U.S. Markets closed

Michael Burry on the Bubble in Passive Investing

A few days ago, Michael Burry hit the headlines when he told Bloomberg he believes there is a bubble in passive investing. Specifically, he said in an email:


"The bubble in passive investing through ETFs and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally."



He went on to say:


"There is all this opportunity, but so few active managers looking to take advantage."



Passive bubble

Burry shot to fame in 2015, when the film version of Michael Lewis' best-selling novel, "The Big Short," hit the big screens. Since then, investors around the world have been fascinated by the hedge fund manager who made millions for his investors betting against the subprime mortgage crisis.

The value investor's crisis trade has earned him a reputation in the financial world for being ahead of the curve. That's why there's been so much fuss about his recent comments on passive investing.

Burry, however, isn't the first to highlight the changes passive investing is pushing onto the rest of the market.

Howard Marks (Trades, Portfolio) noted this trend unfolding in a memo to clients in 2018. Titled "Investing Without People," Marks noted that passive investing was just one of the ways in which securities markets are moving toward a world where people have a much-reduced role.

Read more here:



"Is it a good idea to invest with absolutely no regard for company fundamentals, security prices or portfolio weightings?" Marks said. "Certainly not. But passive investing dispenses with this concern by counting on active managers to perform those functions."

But what happens when active investors quit or are pushed out of business by passive products? It's difficult to tell:


"How much of the investing that takes place has to be passive for price discovery to be insufficient to keep prices aligned with fair values? No one knows the answer to that. Right now about 40% of all equity mutual fund capital is invested passively, and the figure may be moving in that direction among institutions. That's probably not enough; most money is still managed actively, meaning a lot of price discovery is still taking place. Certainly 100% passive investing would suffice: can you picture a world in which nobody's studying companies or assessing their stocks' fair value? I'd gladly be the only investor working in that world. But where between 40% and 100% will prices begin to diverge enough from intrinsic values for active investing to be worthwhile? That's the question. I don't know, but we may find out...to the benefit of active investing."



High multiples

In addition to Marks and Burry, there has been a steady stream of hedge funds, Wall Street analysts and institutional investors over the past several years warning against the rise of passive investing and the impact it is having on security markets around the world.

Only a few weeks ago, in its second-quarter letter to investors, Voss Capital highlighted the curious case of WD-40 Co.'s (NASDAQ:WDFC) valuation. The stock traded at an enterprise value-Ebitda range of between 8.3 and 13.5 for 20 years before breaking out in 2013. It is currently dealing at an enterprise value-Ebitda multiple of around 30, more than double its historical average.

357303346.png

The company's biggest shareholders are BlackRock and Vanguard, which own around 25% of the outstanding shares and have been steady buyers despite the stock's ever-expanding valuation.

What's the answer to this problem? There does not seem to be one. Passive investing will continue to grow in popularity as long as people keep believing it will outperform over the long term.

When it stops outperforming and active managers start to regain their edge, the market will swing back in the other direction. In the meantime, value investors should take advantage of the opportunities passive investing is throwing up.

Disclosure: The author owns no stocks mentioned.

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.