Are Index Funds in a Bubble? | Briefing v12 — MoneyRedPill

If you don’t know who Michael Burry is, you should. He’s the guy who, in 2007, recognized the egregious, unsustainable U.S. housing-market bubble and imminent collapse, and made one of the largest, most successful ‘short’ trades of our lifetime. For the first time since the Great Recession of 2008, Burry has made public another call of his: ‘index funds are in a bubble.’ But is it true?

Let’s consider Burry’s contentions:

1. Massive cash influx into index funds are distorting stock (45% of equity market) and bond (25%) prices, similarly to collateralized debt obligations (CDOs) did with subprime mortgages leading up to the housing market collapse in 2008. Burry claims “passive” funds, essentially baskets of the same company stocks grouped within an index, and packaged as a single product; are being artificially overbought on a huge scale regardless of the underlying fundamentals, and the stock prices are perpetually inflated, completely nullifying any semblance of market price discovery.

Our take: Burry presents solid logic, and this logic is consistent with his concern and massive CDO short position in 2007 leading up to the 2008 crash. And sure, there will be market corrections and stock prices will retrace back to Earth, Index funds included, as they always have. In fact, stocks in index funds may even fall harder. But let’s not forget index funds track the performance of a stock market index, all of which which grow over time, and historically have spent 70% of market history increasing in value. Index funds are long-term investments, and are utilized by investors to set automatic monthly contributions, reinvent dividends, and hold until a retirement target date. Perhaps index funds are overvalued, and perhaps they will, at some point, fall harder compared to smaller-cap stocks not included in index funds. However, long-term market growth, economic fundamentals of nations’ growing GDP’s, and companies’ incentives to continue growth, all point to increase in value over time, despite smaller time frame market corrections. In fact, Fed researchers examined cash outflows during 2008, and found that cash flowed out of actively-managed funds and in to passive funds .

2. Some of the small cap (market-capitalization) stock prices that are artificially inflated from passive index funds have disproportionately lower daily volumes than many other stocks in an index fund. This includes many of the lower-value stocks included near the bottom range of an index fund which tend to garner less attention and thus lower daily trading and investing volumes compared to larger-cap stocks, like Apple, Lockheed Martin, or Berkshire Hathaway. This presents a liquidity problem, which is a common risk in private investing and venture capital. Burry argues if everyone rushes to sell index funds at the same time, there is nowhere near the necessary liquidity in small-cap stocks, let alone larger ones, to be able to accommodate many investors, thus stock prices will suffer.

Our take: Again, sound logic, and a fair point. However, this presumes a few things: the average investor is trading, or more active in their portfolio. For the average investor, which is most people, this is untrue. Most individuals invested in index funds are long-term investors with a buy-and-hold strategy, and don’t intend on cashing out for years-decades. As far as timing goes, it’s unlikely that a majority of long-term index fund investors are or would be cashing out at the same time. In the event of a major market correction or onset of a bear market, there may be increased selling or stop-losses triggered as weak hands fold or retirees look to preserve capital. However, long-term investors typically continue to hold and ignore the shorter-term volatility associated with market fluctuations. Unless Burry believes the majority of long-term investors have weaker hands than most, this is probably less of a concern than Burry’s claim asserts. The point to take here is don’t neglect undervalued securities in the small-cap sector, there may be some fantastic opportunities with greater upside potential than the S&P or DJI.

3. There are some index funds that can see greater volatility and loss compared to an individual stock or even a traditional mutual fund.

Our take: This is mostly referring to leveraged and inverse index funds, both of which are atypical for the average investor and primarily used only by a small percentage of passive fund investors. Leveraged and inverse funds are, by definition, more volatile due to their exponential exposure and tracking of market indices, and are better suited for active investors, fund managers, and even traders. Therefore, this does not concern nor affect most passive fund investors.

In summation, while passive funds have become significantly more popular for average investors as of late, the majority of funds remain in the hands of active managers. Until we see a paradigm shift and an undeniably disproportionate percentage of investor funds being funneled into the same passive funds, the index fund ‘bubble’ is probably more of a headline than a reality.

Originally published at https://www.moneyredpill.com on January 15, 2020.