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In late 2019 Bloomberg News published an article about an interview with hedge fund manager Michael Burry. In the article, he predicted that index funds are in a bubble. So, is he right? And should you be worried about an index fund bubble? That’s exactly what we’re talking about in this blog.

For those of you that don’t know, Michael Burry is the hedge fund manager featured in the movie, The Big Short. He became famous for seeing the real estate bubble that was forming in the years leading up to the 2008 financial crisis. His fund made $700 million betting against subprime mortgages. He’s also made a killing shorting overpriced tech stocks during the 2000 dot com bubble, and he’s made a ton of money for his investors over the years.

Basically, when Michael Burry talks, people listen. So, now he’s saying that index funds might crush one day, and that like most bubbles the longer it goes, the worst the crash will be.

If you’re thinking of investing in index funds or if you’re already invested in index funds, you might be wondering what to make of his prediction.

In this article, I’ll explain Michael Burry’s index fund bubble prediction in layman’s terms, so that anyone can understand. I’ll also examine each of his points one by one and present both sides of the argument. And finally, I’ll end with my own personal thoughts on whether or not you should be worried about the index fund bubble.

Let’s start with a quick explanation of Michael Burry’s index fund bubble prediction. In his exact words, “The dirty secret of passive index funds is the distribution of daily dollar value traded among the securities within the indexes they mimic. In the Russell 2000 index, for instance, the vast majority of stocks are lower volume, lower value traded stocks, yet through indexation and passive investing, hundreds of billions of dollars are linked to stocks like this. The S&P 500 is no different. The theater keeps getting more crowded, but the exit door is the same as it always was.”

So, here’s what this means in plain English. An index is a basket of hundreds and sometimes thousands of different stocks. And an index fund is a fund that mirrors the returns of a particular index by holding the same stocks as that index. Take the S&P 500 for example, an S&P 500 index fund has to buy all the stocks in the S&P 500 index. If Apple is in the S&P 500 index, which it is, then all S&P 500 index funds have to own Apple stock also.

There are a lot of S&P 500 index funds out there, both mutual funds and ETFs, so that’s a lot of money invested in Apple stock. So, what Michael Burry is saying, is that in order to keep up with the demand from passive investors, these index funds are all piling into a limited supply of stocks, which would be the equivalent of a movie theater becoming more and more crowded while the exit door remains the same size.

So, Apple stock is very liquid and easy to buy and sell in large volumes. But stocks of smaller companies in indexes like the Russell 2000, these stocks are not as liquid and readily available to trade. And so, what Michael Burry is saying, if all the Russell 2000 index funds own these thinly traded stocks, then what’s going to happen if everyone runs for the exit door at the same time? With all these huge index funds piling into a finite number of stocks, we’re getting a crowded movie theater with the same size exit door.

The second part of his index fund bubble prediction is that passive index investing is distorting stock prices, which he says is making stocks more vulnerable to a nasty correction. In his words, “Passive investing has removed price discovery from the equity markets. This is very much like the bubble in synthetic asset-backed CDOs before the financial crisis, in that price-setting in that market was not done by fundamental security analysis, but by massive capital flows based on Nobel approved models of risk that proved to be untrue.”

Okay. That’s a lot of financial jibberish. Let’s unpack this. In a healthy market, people buy stocks because of their underlying intrinsic value. People will do a detailed analysis of companies. They’ll look at the company’s cash flows and profits, and they’ll come up with a reasonable buying price for that stock, based on what they find in their research. This is what Burry is referring to as price discovery. For example, let’s say Apple stock is trading at $300.

However, based on the company’s future prospects, is $300 too low, or is it too high, or is it just right? So, that’s what price discovery is all about. It’s about doing the research to find out what is a good price to pay for a stock. Index funds don’t do any of this, because their mandate is simply to just buy whatever stocks are in the index regardless of price. If it’s in the index, they buy it.

Compare this to active investors like Warren Buffet. He’s super selective about the stocks that he buys, and he’ll only buy the stocks at a price that he thinks is fair given the longterm prospects of the company. So, investors like Warren Buffet and this whole process of price discovery, is what keeps stock prices in line with reality. Without price discovery, then all stocks would maybe just go to the moon because nobody’s really looking at whether this company warrants that high of a price.

So, according to Michael Burry, if most of the money going into the stock market is by index fund investors, then no one is doing price discovery, and stock prices are getting totally distorted. And the market has a way of eventually correcting distortions like that. He’s comparing price distortions caused by index funds to what happened in 2008 with CDOs.

