wrong about the fact that active fund managers do a poor job? In the same way that mathematical models failed to account for the <1% unlikely event in the 2007 crisis, and predicted everything was just fine, maybe our mental models are not crediting the fund managers with saving our investment from this particular failure mode of passive index funds.

Unfortunately it's not clear how to tell which fund managers would actually be able to succeed at this.

Maybe one answer is a new fund type that spawns smaller funds automatically at a certain amount of capital raised which invest variable amounts in a broader group of companies.

Can I sell you a mattress?

> 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

That's pretty interesting.

In 2019, the average daily trading volume of Berkshire Hathaway (class A) was 0.04% of the total shares outstanding. If all people that held this stock were forced to sell 1% of the total shares outstanding, look out!

On the other hand, Roku has averaged 15.6% this year, with a standard deviation of 10. 1% of total shares isn't even going to be noticed.

Index funds can and generally should skip Berkshire Hathaway class A and just buy class B stocks without issue. It’s meaningless in this context.

The SP500 has a long tail 150M on a 20B dollar company, which is the median, is 0.75% per day that’s quite a bit of motion normally but you expect volatility to go up on a major sell off.

Anyway, if 1% of all money is removed from index funds on the same day whatever caused that is also going to cause the market is going to crash and crash hard. It would take something like an outbreak of Ebola in NYC to get that kind of a reaction.

If 1% of the money in index funds exited the market in any form (not just index fund withdrawals), it's going to be a bad day any way you look at it.

I think the fund managers know this and will collude to prevent it from happening. They are smart enough to know about game theory, it's not their money. So they can sit and not go on a selling frenzy.

Are they manually managed though ? isn't there an algorithm somewhere responsible for balancing these funds ?

My understanding is that the largest index funds use free-float weighting. This adjusts the weight of a stock in the index by the proportion of the stock that trades freely in the market. https://en.wikipedia.org/wiki/Capitalization-weighted_index#...

In the example you give, this should result in Berkshire Hathaway Class A to have a very small weight in an index fund weighted this way.

Looking at the holdings of VOO, as of July 31, 2019, It holds 806 shares of Berkshire Hathaway (Class A) (worth ~$249 million), but about 37 million shares of Class B, worth ~$7.6 billion.


That's an interesting point; it would seem like the stocks Michael Burry, the Big Short investor, likes would be in the same boat.

Or maybe he's counting on their low volume? :-)

If you are buying Berkshire with as a short term investment and you’re not a market maker, you are an idiot.

> 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

I'd like to point out that while this may be the case for traditional mutual funds, it is not for ETFs. ETFs don't redeem shares for cash they redeem them for equities in the underlying index. So ETFs don't actually buy or sell any securities unless they rebalance.

That depends on:

A) the standard lock-up period of a fund, or

B) an ETF under strong selling pressure can be halted by the exchange. Some contracts presumably allow an ETF manager to halt sales if high outflows and low liquidity? Certainly can occur with funds.

And C) "There are some escape clauses in Vanguard's index funds: The fund may temporarily depart from its normal investment policies and strategies when doing so is believed to be in the fund’s best interest. ... Vanguard funds can postpone payment of redemption proceeds for up to seven calendar days." as per MathNerd314 https://news.ycombinator.com/item?id=20888999

One thing I am trying to understand . lets say there is a super flash crash and take Acme INC

Day 1: (before crash) price : 200$ S&P 500 weight : 2%

Day 2 :next day market crashes. Acme is very low volume so price crashes to 1$ .

what happens next ? do all the EFT that follow S&P have to sell all ACME for 1$ because it is not in the S&P 500 anymore.

Day 5 : ACME jump back to 200 $ and is back in the S&P 500.

So my question is what would have happen to a passive investor. if he bought 1000$ worth of ETF right before the crash. Will he still have a 1000$ dollars at the end of it .

The S&P reconstitutes itself four times a year. But, imagine that your scenario worked anyways -- the investor would have less than $1000 since the S&P index missed the recovery of Acme Inc. But considering the largest constituent of the S&P (MSFT) is only around 4% of the index total weight, the impact of Acme Inc's price decline would not be great.

Index changes don’t happen like that and a drop that large would freeze trading.

There is no market rule that prevents a single stock from dropping 99% in a day. LULD only halts trading for a few minutes, then there's an auction that could result in any price.

There is no market rule that requires a single stock from not being halted.

Please show me a one day 99% drop on a stock. Trading would be halted well before that to prevent manipulation or errors.

The rules are covered here: https://www.sec.gov/oiea/investor-alerts-bulletins/investor-...

LULD is the one that applies to single stocks. It only results in a five minute halt, as I said.

The market-wide circuit breaker can halt the entire market for a full day, but only in response to a 20% move in S&P500, not a single stock.

If it were a straight drop of 99% - say it is trading at $100 at tick_1 and at tick_2, it is trading at $1, trading will be halted at point which happens to be after a 99% drop. In reality, stocks gap downwards in a series of shallow steps which are unlikely to be 99% in one tick.

More info on the 10% trading halt rule: https://www.nasdaqtrader.com/Trader.aspx?id=TradeHalts

> 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.

Index funds generally aren't super rigidly defined in terms of 1% Company A to 1 % Company B to 3% Company C, etc. which grants them leeway to precisely not have to sell off their assets in precise ratios to maintain a certain portfolio composition.

Index funds do not seek to perfectly replicate whatever sector/market they're seeking to index, but rather they are trying to approximately track the overall change. You can ignore portions of the market while still tracking it to a very close degree (i.e. sampling a distribution).

Which is why it is weird he compares them to CDOs.

Indexes typically don't have a fixed set of underlying securities. CDOs do. Your index fund typically won't tank because one of it's holdings become unprofitable, the fund will adjust reducing shares of said fund and thus reducing risk.

That doesn't happen with a CDO. If you're AAA mortgage holder starts having financial troubles, you can't readjust the CDO to reduce exposure.

Take an S&P 500 index as an example. If company 500 starts having a crappy quarter and falls out, what happens to your index? You dump the old 500 for the new one.

This isn't too say they aren't without risk. Just that it is a completely different financial vehicle than a CDO. So different that trying to make comparisons isn't really prudent.

I may have read it wrong (or have a misunderstanding of how it all works) but I also took away that since passive investment is allocated evenly across the market that investors are not properly pricing risk. I take that to mean, if all investors are diligent then the allocation of capital shouldn’t be equal. Since there is so much capital now in passive it sort of distorts the market for investment dollars (of which public companies are consumers). It’s as though instead of having subprime homebuyers with easy access to capital we now have subprime companies with easy access to capital. Again my understanding of how this all works may be flawed but this is how I interpreted it.

But as an index fund investor isn't the dollar amount invested in those tiny market cap companies quite small? It's unclear to me if the cumulative effect of liquidity problems for the stocks of those companies would be enough to make a sizable dent in an index fund portfolio of someone not looking to panic sell.

So the result would then be something like the flash crash?

I share your understanding of the article, it’s not about “index bad active good”, it’s about, “is there a problem when a lot of investors have to move quickly”. I wonder if there is some analysis of this during the last crash.

It could be more serious than the flash crash (again, just an interpretation).

Flash crash gets resolved quickly and is transparent to non-participants because there is a lot of money willing to buy on dips. But fast trading money only buys and sells what they perceive to be highly liquid assets -- there are few things that scare them more than being stuck with an open trade.

The scenario Burry describes is akin to CDO crash. Naively, most CDO assets were not problematic and many/most of the problem ones had an underlying asset of some value guaranteeing the debt. What caused the crash was lack of liquidity that started a vicious circle.

Index fund scenario could be similar: less liquid stocks that are big components of major indices would crash with unknown systematic consequences. Even if only 10% of passive index investors heads for the exits we could see broad, long term damage. And they could: pension funds have been investing huge sums into indices and a targeted PR / a few headlines of the type "look what those financiers doing with worker's money" may nudge a lot of money out of stocks.

On the other side, it is easy to make conspiracy theories on any subject.

The fundamental reason this happens is that Index Funds aren't "real" stocks. You cannot really sell SPY. There is a bucket of shares owned by SPY. Those contain shares of the index' companies. There's an "owned by clients" bucket and there's a "share liquidity reserve" bucket (with shares of companies in the fund). There's also a (small) liquidity "bucket of cash".

And of course, that company can, subject only to it's own chosen limitations, "print" SPY shares and sell them. So there's never any shortage of those.

When people transact in SPY, the trades are satisfied from those buckets. The cash bucket for investors selling SPY, the reserve shares bucket for investors buying. Those buckets are then refilled by the firm behind SPY buying and selling shares so that their share reserve and cash reserve remain at useful levels.

But let's now say there's heavy selling, for whatever reason. Sells really exceed buys and ... the cash bucket runs dry. Well, now sales stop, potentially indefinitely. The company will try to refill that bucket quickly, but there's absolutely no guarantee they will succeed, and there's no timeframe. Because the price for redemptions is only determined when they refill the bucket, you have no control over when this price is determined. It could be days after your order went through. Most index funds also technically have the right to just suspend redemptions entirely, indefinitely. Because of the amount of money in index funds, this will exhaust liquidity on actual shares relatively quickly and the whole market will freeze (because: no buyers)

Burry's claim is that if this ever happens, and investors find themselves stuck in index funds with no way out, there is nothing that will resolve that situation. Buyers won't want in, because once in, no way out. Sellers will panic and REALLY want out. This situation will self-reinforce until the market is driven into the ground.

