This article seems to focus on all of the upsides of indexing, which are all true. However, those upsides don't negate the risk that is being pointed to.
* "The tail is not wagging the dog" - index funds are a relatively small percentage of total share ownership.
* "Benchmark huggers have always been around" - owning ~the index was not started with index funds.
* "Active funds literally own the market" - the sum of portfolios of non-index funds ends up having the same profile.
* "Price discovery is a cop-out" - relatively small part of the trading volume.
* "Liquidity is not a huge problem for index funds" -no market impact to sell (v dubious if you ask me), unlevered.
* "Humans matter more than fund structures" - the absence of index funds did not prevent bubbles/crashes.
You can disagree with those points (I do with some of them) but that's a large part of the article.
Derivatives written against sub-prime holdings tipped the balance when the fan was hit. There are tons of derivatives written against the indices, thus indirectly against those funds.
Those derivatives might be "somewhat in the neighborhood of the funds" or something, but it's not analogous to mortgages.
There's a bit more nuance to it: those derivatives were a problem because a substantial proportion of them were concentrated in a single, widely-connected, entity (AIG).
The derivative market as a whole nets to zero; for every loser there is a winner.
If you're talking about index mutual funds, then the author is just plain wrong. Any open-ended fund offering daily liquidity will trade, and therefore produce market impact, to meet its daily redemptions.
If you're only talking about ETFs, then this is technically correct. Besides the occasional index re-constitution, unlevered index ETFs don't do any trading. However it's definitely not true that there's no market impact. As the fund grows (or shrinks) the shares just don't magically appear in the portfolio. Somebody has to go out and buy (or sell) those shares, and like any trading volume, that creates market impact.
The mechanism that ETFs actually use is something called "Authorized Participants" (or APs for short). Basically market makers have the right to create or redeem shares in the ETF. To create new shares, they go out and buy all the stocks in the index, then hand a basket over to the ETF fund manager, who then hands back new shares of the equivalent value. And to destroy shares, the AP hand over shares in the ETF, and the fund manager hands back a basket of shares from the index.
If there's high demand for investors to own the ETF, that'll push up the ETF's stock price. As the price rises relative to the index value, APs will detect an arbitrage opportunity. They'll go out and buy the basket of stocks in the index at a cheaper price, then create new ETF shares at the richer price, and pocket the difference. Vice versa if there's demand from investors to exit the ETF.
The mechanism keeps the ETF price closely pegged to the index, because the further out of line it gets the more arbitrageur activity pushes it back in line. While also flexibly satisfying investors' specific demand for the ETF at any given time. Basically it delegates the role of trading from the fund manager, who usually doesn't have any special expertise in trading, to highly specialized trading firms and market makers.
However, as you can clearly see, market impact most definitely exists. If a flurry of investors rush to enter or exit an ETF, then a huge amount of trading has to be done to create or redeem the shares. Just because the APs create this trading impact, instead of the fund itself, is a distinction without a difference. The underlying stocks in the index are subject to market impact.
But the trading isn't the cause of the market impact, it's the redemptions that occur first, and force the trading. There had to have been economic or financial reasons for those redemptions to occur. The fact that when everyone tries to sell at one, there's aren't enough buyers is a story of the ages. That ETFs will suffer the same consequences in a run is hardly unique to them as financial assets.
There is already a very well known liquidity problem with index funds that track S&P500. Since stocks come and go from this list, index fund managers need to be very careful about how they buy and share these stocks so as not to greatly effect their prices, and cost the fund too much money.
So index funds already have a pretty big effect in markets. I suspect some of the stretegies used for these events will be similar to how managers mitigate short term mass enters and exits in a fund.
My bigger suspicion in general with index fund mass selling though, is that while they are meant to track the market over the mid to long term, they are actually priced seperate from the market, and this seperate pricing means that if there’s a mass sell off, then fund share prices fall, and others have incentive to buy them at a discount. Eventually both index and benchmark prices reach equilibrium. Maybe there’s total havoc in the market in the meantime, but this mechanism will mitigate it to some degree.
But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.
When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.
(John Maynard Keynes, General Theory, Chapter 12, page 142 in the Google Book edition)
I think they claim is that their is a lot of "dumb money" holding indexed products that are likely to sell all at once when things turn south. By the structure of these funds, their will be large selling pressure on the underlying stocks and a good chunk of them don't have the liquidity to support that pressure. That doesn't mean their will be a metldown, just that prices will tank very hard and a lot of people will lose a lot of money + the economic effects that has I don't understand.