CDOs are fancy financial products, short for Collateralized Debt obligations, and these are fancy financial products that give investors exposure to subprime mortgages. And the problem there was that no one was taking the time to do price discovery on these CDOs. If they had, they would have realized that CDO prices were totally out of whack and that the subprime mortgages underlying those CDOs, were very close to default and on very shaky ground. But because no one was doing this price discovery, CDO prices got totally out of whack. Everyone bought them when they really shouldn’t be. And eventually, when the subprime borrowers started defaulting on the mortgages, the CDO prices came crashing back down to reality. And this is what triggered the domino effect that turned into the 2008 financial crisis. So now, Michael Burry is comparing the CDO bubble in 2008 to the index fund bubble.

That’s a pretty dramatic statement. So, we’ll dive deeper into whether or not this is true later in this article. He also says that the index fund bubble could be even worse because of derivatives.

Derivatives are fancy financial instruments that give investors exposure to stocks without actually buying the stocks. Derivatives create leverage, because they essentially 10X your profit or loss, whereas you’d only make 1X profit or loss if you own the stock direct. So, derivatives allow you to make leveraged bets on stocks. Essentially, magnifying profits and also magnifying losses. “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.” Again, what does this mean in plain English?

What Michael Burry is referring to, is how index funds use derivatives to help them match their benchmark index. For example, for Vanguard’s most popular index fund, VTSAX, they track a total stock market index, and this fund that specifically states on their website, “…to help stay fully invested and to reduce transaction costs, the fund may invest to a limited extent in derivatives.” Most index funds use some derivatives to stay on track with their index. So, Michael Burry is saying that any big market moves could be like 10 times worse, due to the leverage created by derivatives. So, to summarize the key points of Michael Burry’s index fund bubble theory, one, due to the growing amounts of index fund dollars going into a limited supply of stocks, a crash in the index fund bubble would be like everyone in a crowded movie theater running forward the same exit door.

Two, since index funds don’t do any price discovery on the stocks that they’re buying, this is distorting stock prices, and this is going to make them very vulnerable to a nasty correction. Three, the index funds losses could be magnified due to their use of derivatives. Everything Michael Burry says in his argument, it sounds extremely well thought out and valid. But before we take his theory at face value, let’s go through each of these points one by one. His first point about the crowded movie theater and the same size exit door, this is absolutely true. The thing is, this is true of any investment, not just index funds. For example, Tesla stock, stocks all have a pretty fixed daily trading volume and there is a limited number of Tesla stock. So, if everyone who owns Tesla stock tried to sell it at once, that would cause the stock price to crash. So, yes, all the index funds are piled into the same supply of stocks, and so his point is absolutely valid.

He’s not really saying anything new. If everyone who owns something sells it all at the same time, it’s going to crash. But here’s the thing, this crowded movie theater and same size exit door situation is only an issue, if, everyone runs for the exit door at once. Though Michael Burry is making a huge assumption that everyone would run for the exit door at once. But why would people do that? Most index fund investors buy and hold investors. The vast majority would only sell either to cash out for retirement or when they’re re-balancing their portfolios. Sure, there’s always going to be panic selling, as well as some day traders selling to do short term stuff. But it’s hard to imagine everyone in the movie theater running for the exit door at once. There might be a lot of people running for the exit door, but not everyone.

Plus any price drops caused by panic selling would be temporary, because a lot of the people who run for the exit door, will eventually want to get back into the theater. Now let’s talk about the second part of his argument where he’s saying that there is no longer any price discovery and that is distorting the stock prices. So, Michael Burry is absolutely right about index funds eliminating price discovery. Index funds don’t do price discovery, and they just buy whatever stocks are in the index regardless of whether the price makes sense or not. So, the rise of passive investing via index funds, means that fewer and fewer investors in the market are doing price discovery. However, I disagree that index funds are totally distorting everything. While it’s true that fewer investors are doing price discovery due to the rise of passive investing, there’s always going to be stock pickers like Warren Buffet looking for deals.

If prices get really distorted, some smart active investor like Warren Buffet is going to notice, and they’re going to make a profit on that distortion until eventually, the price goes back to a more reasonable level. As a very exaggerated example, imagine if Apple was so distorted due to index funds buying up the stock, and Apple stock went to like $5,000 a share. Again, just an exaggerated example, now if Apple stocks stayed at $5,000 a share, that’s definitely a bubble and we would all be worried. However, I guarantee you, people would notice and they would short the stock, in other words, sell it until the price came back down to earth. So, my take on Michael Burry’s argument is that, yes, index funds are causing distortions in stock prices. However, those distortions are always temporary, because there will always be smart active investors exploiting any obvious dislocations in price.

