Why Index Funds Are Like Subprime CDOs

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.

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.

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.

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.

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.

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.

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

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.

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.]

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.

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

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.

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.

> 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.

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.

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.

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.

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?

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."

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.

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.

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.

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.

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?

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.

https://investor.vanguard.com/mutual-funds/profile/portfolio...

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.

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.

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.

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).

:)

You cannot have a majority of money beating the market. It is mathematically possible for a majority of investors (each relatively small) beat the overall market (albeit unlikely).

(I agree with your overall post, but not that line.)

I'm sure there is a pretty clear criteria for making it to the S&P 500 or the Nasdaq 100. Which means it can be coded up. Index funds don't track the investments of other active investors. They track the performance of companies (typically market leaders) based on some transparent and objective criteria. These performances could be tied to a multitude of factors - Founder managed, innovative, market focus, sales & marketing, slave labor, good copycats who knows (or cares?). The point is they've made it to the top of some list and are generating revenue within a system of "acceptable" checks and balances. If the company doesn't meet that criteria, it will be booted off of that list. The bet is always focused on objective criteria. None of that is free riding on active traders.

-Shoeshine boy starts talking stocks--time to exit the market. [1]

-Dad starts asking me about bitcoin--time to exit bitcoin position.

-Occasionally employed step-sister praising index funds--???

[1] https://archive.fortune.com/magazines/fortune/fortune_archiv...

Edit: The P/E values on Russel 2000 seem to be almost double compared to S&P 500 [1]. Also some point out that the value is not correct as it leaves out negative earnings which are common among small caps [2].

[1] https://www.wsj.com/market-data/stocks/peyields [2] https://goldco.com/russell-2000s-price-to-earnings-ratio-is-...

https://www.sec.gov/Archives/edgar/data/1649339/000156761919...

He holds heavily-indexed companies like Disney, Fedex, and Alphabet.

He holds a couple of small-cap value companies that aren't likely to be included in more than a couple of small ETFs: Tailored Brands (Mens Warehouse) and Sportsmans Warehouse.

The hedge is simply to pay attention and make your own decisions. Index funds are great in general, but not when markets get out of whack (bubbles, etc).

You could own gold, but wait ! any gain is taxed as income ( not capital gain ). Carrying it around has stiff penalties.

"You invest in how we say you invest" - Uncle Sam.

https://www.invesco.com/portal/site/us/ria/etfs/strategies/e...

TLDR: He is't abandoning the current stance that passive > active but rather is discussing the real value of the underlying assets.

And he isn't challenging on that stance either. I don't think the artical is out right advocating people to switch their personal investments from a passive index fund to an active one since he & we both know that passive funds tend to do as well or better than active funds after accounting for fees.

However, the article (at least how I understood it) is saying total effect of everyone moving their money into ETFs and index funds means that the underlying stocks have an increasing risk of becoming or being overvalued since no one is checking the underlying stocks/companies anymore. As someone just tangentially interested in this topic I've thought of this before in a more tangable way: since every college graduate or hacker news type person knows that index funds are the best then at some point 'everyone' or enough of the population has a stake in index funds that it's likely to be overvalued.

The market should/could correct as expected: undervalued companies go unnoticed longer since everyone is passively investing causing actively managed funds to have higher yields (since they can get 'all' of the undervalued companies passive investors miss) and people adjust their holdings accordingly. However, as a few other users stated there a few issues trying to hedge against a buble:

1. Solvency - The market remains 'irrationally' attatched to passive/index funds which means that index funds continue to beat active funds anyway despite their 'real' value/gains being pure speculation. It's difficult convincing people to let you manage their money when your making 4% and the S&P400 is making 8-11% so remaining solvent is an issue.

2. Systemic Risk - Large markets & financial products are intertwined so if index funds are overvalued then it effects the economy & financial institutitions and if it crashes/pops then it sends a shock wave throughout all of them. Finding a hedge that isn't effected by a bubble in one financial product (CDOs, index funds, etc) can be tricky.