I was hoping the original article would tear that reasoning down, and while it did touch on various mechanisms it didn't give a cohesive thesis as to why that is wrong.
There is no evidence for this. During the 2000-2002 and 2008-2009 index funds actually saw higher inflows:
* https://www.etfstrategy.com/three-reasons-why-indexing-and-e...
Perhaps there will be greater correlation between names in a downturn, but then again, factor-based investing might offset some of that.
Imagine if you'd invested in the Russel 3000 index, which aims at tracking the entire US stock market. If the ETF manager transferred the securities as you exited you'd now have to manually sell 3000 securities across many markets. The ETF has tools and processes for this, you don't. You pay them a fee for the convenience of not having to deal with the underlying assets.
Another example would be something like the iShares gold or iShares silver ETF. They hold precious metals in a secure vault on your behalf, for a fee. You probably don't want a delivery from an armored truck every time you exit the ETF! :)
https://www.investopedia.com/terms/r/redemption-mechanism.as...
First, I think he didn't made that point very clearly. Second, why would they be sold at a larger discount than larger holdings? It is all in proportion - they own less and sell less of the smaller holdings.
(There are issues conceivable where you have a liquidity mismatch (bonds, real estate), but I haven't seen a solid elaboration of that point. It's the good old "people worry about bond market liquidity" meme that Mark Levine pokes fun at in his Bloomberg Column "Money Stuff".)
His argument there AIUI was that the daily volume is not in proportion.
Will be interesting to watch the next market crash.
https://awealthofcommonsense.com/wp-content/uploads/2019/09/...
I guess there are more legitimate concerns for funds that hold bonds or real estate or other less-liquid assets. But the solution to that is just, don’t put yourself in a position where you have to liquidate those funds in a crunch.
Other forms of algorithmic trading might still step in though.
The fundamental problem he seems to be pointing at is that notional replicating portfolios can work like an engineering marvel in good times and become inoperable in bad (liquidity) times.
There were many elements to the CDO crisis -- including bad faith by the rating agencies and a prolonged asset-price mania much beyond this stock-market rally. The simpler metaphor is the emission of vanilla stock options. In principle, a bank is only able to offer options because he has the ability to replicate it and neutralize his risk. But if market conditions diverge from the asset replication model, then boom you get LTCM.
He is confused. That was the problem with the synthetic OTC instruments that he used which nearly tripped his winning position because no one wanted to actually trade with them. And even that was largely the case because he was buying not even CDOs but synthetic instruments that were derivatives of the CDOs.
Index funds on the other hand own the shares in companies that publicly trade where the market markers must provide liquidity hence a single trade at +/- 10% will not only move the quote but would trigger other buyers and sellers to decide to want to play.
At least for exchange-traded funds, it would seem that you don't have to actually destroy units of the ETF in the case of a sell-off. The ETF units would just sell at lower prices, just like when there is a 'sell off' of any stock - there are always equal numbers of buyers and sellers, you don't destroy units, you just move the price lower.
With index funds where you have an account directly with vanguard or whoever instead of buying units on an exchange, I'm not sure how it works in a sell-off. Perhaps they sell shares in the individual stocks, or perhaps they just try to sell off your shares bundled together by issuing more ETF units. I don't know what they do, but it seems like there are a bunch of options that should mean they don't have to sell off illiquid stocks on command.
I'm not sure. Happy to be enlightened. As much as I think about it, my intuition seems to consistently say that it's impossible for index funds to be broken in any meaningful way that's any different from the market itself or some sector thereof being in a bubble.
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...
Which came dramatically close to happening in 2008, see, e.g. [0].
[0] http://pages.stern.nyu.edu/~sternfin/pschnabl/kacperczyk_sch...
Yes. It has happened before.
Also, another thing to keep in mind is that this only affects people who are trying to sell at the bottom. Buy and hold investors care little for liquidity issues during a crash.
Yes. Active managers can choose what to sell based on prevailing market conditions. Index funds must sell across the board. That could involve getting hosed on names in a short-term squeeze.
> this only affects people who are trying to sell at the bottom
There are lots of index funds. For a broad-market fund, you're probably right--a patient investor can ride out the bloodshed. For leveraged or specialized funds, on the other hand, a rout could permanently impair the portfolio.
