Investing Nerds - Learn me the "Burry Big short on Index funds"

I like to think of myself as pretty money saavy, and I am interested in financial markets because I am a nerd (and I like money). I have been on the "toss most everything you can into an index fund" train for a long time. I recently read this article:

https://www.bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos

This is from one of the main characters of "the big short" who called the big housing market crash in 2008. He is now saying the passive index fund machine is creating a similar bubble. Which I find interesting because that certainly has become the popular advice. Here is I think the crux of his argument. Help me understand.

“This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.”

Liquidity Risk

“The dirty secret of passive index funds -- whether open-end, closed-end, or ETF -- is the distribution of daily dollar value traded among the securities within the indexes they mimic.

“In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those -- 456 stocks -- traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different -- the index contains the world’s largest stocks, but still, 266 stocks -- over half -- traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”

If I understand correctly, the argument is basically that there is a giant multiplier in place ($1 of trade volume on the individual stock affects hundreds or thousands of dollars in all the index funds tied to that stock), AND the price of the stock is now being overrun by all the money flowing into the index fund which is "buying" the stock based on the "long term = low risk" assumption tied to index funds rather than the price of the stock being independently valued by analysts buying and selling it. 

Also, if I understand correctly, I think he's got a point...

In reply to Robbie :

Thanks for posting this. I had red the Bloomberg blurb but not really understood the full implication of  what was being communicated.

My view of what is going to happen with the stock market is kinda like this video

Pete

Interesting. 

(Pete, can't watch your video at work so I'm not responding to that at all)

My gut reaction here is that as long as you have (1)management compensated primarily by stock options/profit sharing, (2) people who think that they can beat the market, (3) people who think that their advisor can beat the market, there is enough "personal shareholders" that would keep this from happening. 

That, however, is just a gut reaction. Will have to do more reading, look for white papers, other opinions, etc. on this. 

In reply to mtn :

At this point I'm less concerned with whether Burry is right or not, and more concerned with whether I even understand his argument correctly. 

And Pete's video is awesome. There needs to be one pig on the outside who trips the fences but also yanks the food barrel over the fence simultaneously. 

I just re-read the article (read it earlier, rolled my eyes, decided to ignore). The stuff is a little bit ramblish (sorry) but tl;dr a) the guy is talking his book and b) the comparison with CDOs is wrong.

The OMG Index Funds Are Eating The Market hysteria has been around for a while, but if you look deeper you tend to find that it tends to be rolled out by people talking their book. And oddly enough, the guy appears to be someone who does active management.

IMHO the comparison with CDOs is a red herring, and a pretty stinky one to boot. The majority of index fund money is in classes like the S&P500 and other large liquid markets, and represents still a fairly small percentage of the overall market. He is correct that over the last couple of years there doesn't seem to be as much trading going on as the historical averages would suggest, but that doesn't make the market illiquid. It can contribute to volatility, though. What people forget is that volatility tends to be good for your returns, because otherwise all you have is a non-FDIC insured savings account or worse.

Anyway, CDOs were toxic for a whole bunch of reasons, over and above the ratings being off (to put it politely) and investors (especially retail investors) having had junk bonds peddled to them as safe. And then you found out that the originator kept the highest rated tranches, peddled the junk and then were found out that the paperwork was bad. A good book on that is Yves Smith's Econned.

BTW, a price change of a buck in any stock in the S&P 500 affects stock holdings that are in the billions, depending on the stock. Doesn't matter if it's an index fund or an actively managed fund.

The other thing to keep in mind is that "index fund" means squat. There's an index for everything, and if there isn't you can make one up. The reason why index funds that actually track a recognisable benchmark like the Russel 1/2000, S&P etc are so popular is because a) they deliver market returns at very low cost, b) are widely diversified and c) nobody beats the market in the long run. No, 15 years isn't the long run. Try 40+. And most actively managed funds don't even make it for 15 years, let alone beat a benchmark index. Also, make sure you compare both the risk and returns - if I have a high-risk fund, chances are that I can beat the S&P in both directions easy, but the S&P is the wrong benchmark in this case.

The cost factor is very important if you keep c) into account. If you compare two funds that deliver the same return, but one does it for 0.12% and the other for 0.76%, you have a lot more money in retirement if you're invested in the former over a lifetime. And no, I didn't just pluck these numbers out of thin air - 0.5% additional annual return over 40-50 years is a massive difference.