0. some random situation causes that sellers exceed buyers for an index fund enough to initially exhaust the liquidity buffer of that fund

1. liquidity buffer in an index fund is empty

2. because of this transactions in the index fund stop

3. this causes panic, meaning less buyers, more sellers

4. goto 1, with situation getting worse every iteration

It won't be a "flash" crash, you'll just be locked in your index funds until the crash is complete.

It's hard to argue that this situation is impossible, that it cannot develop. It also seems to me that his conclusion that if this ever happens, it'll self-reinforce is correct. That said, we are pretty far from this happening.

Mutual funds usually redeem in cash, but they can also redeem in shares -- if some component of the index becomes untradeable, and becomes a significant enough holding, the fund should just give the shares to people who want out of the fund.

I fail to see how that would ever happen. Authorized participants [0] are always in the market for ETFs. If an ETF share price is crashing out of line with the index it tracks, they will step in and buy shares, swap them with the ETF issuer for the shares of the underlying stock in the index, and sell those shares for an arbitrage profit.

Even if one of the underlying stocks becomes illiquid, a big enough price divergence on all of the other liquid stocks would make it profitable to eat the loss or hold the illiquid ones (risky, but remember, there are many authorized participants competing with each other so if there is some way to make an easy arbitrage profit, they will find a way). You'd basically need the entire market to become illiquid.

[0]: https://www.investopedia.com/terms/a/authorizedparticipant.a...

The market has built-in circuit breakers or collars to stop wholesale panic selling. It's basically a pause so everyone can stop and come to their senses.


Sounds good in theory, and I think that's more for automated trading. In practice if real people panic and are selling, no circuit breaker will stop it, each break will just build up massive pressure and every time it's removed, will result in more drop. If the market is frozen for a long time, all trust will be eroded since it will be seen as pure market manipulation which is what it is.

Sounds like it could be a self fulfilling prophecy once people start to believe it.

How is it different from any other crash?

Or, for that matter, a bank run?

> index funds have to sell 1% of their holdings in the exact ratios defined by the index

SP500 is a market cap weighted index. That would alleviate some of this hypothetical problem, no?

Aren’t index fund investors generally the folk who would just buy more during a huge exist anyway? That seems to be the “common wisdom” that goes with index fund advice.

Imagine there was a cookie market made up of two types of cookies, tasty and meh. An active investor in cookies would spend time determining which cookies are likely tasty and which are meh. They would pay more for the tastier cookies so they can savor the flavor and less for the meh ones they can binge eat in the shower when no one is home.... A passive investor comes along and says, I don't want to do all this research, I'll just assume the market was able to price these accordingly and buy any cookie at the market price. At the beginning, it is great. They just sit back and buy baskets of cookies, some tasty, some meh... but they always pay the higher price for tasty and lower price for meh, so it is fair. Over time, more people start buying baskets of cookies rather than spending time/money figuring out what to pay for them. At some point, no one is left to figure out which cookies are tasty vs meh, so the price of all cookies converge to a single price. Cookie manufactures notice this and figure might as well just make meh cookies as no one can tell the difference until after they buy them... and then we are stuck in a world with meh cookies. With some critical mass of active cookie investors, prices could be set fairly for all cookies. Too many active investors, and there is a drain on the system as there is likely a lot of duplicated work among the investors ( each one has to have a research team, back office cookie trading systems, etc, etc ). Too little and prices become less accurate.

"What if everyone became a passive investor" is like worrying "What if the entire ecology became defenseless herbivores?"

It just won't happen, because there's a negative feedback loop against it, leading to a kind of homeostasis.

> At some point, no one is left to figure out which cookies are tasty vs meh, so the price of all cookies converge to a single price.

Five minutes later someone says: "Holy shit, I can make a ton of money by buying loads of cookies, sorting them, and re-selling them -- except with the definitely-tasty ones at a higher price."

Everyone here doesn't mean literally everyone. It means enough of everyone. And he's arguing it's already happened. And I agree.

Well they will not be able to sell their over priced cookies to the uncaring masses.

At the limit of 100% passive, everyone agrees the system would break down. But that’s not a realistic endpoint. There are studies to suggest that as little as 1% active is enough to keep the markets functioning and we’re nowhere near that point.

Of course at 1%, or really, any sufficiently small and centralized number, it becomes easier and easier to game the system...

I'm thinking specifically of attempts to artificially inflate crypto coin valuations for members, then quickly sell off before anyone catches on. Should be, I would think, impossible to do that across a large area of the market, but if everyone is investing in index funds, it might be, I would guess.

Nonetheless, for my situation, index funds are the best rational solution. That or hiding all my money under my mattress.

> At some point, no one is left to figure out which cookies are tasty vs meh

Except that there’s a lot of money to be made by figuring out which cookies are winners, and buying them cheaply to sell to the passive investors.

A merit of the passive approach is that the act of buying tasty cookies will increase the tasty-cookie price. The passive investors' existing tasty-cookie holdings will increase in value, too.

All the passive investors want is for their cookies (and new-cookie acquisitions) to be properly priced. No matter what, they have an average distribution of cookie-quality in their holdings.

The passive investors are not buying cookies at any price other than the market price. Whatever the clever-cookie-buyer is paying for cookies, they're paying the same. If a clever-cookie-buyer buys low, takes out an ad in Cookie Magazine, and sells high to a bunch of tasty-cookie aficionados, the passive investors win, too. If a too-clever-cookie buyer buys low and discovers that the apparently-tasty cookies have spoiled, the passive investors lose a little, too.

It is hard to bilk a passive investor. The first people to really figure out how will accumulate a lot of money (and ire).

This is confused

> All the passive investors want is for their cookies (and new-cookie acquisitions) to be properly priced.

No, they want the cookies they purchase to be under-priced, and consumed once their price has gone up. The cookie analogy fails here, but passive investors are exclusively seeking return, not an efficient market.

> No matter what, they have an average distribution of cookie-quality in their holdings.

That's not how passive investing works. The classic model is investment in an index -- say the FTSE 100 -- which attempts instead to maximize the quality of holdings, not the most accurately priced.

> It is hard to bilk a passive investor

Yes, but that doesn't mean it's hard to make money off one.

In theory. In practice the people who can control market pricing can force out even passive investors because passive investors still get valuation reports albeit on a less timely basis. Burry almost lost his shirt shorting sub-prime credit, as Morganchase and Goldmans mispriced his derivatives more and more egregiously as the market moved in Burry’s favor in a bid to get his investors to force him out of his/their positions using ignorant fear. Passive investors are generally not market savvy, that’s why they are passive.

Yeah I think the consensus is that 100% passive would be terrible.

Jack Bogle's view was that if the market is 50%+ passive indexed that would be bad news.

Some folks argue that the number is even more extreme, that passive indexing generally increases efficiency, and that as long as there are even a handful of active investors, the market will still be efficient: http://www.philosophicaleconomics.com/2016/05/passive/

The same author had another thought-provoking argument that the popularity of indexing has probably driven up stock valuations: http://www.philosophicaleconomics.com/2017/04/diversificatio...

> Jack Bogle's view was that if the market is 50%+ passive indexed that would be bad news.

According to this source, it already is [0]. HN discussion at the time [1].

[0]: https://qz.com/1623418/index-funds-now-account-for-half-the-...

[1]: https://news.ycombinator.com/item?id=20020997

What i understood was all investors are buying basket of tasty cookies and no one is buying meh cookies' basket or cookies. So tasty cookies are overvalued and meh cookies are under valued.

The quality of the asset has nothing to do with this issue.

In both cases the actual buyer is an intermediary, who is managing many people's money. Those people don't even know or care what is being invested in. If for some reason many of them decide to disinvest around the same time (say a recession) they may be hurting themselves due to the asymmetrical nature of the action.

At that point, an active investor can say that any losses by holding the stock an additional month would be eclipsed by selling immediately. A passive investment does not have that ability.

"And now passive investing has removed price discovery from the [cookie] markets. The simple theses and the models that get people into [cookie baskets] -- these do not require the [cookie]-level analysis that is required for true price discovery."

And the article says that is due to other factors in addition to passive investing, like central bank interest policies.

Where does the article say that? We may be talking about different articles...

I think the flaw in this analogy is that it's impossible to know beforehand whether the cookies are tasty or not. And a cookie that was previously tasty might not be tasty any more.

Not sure I buy the argument, but that's an excellent comment.

> 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 evidence shows that most of us suck at investing. Further, I think Burry's critique is more limited:

> One reason he likes small-cap value stocks: they tend to be under-represented in passive funds.

IMHO, the problem he's stating is that people are focusing on large-cap companies. Basically the S&P500. And the S&P500 index funds probably do hold most of the passively invested money. But to solve this (small- vs large-cap focus), the solution is not to throw away passive investing, but to change the focus.

For example, instead of buying Vanguard's S&P500 fund (VOO), to buy their Total Market fund (VTI) which uses the CRSP U.S. Total Market Index:

* https://en.wikipedia.org/wiki/Center_for_Research_in_Securit...

Or perhaps a fund that uses the the Russell 3000 or Wilshire 5000.

* https://en.wikipedia.org/wiki/Russell_3000_Index

* https://en.wikipedia.org/wiki/Wilshire_5000

It's just that the S&P (and DOW) have more name recognition.