Equity market collapses, furthermore, have a habit of transmitting into the real economy. A sustained downturn could impair funding conditions, which in turn could affect the fundamental characteristics of a portfolio.
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.
And a lot of index fund investors are buy-and-hold so it's unclear if a recession would even cause a liquidity / redemption crisis.
But index funds themselves aren't. They have to sell stock when units are destroyed and vice versa. In addition to other factors, this can result in weird tax effects as well as tracking error to the index.
1) To track the actual index, index funds must continually rebalance their portfolio. In a liquidity pause they may not be able to do this, thereby becoming a non-index fund. Actively managed funds have the portfolio they have -- unless they're defrauding the public somehow. An index fund that becomes a non-index fund would fall in this latter category.
2) The index (not the funds) is assumed to reflect all the information that can be used to make some money by arbitrage. This process is referred as "price discovery". But in a liquidity pause, price discovery grinds to a halt. Actively managed funds have their own idea of what are the fundamental prices beyond what the public leaderboard says; their price discovery is not beholden to the existence of a liquidity market. Actually -- if the market goes for years with very low liquidity, it becomes more likely that people who, say, are shorting Herbalife for fundamental reasons, have more knowledge than the index. In this way the index is like an AI that can become starved for data.
If the index instruments have a lot more liquidity than the underlying names, then that means they won't be able to gracefully absorb the liquidity shocks from an unwind in the index.
Here's some back of the envelope calculations. Between SPY, IVV, and VOO alone, there's $500 billion in S&P 500 index ETFs. Consider if an unwind event leads to 20% of index assets being redeemed in a single day. That's $100 billion from the above ETFs alone.
Now consider a typical thinly traded single-name stock like Chubb Limited (symbol CB). CB makes up 0.3% of the S&P 500 by weight. So in the hypothetical scenario above, the APs would have to collectively sell $300 million worth of CB in a single day. Chubb's entire ADV is only $238 million.
Trying to sell more than 100% of a stock's ADV in a single day is guaranteed to produce huge market impact. The current liquidity providers in CB almost certainly cannot absorb that amount of trading volume all in one direction. In that scenario, Chubb's stock might fall by 20%, for something that had nothing to do with the company itself.
I think the overall point is that a lot of single-name stocks nowadays don't really have much of an individual market. Names like TSLA, FB or TEVA definitely have a robust market with a lot of traders still focused on company specifics. But a lot of the more boring, lower volatility, mid-cap stocks (like CB) mostly just trade along with the index nowadays. If there are technicals related to index capital flows, stocks like that are going to get taken for a ride.
[1] https://www.etf.com/channels/sp-500-etfs [2] https://www.slickcharts.com/sp500 [3] https://finance.yahoo.com/quote/CB?p=CB
This is under the assumption that there will be capital available to flow, if there isn't because of a truly bad scenario, yes it's a downward spiral, but it will take quite an event to get us to that point.
IE if a smart person with a lot of money think there is no "smart money" left, wouldn't (s)he just start their own smart money hedge fund to provide / do this?
If nobody is left to do thing X AND thing X is basically guaranteed profit, isn't it natural for people to step in and do thing X?
Typically the opportunists here would be stat-arb hedge funds. They bread and butter of their strategy is to isolate the non-explainable ("idiosyncratic") movement in single name stocks, then bet on that factor mean-reverting.
E.g. if Microsoft goes down 0.5%, but the market's up 1%, and the tech stocks are up 1.2%, and various other factors that move Microsoft don't explain it being down. Then they'll bet that the movement is driven by random noise, and buy Microsoft, betting that it will re-converge with where it's expected to be. They'll also use various techniques to isolate whether idiosyncratic movements are likely driven by company specific factors or market noise. Like NLP on a newsfeed to look to see if there are any breaking stories, or tracking recent analyst revisions on the stock.
Suffice to say that stat-arb funds in this day and age are very very good at this. In a liquidity unwind event, the signals stat-arb traders use would absolutely be lighting up. The biggest question would be whether stat-arb funds in aggregate have enough capital to counter the absolutely humongous flows that a potential index fund unwinding would release.
