Why Index Funds Are Like Subprime CDOs • Hacker News Board

Re: Why Index Funds Are Like Subprime CDOs

#281

Post by dehrmann » Thu, Sep 05, 2019, 6:29 AM UTC

Michael Burry made his money on the tech and housing bubble busting. The main difference here is that in both, retail investors got the idea that they could get rich quick and bought into asset bubbles. But index funds aren't an asset bubble--people buy them instead of stocks, then the fund buys the stocks on investors' behalves. In aggregate, capital inflows look mostly the same.

His points about liquidity of small cap stocks and price discovery are interesting, though; it's just fundamentally different from what he's been good at spotting. The trigger also isn't as obvious as home prices declining 50%. The S&P 500 dropped 15% in December 2018, and this wasn't an issue.

Re: Why Index Funds Are Like Subprime CDOs

#282

Post by fallingfrog » Thu, Sep 05, 2019, 7:37 AM UTC

I eagerly await the bursting of this new bubble of hubris and stupidity as capitalism continues its self-cannibalistic path to destruction. Believe me when I say that there’s nothing I enjoy more than watching rich people lose all their money.

Re: Why Index Funds Are Like Subprime CDOs

#283

Post by pas » Thu, Sep 05, 2019, 7:57 AM UTC

charwalker wrote: post #179

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…

There is an interesting idea when index funds are taken to an extreme in that if no one is manually playing the market or managing investments then everything is invested in at the same or similar rates. Index funds need active traders to trade and set pricing within the market. My analogy would be if we are all buying tickets to the big game and sit in the stands until it's over, there's no one to yell and shout and…

But the wisdom of the crowd, the price signal, only works if professionals look at the stocks. And it requires only a few [hundred] of them (with big enough leverage, so their position shows up).

For the top 500 stocks there are enough people (and algos) going over every bit released by the corresponding companies.

Re: Why Index Funds Are Like Subprime CDOs

#284

Post by daemin » Thu, Sep 05, 2019, 10:22 AM UTC

Torn wrote: post #256

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 This is misleading, I think. Depends on the fund. Some seek to match the benchmark through a certain exposure to derivatives and synthetic things. Others hold the stocks in proportion. The vanguard funds I'm invested in don't have much synthetics - they own the stocks

As far as I'm aware they also have flexibility in when they sell or buy stocks, so they don't need to buy them the second you move money in etc.

Re: Why Index Funds Are Like Subprime CDOs

#285

Post by lagilogi » Thu, Sep 05, 2019, 10:33 AM UTC

yourapostasy wrote: post #146

jpmattia wrote: post #51

Earlier quoted context omitted.

Most folks here are focusing on Burry's comments regarding price-discovery. However there is another huge point: Liquidity risk. To understand his point, you have to know the gory details of how an ETF operates. First: When you buy a ETF share for the S&P 500 (iShares, Vanguard etc), the share is not backed by all 500 S&P components. Virtually all the large-number component ETFs are using a sampling of shares to matc…

> ..."you can't lose money in the stock market long-term"... Put in a large enough number of years in that "long-term", and it is true. But many people don't have the time horizons of institutional investors, so what is "long-term" to an re-insurance company might be "lifetime" to an individual investor. Now, if we could only resolve the principal-agent problem for institutional investors to the benefit of individual…

There are a number of stock markets that went down significantly and never recovered. I think Japan was one example.

Re: Why Index Funds Are Like Subprime CDOs

#286

Post by fallingfrog » Thu, Sep 05, 2019, 11:33 AM UTC

fallingfrog wrote: post #282

I eagerly await the bursting of this new bubble of hubris and stupidity as capitalism continues its self-cannibalistic path to destruction. Believe me when I say that there’s nothing I enjoy more than watching rich people lose all their money.

Oh I should probably not post in the wee hours of the morning

Re: Why Index Funds Are Like Subprime CDOs

#287

Post by apexalpha » Thu, Sep 05, 2019, 12:11 PM UTC

jpmattia wrote: post #111

wcunning wrote: post #77

Earlier quoted context omitted.

This feels like the most concise explanation of the underlying mechanics that I was intuiting from the article. Now the question becomes: how do I hedge out of this risk without going full day-trader?

> 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…

In what capacity did you do this? A trading firm?

Re: Why Index Funds Are Like Subprime CDOs

#288

Post by heyflyguy » Thu, Sep 05, 2019, 12:25 PM UTC

When I read these articles, I always begin to question if I am a passive or active investor. I strongly believe in keeping a diverse portfolio, mainly because I am keenly aware of my own ignorance as it relates to understanding complex stock moves and changes.

Warren Buffet encourages novices to invest in index funds, since they outperform individual picks.

Understanding asset value and free cash flow changed my life and my entire investment thesis about 10 years ago. Developing my own version of "Rich Dad, Poor Dad" I now seek to buy or build assets that make a return to me. Some return cash, others good feelings or emotions.

I find that my financial situation is far more stable this way, I am semi-insulated from group-think (markets); and I look at re-applying net proceeds on a regular basis. That is a fun activity, using cash from one investment to build a new investment that will hopefully also return cash and build an asset.

It takes precious little to do this, and the most fun of all has been teaching my daughter how to make money. At 8 she looks at apartments, hot dog stands, and many small businesses as an opportunity to "make cash". We now have interesting conversations in the car about what it would take to start "X" business.

Re: Why Index Funds Are Like Subprime CDOs

#289

Post by bgilroy26 » Thu, Sep 05, 2019, 12:47 PM UTC

edmundsauto wrote: post #163

bgilroy26 wrote: post #126

Earlier quoted context omitted.

I think the big moment, if it comes, is when you can envision the difference between how people value the asset in question and how that asset is actually valued. In the case of the housing market, most people in 2003 pictured suburbification and the generation of baby boomer retirement communities as inevitable economic engines. But in the same era, Arrested Development the TV show was skewering over-production of p…

Is your suggestion that overproduction of housing is what caused the bubble?

It was a lagging effect of the bubble. The 'build anything, people will buy it' approach resulted from people's excessive faith in housing and the widespread idea that prices could only appreciate, which I take to be the true cause of the housing bubble.

Re: Why Index Funds Are Like Subprime CDOs

#290

Post by nickles » Thu, Sep 05, 2019, 1:17 PM UTC

darawk wrote: post #185

nickles wrote: post #131

Earlier quoted context omitted.

> A second concern is the collateral effects of a bubble bursting: the inflated assets are tied into many other assets/instruments, and untangling the mess caused by a rapid bubble burst may cause a financial crisis. This is really the main concern. The indexes these funds are based on include names that don't have any liquidity. This means 1) the price of the security is less likely to reflect its intrinsic value; 2…

I don't really see the problem here. Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy. ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV commensurate with the liquidity risk they're assuming.

> Any reasonably competent quant can calculate a liquidity premium and factor it into their ETF arbitrage strategy

Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade.

When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial.

> ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV

Many closed ended funds do in fact trade at a discount to their NAV.