But generally speaking, these decisions are micro-optimizations. Just put away a little every month and re-invest and dividends, and over the long-term you'll do well.

He's saying index funds are invested in companies big enough to be indexed, but too small for the stocks to remain liquid in a market with a lot of sellers.

By this reasoning indexes focussing on small caps would be even worse than the more popular funds.

The point of the article for me is that all of this capital in one place is bad for contagion, and there’s no backstop to even small fluctuations downward / sell-offs that will end up zeroing out the wealth of most index investors. In that way it resembles all the capital in CDOs - but this time instead of being held by banks that can get bailed out it’s being held by individuals. Woof.

Bottom line - they look low risk until they’re absolutely not low risk because of these properties.

As an average investor I’d say diversify is still a good strategy. Don’t just do US Market index funds. Global stocks, bonds, and other small-cap stock collections might help hedge risk of large-caps going bust. Most passive-style funds also have these options. Not an active investor. Just a dude playing a dude disguised as another dude. This is not investment advice.

The article is claiming that index funds are an overhyped bubble, so of course they'll out perform actively managed funds that have better liquidity.

Perhaps they have become that because of their publicity.

But when all the financial gurus are recommending investing in traditional securities (stocks and bonds), and millions of people wishing to get a leg up in life obey their advice, doesn't that turn the securities market in general into an "overhyped bubble"?

The market behavior and health of any investment, no matter how theoretically sound it is, will be strongly affected by investors' behavior around it. So the fact that index funds are popular (and thus perhaps inflated/overpriced) isn't a knock on the fundamental idea. It's merely an indication of a particular market situation at present.

I agree, I saw below in someone else's comment that the issue is with the attitude of "[index] stocks will always go up in the long term", which is similar to the attitude "house prices always go up in the long term" which caused the 2008 crash.

This short explanation put the reasoning behind this in the best context for me, but makes me wonder more about the dissimilarities.

Are there other factors like in the housing market of a decade+ ago? Is there a lot of risk for Joe Six-Pack? Are there people out there borrowing money from banks with poor underwriting practices getting into index funds when they should not be doing so?

I'd think if this is most peoples' 401k and surplus income at risk that there may be a huge market correction but it won't devastate the economy. If people take the long term view and if investors sit tight and wait for the cycle to move into recovery again they'll be OK. If however they need to live off returns on their investments in the present (like homeowners needed a place to live during the crash) then they're in trouble.

A lot of 401k providers have been pushing passive Index funds as "stable" late-life investments with higher return rates than actually stable securities such as bonds. So maybe there is a fear to find there that there is a lot more short term thinking and short-term investors in Index funds than there "should be" (and that market adjustment there could be disastrous to a lot of retirees).

Even basic investment courses, and any investment guru, will say any stock investment is not low risk enough if you need the money short term.

Sure, but 401(k)s have nicely~ distributed investment planning across the lowest common denominator worst case on both sides: banks with too much vested interest in cumulative commissions and fees on one side, investors with effectively zero knowledge and a large number of competing (mis)information sources with arguably little opportunity to discern proper advice versus zeitgeist and marketing.

I guess I'm not old enough to have thought through this already, but it was explained to me early on in my career that 401k plans should be divested slowly as one approaches the end of their career. Is this atypical compared to how it actually works in reality?

That's still almost the usual good advice: as much as possible with one's personal 401k you want to manage it as close to a classic pension as possible. Your best case will always be that you build it up enough over your working career that you only withdraw "passive income" (dividends/interest) from it as your "retirement salary" (and leave the bulk of it to continue generating passive income). Generally early in your career you can afford higher risk/higher reward investments, and as you transition through your career towards your inevitable retirement you rebalance from high risk investments (stocks) to lower risk securities with stable passive income (bonds).

Most "age-based" or "target-date" Active Funds that 401k providers sell are built precisely around managing this gradual multi-decade progression from mixtures high in stocks to those higher in bonds.

(You probably don't want to divest from the account before you retire because you'll pay heavy taxes on it. You simply want to manage the asset mix inside it. You generally want to avoid divesting as much as possible [and want to try to keep it as slow as possible] after you retire simply because passive income is more sustainable than asset liquidation in the long term.)

The reality though is that 401ks are individual accounts for better and (mostly, much) worse. Even when people follow the best advice, they rarely hit the right passive income numbers for a living wage. 401ks also wind up with more people gambling with such savings without thinking about the long term. Then there's simply the fact in the horribly messy transition between group pensions and individual 401ks that there are a lot of "short timer" 401k accounts out there among "Baby Boomers" and "GenX", that people will just cash out when the right retirement age happens to avoid tax penalties, or when the need is greatest (or anything in between), because there's no chance they'll ever make enough passive income and the account itself at that points for most purposes is merely a tax shelf.

Reality is full of a lot a 401k accounts that are managed only so well as the account owner and maybe the interests of the bank involved in holding the account. Which is also why the world is full of a lot of bad 401k advice and advice managers, because we've distributed that cognitive load across almost the entire populace. (As opposed to classic group pensions that could afford full time managers with CPA degrees.)

A lot of the possible "mismanagement" advice lately is a Boomers in particular were sent a lot of advertising / clickbait / thoughtpieces on how much Index ETFs are generally better than Active Funds for the simple reason of Fees. An Active Fund, especially one such as the age-based or target-date funds, charges higher fees than a passive fund like an Index ETF. In the same magic that creates passive income, compound interest, whatever you save on fees multiplies greatly over time. Unfortunately for the Boomers, while this is potentially great early career advice [1] when the age-based/target-date active funds are most active (higher stock mixes), passive funds are still a higher risk late career than the usual bonds and similar securities such funds push to late career.

(Which returns to the topic of the article at hand, this is why Burry, as at least one investor, is worried about this over-sale of Index ETFs. Index funds in the last few years have generally done better than both traditional securities [not really a surprise] and active funds [possibly a surprise; Burry describes it as an unstable bubble, but may be hyperbolic], so there's been a lot of short term investors in that game. There probably are enough Boomer 401ks alone that are in "short time" mode ticking time bombs full of Index ETFs that should they all start coming due and trying to liquidate/divest, we might see if passive Index ETFs can handle the trade volume the hard way, which is what Burry is worried about.)

[1] Depending on your investment management time, of course. The majority of people with 401ks already have at least one full time job and likely don't have time to also become their own personal pension fund manager.

> so of course they'll out perform actively managed funds that have better liquidity

I don't get this at all. So why aren't active fund managers investing in the same stocks the index funds are buying in order to take advantage of the price increase for their investors? Isn't that their job? And what do you mean by "better liquidity?"

Index funds aren't CDO's though, they are quite well established and their outperformance of active management goes back decades (IIUC).

There is an interesting idea when index funds are taken to an extreme in that if no one is manually playing the market or managing investments then everything is invested in at the same or similar rates. Index funds need active traders to trade and set pricing within the market.

My analogy would be if we are all buying tickets to the big game and sit in the stands until it's over, there's no one to yell and shout and drive the energy of the crown or possibly no one to even compete on the field therefore why are we even showing up?

It's definitely the extreme - active trading isn't going away any time soon but fears of a only a limited group playing the market and managing or controlling stock prices for their gain isn't 100% unrealistic.

But the wisdom of the crowd, the price signal, only works if professionals look at the stocks. And it requires only a few [hundred] of them (with big enough leverage, so their position shows up).

For the top 500 stocks there are enough people (and algos) going over every bit released by the corresponding companies.

That's a contradiction. It's not the wisdom of the crowds if only a few hundred people are really looking at things. The whole point of that expression is that you need a crowd, to avoid groupthink, capture etc

Not really, because passive funds just piggy-back on the price finding results of the market.

And the active market is very sensitive. Especially if someone is so confident that they are willing to use drastically leveraged positions.

The more interesting question is, if there is an index fund crash, will the actively managed funds benefit from it, or crash right alongside the index funds? How much are actively managed funds contaminated by stocks that are in index funds? (That probably depends on the type; a small-cap or emerging markets managed fund will probably be mostly clean of the indexed stocks, but a managed large-cap is probably full of them.)

There’s a clear narrative in favor of actively managed funds: they analyze the underlying stock and avoid stocks that are overvalued according to their fundamentals, and buy those that are undervalued.

The consequence would be near total avoidance of the S&P 500 as a good strategy for the long run. There would be exceptions for those stocks that are quite undervalued, or so overvalued that they are worth shorting (despite the tailwind of index funds).

Don’t worry, strategies like these have predicted 12 out of the last 5 asset bubbles.

Right. Which begs a question... are the large-cap stocks that dominate the index funds overvalued relative to their fundamentals? That should be easy enough to determine, and we should see a lot of "hold" or "sell" from the analysts.

And if they're not overvalued, are index funds really a bubble?

> and we should see a lot of "hold" or "sell" from the analysts.

That's not how that works... Sell-side analysts have a systematic bullish bias, that's what they are paid for.


The concept of "overvalued" assumes a valuation model that everyone agrees on. Large companies are complex organisms and equally complex to value. It follows, with ample evidence, that simple reductionist valuation models based on P/E, book value, and other easy-to-obtain numbers are going to be inadequate. And most valuation models are terrible at incorporating myriad risks.

