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Why Index Funds Are Like Subprime CDOs

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Re: Why Index Funds Are Like Subprime CDOs

#131

Post by nickles »

motbob wrote: post #108

So there are two concerns here. One concern is a problem with a certain asset being inflated, in this case S&P 500 stocks, and the money you might lose if you hold those assets and their value goes down to normal. 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…

> 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) attempting to unwind any position may cause substantial issues.

Let's expand on 2) by examining an ETF (say SPY). This ETF is a fund that is meant to track the value of the S&P 500 (a weighted basket of securities). The value doesn't drift too far from the value of the underlying securities thanks to the creation and redemption mechanism, which allows for arbitraging the ETF against the underlying basket of securities. If constituents are illiquid, it becomes more difficult to perform this arbitrage, and the NAV of the ETF diverges from the market cap of the ETF.

This is a bigger issue with instruments like HYG or JNK, which track high yield (AKA junk) bonds. Many of these bonds are highly illiquid, and trading them directly could significantly impact their prices. Instead, many funds trade the ETFs, relying on the basket of high yield bonds as a proxy. These ETFs may then have greater liquidity than the entire underlying basket. This situation clearly undermines price discovery of the underlyings, as the implication is that investors don't particularly care about which names they have exposure to within the basket.

These concerns aren't merely theoretical. In August, 2015 there was a flash crash in which the values of a number of ETFs significantly diverged from their NAVs.

Re: Why Index Funds Are Like Subprime CDOs

#132

Post by beat »

strstr wrote: post #123
beat wrote: post #89

Earlier quoted context omitted.

The more interesting question is, if there is an index fund crash, will the actively managed funds benefit from it, or crash right alongside the index funds? How much are actively managed funds contaminated by stocks that are in index funds? (That probably depends on the type; a small-cap or emerging markets managed fund will probably be mostly clean of the indexed stocks, but a managed large-cap is probably full of…

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?

Re: Why Index Funds Are Like Subprime CDOs

#133

Post by onaraft »

ChuckMcM wrote: post #129
bob33212 wrote: post #116

Earlier quoted context omitted.

A hedge from this theory would be to buy stocks just outside the SP 500? Something like TSLA. That would be a crazy situation, where the SP 500 is crashing and the rest of the market it taking off

A simpler option is to buy options on the index. You can butterfly the index with calls and puts around your minimum return / maximum loss tolerance.

Which requires a margin trading account, a non-trivial amount of trading experience, a non-trivial amount of capital, constant management, and is highly leveraged. The risk profile is totally different.

Re: Why Index Funds Are Like Subprime CDOs

#135

Post by dlp211 »

whatok wrote: post #87
pwthornton wrote: post #46

Isn't a big part of the issue with actively managed funds the fees, which usually wipe out any gains above index funds. Wouldn't the market correction be to close the delta in fees between active and passively managed funds to encourage more people to go the active route? A lot of the grousing about passively managed funds come from people who are running actively managed funds that charge huge fees to under perform…

You can't run most active management strategies on anything approaching the average passive fee structure. Additionally, you run into problems with scale. An S&P 500 tracking fund scales extremely well and could add several billion of AUM without having to incur additional expenses. A long only equity fund would probably not be able to do the same without hiring more people, building more infrastructure, etc.

But there is no reason that they need to be so high. Vanguard Primecap is like .45. Unfortunately it's closed to new investors.

Re: Why Index Funds Are Like Subprime CDOs

#136

Post by nabdab »

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…

It’s all fine to say that active funds can’t outperform index funds... but if it’s a bubble and it crashes, then people in active funds will be having a field day while the people who bet it all on index funds will be left behind like the people who leveraged their 3 homes to buy 5 more during the “real estate always and consistently goes up” days of pre 2008.

The problem with bubbles is that everyone’s a winner and every indicator is confirming the everlasting increase.. on the way up.

Re: Why Index Funds Are Like Subprime CDOs

#137

Post by southphillyman »

Kiro wrote: post #130
southphillyman wrote: post #28

Timely article, I was just thinking about this last night...while browsing Vanguard's site looking for index funds to invest in. Everyone blindly putting their money into similar instruments and getting double digit gains nearly every year just seems like it can end catastrophically. I want to do more research on how these passive funds affect the overall market and vice versa.

Stupid question but what are you looking for when browsing Vanguard? I thought all the index funds were the same, just following the index.

They have different asset classes, different minimums, different historical returns. Etc

Re: Why Index Funds Are Like Subprime CDOs

#138

Post by sokoloff »

graeme wrote: post #96

Index funds definitely have a free rider problem. Warren Buffett lucidly pointed out that the average performance of active investors will be....the market average. You cannot, by definition, have a majority of investors beating the market. And once you add in fees, index funds produce above average performance, as they have low fees. So far so good. But, the index funds are free riding on the decisions taken by acti…

> You cannot, by definition, have a majority of investors beating the market.

You cannot have a majority of money beating the market. It is mathematically possible for a majority of investors (each relatively small) beat the overall market (albeit unlikely).

(I agree with your overall post, but not that line.)

Re: Why Index Funds Are Like Subprime CDOs

#139

Post by southphillyman »

lunchables wrote: post #47
southphillyman wrote: post #28

Timely article, I was just thinking about this last night...while browsing Vanguard's site looking for index funds to invest in. Everyone blindly putting their money into similar instruments and getting double digit gains nearly every year just seems like it can end catastrophically. I want to do more research on how these passive funds affect the overall market and vice versa.

Aren't most of those double digit gains just from the market rebounding from the 2008 recession?

Rebound to inflated values? Reminds me of the housing market in my area now. It's "rebounded" to higher than 2008 levels on the basis of speculation and gentrified neighborhoods being hot. Seems like another bubble. I need to do more research, but I'm curious what the long term viability of these index funds are as more and more people gravitate towards them

Re: Why Index Funds Are Like Subprime CDOs

#140

Post by ptero »

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: individuals easily move through doors at will; but if a crowd rushes out through the same door, injuries happen.

His premise is that many stocks that index funds invest in have low liquidity (small door): half of stocks in SP500 trades less than $150M a day. This is tiny (he quotes total market cap of indices of $150 trillion). What happens if there is a small, but synchronized outflow for any reason? If customers ask for 1% of index funds to be sold, index funds have to sell 1% of their holdings in the exact ratios defined by the index, including stocks with low trading volumes. Which is a problem, as there may be no one to sell them to, so prices of those stocks may crash and create a big panic causing additional sales of index funds bringing down bigger chunks of the market.

That is the gist of it I think.

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