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Why Index Funds Are Like Subprime CDOs

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Re: Why Index Funds Are Like Subprime CDOs

#151

Post by jandrewrogers »

beat wrote: post #132
strstr wrote: post #123

Earlier quoted context omitted.

There’s a clear narrative in favor of actively managed funds: they analyze the underlying stock and avoid stocks that are overvalued according to their fundamentals, and buy those that are undervalued. The consequence would be near total avoidance of the S&P 500 as a good strategy for the long run. There would be exceptions for those stocks that are quite undervalued, or so overvalued that they are worth shorting (de…

Right. Which begs a question... are the large-cap stocks that dominate the index funds overvalued relative to their fundamentals? That should be easy enough to determine, and we should see a lot of "hold" or "sell" from the analysts. And if they're not overvalued, are index funds really a bubble?

The concept of "overvalued" assumes a valuation model that everyone agrees on. Large companies are complex organisms and equally complex to value. It follows, with ample evidence, that simple reductionist valuation models based on P/E, book value, and other easy-to-obtain numbers are going to be inadequate. And most valuation models are terrible at incorporating myriad risks.

Currently, I would argue that some large caps are clearly overvalued but others are also clearly undervalued, based on my own valuation model. The indexes are almost always a mixed bag but I buy individual large caps so that doesn't concern me much. It is rare for the entire market to become overvalued, in which case the smart move is not to buy in.

Re: Why Index Funds Are Like Subprime CDOs

#152

Post by whatok »

pwthornton wrote: post #149
whatok wrote: post #144

Earlier quoted context omitted.

Define "so high". If fees are too high, why is anyone paying them? How do you determine what's high?

People are fleeing to index funds, which is what is spurring posts like this. There are all of these complaints from people who run actively managed funds, never once mentioning that the fees might be why so much capital is going to passively managed funds. People like myself who invest exclusively in index funds do so because the fees charged by actively managed funds are not supported by performance.

People are investing more in index funds because we've had a ten year bull market and index fund fees have dropped in an attempt for competition for assets.

Most active management is probably not appropriate for most individual investors because their investment needs and timelines are much different than high net worth individuals/pensions/foundations, etc.

Re: Why Index Funds Are Like Subprime CDOs

#153

Post by beat »

jandrewrogers wrote: post #151
beat wrote: post #132

Earlier quoted context omitted.

Right. Which begs a question... are the large-cap stocks that dominate the index funds overvalued relative to their fundamentals? That should be easy enough to determine, and we should see a lot of "hold" or "sell" from the analysts. And if they're not overvalued, are index funds really a bubble?

The concept of "overvalued" assumes a valuation model that everyone agrees on. Large companies are complex organisms and equally complex to value. It follows, with ample evidence, that simple reductionist valuation models based on P/E, book value, and other easy-to-obtain numbers are going to be inadequate. And most valuation models are terrible at incorporating myriad risks. Currently, I would argue that some large…

I wouldn't say simple reductionist valuation models are inadequate... just incomplete. Most of the time, a deeper analysis should be in line with rule-of-thumb tools like P/E. This is even more true for large companies that value not-losing over winning big.

If you can come up with a clever valuation mechanism that can reliably outperform the well-understood mechanisms, then enjoy pocketing the profits!

Re: Why Index Funds Are Like Subprime CDOs

#154

Post by UnFleshedOne »

notyourday wrote: post #8
throwaway713 wrote: post #4

Can someone who understands investing well explain what he’s saying in terms that someone who isn’t knowledgeable about this could understand? I kind of think he’s saying that everyone is just shoveling their money into index funds without thinking about it and this leads to incorrectly valued stock that will correct in the form of a crash at some point. Is that sort of the gist of it?

When people invest money into index funds, then the funds must spend all that money buying the shares of the underlying fund companies . So that creates tons of buy orders for the underlying stocks, which creates the buying pressure, which makes the prices rise. As long as more money comes into the index funds the prices of underlying stocks will keep rising. But the higher the prices of the underlying the more money…

So, a normal decade in the markets?

Re: Why Index Funds Are Like Subprime CDOs

#155

Post by fragsworth »

dcolkitt wrote: post #59
spenczar5 wrote: post #5

He says he's (reluctantly) doing active stock picking. He's a professional investor; I'm just some software engineer with a nest egg, which is 100% in index funds today. What should I be doing, as a schmoe who wants to save money?

The thing is even if Burry is right (and that's a big if), it doesn't mean that you as an individual investor with a long time-horizon should do anything different. Burry's argument is that many of the underlying stocks inside the index have a lot less liquidity than the index funds and securities themselves. E.g. if a lot of capital quickly exits the index funds, then some of the single-name stocks may be overwhelme…

> If some stock falls 50% because of panic selling, without anything having to do with the underlying company, it will eventually return to the correct price. And much sooner than the decades long timeline that you're saving for.

But that's not true, because suppose if 99.9% of investors are buying ETFs and only 0.1% are actively managing, there won't be enough funds to bring all these panic dislocated stocks back up for many, many years.

Re: Why Index Funds Are Like Subprime CDOs

#156

Post by kgwgk »

beat wrote: post #132
strstr wrote: post #123

Earlier quoted context omitted.

