There was a recent article published by Michael Burry, one of the main characters of the big short. He was the guy who made a ton of money by betting against CDOs before the subprime mortgage crisis. Needless to say when it comes to talking bubbles, his voice is always heard.
In this article he explained that with this ever growing trend of dumping money into passive index funds he see’s 2 problems…
Price Discovery
“Central banks and Basel III have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in interest rates anymore. And now passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies — these do not require the security-level analysis that is required for true price discovery.
Liquidity
“In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those — 456 stocks — traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different — the index contains the world’s largest stocks, but still, 266 stocks — over half — traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”
Now I’m not a big fan of forecasting bubbles. There’s more than enough data out there showing even the best stock pickers have barely a better than 50 to 50 chance at forecasting correctly. And that those that get one major prediction right, likely aren’t able to get the next one right. But let’s assume that he is right.
It’s been no secret but I think there are better options than passive investing. I don’t think passive investing is bad by any stretch of the imagination and I actually advocate it for some people like my sister, but it’s certainly not the end-all be-all that the Bogle head crowd cracks it up to be.
The thought of a passive investing bubble does seem perfectly plausible. Burry isn’t the first person to predict it. And when you think about it with so much passive investing going on everyone is just dumping their money into whatever else the crowd is dumping their money into. For no fundamental reason (the ‘price discovery’ problem). So if the passive investing Bible does crash that could mean opportunities for those investing in other factors.
Market Cap Weighting Is Just Another Factor (method of weighting stocks)
Remember index funds are market cap weighted, essentially just another factor. There are other factors that exist such as value, momentum, low volatility dividend, and a few others. So if the stocks that are being heavily returned by a dump in the passive funds, stop returning there would be other opportunities for other factors to out perform market cap weighting. In my opinion, I think value would do quite well as it radically under port performed for the last decade or so. Some people collect the value pain train. Basically any method of weighting besides market cap, which leans towards the largest companies (which keep getting larger with blind index fund investing) could do better.
The Collapse of Market Cap Weighting In Japan Nikkei 225
Japans market provides a unique look at bubbles in market cape weighting. It peaked in the late 80s and has been in downward trend for um the last 30 years. Yet there is much research that shows value factor investing has done quite well there.
Here’s the research on that. The image above belongs to the first link.
https://archives.ust.hk/dspace/bitstream/9999/41727/1/2013-06-28.pdf
https://tandfonline.com/doi/full/10.2469/faj.v72.n5.6
Quite frankly I would like to see a passive investing bubble crash, but I don’t think we’re near that level. I would expect to see significantly higher CAPE ratio of the SP500 then we have had preceding other ‘bubbles’ hence indicating money is truly being thrown into the market with little regard for value of earnings.
Admittedly it would be nice to see some factors outperform although I don’t have much allocated to factor investing. I am a trend following and global momentum investor. As always stay the course is the bottom line, even a passive investing does crash it will rebound as it always has. If you are passive investor