The one thing I actually agree with him is that small cap value is likely undervalued at the moment, as the average annual return of that asset class tends to be a couple of percent higher than Large Cap Blend (aka S&P-ish) and that hasn't been the case for almost a decade by now.

So, yeah, whatever. Circular file, together with all the other self-annointed investment gurus.

In reply to BoxheadTim :

I understand the $1 price change affecting billions in value, but I thought Burry was talking about volume... Meaning that if lots of people try to get out of the 'index' funds at the same time, those stocks don't have the normal volume capacity and the price will drop WAY more than 'market', ie it would spike down. 

Like if a stock has 1 million trades per day that means 1 million sell and 1 million buy. But if one day 20 million showed up to sell, there would not be enough buyers and the price would plummet because you cant sell at any price if there are 20 million sellers and one million buyers. 

And I think that if you buy an index fund, you are basically buying some of each stock in it. Conversely if you sell an index, you sell some of each stock in it. Right? So if an index fund starts having more volume each day than the stocks inside it, what happens? All those 'buys' are probably inflating the value of many stocks inside the index that don't deserve the value increase. 

I'm not disagreeing with you. Just trying to understand. I also will note that I understand volume = supply and demand = stock price, but other than that I really don't understand why volume is that important to track. 

Here's a contrary opinion - there's not enough concentration in passive funds to cause a run for the exits and a crash.

https://awealthofcommonsense.com/2019/09/debunking-the-silly-passive-is-a-bubble-myth/

The idea that small caps are undervalued because investors are pouring money into passive funds that don't contain a lot of small caps is an interesting take on things.

In reply to NOHOME :

Great video you posted!

In reply to T.J. :

Kinda reflects my belief that the collapse of 2008 was deliberate, the tax payer bailout from the Gov was already in place, and by subsequently stealing interest income from responsible savers, Wall St. was able to force the last major concentration of wealth into the market ( Gen X inheritance ) so that they can repeat the same stunt.  I am gonna sit outside the fence with a bucket of popcorn and watch the show.

Pete

Robbie said:

In reply to BoxheadTim :

I understand the $1 price change affecting billions in value, but I thought Burry was talking about volume... Meaning that if lots of people try to get out of the 'index' funds at the same time, those stocks don't have the normal volume capacity and the price will drop WAY more than 'market', ie it would spike down.

Couple of terms here - "volume" means the number of shares that have traded that day. It's generally a measure of activity, not capacity. Capacity (also, liquidity) is generally considered to be "market depth", which is the total number of shares available for purchase or sale in the market at any price. That's a bit simplified, but should work as a mental model. So volume being down means that there wasn't that much activity, not that the market couldn't absorb more. It does mean that smaller trades can have a bigger impact on the price of a stock than we would've considered normal a decade ago.

You're correct that an index fund holds the shares in approximation of an index, plus usually some cash for redemptions if it's a mutual fund, and possibly some options and futures. However, if you sell your share in an index fund and there is a buyer for it, this just nets out for the fund company and your mutual fund shares just get to transfer to someone else, potentially at a lower value.

Only when you sell (ie redeem) your mutual fund shares, there is no buyer and the mutual fund's cash reserves are getting low tend most funds start to sell shares. Most funds - especially the big ones trade - fairly infrequently to balance out between new money flowing in and redemptions. That's one of the reasons why index mutual funds tend to generate more favourable tax treatments than actively managed funds.

ETFs (exchange traded funds) work slightly differently inasmuch as they're traded on the open market almost like "shares of shares" (which is kinda what they are) whereas with mutual funds, you deal with the fund company or their resellers. But the underlying structure is reasonably similar and the underlying shares are really only traded when adjustments needed to be made, not every time someone buys or sells an ETF share.

Like if a stock has 1 million trades per day that means 1 million sell and 1 million buy. But if one day 20 million showed up to sell, there would not be enough buyers and the price would plummet because you cant sell at any price if there are 20 million sellers and one million buyers. 

That's correct, for stocks or funds.

And I think that if you buy an index fund, you are basically buying some of each stock in it. Conversely if you sell an index, you sell some of each stock in it. Right? So if an index fund starts having more volume each day than the stocks inside it, what happens? All those 'buys' are probably inflating the value of many stocks inside the index that don't deserve the value increase. 