Currently, I would argue that some large caps are clearly overvalued but others are also clearly undervalued, based on my own valuation model. The indexes are almost always a mixed bag but I buy individual large caps so that doesn't concern me much. It is rare for the entire market to become overvalued, in which case the smart move is not to buy in.

I wouldn't say simple reductionist valuation models are inadequate... just incomplete. Most of the time, a deeper analysis should be in line with rule-of-thumb tools like P/E. This is even more true for large companies that value not-losing over winning big.

If you can come up with a clever valuation mechanism that can reliably outperform the well-understood mechanisms, then enjoy pocketing the profits!

Well the argument, if I correctly understand, is that the less liquid stocks in index funds are getting pumped up because investor demand for passive stocks is outweighing active price discovery. This would exhibit a cyclical pattern where as passive outperformed, more investors switch over which continues to pump bad stocks and so on. Then in a downturn, even if you hold, as investors get scared and pull their cash out of the index fund, those less liquid stocks will get hammered by the double factor of their being already overvalued and also thinly traded, dragging passive performance way down.

Not saying I agree but, if he's right it makes complete sense that passive would outperform active right now, just that in the next downturn it would dramatically underperform.

The market is in peril because there are too few actors setting value based on the merits of the company instead of betting on other investors' behavior.

You want to help? Pull some, not all but some assets out of index funds and put them into individual companies you understand and believe have long term profitability. Sell those assets when you think they're overvalued by the market.

Trading less often is correlated with better performance (you are not an HFT)

There is some responsibility you have. Your money isn't going to just magically work for you, you have some obligation to research and understand what you are investing in. When nobody does it, the market is in trouble.

> put [your money] into individual companies you understand and believe have long term profitability

If anyone was able to do this, they'd be a successful money manager themselves. Yet few professionals actually manage to do this at all, let alone sufficiently to justify their fees, which is why index-fund investing is so popular in the first place.

The only real way to reduce the reliance on index funds is for professional investment services to become sufficiently competent that it makes sense to use their services. Asking the average person to "take one for the team" and throw their dart at the same dartboard the pros can't even hit isn't a great solution.

[EDIT: phrasing]

There’s a lot more that goes into the success of a business than the financials that investment services firms have access to. It’s entirely possible for someone that interacts with a company on a daily or weekly basis to have a better idea of how well that business is doing than professional investors, especially if they also bother to look at the public financials.

Gathering this kind of information may be too labor-intensive to justify doing it as a profession but rewarding enough for an interested amateur.

That assumes it's possible to retain a deep understanding of a company or industry whilst being outside of and focusing full time on "money management". It's the same school of thought that says corporate management is a generic skill that people can/should be taught and then they can manage anything.

I think his point is that most index funds are weighted towards large caps and ignore small ones. With more and more money pouring in, it creates an inflation in value there whereas the small caps get ignored. That is the most logical interpretation I can draw out of his statement (although I am a 100% index investor myself).

It seems like that point doesn't stand, though. In the boggleheads thread linked elsewhere several posters seem to show that there is actually more small cap diversity in the index funds.

Huh. I thought standard index fund advice was to split up you investments. I have 25% (of my investments) in a small cap fund. Does that count as ignored, or am I an outlier?

A total market index fund is proportioned by market cap. As the large cap gets larger, it proportionally becomes a higher percent of the pie. If large cap is overvalued, youre owning less small cap than "true price market cap."

Ah got it. So I by sharding my investment into several different different targeted funds (with auto-rebalancing) avoid that issue.... I think.

If, for example, you thought small caps were under valued, and you wanted to tilt small cap, you could keep doing exactly what youre doing, and just add a small investment into small caps on the side. So at Schwab, if you hold Schwab Target 2060 Index Fund (SWYNX) you can tilt by making sure Schwab U.S. Small-Cap ETF (SCHA) is 10% of your portfolio. At the moment, SCHA is 6.8% of SWYNX, so you would need an additional 3.2%. I dont know if you even need autobalancing for something so simple, just fix your allocation every time you make a contribution.

You’re trading one issue for another. By holding x% of a small cap fund, where x does not equal the actual market proportion for small cap funds, you’re choosing to over or under weight that asset class.

It’s all fine to say that active funds can’t outperform index funds... but if it’s a bubble and it crashes, then people in active funds will be having a field day while the people who bet it all on index funds will be left behind like the people who leveraged their 3 homes to buy 5 more during the “real estate always and consistently goes up” days of pre 2008.

The problem with bubbles is that everyone’s a winner and every indicator is confirming the everlasting increase.. on the way up.

This would assume that active funds exit at the right point in the crash. What if they wait to the bottom to sell? What if they sell during a temporary dip, then the market rallies (pseudo-bubble that never happens?)

> It’s all fine to say that active funds can’t outperform index funds... but if it’s a bubble and it crashes, then people in active funds will be having a field day

The CNBC article I linked claims that actively managed funds have been beaten by the S&P 500 for _nine straight years_. How long do the investors in actively managed funds have to wait for their big celebration?

This is my question as well.

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

This is a good point:

Post by ltlurker » Thu Aug 29, 2019 1:24 pm

I'm an index investor, like most Bogleheads, and I subscribe to Bloomberg digital so I can read articles such as this and did see this one at lunch (EDT). I'm open to various perspectives especially if there appears to be a rationale behind them. And of course this individual was behind the "big short" so that intrigued me.

If I recall correctly, I believe his position is that Index funds tend to favor the largest companies - naturally - as they're mostly market cap weighted. The S&P 500 as we've noted is widely invested in, but the Total Stock Market also has an average weighting that makes it a Large Cap Fund - by Vanguard's standards. Relatively few people directly invest in the Russell 2000 Index or even have those options in their employers' retirement plans. (I have the opportunity to invest in the Completion Index in my retirement plan so that's partway there).

I think Burry sees this as an opportunity to look at small cap value, which has been out of favor and not had a good run for some time. I think he must be thinking that a reversion is going to start at some point. None of us can know when, of course. And of course others are looking at the ratio of stock valuations to GDP (apparently one of Warren Buffet's key measures) and believe that there's significance to that, as well.

Not sure if it's mentioned in that thread yet or not (I've been meaning to post it), but Jack Bogle himself said the markets would start to get weird if 75%+ of investments were indexing:


There are fewer publicly listed companies than ever before:


>In 2015, for example, the top 200 companies by earnings accounted for all of the profits in the stock market, according to calculations by Kathleen Kahle, a professor of finance at the University of Arizona, and Professor Stulz. In aggregate, the remaining 3,281 publicly listed companies lost money.

I'd love to see 2016 to 2019 stats on that, but I think there are structural advantages (proliferation of databases, price transparency) that large corps are enjoying right now with which small companies just can't compete. Technology is obviating many people (and therefore businesses), and allowing the big to get bigger with no marginal cost.

Would you bet against the top ten holdings in VTI, which take 1/5th of all investments?


And also, we know the government will bail out all large entities, especially if many voters are invested in them (which they are due to 401k/pension funds being invested in the very same companies).

Who is going to outcompete the few big airlines, telecom providers, FAANG, hotel brands, car rental brands, banks, pharma companies, etc that have national and worldwide reach? I'm sure a few companies here and there might, but by and large, I bet the big players are here to stay (until the whole system breaks down, but then you have bigger problems).

> 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.]

You would think so, but I've been surprised at the diversity of topics on there. There's especially good stuff for folks who are interested in some of the ideas of people like William Bernstein[0], who advocate for index-based portfolios that are more complicated than the bog standard two- or three-fund ones.

[0] https://www.bogleheads.org/wiki/William_Bernstein

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.

Including Hacker News, no doubt.


Depends on where your interests lie. Personally I find that forum insightful.

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.

> 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.

This is really the main concern. The indexes these funds are based on include names that don't have any liquidity. This means 1) the price of the security is less likely to reflect its intrinsic value; 2) attempting to unwind any position may cause substantial issues.

Let's expand on 2) by examining an ETF (say SPY). This ETF is a fund that is meant to track the value of the S&P 500 (a weighted basket of securities). The value doesn't drift too far from the value of the underlying securities thanks to the creation and redemption mechanism, which allows for arbitraging the ETF against the underlying basket of securities. If constituents are illiquid, it becomes more difficult to perform this arbitrage, and the NAV of the ETF diverges from the market cap of the ETF.

This is a bigger issue with instruments like HYG or JNK, which track high yield (AKA junk) bonds. Many of these bonds are highly illiquid, and trading them directly could significantly impact their prices. Instead, many funds trade the ETFs, relying on the basket of high yield bonds as a proxy. These ETFs may then have greater liquidity than the entire underlying basket. This situation clearly undermines price discovery of the underlyings, as the implication is that investors don't particularly care about which names they have exposure to within the basket.

These concerns aren't merely theoretical. In August, 2015 there was a flash crash in which the values of a number of ETFs significantly diverged from their NAVs.

I don't really see the problem here. Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy. ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV commensurate with the liquidity risk they're assuming.

> Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy

Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade.

When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial.

> ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV

Many closed ended funds do in fact trade at a discount to their NAV.

> Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade.

Those are the same thing. An illiquid asset cannot be liquidated without slippage - that's why there's a liquidity premium.

> When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial.

Again...slippage is the thing caused by a lack of liquidity.

> An illiquid asset cannot be liquidated without slippage - that's why there's a liquidity premium.

We agree here.

> Those are the same thing.

We disagree here.