Another complicating wrinkle is that most stat-arb desks are no longer independent hedge funds, but units within larger multi-strategy funds (like Two Sigma or Millennium). There's good and bad. The good is that if there's all of a sudden massive opportunity the multi-strat fund can quickly reallocate more capital to the stat-arb desk.
The bad part is that stat-arb desks may be unwound due to arbitrary contagion in other parts of the market. If the multi-strat fund sees a big loss in another unit, it may pull capital from the stat-arb desk to meet margin calls or redemptions. For example this happened in August 2007 [0]. The subprime mortgage market blew up, then all of a sudden a bunch of esoteric stocks started behaving crazy for the next weeks. And that was largely because multistrat funds were pulling capital to meet margin calls on their mortgage portfolio.
"i'm supposed to sell 500m of this small stock but i only got to sell 300m before it was frozen out...now my basket of holdings is slightly off from the actual index...hopefully i can rectify it tomorrow..."
Arguably, after the crash they might be able to take advantage of the opportunity. If they concentrate into the stocks with the biggest price displacements, then as those stocks return to normal, they may make up some or all of their initial losses. Passive indexers can't do this, because they don't have the mandate to deviate from their pre-defined allocations.
But I think the broader issue is that excessive amounts of indexing present potential systematic risks for everybody. Burry's hypothesis is more relevant for policymakers than it is for investors.
As an individual, long-term buy-and-hold investor, low-cost index funds are without question the best option for investing. The problem is behavior that's rational on an individual level, may produce irrational results at the collective level.
I'm asking for a comparison of two scenariors. In the index fund scenario, we're in the world where index funds represent a large and growing chunk of the market. In the active funds scenario, index funds aren't a thing. Why is it that in the active funds scenario, what you're describing in the previous post doesn't happen? Why doesn't a 20% marketwide downturn cause chaos in these smaller stocks? Is it because there would be higher volumes if those stocks were held by active funds? Or because the active funds wouldn't hold stocks like that?
Basically, I'm asking for a comparison of the scenario you described with what happens in a no-index world, because I can't quite think through the difference myself.
Yes in theory the manager can try to alter the composition of the fund by selling the stocks that are still going strong. But why would they? That just exposes them to known hazards even more.
So, probably the active funds will be the first ones to drop the small stocks first in a crash.
First as mentioned before, active investors have discretion. There's strong reason to believe that as the sell-off's happening that they'd move into the most dislocated stocks. That acts as kind of a negative feedback loop. It wouldn't stop a market-wide selloff, but would keep things more balanced between single-name stocks vis-a-vis the rigid rules governing passive index managers.
Second, by definition active funds are more differentiated from one another. Passive indexing produces a mono-culture with analogous ecological risks to what we see in nature. The typical active fund only holds about 50 positions at any given time. So, on the whole while active investors in aggregate hold 0.3% of their portfolios in Chubb, at an individual level most funds hold zero. And some minority may hold 1%, 5%, 10% or more of their assets in Chubb. So if one fund fails, that's less likely to spread contagion to every other fund in the universe.
In that type of unwind scenario, some funds will do pretty decently, and some funds will do horribly. But the point is there will be a dispersion of results. That makes the market as a whole more robust. Panicking investors are more likely to re-allocate their capital from the bad funds to the good funds, rather than pull all their out in a flight to quality.
Burry’s money quote in the original Bloomberg article was on limited liquidity for a largish number of stocks - over a 1,000 stocks in Russell 2,000 weren’t traded heavily (by his benchmark).
So what? Let the weak long positions panic and sell at the bottom. Everyone else gets a few years of discount prices to buy. The hardest hit will be those who are leveraged and arguably deserve to get hosed for taking that much risk.
If you don’t have to meet a margin call, you can ride out a crisis; if you’ve got cash in reserve, you can profit from it.
Doing that during a crisis hurts. This risk diminishes the value of investments as a safety cushion.
In all of those scenarios you should not be in stocks/equities in the first place. If there is a possibility of needing cash with-in the next 5 years, that money should be in either bonds or term deposits.
One's downpayment, first/next few retirement years' income, and emergency fund(s) should not be in equities.
* https://www.etfstrategy.com/three-reasons-why-indexing-and-e...
See also Vanguard's (biased) opinion:
* https://www.vanguardcanada.ca/individual/articles/education-...
The people using index funds generally don't think about their portfolios—which is the whole point of them. It's probably the cocaine-fueled traders that are causing all the ruckus.