As mentioned above, the volume in a mutual fund is kinda decoupled from the trading volume on the exchange. They're settled at the end of the day and the purchases and sales are netted out. Only if there is a noticeable surplus or deficit do some of the trades "spill through" to the actual market.

Again, ETFs are slightly different because they can be traded at any time when the market is open, but the underlying fund still works in a similar fashion.

The important takeaway is that just because you bought or sold a mutual fund share or index fund share doesn't mean that the company running the fund has to go out and immediately purchase or sell stocks based on your activity, but only on the netted out activity.

I'm not disagreeing with you. Just trying to understand. I also will note that I understand volume = supply and demand = stock price, but other than that I really don't understand why volume is that important to track. 

Volume is mostly important to keep an eye on activity in the market and there has been some concern over the last few years about the declining volume (and the fact that a lot of trading activity is bots trading with each other). It's also an important measure if you're a trader, but not necessarily if you're an investor who is looking for long term gains.

For an investor, liquidity is important - ie, the ability to sell something at very short notice. The real problem starts when you can't sell your investment (fund/house/car/gold/elbonian mud futures) because the market has seized up or the investment has been found defective.

jwagner said:

Here's a contrary opinion - there's not enough concentration in passive funds to cause a run for the exits and a crash.

https://awealthofcommonsense.com/2019/09/debunking-the-silly-passive-is-a-bubble-myth/

That opinion makes a lot more sense to me. Also, don't forget that there is a difference between a severe correction (like your funds losing 50%-70% of their value) and the market seizing up like it did in 2008 for different reasons.

The idea that small caps are undervalued because investors are pouring money into passive funds that don't contain a lot of small caps is an interesting take on things.

That part I don't quite buy (but I buy small cap funds - baboom tish, I'll be here all week). Small cap value hasn't delivered the returns recently, as those had mostly been concentrated on the large cap growth stocks. This is unusual for this length of time, but I don't think it's because people didn't pour money into small cap funds.

In reply to NOHOME :

I kinda disagree - the crash in 2008 was more of a house of cards collapsing and then the banks looked at each other and found they had no clothes. Not a pretty picture, but one I got to see first hand as I was working at investment banks building debt derivative trading and pricing software, often right on the trading floor.

Did (some) people know that it was a house of cards? Yep, like some people did in 1928/29.

Did they care when their bonuses were tied to assuming that everything was fine and their counterparties would extend overnight credit when needed? Yep, until they stopped extending credit to each other in the wake of Lehman, because they didn't know if the counterparty was going to be around the next morning. That seized up the whole system.

Edit: None of this has anything to do with the markets being overdue for a correction, and the expectations of a recession helping that along.

In reply to BoxheadTim :

Thanks! Lots of info here. Need to read more on this kind of stuff (because I find i interesting). 

I actually read a book once:

https://www.amazon.com/Bailout-Nation-New-Post-Crisis-Update/dp/0470596325/ref=sr_1_1?keywords=bailout+nation&qid=1568125553&s=gateway&sr=8-1

Bailout Nation is a pretty good and damning summary of the cause and aftereffects of the Great Recession.  Michael Lewis' The Big Short is an easier read and there's a movie if TLDR.

In reply to BoxheadTim :

But you do agree that regardless of if it was intentional or just a by-product of uncontrolled greed, the taxpayer was handed the bill to reconstruct Wall Street's house of cards? Whether it was agreed to before or after the fact, does not really matter, the cost was absorbed by the general population.

The question then became how to get the next round of hogs into the pen. We are talking about the ones who were suspicious of Wall Street trap before the 2008 collapse. Or the ones that wandered out just before the gates slammed. The simple answer is to strip all of the food for as far as the eye can see, and put it inside the pen-trap; enter zero interest rates. This left a barren field of zero interest to live on for those that did not trust the pen, and no where to go unless they wanted to starve.

In reply to NOHOME :

Hmm. I've been noodling on this for a while to figure out if I can respond to this without a political angle, and decided that I unfortunately can't. I don't want to flounder this thread so I'm going to ask a mod to review this post and delete it if they feel I'm crossing a line.

The "taxpayer footing the bill" part is problematic, and the answer to that entirely depends if you believe that taxes fund government spending exclusively, or not. I happen to be on the MMT (Modern Monetary Theory) side of that debate instead that says a sovereign government that controls its own currency[1] can always pay its debts. Please keep this in mind.