"In economics, a liquidity premium is the explanation for a difference between two types of financial securities (e.g. stocks), that have all the same qualities except liquidity." [0]

"With regard to futures contracts as well as other financial instruments, slippage is the difference between where the computer signaled the entry and exit for a trade and where actual clients, with actual money, entered and exited the market using the computer’s signals."

The concepts are related, but not identical.

[0] https://en.wikipedia.org/wiki/Liquidity_premium

[1] https://en.wikipedia.org/wiki/Slippage_%28finance%29

Yes, but they are functionally identical in this context. The liquidity premium exists because of slippage.

I think the big moment, if it comes, is when you can envision the difference between how people value the asset in question and how that asset is actually valued. In the case of the housing market, most people in 2003 pictured suburbification and the generation of baby boomer retirement communities as inevitable economic engines. But in the same era, Arrested Development the TV show was skewering over-production of prefab houses and they were closer to the truth.

If you could make an analogous case today that the majority of the companies that make up the S&P 500 are over-valued then you could presage the popping of the ETF bubble. In this case, however, the population size of the S&P 500 is much easier to monitor than the population of houses in the US Housing Market, which in 2003 were being built far from Wall Street in pockets of Arizona, Nevada, and Florida. In addition, companies can be subbed in and out of the index with ease in a way that houses cannot pop in and out of the market.

That is why I think the housing bubble pop in 06/07 is not analogous to the current era with ETFs

Is your suggestion that overproduction of housing is what caused the bubble?

I could see overproduction of housing as a sign of the bubble. E.g. why are we suddenly giving out more loans?

New large generation (Millenials) coming to the housing market. Low interest rates driving folks to refinance. New housing is flat YoY if you look at "House Starts" statistics.

It was a lagging effect of the bubble. The 'build anything, people will buy it' approach resulted from people's excessive faith in housing and the widespread idea that prices could only appreciate, which I take to be the true cause of the housing bubble.

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

I don't know about that. If a general financial crisis is the concern, stocks outside the S&P 500 would not be spared.

What I got from this interview was just a reminder that it makes sense not to get caught up in enthusiasm for a certain asset. And investors (including me) are certainly enthusiastic about the S&P 500 index fund.

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.

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.

This is the right answer, even if it's a fucking terrible idea.

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.

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.

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.

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.

Lots of active funds just change the weights of their capital allocation a bit compared to their benchmark. So there's not necessarily more people or infrastructure required - just analyzing a few companies in more detail.

But there is no reason that they need to be so high. Vanguard Primecap is like .45. Unfortunately it's closed to new investors.

Define "so high". If fees are too high, why is anyone paying them? How do you determine what's high?

People are fleeing to index funds, which is what is spurring posts like this.

There are all of these complaints from people who run actively managed funds, never once mentioning that the fees might be why so much capital is going to passively managed funds.

People like myself who invest exclusively in index funds do so because the fees charged by actively managed funds are not supported by performance.

People are investing more in index funds because we've had a ten year bull market and index fund fees have dropped in an attempt for competition for assets.

Most active management is probably not appropriate for most individual investors because their investment needs and timelines are much different than high net worth individuals/pensions/foundations, etc.

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... 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"?

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.

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


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).

Mind explaining the concept of the marginal investor in this context?

It should be self-regulating, though. The higher the portion of the market that is passively investing, the easier it should be to beat their returns by actively investing so the more incentive there will be to actively invest.

Once indexing gets to be a certain size, you run into the "markets irrational longer than you can stay solvent" issue at a much higher level. Active management "correction" doesn't really work if active managers are a much smaller portion of the market or no longer around at all.

You're only taking into account making money via stock trading. There is always the option of buying a company to actually run it for a profit which is not reliant on the market's belief in the company's value.

Holding doesn't change the price: buying moves it up and selling moves it down. An index fund holding 50% of all shares on the market but not trading them would have no influence at all on prices.

Does this exist, though? If you presume some % of America is putting their paycheck into indexes via Vanguard, Betterment, and some other % is selling due to being retired or whatnot, then this isn't an equilibrium.

There's maybe some room for redeeming index value and "caching" that demand from within Vanguard, etc, but I tend to doubt this action wouldn't hit the market at all.

It can lead to pricing inefficiencies with shares inside vs outside the index. And those should be kept in check by non-indexing value investors.

Did you mean to reply to my post? I don't see the relevance.

An index passively holding 99% of the market would not interfere with price discovery because the remaining 1% would go about its business as if nothing was different. Indexes can't sustain irrational prices because they have no impact on prices.

A single entity holding 99% of anything will absolutely have an impact on liquidity which absolutely impacts price discovery.

> An index passively holding 99% of the market would not interfere with price discovery because the remaining 1% would go about its business as if nothing was different.

That may be true at the point in time where it's already at 99%, but consider the impact on prices as funds were poured into it over time on the way to 99%..

If the funds put in to the index were taken out of mutual funds, there might not be any impact on the prices at all.

There’s an equilibrium to be reached, for sure. The market just hasn’t discovered what it is yet.

I am not an economist either, but it seems that there is a danger in assuming there will be an equilibrium. I think it is entirely possible that there won't be one.

If there is an equilibrium, it may take a significant price shock to discover where it is. I.e. that equilibrium could be years behind us, and if there is a crash we might never recover the value that our current market assumes is there.

> index funds can't work after a certain amount of the money poured into the system is managed by index funds

That's not true. They'll still function just fine.

What will likely change is that they will begin to underperform other strategies, including different types of indexing and active investing.

At that point the market will self-correct and simple indexing will fall out of favor.

Index funds have become successful since they've performed well compared to active investment funds. Why would the active investors suddenly get better at guessing the future?

Active investors are already really good at guessing the future. Index funds work because they follow the decisions made by active investors without needing to pay said investors.

As more of the market moved to indec funds, a smaller amount will be controlled by active investors, which will make the entite market dumber (I would say less efficient, but that would include the cost of managing the fund). As the market gets dumber, an active investor can make more profit without needing to be any better then he currently is.

At some point (in theory), the marginal profit one can make with an active fund will equal the added cost.

I think all available evidence points to active investors NOT being good at guessing the future, when compared to the general consensus. The second half of your argument seems like an interesting opinion, but I'm curious where the evidence is for it.

What do you mean by "general consensus"?

If you mean "current market values", then those are being set by the aggragate opinions of active traders. If there are less active traders, there is less brainpower being devoted to finding this consensus, so it would be suprising if the consensus did not get less accurate.

Isn't the price set by everyone, not just the active traders? It's set each time a sale happens, but the price itself is also related to how many people are holding the stock long term.

I don't really consider it possible for pricing to be "accurate". It is what it is, but accurate implies there's a correct valuation, which I don't think there is.

For financial products, there is a correct price but it cannot be known for certain until far in the future. Stocks in particular represent a claim on the future dividends of the company, whether issued during operation or at the dissolution of the company. If both those future dividends and future inflation were known, you could accurately calculate the present value of that cash flow and get the correct price.

I'm over my toes here, being a programmer and not a finance person, but isn't this viewpoint controversial? IE, does everyone (relatively well informed) agree there are correct prices?


There is arguably an objectivly true answer for exactly what payments a given stock will make, and so there is an objectivly true answer for what the present value of the stock is (also dependent on other aspects of the future market). This is somewhat of a philosiphical question, largly boiling down to determinism; and is largly moot because no one claims to be able to predict the future well enough for this to work.

Instead, the working position that most take (at least implicitly) is that there is an objectivly correct probability curve of what the future payouts will be, and therefore an objectivly correct probability curve of present values. How to determine what this curve is is a matter of great debate. Further, there is a sufficient lack of objective methodology, that many of the factors that people use in this calculation would be refered to as "opinion", but there is still an objective reality out there.

However, this only gets us an (unknowable) objective probability curve of present values. In general, there is no objective way to turn this into a price. That is to say it is a matter of opinion how much a 50% chance of making $100 is [0].

In an ideal market, you would be able to sell a stock for its objective value at any time. However, "the market can stay irrational longer then you can stay solvent", so you may pay a premium for stocks that you expect to not be undervalued when want to sell them.

Conversly, you may by a stock not because you think it is worth what you are paying, but instead because you expect to find a greater fool to pay you even more then you paid.

There are also cases where people value stocks not just because of their future payments, but because they actually care about the company (or, in the case of divestment, people dont buy them becausr of personal preferences).

In short, there is some matters of opinion in determining a correct price; but most of the disagreement comes from a factual disagreement about what the future looks like.

[0] this calculus changes when you have many such gambles with varying degrees of corralation (and many a financial problem have stemmed from underestimating this corralation)

Do you consider a probability distribution function as objectively true? If it's not obviously true beforehand, I'm not sure if it's only clear in hindsight, which has all kinds of psychological issues in interpretation.

IOW, is there any practical difference between "there is no objectively correct price" and "we'll never know what it is"? The price at any given time reflects the current consensus of the objective price, distorted through the current average psychological lens of the market?

If something is unknowable before it occurs, we will never know what the objectively true measure is until it's occurred. At which point it changes, since the market is dynamic. How could we ever know which point is the correct price?

There is a difference between "truth does not exist" and "we cannot know the truth".

In theory, we can take a now worthless stock and look back in time to determine the actual present value at a given point in the past.