I am not a specialist and would love to read an informed analysis and counters to Burry's article. I was hoping that this is what the author tried (as the title suggests), but to me he fell far short of that goal. My 2c.
This is a smaller example the liquidity problem that Mr Burry was making - it would much worse if a market crash did this to the realy realy big index funds.
When investors sell that amount, it doesn't matter whether they hold the underlying assets directly, or via index funds or ETFs, or via actively managed funds. The market will go down. So, which part of the problem is uniquely due to index funds?
Burry hasn't made that point very clear.
There might be issues with (liquid) index funds that give exposure to inherently less liquid assets, such as bonds or real estate. There might also be issues with index funds that do not hold the assets themselves, but replicate the exposure synthetically by entering a swap with a third party, giving rise to tracking error, counterparts credit risk, etc.
However, as I said, Burry hasn't enunciated these concerns very cogently (at least in the extracts quoted by Bloomberg). This article here does nothing to address those concerns.
If those fund-holders were owning the stocks directly, instead of ETFs... Those same fund-holders would be... Selling their stocks. Causing the exact same downward price pressures.
Suppose stock X gets 1% in that basket. The issue is if stock X happens to be very illiquid, the APs selling stock X could drive down the price.
In a non ETF, managers could decide to relatively slow down the sale of X, to prevent crashing the price. However, in an index fund the mechanism dictates all stocks are sold in the same proportion.
If you are panicked, and are selling your ETF, your evil twin is panicked, and selling all their stocks.
This causes the exact same downwards pressure on the market.
I don't buy an ETF because I want someone to do financial malarkey with my money. I buy it because I want to own stocks, and I can't be assed to deal with my own brokerage account. Besides the convenience aspect, there is zero difference between the two.
Moreover, if my evil twin a) owned a managed fund or b) sold in a slightly smarter way, then they would lose less on X due to liquidity.
Moreover, the hit on Xs price also has a slight hit on the ETF value. Hence there is a small positive feedback loop.
They'd still follow the same herd mentality that they would, had they owned ETFs.
What is special about an ETF, that makes this situation any worse?
https://www.investopedia.com/articles/markets/101415/4-best-...
In any crisis, the people who get really screwed are those who decide they have to sell, at any price. Instant liquidity - by whichever route - gets really expensive. An actively managed fund can at least decide which assets to sell to meet redemptions, holding those it thinks are undervalued at the moment. Whereas an index fund is effectively exposed to a crisis anywhere in the market.
Further, if there is a stampede for the exits, there still have to be buyers on the other side of the sellers. Those buyers will undoubtably include active managers along with those indexers with different time horizons and/or braver constitutions. Both will likely be rewarded for their patience.
That is a key point in the debate. I do not see that above is necessarily true. Say a price of a low volume stock X is driven down below fundamentals just because index funds have to sell 1% of holdings and cannot find enough buyers for X. While price of X might be irrational fund managers might not be able to act on it because there would be a worry that it may go lower still if selling extends.
Could next round get X removed from index? delisted? "The market can stay irrational longer than you can stay solvent" is not an empty worry. My 2c.
> Liquidity is not a huge problem for index funds. But, Ben, what if everyone rushes to the exits all at once? Index funds and ETFs are going to cause a massive crash!
> When an index fund investor sells, they’re technically selling their holdings in direct proportion to their weighting in the index. So there is literally no market impact.
Yeah, I wanted to highlight that that's not true. Of course there is a market impact, it'll go down. The author might have wanted to say that there is no differential market impact, ie all shares would go down to the same extent (so that there is no impact, say, on capital allocation), but even that is not necessarily true, it clearly depends on the homogeneity (or lack thereof) of the liquidity/elasticity on the other side of those trades.
I'm still driving the price down, causing other holdouts to sell off, driving the price further down. It's the definition of a market crash.
This article does mention it, but pretty briefly.
It'd be interesting to hear from people more familiar with the details of how all this works... perhaps there are some in the initial thread, but I haven't had time to skim it all: https://news.ycombinator.com/item?id=20877700
What is unique about no liquidity during a sell-off driving markets down? It's the definition of a sell-off. The fact there's no liquidity is what drives down the market in every sell-off.
Like my parents did in 2008/9, and I didn't think to caution them not to. Ugggg...
A large number of investors leaving the market will see a sell off no matter what vehicle they're in.