Now let’s talk about the last point of Michael Burry’s index fund bubble theory, derivatives. Now, derivatives are a double-edged sword, because they can magnify profits but they can also magnify losses. And as we all know, derivatives were the cause of a lot of the notorious market crashes in history, like the 2008 financial crisis. And you might remember the implosion of Long-Term Capital Management, which was a hedge fund that blew up in 1998, and they had to be bailed out in order to prevent a catastrophe. Basically, in the financial world, derivatives are like weapons of mass destruction. So, when I heard Michael Burry mention derivatives and index funds, I got a little worried and decided to do some research. Because if index funds are using derivatives the way those huge wall street banks and hedge funds were doing, then we should all be very, very, very worried.

I did a deep dive into the prospectus of one of the index funds that I own, FSKAX, which is the Fidelity Total Market Index Fund. In the schedule of investments, as of February 28, 2019, you can see the entire list of stocks that the fund holds, as well as the dollar amounts and actual stock holdings. So, you can see here that their actual stock holdings totaled $59.5 billion. You can also see that FSKAX is holding $1.7 billion in money market funds. So, that brings FSKAX’s total investments to 61.2 billion. Then, right below that, you can also see the funds derivative positions. As you can see, they hold some futures contracts, which are one type of derivative. And the total notional amount of these futures contracts is roughly $141 million. That’s just a fraction of the funds’ total assets. They even state it right here.

The notional amount of futures purchased as a percentage of net assets is 0.2%. 0.2% is peanuts. That’s how much some mutual funds charge in annual management fees alone. So, my conclusion is that derivatives are a very small portion of an index fund’s overall assets, so they’re really not something to worry about. Derivatives are actually more of a problem for leveraged index funds and synthetic index funds, which are specific types of funds that use derivatives to get exposure to stocks without actually owning those stocks. For example, the UltraPro S&P 500 or UPRO, is an ETF that uses derivatives to give you three times the returns of the S&P 500. The prospectus specifically states. “The fund invests in derivatives as a substitute for investing directly in stocks. And that investing in derivatives may be considered aggressive and may expose the Fund to greater risks, and may result in larger losses or smaller gains, than investing directly in the reference assets underlying those services.”

Bottom line, unless you’re an experienced trader, stay away from these leveraged funds that use a lot of derivatives and you will be just fine. The reality is, the future is uncertain and Michael Burry could very well be right. But there’s plenty of experts and arguments that support the other side as well. Warren Buffet is a master investor who’s been around much longer than Michael Burry has. And he is a believer in index funds. To quote Warren Buffet, “A low-cost index fund is the most sensible equity investment for the great majority of investors.” He also is putting his money where his mouth is. Because in his 2013 letter to shareholders, he shared that he has instructions in his own will to invest 90% of his wife’s money into a very low-cost S&P 500 index fund. So, apparently Warren Buffet isn’t worried about an index fund bubble, and if he’s not worried then I don’t think you should be either.

Now, even if you are worried about an index fund bubble, Warren Buffet has some advice for you. So, in his letter to shareholders, he says, “The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance. The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs.” So, accumulating shares over a long period of time is a strategy known as, dollar-cost averaging, and it’s the safest way to invest in index funds.

In this article, I go into detail about how to do dollar-cost averaging. So, you should definitely check it out. Here’s something else I want you to keep in mind, Michael Burry has been right many times in the past, but that doesn’t guarantee that he’ll be right about everything going forwards.

No one has a crystal ball and no one really knows what the future holds. So, I think you need to be careful about making sweeping decisions, such as refusing to invest at all in index funds, just because of what one expert is saying. History has shown that investing in the stock market via low-cost index funds has been a very successful profitable strategy. Lots of millionaires have happened because of low-cost index fund investing, and Michael Burry is basically saying that everything as we know it, the stock market as we know it, is going to change drastically. So, that’s a very dramatic prediction to make. So, I’m going to really question it before I just believe it. If you don’t have any factual basis of your own, it’s pretty easy to get spooked by headlines like this. It also doesn’t help that the news loves to sensationalize stories like this, because stories about pending market crushes and bubble predictions and disaster and financial catastrophe, these kinds of stories always get tons of clicks. And the news is out there to get clicks, to get eyeballs on their stories.

So, bottom line, there will always be something scary in the news, and it could make you second guess your entire investing strategy if you let it. But the more educated you are, the more you can filter all the news and the noise out and just stick with your investing plan. It’s important to educate yourself so that you can base your financial decisions on facts, not emotions.

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YouTuber, Money Expert, Educator, Traveler, Rebel, and #1 Book Nerd. My mission is to empower you with the mindset and financial know-how to create a life of TOTAL freedom.


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YouTuber, Money Expert, Educator, Traveler, Rebel, and #1 Book Nerd. My mission is to empower you with the mindset and financial know-how to get more of what you want out of life.