Index funds have enjoyed an explosion of popularity over the past decade. They owe their success to a myriad of factors, including disappointing active manager returns and reallocations following the 2008 financial crisis and subsequent Great Recession.
While their appeal is undeniable, the long-term consequences of the rise of passive investing strategies are not fully understood. According to Michael Burry, of "The Big Short" fame, index funds represent the next great asset bubble. Indeed, in a recent interview with Bloomberg, the contrarian hedge fund manager said the index fund bubble is akin to the subprime collateralized debt obligation bubble that sparked the last downturn.
Undermining price discovery
By Burry's reckoning, the rise of index funds has resulted in a deterioration of the market's ability to serve its crucial function as a vehicle for price discovery:
"Central banks and Basel III have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in interest rates anymore. And now passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies -- these do not require the security-level analysis that is required for true price discovery. 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."
Burry's key point here is that, like the synthetic subprime CDOs that precipitated the last financial crisis, the pricing of index funds is at the whim of model-based capital flows rather than bottom-up fundamental analysis. While this may sound all right to value investors at first, since a growing pool of passive investing capital will inevitably result in at least some exploitable inefficiencies arising, it is not so clearcut.
Deepening liquidity risk
If Burry is right about the index fund bubble, then weakening the price discovery process should be the least of investors' worries. According to Burry, the real risk is that liquidity will dry up in a crisis scenario:
"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 the price discovery mechanism is overridden by models and capital flows, it can result in cascading systemic problems. That could be bad news for everyone, not merely those with heavy exposure to index funds or exchange-treded funds like the SPDR S&P 500 ETF Trust (SPY). While value investors might, at first glance, like the idea of exploiting passive capital-induced market inefficiencies, even the small-cap stocks that tend to underindex would be affected in the event of a genuine liquidity problem.
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Recipe for disaster
Index funds clearly have the potential to damage both the price discovery process and market liquidity. Unsurprisingly, Burry does not see that ending well for anyone:
"This structured asset play is the same story again and again -- so easy to sell, such a self-fulfilling prophecy as the technical machinery kicks in. All those money managers market lower fees for indexed, passive products, but they are not fools -- they make up for it in scale. Potentially making it worse will be 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. This fundamental concept is the same one that resulted in the market meltdowns in 2008. However, I just don't know what the timeline will be."
ETFs, passive index funds and the many "active" mutual funds that functionally mimic passive strategies have grown in scale and importance, resulting in a comparative crowding out of active participants, i.e., the actors doing the actual trading necessary for efficient price discovery and price setting. At the same time, the computerized liquidity on which index funds and algorithmic trading programs rely may prove to be extremely brittle to shocks.
No one knows exactly what will happen when index funds (and other passive vehicles) and the post-recession computerized liquidity infrastructure are put to the test. But the test is coming. Investors would be wise to prepare accordingly.
Burry has painted a rather bleak picture of the index fund bubble. Investors would be wise to listen closely, even if they do not agree with his conclusion. Just as with his contrarian GameStop Corp. (NYSE:GME) long play, attention is deserved, if not agreement.
All told, it pays to listen when successful contrarians speak up. That may go double when someone like Burry is presenting such an unambiguous warning:
"Like most bubbles, the longer it goes on, the worse the crash will be."
Disclosure: No positions.
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This article first appeared on GuruFocus.