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A critique of the claim that passive investing is a bubble

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Re: A critique of the claim that passive investing is a bubble

#31

Post by gzu »

frgtpsswrdlame wrote: post #18

Does this guy not see the contradictions in his own argument? He simultaneously believes that active funds are doing a fine job of price discovery AND that managers at active funds who deviate too much from their (passive) benchmark are likely to be fired. Also he jumps around Burry's arguments by focusing on liquidity and in AAPL and FB. Burry's whole point is about less liquid components at the bottom of indices wh…

I believe this is related to the rise in buybacks where price fundamentals no longer matter, only goal for companies is to get the largest market cap as possible ignoring long term risks in order to attract an increasing flow of passive money being poured into the markets.

Re: A critique of the claim that passive investing is a bubble

#32

Post by mrfredward »

awillen wrote: post #7

As I read it, the word bubble in the Burry interview was really just used for clickbait purposes - his argument wasn't so much that index funds are overvalued, it was that there's opportunity in small caps because they're underrepresented in index funds, and everyone else is investing in index funds.

The Bloomberg article mixed Bury's words and the author's words quite a bit, and I'm beginning to wonder if the whole reason we're having this discussion is because some important nuance was lost.

It's hard to see why Mom and Pop buy and hold index investors should care about the liquidity risk Bury talks about...market cap weighted funds will be fine in the long run because the ratio of each underlying stock to a fund share will be constant through the temporary price fluctuations...so no money is lost if the price crashes and then comes back to the same sport shortly after.

Perhaps there are other market participants who are leveraged and would find themselves insolvent if indexes cause a liquidity problem? I just don't see how the fund investors themselves would be hurt if underlying stock prices went out of whack for an afternoon.

Re: A critique of the claim that passive investing is a bubble

#33

Post by cryptica »

I think this idea of an index fund bubble makes a lot of sense in terms of metrics like economic efficiency. Investors are paying more money to buy stocks which provide less economic value per dollar invested... but low productivity and economic inefficiency doesn't mean low profits. Indexed companies often have monopolies in their fields and can derive profits from rent seeking activities and lobbying for beneficial regulations so they don't need to be efficient in order to derive profits.

Re: A critique of the claim that passive investing is a bubble

#34

Post by JumpCrisscross »

asdkfjasl wrote: post #29
josu wrote: post #19

Earlier quoted context omitted.

>You'd basically need the entire market to become illiquid. Yes. It has happened before.

OK, but in that case is there a distinction between index funds and actively managed funds? Is this a risk that index funds are uniquely exposed to? Also, another thing to keep in mind is that this only affects people who are trying to sell at the bottom. Buy and hold investors care little for liquidity issues during a crash.

> in that case is there a distinction between index funds and actively managed funds?

Yes. Active managers can choose what to sell based on prevailing market conditions. Index funds must sell across the board. That could involve getting hosed on names in a short-term squeeze.

> this only affects people who are trying to sell at the bottom

There are lots of index funds. For a broad-market fund, you're probably right--a patient investor can ride out the bloodshed. For leveraged or specialized funds, on the other hand, a rout could permanently impair the portfolio.

Equity market collapses, furthermore, have a habit of transmitting into the real economy. A sustained downturn could impair funding conditions, which in turn could affect the fundamental characteristics of a portfolio.

Re: A critique of the claim that passive investing is a bubble

#36

Post by gzu »

wbl wrote: post #15
derivagral wrote: post #12

The dig at "Active Management" feels like it detracts from the article, but I guess they're playing a bit to the audience. What I found a little more concerning is their glossing over of the liquidity risks. If everyone wants to sell an index, then at some point that index needs to liquidate shares (proportionally). Those shares won't have uniform demand, which is going to cause both price fluctuations (drops) which…

No they don't. Let's suppose we have A Corp and B Corp both 50٪ of the total market and A Corps price and hence market cap falls by 50٪, making it 33٪ of the total market. The holdings of a fund haven't changed but the exposure still equals the market.

He is saying when people exit and index sells all their stocks equal to current market cap rankings that the opposite side of trade buy demand for all those won’t be equal. Bad stocks may go down further than solid companies. A shift in value vs growth preferences caused by the downturn itself could be the cause of that. The entire index and all holdings would then HAVE to readjust for this discrepancy and lead to more forced selling of bad stocks and buying of solid companies creating more liquidity crisis.

Re: A critique of the claim that passive investing is a bubble

#37

Post by FabHK »

talolard wrote: post #2

I think this article really misses the point that Burry was making, which is that if the indexs see a sell off they won't find the liquidity in the market to cash out their positions and will drive the market down. This article seems to focus on all of the upsides of indexing, which are all true. However, those upsides don't negate the risk that is being pointed to.

> if the indexs see a sell off they won't find the liquidity in the market to cash out their positions and will drive the market down

When investors sell that amount, it doesn't matter whether they hold the underlying assets directly, or via index funds or ETFs, or via actively managed funds. The market will go down. So, which part of the problem is uniquely due to index funds?

Burry hasn't made that point very clear.

There might be issues with (liquid) index funds that give exposure to inherently less liquid assets, such as bonds or real estate. There might also be issues with index funds that do not hold the assets themselves, but replicate the exposure synthetically by entering a swap with a third party, giving rise to tracking error, counterparts credit risk, etc.

However, as I said, Burry hasn't enunciated these concerns very cogently (at least in the extracts quoted by Bloomberg). This article here does nothing to address those concerns.

Re: A critique of the claim that passive investing is a bubble

#38

Post by gzu »

kolbe wrote: post #26

Reminder: "index funds" are also managed by humans. For example, all stocks in the S&P 500 are chosen by Standard & Poors. Stocks are added and removed as they see fit based on various criteria such as profitability, float, market cap, &c. The only things that I can see that truly differentiate S&P from other active managers are that they (a) have very little skin in the game. (b) they get to make decisions about wha…

The S&P 500 is basically a group of largest established 500 market cap stocks traded in the US proportioned to market cap. There is no active management determining price and weights here.

Re: A critique of the claim that passive investing is a bubble

#39

Post by bwanab »

sambe wrote: post #22
talolard wrote: post #2

I think this article really misses the point that Burry was making, which is that if the indexs see a sell off they won't find the liquidity in the market to cash out their positions and will drive the market down. This article seems to focus on all of the upsides of indexing, which are all true. However, those upsides don't negate the risk that is being pointed to.

These sections seem to address the point to me: * "The tail is not wagging the dog" - index funds are a relatively small percentage of total share ownership. * "Benchmark huggers have always been around" - owning ~the index was not started with index funds. * "Active funds literally own the market" - the sum of portfolios of non-index funds ends up having the same profile. * "Price discovery is a cop-out" - relativel…

Right, but consider that the sub-prime mortgage market was a tiny portion of the overall mortgage market in 2007.

Derivatives written against sub-prime holdings tipped the balance when the fan was hit. There are tons of derivatives written against the indices, thus indirectly against those funds.

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