In theory, we can imagine an outside observer running an arbitrarily large copies of our universe from a given point in time to determine the probability curve at said point in time (under whatever model of randomness you want to use). More plausibly, we can take a set of predicted probability curves and look back to see how accurate they were (did events predicted with uncorralated 50% probability happen half the time?).

Economics is hard, because it is very difficult to determine these facts, even in retrospect, but they still exist.

> There is a difference between "truth does not exist" and "we cannot know the truth".

If we can't know the truth, how do we know it exists (in this situation)? I'm not convinced there's an objective true value of a stock -- it seems like stock prices are the general consensus of a huge number of subjective inputs. And that will always be the case.

(Definitely appreciate the time and thought you've put into your responses, btw! Thank you.)

At any given point in time, it's possible to calculate how much value a stock has already given to its bearer via dividends, and adjust those values for the changing purchasing power over of currency over time.

Once a company dissolves, we have enough information to do this calculation over the entire lifetime of the stock issue. At that point, we can determine what real value that stock had at any point in the past for the bearer.

This explains how value investors interpret stock value, but most traders are speculators that expect to make their profit by selling the shares on to someone else. They will only buy a share of stock if they believe that a future investor will buy it off of them at a higher price. This future investor will either be a value investor that expects to get the dividend returns or another speculator that is making the same calculation. Thus, even if a share of stock will pass through many hands before it lands in the portfolio of a value investor, that value investor is the only real price anchor, and the entire chain of speculators are ultimately trying to sell to him/her.

Because when enough of the money is in an index fund, you can predict how a large part of the investors are going to invest (using the same algorithms they're using) and adjust based on that.

That's it exactly. If the index funds get so big that they basically are the market, then active investors will have to adjust their view of the market to be effectively just whatever the index funds do.

It may be possible that although they can't beat other active investors enough to justify their fees, they can beat a big dumb index fund enough to make their services worthwhile. That remains to be seen however.

Kinda makes sense. Still, it sounds like a very fragile system.

So instead if active fund managers "knowing the market better", we'll get active fund managers, "knowing the passive investor crowd better".

This is madness.

I mean, if the majority of the market is dumb passive index funds, those are one and the same :)

I'd assume there's some stability to knowing that X% of the market is passively invested in indexes. It could give active traders some extra edge, since it would make things more predictable? If everyone's an active trader, it's everyone competing against everyone else, where everyone is a live actor. On the other extreme, if you're the only active trader, and literally everyone else is in indexes, you'd be the only person actually moving the market in response to news, and could use that to your advantage.

Obviously we're not in either state, but presumably the closer we get to the latter state, the game gets a little easier for the active traders, not that that necessarily means they'll get a free "win"

>I'd assume there's some stability to knowing that X% of the market is passively invested in indexes.

Indexes holding shares have no influence on the price. The price only changes when traders trade.

To make money you don't need to "Guess the future" in an absolute sense, you just need to "guess" better than the rest of the market participants.

When there is a majority buying/selling all the shares in block without any consideration to the differences in liquidity and fundamentals between stocks it may be easier to find opportunities than when everyone buys and sells individual stocks. (But one could also say that the average stock-picker is so bad that having more active investors actually increases the gain for the talented ones rather than pressuring profits due to competition).

Index funds work because weve been in a 20 year long bull market. If the market goes sideways for a decade, or down for a decade then active investing is alot more profitable.

It's been a ~10 year bull market. 1999-2009 was basically flat.

That has never happened (as far as I know, in modern history). Of course that's not a reason it can't happen, but I feel like you owe us at least a plausible decade downturn scenario.

It has happened for specific stretches of time.

For example, if you bought near the top in 2000, you were still underwater a decade later.


> Bogle pointed out that as indexing increases to a certain point, it opens opportunities for active investors to exploit inefficiencies in the pricing of some stocks. But past that point, wherever it might be — somewhere beyond 75%, in his view — the market could become a dangerous place.

I’m know I’m a dummy when it comes to economics, and an investor in index funds because of that.

But it strikes me that index funds are parasitical in a way and depend on price signals from active investors.

Some people say that it’s ok, the situation is self-correcting.

But what if the smart active money is active in places we can’t see in the public markets? Again, I’m a dummy, but I believe a lot of investment is happening privately these days.

Private investment is absolutely where the money is these days. Look at how the media claims an IPO that doesn't pop 30% or more on day one is a "failure." No one who actually contributed to that company's value benefits from that pop, and best case scenario is really to either have the IPO be flat or even go down a little. But those elite that buy their way to the front of the line demand to have that 30% pop for contributing nothing.

I'll just point out there's the argument about market makers and underwriting and blah blah blah. If that's such an issue just price that into the underwriter fees to begin with. No reason the public markets should lose out on a 30% gain to people that didn't actually take a risk and invest early in the company, and only intend to hold the stock for 8 hours at most.

You are not a dummy. Over the past 30 years, index funds have outperformed active management, especially when you consider the fees.

You are a ”dummy” in the sense you don’t have perfect information awareness on every possibly tailwind or headwind that could impact a particular stock. But everyone is a dummy in that sense.

> But everyone is a dummy in that sense.

And even honest people well versed in economics will tell you that they are too.

> What's the limit - 30% 40%, 50%, 60%?

I'd wager at least 90 percent. Passive investing is generally designed to track active investor activity without effort, so it shouldn't add much inertia to the system. If Dave thinks IBM is overvalued and Under Armor is overvalued, the act of buying and selling will shift those numbers, and the index investors, instead of taking the opposite trade and undoing that flow of information, hold their portfolio.

IMO, the real challenge is active investors competing for access to that 10 percent of active invested money. There's no shortage of people happy to manage money under the 'heads I win, tails you lose' fee structure, and one hopes that the same people fighting over a smaller pool of cash would (more strongly than status quo) favor people who can actually produce results.

>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.

If you have one trillion dollars invested, and the entire exchange volume is based on me and my friend trading a single share back and forth, everything will still work. It doesn't matter how much you own, because my friend and I are going to want a fair price for that one share in any case. There's no practical limit to how passive things can get before a problem kicks up, as long as a few hedge funds stay in.

> entire exchange volume is based on me and my friend trading a single share back and forth, everything will still work

You are talking like such a market is extremely liquid (there are enough shares for everyone). I think when a third person enters such a market your example breaks apart. Now you have one person who constantly wants to buy a stock but is unable to do so. Because you and your friend trade at a fair price and index fund does nothing. So he have to buy at an unfair price and rises his bid until index funds kicks in the game.

> 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

How so? I can certainly see "lost opportunities" where good stocks are undervalued just because they aren't in the index funds, but I don't understand why you think index funds can't work. Can you elaborate?

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?

Most folks here are focusing on Burry's comments regarding price-discovery. However there is another huge point: Liquidity risk. To understand his point, you have to know the gory details of how an ETF operates.

First: When you buy a ETF share for the S&P 500 (iShares, Vanguard etc), the share is not backed by all 500 S&P components. Virtually all the large-number component ETFs are using a sampling of shares to match the underlying index. (They would be buried by transaction fees otherwise.) The subsampling of the index is reasonably well-understood math, but relies on an assumption: That the buying and selling each component share will not be greatly affected by the ETF purchase or sale.

[Edit: I may be out of date - Some ETFs are full samples. Nevertheless, the bigger point that the ETF purchase/sale does not much affect the price stands.]

Second: The ETF uses a very clear process to keep the price of the ETF in equilibrium with the index it represents. Large players are allowed to go to the ETF adminstrator (say iShares) and turn in a bunch of the ETF shares, and iShares will transfer back the underlying components. So if the ETF price ever gets too cheap relative to the index, the big players will redeem the ETF share, and then sell the underlying shares they received, which results in a quick, nearly guaranteed profit.

Conversely, if the ETF price goes above the index, a large player will bring a basket of the underlying component shares to iShares, and iShares will give them corresponding ETF shares. So they buy the components cheap, sell the expensive ETF, again making a quick profit.

Now to what Burry is saying: Several components of the big indices are thinly traded compared to the amount of money in the index funds. In a large index drop, there will be disproportionate downward moves in those thinly traded shares: As large players will be redeeming the ETFs for underlying shares and then sell, these thinly traded stocks will drop further than you'd predict from the index. This will cause the index to drop further, which will cause more ETF shares to be redeemed, perpetuating the cycle.

I think his point should be better known than it currently is: The current wisdom that "you can't lose money in the stock market long-term" is reminiscent of "you can't lose money buying a house."

Yes, the liquidity risk seems the more interesting piece.

He seems to say that if you have trillions of dollars in ETFs, you should be seeing more volume in the shares in these indexes than we actually observe.

So some of this cash is going toward synthetics -- mathematical models that are supposed to mimic the underlying securities -- and not the actual stocks in the index.

In a general rout, the synthetics won't perform like you'd expect them to. Prices might eventually clear, but it's not "as good as cash" like many investors assume.

This feels like the most concise explanation of the underlying mechanics that I was intuiting from the article. Now the question becomes: how do I hedge out of this risk without going full day-trader?

> Now the question becomes: how do I hedge out of this risk without going full day-trader?

Here's anecdata from the past: I spent a lot of time during the housing bubble working on a similar strategy. I came to the conclusion that shorting the banks (with leverage!) would be a profitable way to make money.

