Market Outlook

Passive investing bubble: Are we sleep walking into a crisis?

The warning that passive investing in index funds could trigger the next financial crash could be easily brushed off as another financial scare story. But when that warning comes from Michael Burry (pictured), the man who foresaw the sub-prime mortgage crisis and made a fortune shorting housing market collateralized debt obligations (CDOs), it may pay to listen. 

The contention according to Burry – who gained fame after being depicted in ‘The Big Short’ – is that people flocking to index funds in recent years have created a large-cap “bubble in passive investing”, unnaturally beefing up the performance of both the indexes and the stocks that form them.

Index funds track specific indexes, aiming to follow or match their performance rather than actively looking for market-beating stocks. They are geared for more long-term investment strategies because traditionally the stock market rides through volatility and increases over time.

 

Primed to pop?

Despite the appeal, Burry recently told Bloomberg, “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.”

“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.” - Michael Burry

He warns of similar patterns to those seen pre-2008. “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.”

Passive investing, he says, has “removed price discovery from the equity markets,” and that the “simple theses and models…mimicking those strategies” simply don’t have the same level of security-level analysis “required for true price discovery”.

Burry’s concern is that many of the stocks traded are low volume with lower liquidity. According to the Motley Fool “the prices of these less-traded equities are being influenced by the billions of dollars flowing into them from funds. If passive investors suddenly sell their funds including institutional investors and pension funds, the stocks linked to them will be badly affected and their prices rapidly decline.”

Even if a company is doing well, they will fall in line with the index. A big geo-political event could be the trigger and we certainly have our pick of those from the US/China trade war to Brexit.

“[Passive investing has] removed price discovery from the equity markets” - Michael Burry

 

But are the fears valid?

Analysis from Vanguard founder John Bogle found that US index funds have grown in recent years, with their holdings of US stocks jumping from 3.3% of their total market value in 2002, to 14% in 2018. Furthermore, indexing in stocks and bonds represents less than 5% of global assets, according to Fortune. In contrast more than 85% of the equity market and more than 95% of the bond market are invested in some form of active management such as hedge funds, says investment guru Andrew Hallam, quoting figures from Vanguard’s Chris Philips.

Is the passive proportion really enough to destroy the market compared with some of the more erratic and personality obsessed active fund managers? Active traders are in the majority – they set the prices in the marketplace not the passive funds.

“When an index fund investor sells, they’re technically selling their holdings in direct proportion to their weighting in the index. So, the market impact is muffled,” writes Ben Carlson, director of Institutional Asset Management at Ritholtz Wealth Management, in an article for Fortune.

“When an index fund investor sells, they’re technically selling their holdings in direct proportion to their weighting in the index. So, the market impact is muffled” - Ben Carlson, director of Institutional Asset Management at Ritholtz Wealth Management

Hallam tends to agree: “Rabid selling occurred long before index funds existed. When it happens again index funds won’t be to blame.” He points out that index funds outperformed actively managed funds when the stock market crashed in 2008.

Investment expert Marcus Padley writes in Livewire that there is a risk with passive funds “when everybody tries to do the same thing at once”. However, he highlights that a “once-in-a-lifetime event” is “when the problem will arise”. 

This is also something Burry notes: “I just don’t know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be”.

As blogger Mr Money Mustache states, “peak indexing” will be reached when active funds begin to consistently outperform index funds across the industry and at this point “you should switch to a good low-fee active fund”. However, he points out that this is far from happening.

As with most investing, diversification is the key. Both passive and active can give you plenty of upside in times of both recession and boom.

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