Why Index Funds Are Like Subprime CDOs

> Now the question becomes: how do I hedge out of this risk without going full day-trader?

Here's anecdata from the past: I spent a lot of time during the housing bubble working on a similar strategy. I came to the conclusion that shorting the banks (with leverage!) would be a profitable way to make money.

It turns out that was a beautiful and correct strategy, up until the moment the SEC decided to ban shorting. We got out with profit, but it was stressful and certainly nothing life-altering as a consequence of the SEC action. (bastards!) If you have seen The Big Short, they had a similar problem: Because the CDOs stopped trading, Goldman and company unilaterally declared that there was no problem. Since there was no market, there was no mark-to-market. Burry and friends were able to wait it out, but you'll notice that Burry had to exercise some extraordinary clauses in the contract; Dealing with your investors after that must have been all kinds of fun.

The moral of the story is probably something like: When you are profiting from the system melting down, the system will invent new rules to impede your profit, so be prepared.

Edit: BTW, I don't think mark-to-market accounting has ever been fully restored, but it's been a while since I checked.

Well the argument, if I correctly understand, is that the less liquid stocks in index funds are getting pumped up because investor demand for passive stocks is outweighing active price discovery. This would exhibit a cyclical pattern where as passive outperformed, more investors switch over which continues to pump bad stocks and so on. Then in a downturn, even if you hold, as investors get scared and pull their cash out of the index fund, those less liquid stocks will get hammered by the double factor of their being already overvalued and also thinly traded, dragging passive performance way down.

Not saying I agree but, if he's right it makes complete sense that passive would outperform active right now, just that in the next downturn it would dramatically underperform.

A total market index fund is proportioned by market cap. As the large cap gets larger, it proportionally becomes a higher percent of the pie. If large cap is overvalued, youre owning less small cap than "true price market cap."

This short explanation put the reasoning behind this in the best context for me, but makes me wonder more about the dissimilarities.

Are there other factors like in the housing market of a decade+ ago? Is there a lot of risk for Joe Six-Pack? Are there people out there borrowing money from banks with poor underwriting practices getting into index funds when they should not be doing so?

I'd think if this is most peoples' 401k and surplus income at risk that there may be a huge market correction but it won't devastate the economy. If people take the long term view and if investors sit tight and wait for the cycle to move into recovery again they'll be OK. If however they need to live off returns on their investments in the present (like homeowners needed a place to live during the crash) then they're in trouble.

I think there are a few good points made by Burry. When comparing across different market segments, today's climate of popular-index-funds can cause bubbles in some segments. For example, everyone and their grandmother invests in the S&P 500, whereas much fewer people are investing in the MSCI EAFE. Because of this, VOO can become over-valued relative to VEA.

I agree with this point and have wondered about it myself. I highly encourage everyone to diversify across all market segments, including the S&P 500, mid-cap, small-cap, developed markets and emerging markets. That mitigates the potential S&P-500 bubble that Burry might be warning against.

But that said, I don't think it's fair to accuse index funds of causing specific stocks to become over-valued relative to other stocks within the same index. By design, market-weighted index funds maintain the relative prices of different stocks within the same index. Ie, if a whole bunch of people sell their houses tomorrow and invest in the S&P 500, all the stocks in the index will get an equal percentage lift, and pricing ratio of GOOG to MMM will still remain consistent.

Note however, that equal-weighted indexes do not have this property. Imagine if the US government decided tomorrow that it was going to invest $10T in the stock market, using equal-weighting. This would translate to ~$20B for every stock in the S&P 500. The biggest stocks like GOOG would see an incremental boost, because $20B is still only ~2% of their market cap. Whereas the smallest stocks in the index would see their share price skyrocket because $20B would more than double their market cap.