IMHO the big issue was that instead of winding up insolvent banks like the regulators did after the S&L crisis, they bailed out the TBTF banks with both cheap money (by reducing the rates on the benchmark rates the treasury controls) and direct loans in exchange for the maybe promise that the banks would clean up their act. What happened instead was that the smaller banks that were wobbly but often could've been saved if the regulators had been willing to do so, got fed to the larger banks that became truly too big to fail and so systemically important that they now truly can say "bail us out or the economy gets it (again)".

The funny thing is that AFAIR, the governor of the Bank of Japan warned several of the Western economies that it wasn't a good idea to do that instead of going through an orderly write-down of bad debt and unwinding the institutions that failed as a result in an orderly fashion. There obviously wasn't a lot of appetite for that sort of actual resolution.

The part that hit the general population was the largely successful attempt to keep the giants from keeling over by reducing their borrowing costs, which then led to a) lower interest rates on savings and less risky investment choices like low-risk bonds and b) asset price inflation both in the stock market and "alternative investments" (you know, like art, rare guitars, collectible cars and stuff like that). It also led to a whole bunch of large companies loading up on debt cheaply if they needed the money or not, and not for productive uses either. Hey, all of those stocks don't buy themselves back (and other shenanigans), nor do those dividends pay themselves from companies that still believe paying dividends is a nice idea.

The depressed interest rates (to keep the TBTFs from showing which one of them didn't have any clothes on when the tide went out) led to too many investors chasing yield (ie, accepting considerably higher risk for a little more interest/return). Pension funds and the like ended up pouring more money into the stock market and into riskier bond investments to get close to their benchmark numbers as a result.

One point I disagree with you on is that this was all orchestrated to funnel people into the stock market. Investing for the long term at least in the last 100-150 years pretty much has always required either investing in the stock market for a medium risk (proper diversification assumed) or building something yourself to sell that turns a good profit (high risk). Savings accounts and lower-risk bonds have never done much more than keep up with inflation if they kept up with inflation at all - they offer a return that is in line with the risk they represent (low, and low) and have their place, but don't offer the sort of returns you'll need to either sustain a pension fund or someone's 401(k), and haven't for a long time. That hasn't changed, it's just that the gap between the two has grown since 2008 compared to the historic delta.

[1] This is an important differentiation between, say, the US or UK, and the Eurozone members.

I'm not sure that following Bank of Japan advice makes sense. They've had some systemic issues that don't seem to have been dealt with even today. Maybe it's their demographics? 

Low bond rates are a global issue currently. That's bigger than just US investors. Interestingly, the bank stocks haven't really recovered, even today, though much of the rest of the market has. 

mazdeuce - Seth said:

I'm not sure that following Bank of Japan advice makes sense. They've had some systemic issues that don't seem to have been dealt with even today. Maybe it's their demographics? 

Well, the BOJ actually advised not to follow in their path, which was advice most of the Western countries (other than for example Iceland) didn't follow.

Japan has its own issues over and above this particular kind of long term hangover, namely much higher saving rates and a massive distaste amongst the population for investing outside of Japan.

Low bond rates are a global issue currently. That's bigger than just US investors. Interestingly, the bank stocks haven't really recovered, even today, though much of the rest of the market has. 

Yep, it's an issue everywhere these days. Mainly because a lot of other countries that caught some or a lot of the fallout also ended up pushing interest rates down. I also think that the fact that a lot of bank stocks haven't recovered much is a result of the market pricing in the additional risk they represent.

BoxheadTim said:

In reply to NOHOME :

Hmm. I've been noodling on this for a while to figure out if I can respond to this without a political angle, and decided that I unfortunately can't. I don't want to flounder this thread so I'm going to ask a mod to review this post and delete it if they feel I'm crossing a line.

The "taxpayer footing the bill" part is problematic, and the answer to that entirely depends if you believe that taxes fund government spending exclusively, or not. I happen to be on the MMT (Modern Monetary Theory) side of that debate instead that says a sovereign government that controls its own currency[1] can always pay its debts. Please keep this in mind.

Can you expand a bit into what you find compelling about MMT?  I've heard a primer on Marketplace's Make Me Smart podcast and in theory it sounds all well and good, but my understanding is that application of MMT requires the ability to adjust tax rates to manage inflation, which current political systems seem to not be set up to accomplish.