Back in September, Bloomberg published an article about index investing that made a few waves. If you read the book or watched the movie “The Big Short”, you might remember Michael Burry. He’s the former doctor turned hedge fund manager who lives in Silicon Valley (and rocks out to death metal in his office while pondering investment strategy).
The article made waves because Burry claims that index investing is a massive bubble. Comparing index funds to CDOs (collateralized debt obligations), Burry’s perspective stoked fear in the hearts of more than a few investors. Here’s the guy who correctly identified one of the biggest bubbles and upcoming crashes of all time. And he’s saying that index investing could be a bubble too? Maybe the simplicity we’ve enjoyed of investing in index funds was really a big mistake. What if he’s right?
Don’t run for the hills just yet. There’s been some great discussion of whether the argument is fair (here, here, and here, for example). Here’s my take on whether index investing really is a bubble.
Why Michael Burry Thinks Index Investing is a Bubble
Michael’s interview was conducted via email. The article itself summarized his points with a lot of copy/paste. Assuming his position was accurately portrayed by the reporter, Burry has three main arguments. Let’s review each.
1: Price Discovery
Burry’s first argument has to do with how markets “work”. The price of any stock trading on an exchange is a function of what buyers and sellers think it’s worth. Whenever Apple has a positive earnings announcement, the price tends to jump. The rosy news makes investors believe that the stock is more valuable, inducing them to buy and drive up the price. But when the price gets too high, investors start to sell. The equilibrium is the market’s price for the stock, and is where buyers and sellers agree to transact. The mechanism is called price discovery.
The more rational parties involved in price discovery, the more accurate the price. Think of it this way. If you have 100,000 rational investors buying and selling a particular stock, the activity from their trades will likely cause the market price to be pretty close to the stock’s intrinsic value.
But what if you only have ten?
Fewer rational opinions weighing in allows the market price to deviate further from what the stock’s actually worth.
Burry’s argument here is that index funds do not weigh in on the value of the securities held in the fund. They’re simply buying each and every security on the list. And as index investing accounts for a larger and larger portion of market activity, prices will deviate further and further from the “truth”.
2: Liquidity Risk
The second argument is that index funds present liquidity risk. Several of the total market index funds out there (like VTI) account for a substantial portion of small cap buying volume. This isn’t a big deal when money pours into funds consistently. Burry’s point is that if index investors sold en masse during a crisis, small cap stocks would get crushed. Whereas active investors can account for momentum and price movement when making buying and selling decisions, index funds are forced to sell indiscriminately. This could cause small cap prices to plummet.
3: Derivative Exposure
Burry’s third argument in the article is that not all index funds are built by purchasing the actual securities listed in the index. Some use options, derivatives, and other complicated financial products behind the scenes. This isn’t bad in and of itself. The main problem he seems to be implying (this part wasn’t explicit in the article) is that these trades are hard to unwind in times of financial stress. When things go sideways, as they did in 2008 and 2009, the market for derivatives can break. Funds using derivatives may not be able to mark to market (settle up gains & losses) or even value their holdings appropriately.
Where I Think the Arguments Fall Short
1: Price Discovery
Burry’s point about price discovery is legit. But only if indexing began to represent a substantially greater portion of market participation. This is total conjecture, but my guess is that there would be ample price discovery until indexing became the majority strategy in the marketplace. And maybe even well beyond that.
So how much of the total stock market is comprised of indexing currently? Ben Carlson has a great post here where he quotes Vanguard’s CEO Bill McNabb. According to McNabb, indexing makes up 15% of the US stock market, and only 5% of the global market. Intuitively, if 85% of the market is still buying and selling stocks actively, I have a hard time seeing price discovery suffer.
2: Liquidity Risk
Again, legitimate argument here. But I don’t think index fund investors have a need to worry. Yes, if everyone ran for the door at the same time it would create a liquidity crunch. But investing has come a long way since the last serious period of turmoil in 2008 and 2009. We have tons of additional research on why market timing doesn’t work & how the path to the best investment outcome is a consistent, long term strategy.
Don’t get me wrong, there will be a ton of people who panic, throw in the towel, and sell everything during the next market event. But with any luck, thanks to the progress the investment industry and the platforms available today, the door doesn’t get entirely “jammed”.
And what if it does? Those of us who are actual proponents of a long term, consistent strategy should not be worried unless your time horizon is inside of 5 or 8 years. If you’re not going to sell anything for 10 years or longer anyway, who cares what the price is now?
And for investors in or approaching retirement who do plan to sell their index funds sometime soon, their financial plan should have an ample margin of safety to accommodate for such an event. On top of a healthy allocation to bonds.
3: Derivative Exposure
This is another legitimate argument, but a little misplaced in my opinion. Most of the funds index investors are purchasing buy the actual securities underlying the index. It’s the leveraged funds and those tracking obscure asset classes that use derivatives. I don’t disagree that using derivatives or options to track an index presents additional risk, but I don’t think investors in VTI, SPY, or other mainstream index funds have a need to worry. Those funds do not use derivatives.
Where We Go From Here
I don’t disagree with any of the theory that Burry relies on here. But I do disagree with the application of that theory to our current market structure. The stock market is still a very diverse place with tremendous volume from active stock pickers. If the index investing trend continues, there will be a point where the pendulum swings and the issues Burry points out will become salient.
I don’t claim to know when that point is, nor do I claim to be able to identify it when we get there. But when 85% of the market is still making investment decisions on the merits of individual securities, it’ll be a long time until price discovery really goes away. Just make sure you don’t run for the door when everything turns again. The exit could certainly be a little crowded.