There’s a clear narrative in favor of actively managed funds: they analyze the underlying stock and avoid stocks that are overvalued according to their fundamentals, and buy those that are undervalued. The consequence would be near total avoidance of the S&P 500 as a good strategy for the long run. There would be exceptions for those stocks that are quite undervalued, or so overvalued that they are worth shorting (de…

Right. Which begs a question... are the large-cap stocks that dominate the index funds overvalued relative to their fundamentals? That should be easy enough to determine, and we should see a lot of "hold" or "sell" from the analysts. And if they're not overvalued, are index funds really a bubble?

> and we should see a lot of "hold" or "sell" from the analysts.

That's not how that works... Sell-side analysts have a systematic bullish bias, that's what they are paid for.

https://www.bloomberg.com/opinion/articles/2017-01-20/wall-s...

Re: Why Index Funds Are Like Subprime CDOs

#157

Post by groundlogic »

avvt4avaw wrote: post #9
groundlogic wrote: post #3

Not an economist, but it's obvious to anyone used to thinking in terms of systems that index funds can't work after a certain amount of the money poured into the system is managed by index funds. What's the limit - 30% 40%, 50%, 60%? What's the current level in terms of managed capital? (Edit: https://www.cnbc.com/2019/03/19/passive-investing-now-contro... says 45% for US stock-based funds, half a year ago, so maybe…

You only need the marginal investor to be informed, so it's not clear that you couldn't have a much higher percentage of passive investment (say 90%) and only a small amount of active investors who are providing price discovery. The bigger problem is that most passive investments are not really passive - for example, choosing to invest in a "passive" S&P 500 ETF over a "passive" Russell 2000 ETF is an "active" invest…

Mind explaining the concept of the marginal investor in this context?

Re: Why Index Funds Are Like Subprime CDOs

#158

Post by ptero »

entee wrote: post #150
ptero wrote: post #140

Earlier quoted context omitted.

I will try to interpret, but obviously it is just my interpretation (and personally I mostly agree with many theses Burry gave). First, he does not really talk about being a "good citizen" or not. His points are for "greedy citizens" who, in his view, should be worried (about his pocketbook) if he is heavily invested in passive index funds. This is due to his "bigger and bigger crowds, same exits" analogy: individual…

So the result would then be something like the flash crash? I share your understanding of the article, it’s not about “index bad active good”, it’s about, “is there a problem when a lot of investors have to move quickly”. I wonder if there is some analysis of this during the last crash.

It could be more serious than the flash crash (again, just an interpretation).

Flash crash gets resolved quickly and is transparent to non-participants because there is a lot of money willing to buy on dips. But fast trading money only buys and sells what they perceive to be highly liquid assets -- there are few things that scare them more than being stuck with an open trade.

The scenario Burry describes is akin to CDO crash. Naively, most CDO assets were not problematic and many/most of the problem ones had an underlying asset of some value guaranteeing the debt. What caused the crash was lack of liquidity that started a vicious circle.

Index fund scenario could be similar: less liquid stocks that are big components of major indices would crash with unknown systematic consequences. Even if only 10% of passive index investors heads for the exits we could see broad, long term damage. And they could: pension funds have been investing huge sums into indices and a targeted PR / a few headlines of the type "look what those financiers doing with worker's money" may nudge a lot of money out of stocks.

On the other side, it is easy to make conspiracy theories on any subject.

Re: Why Index Funds Are Like Subprime CDOs

#159

Post by edmundsauto »

drelihan wrote: post #127
markbnj wrote: post #58

Not knowledgeable on these matters, so my money is in index funds. Obviously a lot of other people are in the same category as myself. The article seems to be saying we'd all be better financial citizens if we put our money into actively managed funds, or did our own investing. The latter is out of reach for most people, and with respect to the former it's somewhat puzzling that managed funds can't consistently outpe…

Imagine there was a cookie market made up of two types of cookies, tasty and meh. An active investor in cookies would spend time determining which cookies are likely tasty and which are meh. They would pay more for the tastier cookies so they can savor the flavor and less for the meh ones they can binge eat in the shower when no one is home.... A passive investor comes along and says, I don't want to do all this rese…

I think the flaw in this analogy is that it's impossible to know beforehand whether the cookies are tasty or not. And a cookie that was previously tasty might not be tasty any more.

Re: Why Index Funds Are Like Subprime CDOs

#160

Post by jpalomaki »

omarhaneef wrote: post #106

A lot of people seem to have read this and think that Burry is worried that the indices are weighted by market cap. That is not the issue. The issue is that a large proportion of the index is smaller caps that no one bothers to look at and price properly, and yet massive amounts of money are in ETFs and other contracts that take a position on those smaller, less followed names. So these small names in the large index…

If the small cap valuations are totally wrong, shouldn’t some simple measures like P/E show it clearly?

Edit: The P/E values on Russel 2000 seem to be almost double compared to S&P 500 [1]. Also some point out that the value is not correct as it leaves out negative earnings which are common among small caps [2].

[1] https://www.wsj.com/market-data/stocks/peyields [2] https://goldco.com/russell-2000s-price-to-earnings-ratio-is-...

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