Views Article – Sharenet Wealth

Editor's Choice

Are index funds a stock market bubble?

Michael Burry shot to fame after the 2008 financial crisis where he bet against the US housing market and collateralised debt obligations (CDOs) – the very instruments that nearly destroyed the global economy. A best-selling book and an Oscar winning moving has chronicled his feat. Despite this Burry has kept a low profile and in subsequent years focused on his hedge fund, Scion Capital, on water, gold, and farmland.

Recently, Burry has made news after a recent interview with Bloomberg, in which he drew parallels between index funds and CDOs. He argues the rising popularity of passive investing and flows into index funds distorts the prices of the underlying securities (i.e. stocks and bonds). But how?

Price disparity

Large market cap-weighted indices tend to favour large stocks while smaller-cap stocks are being neglected and consequently undervalued. Overall, small-cap stocks are under-represented in passive funds while funds tend to track large cap stocks. This creates a disparity in pricing. It isn’t only that large caps are hyper-inflated (or a bubble), but there is ample value opportunity amongst smaller stocks.

Volume and liquidity

Through ETFs – cue Trump voice – “billions and billions of dollars” are indexed to the underlying stocks that they track. However, the actual amount that the stocks trade daily, is a tiny proportion of the dollar value indexed to them; creating an overcrowding effect. Burry implies that there is a serious liquidity risk should many investors decide to move out of the said ETFs.

No need to fear

Despite what Burry warns, there is no need to panic just yet. There has always been a debate surrounding active and passive management. The good news is there is room for both active and passive investing. A strange symbiosis exists between the two: passive funds buy the index ETF in proportion to the shares held by active investors. Even Vanguard (one of the largest ETF providers) has a significant amount of money invested in active funds.

A human element is what causes stock market crashes – not index funds. Index funds did not cause the Great Depression nor the ’87 crash. Index funds weren’t even around during the Tulip bubble. If history is anything to go by, there will always be bubbles and subsequent crashes. It doesn’t mean that index funds should be something to fear – they give you all the ups of the market but also all the downs. That is a fundamental element of the stock market.

What would Michael Burry do?

I do, however, seem to agree with Michael Burry. I do not think, however, index funds are anything to fear. Instead, I feel more attracted to the potential opportunities created in small-cap stocks. The stock market is merely a pricing mechanism for the companies that it underwrites and currently that mechanism is neglecting smaller caps.

So, what exactly is Michael Burry betting against? Unfortunately, under US law, Scion Capital does not have to disclose their short positions. Fortunately, they must disclose their long positions. It looks like this:

Make of that what you will, but Burry is an avid proponent of Ben Graham’s value investing style. It’s likely that you’ll see a couple of the companies trading well below book value. It’s worth noting that the value of these holdings totals about $100 million dollars, while the fund’s total AUM is about $260 million. What’s the other $160 million betting on? Unless you’re Michael Burry there’s no way of knowing.

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Aidan van Niekerk

Junior Investment Analyst

Aidan is responsible for quantitative research and stock-market analytics. He has a keen interest in all things numbers and - in addition to working for Sharenet -  is a full time BSc Mathematics and Statistics student at Unisa. Aidan has represented South Africa at a professional level in road cycling where the rigorous demands and self-discipline has prepared him for the markets. He aspires to one day complete a Master's degree in statistics and delve deeper into the world of algorithmic trading, market analytics, and financial modelling.