It turns out that was a beautiful and correct strategy, up until the moment the SEC decided to ban shorting. We got out with profit, but it was stressful and certainly nothing life-altering as a consequence of the SEC action. (bastards!) If you have seen The Big Short, they had a similar problem: Because the CDOs stopped trading, Goldman and company unilaterally declared that there was no problem. Since there was no market, there was no mark-to-market. Burry and friends were able to wait it out, but you'll notice that Burry had to exercise some extraordinary clauses in the contract; Dealing with your investors after that must have been all kinds of fun.

The moral of the story is probably something like: When you are profiting from the system melting down, the system will invent new rules to impede your profit, so be prepared.

Edit: BTW, I don't think mark-to-market accounting has ever been fully restored, but it's been a while since I checked.

In what capacity did you do this? A trading firm?

My guess is that would be more expensive than what the index fund / ETF would cost you even in a worst case scenario. Read my comment where over the last 10 years Vanguard has only deviated by 1%, even after factoring in trading costs. A typical active fund is going to charge .5% per year, minimum, which adds up to 10% over 10 years, assuming a 7% annual return. A more typical 1% expense ratio is going to be 20%. Active management is extremely expensive. But trading yourself, unless you have a million, is going to be expensive, too. IF you wanted to DIY, $5 a trade adds up if you're putting money into multiple stocks every month. $1000 divided into 10 stocks a month is going to be a 5% expense before you even get started.

A large cap index fund wouldn't have the same liquidity problems, but it has the problem that if this were to happen, funds might have to sell their large cap holdings to cover outflows, driving down those prices. At least it would reflect the NAV, though.

You could buy a closed-end mutual fund since it won't be balancing its holdings in the same way.

You could buy a small cap fund and short a large cap fund, betting that small cap shares will get distorted in the positive direction if there's a liquidity crunch.

I guess I'm somewhat less worried about people not picking stocks because hedge funds, and really, anyone greedy, will always try to do that, bringing some amount of pricing to the market.

There is a range of active - passive even within ETFs that are trying to perform like an index. An example of this in Canada is say Horizons vs Vanguard that's "fully" passive. You pay higher fees for someone else to do the hedging (= protection from having your money in a passively managed ETF that has underlying assets that don't have a high trading volume) for you.

> ..."you can't lose money in the stock market long-term"...

Put in a large enough number of years in that "long-term", and it is true. But many people don't have the time horizons of institutional investors, so what is "long-term" to an re-insurance company might be "lifetime" to an individual investor.

Now, if we could only resolve the principal-agent problem for institutional investors to the benefit of individual participants that make up the institution's backers...

There are a number of stock markets that went down significantly and never recovered. I think Japan was one example.

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.

He seems to be implying that the naive idea of passive funds of actually holding a basket of the indexed stocks is not the reality and that there are various financial shenanigans going on analogous to the issues seen in the run up to the last financial crisis.

He points to a mismatch between the daily trading volume of various of the smaller components of these indexes and the amount of money globally indexed to them. The suggestion as I understand it is that some of the indexed money is not directly holding the indexed stocks but is using financial instruments to track the indices indirectly and that in the case of another global financial crisis those instruments could break down and you'd potentially see significant divergence between the tracking funds and the actual indices.

That's just my layman's interpretation though, I'm not an expert on this stuff.

> 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.

> 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.

>As more and more money switches from active to passive, we have more and more money relying on less and less intelligence.

That's assuming that the mutual fund managers who are being moved away from are all contributing their own unique information to the market, as opposed to repeating textbook business analysis techniques. If the fund managers that survive are smarter than the ones being replaced by indices, the intelligence of the market will improve.

Or, if the fund managers that survive aren't smarter - but are luckier than the ones being replaced by indices, the intelligence of the market will remain static.

Anyone can go all-in on red five times at the roulette table. One out of every 33 players will see 3100% returns from this investment 'strategy'!

The problem with that interpretation is the following:

Each active investor gets some return and contributes some movement to the market. If there are enough active investors, the aggregate move of the market matches the actual value movement of the stock in a company. Then, on the sidelines, over some time period the market's moves are copied by the index (a balancing of the index). If, however, there are too few active investors, the index funds will be causing feedback into the system by being the only source of liquidity in a stock. If active investors then attempt to capitalize on this "failure", they will be the movements of the market. Then the index funds will copy them in the next round of balancing. In the end, there is a level where the market is not something the active investors can get a good return in because all the momentum is in the index and nowhere else. If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well... Right?

> If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well.

Passive investors are copying the average of the active investors. Just as you would never have a situation where all active investors are outperforming passive investors, you would always expect there to be some active investors outperforming the average. The big question is the extent to which individual managers can keep it up over time (and as more AUM flows into their funds) and the magnitude of their out-performance.

And you're right - as active investors find new opportunities and make money out of them, they will improve the average and hence the performance of the passive investors.

You can add up the performance of all active funds and see how they are doing as a whole. My understanding is that at the moment, the sector as a whole is doing OK, but almost all of the returns are from the top performing funds, so an active fund chosen at random is likely to be destroying value. However, this could change as more mispricing opportunities arise in the market.

Where do robo-advisors like Betterment fall into this? It seems like they combine a variety of different funds; do they typically stick with only passive funds or a mixture?

Thank you, this clarified so many things.

Other replies were good. But I'll add my two cents.

Index investors are basically free riders off the information and research generated by active investors. Indexing basically works pretty well because the market's efficient.

An index investor just comes in and just pays whatever the current market price is and allocates in proportion to whatever current market valuations are. He doesn't even need to know anything about the underlying companies. "Microsoft? Never heard of it. But the market says it's worth 3.8% of all major American stocks, so I'll put 3.8% of my money in it"

Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.

And the reason it does work is because the active managers compete so fiercely with each other. They end up showing all their cards to the market. And all the information they have, and the research and the analysis winds up reflected in the publicly available stock prices. In effect active investors pay their managers big fat salaries to analyze stocks, and passive investors get nearly all the benefits without any of the costs.

> Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.

Well, what also works fine is picking (enough) random stocks and buying them for an equal amount of money.

That index funds base the allocation on market share is (in my understanding) not a method to increase performance, but to greatly simplify any rebalancing of the stock allocation. If the price of a stock changes, an index fund does have to do anything. The allocation will always automagically reflect the market cap of the stock - more or less by definition.

Every other allocation (e.g. equal weight) would need to rebalance every now and then to return to the initial allocation. This can be complicated and/or costly. However, it might still perform better than the market cap index: https://www.realizeyourretirement.com/comparison-sp-500-inde... (of course it might perform worse in the future).

The harsher reality is that most retail and professional investors have no business trying to be active investors.

Throwing darts is cheaper and safer for them.

Index investors are only really messing with the market if there’s more capital chasing fewer goods than there otherwise should be if they were being “active”, which isn’t proven.

I'll try. Price discovery means finding out the value of a stock by people bidding to sell and buy it. Historically, beating the stock market is hard to do, so one strategy is to just go along for the ride, buy a little of everything. This is what ETFs do. You're not bidding your guess of the value a company should have, you are just saying "hey, I'll pay what that other guy is willing to pay". Now, thats not a problem necessarily, but if the majority of people are not placing their own bids, and everyone is just saying I'll take what the market rate is, then the price of a stock isn't really tied to anything. This is the world we are in today. ETFs have become so massive, some of them are starting to be the majority shareholder of the companies in their portfolio. Now let's say our dear leader really tanks the economy and everyone rushes to sell their ETFs. The companies most effected by whatever policy fuckup are not the only ones that go down, the whole market will go down. Scary stuff.

> This is what ETFs do

ETFs aren't necessarily index funds


Much of the market gain is around handfuls of stocks like FAANGs. And our leader has issues with 4 of those.

So there is a very closely coupled lever to the market.

I wonder if there are high speed shorts triggered by twitter already.

> I wonder if there are high speed shorts triggered by twitter already.

There are: https://www.marketplace.org/2019/08/29/meet-the-algorithms-c...

Amazing. Would it be insider trading if twitter held his tweets for 5 seconds and sold early rights to the content?

Twitter Flash Trade Platform?

The more sophisticated part of the argument is that indexes require overexposure to thinly traded stocks and that in a market sell off the assets linked to the index would see outflows, which require selling the underlying(s), which would cause a material price hit in illiquid stocks, which could cause a partial feedback effect as the index would then slip more.

If one believes this to be true, one necessarily believes that illiquid index constituents are overvalued today relative to their actual enterprise value and will, at some point in the future, be sharply undervalued as a large number of computers controlling trillions of dollars attempts to implement a for loop shoveling money at you.

When people invest money into index funds, then the funds must spend all that money buying the shares of the underlying fund companies. So that creates tons of buy orders for the underlying stocks, which creates the buying pressure, which makes the prices rise. As long as more money comes into the index funds the prices of underlying stocks will keep rising. But the higher the prices of the underlying the more money needs to come in to buy them at those prices.

What eventually happens is that there's not enough new money coming in for index fund buy orders to maintain the bottom of the underlying prices, which means that the prices start drifting lower, the popular financial press goes nuts, CNBC/FoxBusiness/WallSt Journal/etc blast it in the headlines and the same way goes the other way. People start selling their index funds, which makes the index funds sell the underlying which creates a massive wave of the sell orders creating a downward pressure, which in turn puts brings the indexes lower which makes press go screaming more which causes more people to want to "protect their test egg" by selling the index funds they had.

But this doesn't seem to have anything to do with index funds. Wouldn't the same thing happen regardless of the way people are invested into the stock market?

