The Index Fund/ETF Bubble - How Bad Is It Really?

a while ago a friend of mine sent me a link to an interview between Michael burry and Bloomberg Michael burry is a famous hedge fund manager who made quite a bit of money shorting the real estate market right before the 2008 financial crisis he's even depicted in the big short by Christian Bale and in this interview he came out with a new staggering bet that index funds were in a bubble index funds are a popular passive investment used by many beginner investors to gain exposure to the markets the sp500 ETF and index fund has got to be one of the most popular investment vehicles ever and yet in this interview Michael burry argued that because these funds are seeing so many inflows from active and passive investors alike it's obscuring price discovery in other words people are simply buying the stocks that underlie these indices because they're included in the index and not because of fundamental research therefore the price of these stocks aren't reflecting their intrinsic value Michael burry even went as far as to say that there are parallels between index funds and CDOs collateralized debt obligations the investment that helped fuel the 2008 meltdown so my friends question to me was is this plausible could index funds and ETFs truly be in a bubble and my answer to that is maybe but this isn't actually a new argument this is something that's been discussed quite a bit within the investment community and there are plenty of other investors who have come out with this claim but I'm always skeptical when I hear it because it essentially argues that passive investment is causing problems and that's a little too convenient for active investors to argue because obviously they want to prove that passive investing doesn't work so that you'll go with them and don't get me wrong I'm an active investor if it turns out that index funds in passive and investing doesn't work that's great for me but I've never had gripes against passive investing I think anything that it helps empower people to invest is great and index funds have done wonders on that front if it turns out that there's a problem with index funds of course we want to explore that but I am always skeptical when I hear active investors touting that we're in such a bad situation that there's a bubble not to mention that there's a lot of misconceptions with the argument here firstly index funds don't own half the US stock market there plenty of news headlines that argue that like this one from CNBC which reads passive investing automatically tracking index now controls nearly half the US stock market but that's not true yes it's true that pass the funds I've seen massive inflows and active funds have seen outflows in the US and for the first time ever it does seem like passive funds have more assets under management than active funds in the United States but they don't own half the stock market funds only represent a segment of the stock market and in terms of how much they own of the whole stock market it's a lot smaller in fact according to a 2018 paper by the Bank of International Settlements passive index funds only hold roughly 15% of the US stock market and that's not to mention that the United States has a higher than average utilization of passive funds in Canada for example according to Morningstar active funds have seen three times higher inflows than passive funds so it goes to show that this problem is a lot smaller than it's been painted secondly the term index fund has been broadly used to reference both index mutual funds and ETFs and not all ETFs are passive you know the Bank of International Settlements does argue that only roughly 2% of ETFs don't track an index of some sort so 2% of ETFs could be are treated as active but it does show that there is a small segment at that market that isn't truly passive which is kind of being tossed into there thirdly and this is something that a lot of people brought up CEOs are a lot different from index funds they are similar in the regard that you know CEOs hold a portfolio of mortgages while index funds hold a portfolio of stocks but CEOs also did this kind of restructuring of cash flows and obscured the risk profile of the underlying mortgages they're being filled with worse and worse credit mortgages but the CDO product was being labeled as triple-a safety whereas ETFs don't do that same restructuring so there is quite a fundamental difference between the two but in Michael burries defense I don't know if he was necessarily arguing about the structure of the two but rather what's happening with them with CEOs what happened was there was a lot of investor demand for this product and that drove demand for the underlying mortgages rather than housing purchases in other words there was kind of this vacuum being created where investors wanted more mortgages than existed and that kind of led to banks be more aggressive in their lending practices leading to riskier and riskier mortgages filling these CDOs and you could argue that etf's could see a similar thing with the law demand for the etf product you could see underlying demand for the stocks increase so I do see his point there and also strangely enough he actually referenced synthetic CDOs not the true CDO that most people are familiar with synthetic CDOs are like CEOs but they don't hold any mortgages they only hold derivatives and I'll touch more on that later and why might actually be a valid concern with ETFs but for the most part the main point being that CEOs are quite a bit different from index funds but finally a last point of clarification here while index funds do represent a sizable 15 percent of the US stock market they only represent roughly 5 percent of daily trading volumes meaning they probably have a muted impact on price discovery there's actually great video by ben felix from common sense investing who we've worked with before on this channel about the index fund bubble and how it doesn't matter how much assets you have under management but how much you're trading right it's the buys and sells of a stock that change its price not the assets being held by passive and active funds and because these passive funds aren't trading as much as active funds only 5 percent of daily volumes they might not necessarily have as much of an impact as we think now the reason why the volume is so low for passive funds is that a it's just part of the strategy because they're buying hold funds but the second reason is that at least on the ETF side of things a lot of ETF trades don't directly impact the underlying securities because a lot of ETF trades are done between ETF holders they aren't trading the underlying securities and the underlying securities are typically only traded when the authorized participant the person who's managing the the ETF when they redeem or create more units so when they destroy or make new units of this fund and that's rarely done on a daily basis that's only typically done when there's excess demand or not enough demand for this ETF so because you have this buy and hold strategy being done by these index funds and because on the ETF side of things you don't actually have a lot of trading of the underlying directly then you might necessarily have a price discovery problem so even before jumping into the problem itself and just by clearing up the facts around it