Are Index Funds a Bubble?

Michael Burry of ‘The Big Short’ predicted the 2008 housing market crashed. Now, he calls ETFs and passive investing another bubble.

Well, does his fortune betting against CDOs actually hold any weight with this new index fund bubble hypothesis? Is there something that should scare you? Are his concerns misguided?

(1) Price Discovery

Burry argues that the wave of money flowing to index funds is distorting price discovery process in the stock market in a similar way that CDOs distorted the subprime mortgage market in 2008. This is because, when you invest in a passive index fund, you are not doing any fundamental analysis, which is required for true price discovery. What index funds do when receiving money from investors is to allocate money among the securities within the indexes they mimic. Hence, index fund investing could artificially inflate the price of stocks – funds are not distributed to a security because it is a good buy, but rather because they are included in the index fund. These stocks are thus overvalued, leaving others not within the index funds as being undervalued. Therefore, the constant allocation strategy regardless of a fundamental value increases the probability of a market price distortions or a bubble.

  • In fact, asset management do not set stock prices. The vast majority of equity ETF trading happens on the secondary market, where holders of ETF units trade with each other without touching the underlying securities. The only exception is when there are deviations between the price of the ETF and the value of the underlying stocks. Instead, stock prices are set by trading. Each trade is a vote for the price going up or down. The aggregate of all of these votes is the market’s best guess at the true value of a stock.
  • Even if people are blindly throwing money into index funds regardless of the performance of individual companies within the indexes, stock price movements due to index investing are probably going to be temporary. Passive fund inflows just create purchasing opportunities for investors to be exposed to the overall market at lower costs and will not add to a long-term boost in stock prices.
  • I guess what Burry meant is that passive funds are just free-riding active funds and passive investing could damage the function of the market. In a world with a large number of active investors, the market is efficient and passive investors can do just fine. However, if active management is completely crowded out by passive funds, how could we know the fair value of a security without price discovery? So we need at least one active investor to trade on perceived mispricing and set up a benchmark that someone else could follow.
  • From a capital allocation of view, this scenario would also be disastrous – the growth of passive investing could reduce the amount of information embedded in prices and therefore contribute to the misallocation of capitals. Moreover, the trading pattern that passive investors buy and sell the entire basket of index constituents in response to fund inflows and outflows can induce greater co-movement of securities in the index. As a result, this would reduce the potential benefit of holding a diversified portfolio.

(2) Liquidity Risk

To explain the hidden liquidity risk, Burry provides an example with the Russell 2000 index. Many stocks within the index are small, and they don’t really get traded a lot in the open markets. During a bull market, this isn’t a problem. However, if there is a major market crash and a lot of people want to sell at the same time, it could cause major liquidity problems. In particular, less-liquid assets, such as those small-cap stocks, could gap down hard in price.

  • So will liquidity shortage fuel explosive stock swings when investors rush out of index funds in emotional panic selling? First, index funds just represent a small part of the global market. In a 2018 research paper, Vanguard says index funds account for only 10% of the global investable market and 5% of trading volume on US exchanges. So, we blame index funds when the market falls? Probably not.
  • Second, if the index funds start to sell off, small and micro caps will only make up a small fraction of the ETF sellings. Moreover, micro caps are in general not included in many indexes because of their illiquidity and regulatory constraints on the amount of ownership that may be acquired. In this sense, when a lot of money is pulled out of index funds in a relatively short period of time, most of those outflows will come from large caps, which do have large volumes to support redemptions or withdrawals from index funds. In addition, tradings in ETFs don’t yield equal trading volumes in the underlying stocks when it comes to sell-offs. Hence, we might not observe abnormally large swings in the short term.
  • However, this only holds when there are enough active investors in the market. If passive funds were 100% of the market, then Burry’s argument would have real force that there would be all herding and no price discovery. When the market goes down, passive investors will be forced to sell stocks in order to track the index. In particular, once large investors start selling, others will follow suit and then the price will plummet. If there are no active investors to step up and buy, the selling force could accelerate the market crash. Therefore, even a small amount of price discovery can help guide market prices to reflect true underlying values.
  • So when Burry calls passive investing a bubble, I suspect his primary complaint is that investors are shifting from active investing and blindly pouring money into index funds. Given the hypothesis that a market dominated by rational arbitrageurs remains efficient, a significant reallocation of money from active funds to passive ones could distort the efficient pricing and cause bubbles.

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