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Why Index Funds Are Like Subprime CDOs

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Re: Why Index Funds Are Like Subprime CDOs

#231

Post by Terr_ »

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…

"What if everyone became a passive investor" is like worrying "What if the entire ecology became defenseless herbivores?"

It just won't happen, because there's a negative feedback loop against it, leading to a kind of homeostasis.

> At some point, no one is left to figure out which cookies are tasty vs meh, so the price of all cookies converge to a single price.

Five minutes later someone says: "Holy shit, I can make a ton of money by buying loads of cookies, sorting them, and re-selling them -- except with the definitely-tasty ones at a higher price."

Re: Why Index Funds Are Like Subprime CDOs

#232

Post by mcguire »

empath75 wrote: post #196
candiodari wrote: post #188

Earlier quoted context omitted.

The fundamental reason this happens is that Index Funds aren't "real" stocks. You cannot really sell SPY. There is a bucket of shares owned by SPY. Those contain shares of the index' companies. There's an "owned by clients" bucket and there's a "share liquidity reserve" bucket (with shares of companies in the fund). There's also a (small) liquidity "bucket of cash". And of course, that company can, subject only to it…

Sounds like it could be a self fulfilling prophecy once people start to believe it.

How is it different from any other crash?

Or, for that matter, a bank run?

Re: Why Index Funds Are Like Subprime CDOs

#233

Post by rubyfan »

ptero wrote: post #140
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…

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…

I may have read it wrong (or have a misunderstanding of how it all works) but I also took away that since passive investment is allocated evenly across the market that investors are not properly pricing risk. I take that to mean, if all investors are diligent then the allocation of capital shouldn’t be equal. Since there is so much capital now in passive it sort of distorts the market for investment dollars (of which public companies are consumers). It’s as though instead of having subprime homebuyers with easy access to capital we now have subprime companies with easy access to capital. Again my understanding of how this all works may be flawed but this is how I interpreted it.

Re: Why Index Funds Are Like Subprime CDOs

#234

Post by blacksqr »

ptero wrote: post #140
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…

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…

Burry's point is not that a lot of indexed stocks are relatively illiquid and thus index funds would have a hard time getting out of them in a serious downturn.

His point is that the index funds don't own the stocks at all; they trade derivatives like futures and CDO's that mimic the movement of the stocks in leveraged fashion, and the more people who dump their money into index funds without doing their own research, the more leveraged the funds become.

He's warning that in the next serious downturn, over-leverage may cause cascading collapse of index funds and the economy with them, like it did in the mortgage finance crisis.

Re: Why Index Funds Are Like Subprime CDOs

#235

Post by mcguire »

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…

Not sure I buy the argument, but that's an excellent comment.

Re: Why Index Funds Are Like Subprime CDOs

#236

Post by jldugger »

ptero wrote: post #140
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…

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…

> index funds have to sell 1% of their holdings in the exact ratios defined by the index

SP500 is a market cap weighted index. That would alleviate some of this hypothetical problem, no?

Re: Why Index Funds Are Like Subprime CDOs

#237

Post by ng12 »

blacksqr wrote: post #234
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…

Burry's point is not that a lot of indexed stocks are relatively illiquid and thus index funds would have a hard time getting out of them in a serious downturn. His point is that the index funds don't own the stocks at all; they trade derivatives like futures and CDO's that mimic the movement of the stocks in leveraged fashion, and the more people who dump their money into index funds without doing their own research…

> His point is that the index funds don't own the stocks at all

What? Where did you see that? Not only do the index ETF issuers own the stock but I believe they are legally obligated to do so.

Re: Why Index Funds Are Like Subprime CDOs

#238

Post by foobarian »

dfabulich wrote: post #184
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…

That doesn't answer markbnj's question. You elaborate why the passive market is in peril (because in the event of a sell-off, the ETFs will be forced to sell a bunch of low-volume stocks, crashing them), but that's just explaining in detail that the market is in peril because not enough money is flowing to people who do a poor job of managing it. But, granting that Burry is right and you're interpreting him correctly…

Maybe we are wrong about the fact that active fund managers do a poor job? In the same way that mathematical models failed to account for the Unfortunately it's not clear how to tell which fund managers would actually be able to succeed at this.

Re: Why Index Funds Are Like Subprime CDOs

#239

Post by lutorm »

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…

But this doesn't seem to have anything to do with index funds. Wouldn't the same thing happen regardless of the way people are invested into the stock market?

Re: Why Index Funds Are Like Subprime CDOs

#240

Post by blacksqr »

ng12 wrote: post #237
blacksqr wrote: post #234

Earlier quoted context omitted.

Burry's point is not that a lot of indexed stocks are relatively illiquid and thus index funds would have a hard time getting out of them in a serious downturn. His point is that the index funds don't own the stocks at all; they trade derivatives like futures and CDO's that mimic the movement of the stocks in leveraged fashion, and the more people who dump their money into index funds without doing their own research…

> His point is that the index funds don't own the stocks at all What? Where did you see that? Not only do the index ETF issuers own the stock but I believe they are legally obligated to do so.

"Potentially making it worse will be the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day. This fundamental concept is the same one that resulted in the market meltdowns in 2008."
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