you can see that the problem is likely a lot smaller than it's been painted to be and even if passive investing did represent more of the market John Bogle who effectively created the first index fund argued in the past that we would still have sufficient price discovery even if passive investing represented ninety percent of the market so there's not necessarily a bubble being created by index funds at this time though I do hesitate to say there's not a problem don't get me wrong I don't want to fear monger here and I think it's kind of silly to make these tall claims about index funds and the next bubble because Black Swan events are very hard to discover beforehand but at the same time there are a lot of unknowns and uncertainties around these issues and when I look at these data points a lot of questions do come to mind firstly while only 5% of daily trading volumes are directly tied to index funds I don't know if that's representative of the impact indices have on all trading in the market we have things like closet indexers which are mutual funds and other asset managers who mimic a market while claiming to be active they effectively hold a lot of what the index holds because they don't want to deviate too much and risk being way off from their benchmark and the problem with that is that even though they're being classified as active traders they are effectively being passive and while the practice of closet indexing is certainly discouraged within the investment community it does still happen in fact there's a 2016 paper done by Kremers at El Kremers yeah al there's a 2016 report in which they argue that within countries the share of closet indexing is roughly equal to the explicit indexing practices so by rough extrapolation you could argue that with 5% of the trading being actual indexing another 5% might be closet indexing so that impact is a bit bigger there and even outside of closet end mixers there are a lot of ways in which indices might affect active trades for example there's a well known phenomenon known as the SP effect or by companies are included in the SP 500 automatically see their price increase it might not be a permanent price increase but does show that prices might increase when included in an index without any fundamental change to that company because passive investors buy it up when it's included and secondly that stock becomes more visible to active traders even the argument we made about etf's not affecting the underlying prices of its assets might not necessarily pan out because it's something known as arbitrage this is something that was highlighted in the BIS report as an area that needs further research but effectively what it means is that there are active trades that might be affecting the underlying assets of an ETF what happens in theory is that when an ETF price inflates more than it should be more than what the value of its holdings are then the authorised participant will create more units trade the underlying to adjust and that will be recorded as a passive trade but what might actually happen before the authorised participant does that is that active traders might buy the underlying securities and do an arbitrage trade effectively selling the ETF unit and buying the underlying assets and that will close that gap but in the process the active trades are inflating the underlying securities now the second reason why I hesitate to say there isn't a problem is what Michael burry says about liquidity these ETFs and these index funds are causing a lot more demand for stocks lease stocks can individually handle for example he goes through an index and he finds a lot of companies that are trading less than a million dollars a day with hundreds of billions of dollars tied to them he even goes on to tie derivatives into the equation to show that there might be a problem if we see a sell-off in the area a quote from the interview is 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 and I think this is what Michael burry was talking about when he mentioned synthetic CDOs synthetic CEOs didn't hold any mortgages but they still had a huge impact on mortgage prices because people were effectively betting on the side about the price of those mortgages and there are some ETFs that have a similar structure for example things like leveraged ETFs if you ever see an SP 500 two times levered ETF that is probably using derivatives now according to Vanguard synthetic ETFs so ETS that use derivatives only make up 2.9 percent of ETF assets in North America but in Europe where they're a lot more popular they make up 35% of ETF assets and the problem there the tricky thing is that those European ETFs can mimic United States stocks so even though they're in Europe they could still be influencing the underlying prices of the assets if we saw a downturn where people were rushing out of stocks and ETFs now only would we have a situation where authorised participants are redeeming units and applying huge selling pressure to the underlying stocks but we would also have these derivatives trying to unwind and deliver on the assets they promised and that would just apply even more sell pressure on these lightly traded stocks so in my eyes that's the real concern here it's not that there's too much demand for index funds in that passive investing is ruining stock markets but it's that we don't fully understand what will happen when we have authorized participants redeeming units when we have these derivatives unwinding if there's a downturn where stocks and ATF's are being sold but admittedly it's very hard to quantify that risk and it's by no means a basis for claiming that there's a bubble coming or that we're currently in a bubble and at the end of the day a lot of investors make claims without bubbles that never materialized Steve Eisman is another investor who shorted the housing market who's also pictured alongside Michael burry in the big short but he's been calling for people to short Canadian banks since 2013 and that call has largely not led to anything it's not to say he's not a smart man in that you know there's some validity to the concerns he raises but it goes to show that bubbles are very high to predict it's almost as if economics and finance are very complicated fields and nothing is black and white who'da thought so while there may be reasons for concern within the index fund industry I'm very skeptical of the tall claims that were currently in an index fund bubble but with all that being said Michael burry is a very intelligent man certainly more intelligent than myself you know he's a doctor I'm a youtuber I work in investments but you get my point so while I am skeptical of the claim I will be keeping my eyes open to see what happens with the index fund industry thank you very much for watching today's video if you liked it please let me know like the video share all that good stuff if you have any topics you want me to cover in a future rant video or a lesson video like I do leave a comment down below and if you have any thoughts on the topic at hand I'd love to hear your feedback thanks for joining me today and as always be safe up there

Channel: The Plain Bagel

Views: 401,859

Rating: 4.9244819 out of 5

Keywords: The Plain Bagel, Index Funds, Bubble, Index Fund Bubble, Michael Burry

Id: 1s7ULX45fjw

Length: 13min 15sec (795 seconds)

Published: Fri Nov 15 2019