It is directly related to the index funds. They are now marketed as the "correct" way of invest into the market where they in fact invest into a very small number of companies creating an artificial wave of the buy orders.

Actively managed funds have choices in what they invest, and how much they put into any of the companies. Index funds do not.


for an example.

So, a normal decade in the markets?

A bit more exciting probably since the market is higher now which means that the oscillation will be more impressive.

The rest is chicken little - we got into that mess before because neither CDOs nor CDSs were liquid which means that as long as they were not trading banks were able to continue book them at the nominal value and since to trade them one needed to have banks that were on a hook for them to do the trade nothing was moving. That's the biggest issue with those kinds of instruments.

Nothing of sort could happen with the index funds because both the derivatives and the underlying are sufficiently liquid, so the drop won't be 100->20 but rather 100->99.9->99.8->99.7->....->20.1->20 which in turn would re-balance everything.

Someone that knows more than me: how is a correction going to happen on index funds?

Retail investors are told to shovel money in and keep it there. Who's going to be selling to pop the bubble? Do investment banks have a lot of index funds and their derivatives bought? Does there have to me some major re-allocation within the fund that causes investors to sell?

If a single stock is valued incorrectly, how is that going to bring down the entire index?

I think https://news.ycombinator.com/item?id=20879296 answers this by saying "The big players making money on the spread"

That's the essence of it.

I can explain the analogy at least, though I think there's a serious flaw in his reasoning.

CDOs are collections of mortgages with rules about how they pay out. During the last bubble they were sold (and rated by supposedly respectable third-party arbiters) as among the safer investments available. This was because the CDO had a safety feature where a certain percentage of the mortgages were expected to default, and so you didn't need all top-quality mortgages, lousy ones were okay, too. Thus the sudden availability of "NINJA" (No Income, No Job, no Assets) loans, which were completely inexplicable to basically everyone. No one would have lent their own money to poor credit risks, but the CDOs would buy that loan and stick in in their security in a heartbeat. The problem came that once the expected maximum level of default was breached, the CDO started paying out very little or nothing, and the value fell to near zero.

So his analogy is that the same thing will happen to index funds, which invest on the principle that you don't need to pick top-quality stocks, that you just buy all of them. As far as it goes, there is a significant similarity with CDOs. As an index investor, I don't try to find my own good stocks, I don't even need someone skilled in stock picking. I'm relying to an extent on financial engineering and the rest of the market to make sure that I'm not grossly overpaying for the lousy companies that are in the index. He notes that there is a huge multiple on many of the stocks, such as the 266 that have less than $150 million in daily trades, but represent trillions held by index funds. Trading is the "price discovery" mechanism of the market, and lightly traded stocks are subject to all kinds of manipulations and volatility, to be sure.

But there are several places where I think he's making a major stretch with this argument. First, the CDOs were sliced into "tranches", so when you bought a CDO you didn't get the underlying assets, just the right to a payment stream. The index fund sticks very close to the current market value of its assets; you get what you would have gotten if you just bought all 500 stocks individually, without any financial magic. For instance, on a $10K investment the Vanguard S&P fund trails its index by about $100 over 10 years. There's no daylight for shenanigans there, so I think the financial engineering argument is categorically false.

It also doesn't bother me that the stocks are thinly traded relative to the assets, because one of the big advantages of passive investing is that you're not trading all the time. Again looking at Vanguard, they turn over less than 4% of the stocks in a given year. But that's what you should do if you don't want to get killed by trading fees. Buy and hold and all that. For there to be a problem you'd have to see that those stocks were getting volatile, or that the index funds were constantly buying at a disadvantage. It is true that there is a certain amount of trying to beat the index funds to the punch; kind of hard to keep from telegraphing your investment choices when they're literally written into the name of the fund and you need to buy for a half-billion dollar fund. But these are tiny in magnitude. If anything, things are much more efficient and rapid then they were before computers took on most of the trading.

Finally you get to the thing I worry he has a point. If 100% of the money was passive, there would be huge opportunities to exploit. There's no law that says passive investing is going to be better than active. It's been true so long that maybe it's taken as gospel when it shouldn't be. Nothing is forever, and anyone who argues "it's different this time" is probably wrong, eventually. But there's still a ton of money out there in active funds, hedge funds, pensions, etc. If they saw a good opportunity, they would take it. There's too much money to be made by sharp-eyed investors to let the market as a whole get to the point where bad stocks and good stocks are treated the same.


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?

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.

> 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.

> 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.

Take a look at opportunity zone funds today.

You can pull your money out and pay zero capital gain taxes for seven years. Then get a 15% discount on your capital gains at that time. All returns you realize from the fund are capital gains tax free.

The benefits end this year.

I know a bit about Opportunity Zones (roommate bought property that was subsequently designated one, to his delight), but not about the funds. Do you have any particular recs on where I can read up on them?

This is likely the best first stop for OZ info from a reputable source:


The timing restrictions around OZ investments (180 days after cap gains event) make it a bit difficult and will result in lots of bad investments with non-experienced, first-time fund owners.

But maybe you have a connection to an OZ that you are familiar with and can rehab a property there. You should get help from a CPA and lawyer, but the basic process would be:

  1) Sell stock and now you have cap gains
  2) Setup OZ Fund XXX LLC
  3) Fund the LLC with your cap gains within 180 days
  4) Setup OZ Property YYY LLC
  5) Purchase property inside the YYY LLC and fund purchase with XXX LLC
  6) Rehab property within 31 months
  7) Hold for 10 years
    a) Pay original cap gains tax bill (minus 15%) in 2026 tax year (negative interest loan from gov)
    b) Pay zero cap gains on the increase in property value over the 10 years

Here's an example fund, https://fundrise.com/offerings/opportunity-fund/view, but it has steep fees:

Annual investment management fee 0.75% Annual tax and accounting fee 0.45% Annual carried interest / promote 15% over 8% return

Maybe it's not as high when you consider that they purchase the property directly, but it still seems a bit too risky to lock myself into those high fees for 10 years.

I think the main benefit is the 7 year deferment of your capital gains, which given that your money will be compounding from that point onward, is a pretty significant break if you have a lot of gains you haven't triggered yet.

Main benefit has to be the zero capital gains you pay (on the new gain) if you are patient and hold for the full 10 years. Second benefit would be the cap gains deferral (negative interest loan).

I think the key is to have some level of luck. Then you can lecture others who didn’t have luck that they didn’t do it right but you did.

In my view there are two take-aways from this: 1. Diversify, but 2. not too much.

1. Even among index funds, maintain some diversification. Don't put all in US large caps (S&P 500), but also some international and some small caps (Russel 2000).

He is saying that given how much money is invested via index funds now, there are opportunities in assets that are not (or insufficiently) represented in index funds. (This is hard, though, and the standard advice to refrain from trying and placing your bets on index funds instead remains valid, I think, particularly for mature markets in which you don't have an edge.)

The second take-away is at a tension with the first:

2. Avoid ETFs that handle illiquid assets (real estate, bonds, etc.) or create synthetic exposure using swaps and derivatives.

For big, liquid assets, the ETF or index fund can just take the investor money and go buy the assets. Then the value of the fund is approximately the value of its constituent assets, sort of by definition, and that value is relatively easy to realise (that is, if you want your money back, you get it - they'll have to sell some of the assets, but they're liquid, and that won't influence price too much).

For smaller or more exotic assets, a fund might not buy them outright, but contract with a third party (an investment bank, typically), and give the bank the money, with the bank promising that it will return the value of the asset. So, it's "like" holding the asset, except that you get the credit risk of the bank - there's a risk the bank might not be able to uphold its promise. And this is most likely to happen when everyone runs for the exit.

> 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.

> ... the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day.

So, an ETF promising to deliver the value of an index can generally do it, and there was no big failure so far, but scenarios are conceivable where it cannot deliver.

The best passive way to approach your situation, is probably what you already know: gradually keep investing passively with the savings from your income. Over the long haul that has a reasonably high probability of turning out well with very little intervention on your part as a non-professional.

There is also nothing wrong with adjusting the ratio of cash vs equities that you're accumulating (eg the share of your income going into the market vs going into cash in a span of time). It's the exact same safety vs risk lever that is commonly utilized in adjusting equities vs bonds as you get older. Some will call it market timing, it is not, as you are not attempting to time a top or bottom. With recession alarms going off in most global economic data, increasing your conservative posture is nothing more than being modestly prudent (and it doesn't have to be an extreme adjustment; if 100% of your net savings is going into the market now, changing that to 75/25 or 50/50 with cash, is entirely reasonable). Even Warren Buffett has turned hardcore conservative with this market, he's buying nothing and sitting on a $122b record pile of cash that is very much annoying him (by his own admission). The reason for his behavior, beyond the obvious blaring economic data, is that the valuations are terrible vs the growth we're seeing (both macro economy and corporate earnings); right now investors are paying a steep premium in most cases for the value they're getting. Buffett doesn't like the price he's paying for the value he's getting, so he has gone into bunker mode, as he has done prominently several times in the past. The simple, non-professional approach to that move, is to just make a reasonable adjustment to how much cash you're accumulating (which can obviously later be deployed if an opportunity presents; in the meantime you're likely to see a very modest inflation debasement to the fiat).

First and only piece of advice. This probably isn't the forum to get investment advice.


Most importantly what you should not do is freak out and sell everything.

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