The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs Reed Stevenson , Bloomberg•September 4, 2019 The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs (Bloomberg) -- For an investor whose story was featured in a best-selling book and an Oscar-winning movie, Michael Burry has kept a surprisingly low profile in recent years. But it turns out the hero of “The Big Short” has plenty to say about everything from central banks fueling distortions in credit markets to opportunities in small-cap value stocks and the “bubble” in passive investing. One of his most provocative views from a lengthy email interview with Bloomberg News on Tuesday: The recent flood of money into index funds has parallels with the pre-2008 bubble in collateralized debt obligations, the complex securities that almost destroyed the global financial system. Burry, who made a fortune betting against CDOs before the crisis, said index fund inflows are now distorting prices for stocks and bonds in much the same way that CDO purchases did for subprime mortgages more than a decade ago. The flows will reverse at some point, he said, and “it will be ugly” when they do. “Like most bubbles, the longer it goes on, the worse the crash will be,” said Burry, who oversees about $340 million at Scion Asset Management in Cupertino, California. One reason he likes small-cap value stocks: they tend to be under-represented in passive funds. Here’s what else Burry had to say about indexing, liquidity, Japan and more. Comments have been lightly edited and condensed. Index Funds and 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. “This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.” Liquidity Risk “The dirty secret of passive index funds -- whether open-end, closed-end, or ETF -- 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. 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.” It Won’t End Well “This structured asset play is the same story again and again -- so easy to sell, such a self-fulfilling prophecy as the technical machinery kicks in. All those money managers market lower fees for indexed, passive products, but they are not fools -- they make up for it in scale.” “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. However, I just don’t know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be.” Bank of Japan Cushion “Ironically, the Japanese central bank owning so much of the largest ETFs in Japan means that during a global panic that revokes existing dogma, the largest stocks in those indexes might be relatively protected versus the U.S., Europe and other parts of Asia that do not have any similar stabilizing force inside their ETFs and passively managed funds.” https://finance.yahoo.com/news/big-short-michael-burry-explains-104146627.html
,, Bank of Japan Cushion “Ironically, the Japanese central bank owning so much of the largest ETFs in Japan means that during a global panic that revokes existing dogma, the largest stocks in those indexes might be relatively protected versus the U.S., Europe and other parts of Asia that do not have any similar stabilizing force inside their ETFs and passively managed funds.” '' Local, smaller ones are in deep doo-doo as well :
It's hard to see what could kick off a panic that would make any of this actually matter. The problem with CDOs wasn't a liquidity mismatch but rather the worthlessness of the underlying assets (loans); a fact exposed when homeowners started to walk on their mortgages and the CDO coupon payments dried up. In this case, you can have a "run" on ETFs that saturates liquidity in the underlying equities on a scale of minutes, possibly hours, a few days at the very most. These type of events have happened before (think the flash crash) and it's ultimately an arb opportunity. Probably the biggest risk is you step up to buy small cap XYZ down 50% on no news, only for the exchange to bust your trade.
I like to ask a clarifying question. He wrote: Don't a lot of the large index funds and ETFs(Vanguards, Blackrock, Fidelity of the world) BUYS the stocks to put in their index funds and ETFS? I guess his main point that they might have bought it but there's not enough liqudiity if everyone runs for the exit given the average daily volume is not enough? Just want to make sure I understand his point. It's NOT like the index funds are 100% synthetic anyways. Some of it is through futures and forwards and other synthetic instruments. But for the most part, if I understand it correctly, index funds buy the underlying stocks outright. correct me if i'm wrong here...
I'm not an expert in ETF mechanics, but broadly you're right: the ETFs (specifically, not necessarily ETNs or other products) buy and hold the underlying shares. The problem Burry alludes to is that moment-to-moment liquidity in popular ETFs can be, or appear to be, greater than that in the underlying index. E.g. heavy selling pressure in IWM can be absorbed for a while, but as arbs keep transmitting selling pressure from the highly liquid ETF to the often much less liquid underlying shares, liquidity in those shares can become saturated leading to flash crashes and other market dislocations. But there's no real threat to the integrity of the ETF or the financial system, as he implies there is; the only issue is you might get stopped out, or panic out manually, at a bad price. The other point he makes is better: indexing and passive investing are creating a bifurcated market, with over-valued, over-owned index constituents on one side, and under-valued, widely ignored symbols on the other, watched by ever fewer analyst eyes.
Very interesting. Two questions, perhaps you or anyone care to comment: 1. When will it reaches a tipping point? 2. How to trade this? Thanks.
Nobody knows the answer to #1. My impression is that the market is more robust against these types of liquidity events than in the past, because it's such a huge and obvious edge for quant shops who have the capital, infrastructure, and real-time risk management capabilities to trade these events. Things seemed to hold up fine last year, for instance. There was an ET member (Lescor) who traded mainly systematic RTM strategies, and kept a journal in 2010. He made around $100k on May 6th, $700k for the full year.
I do have another question for you: An index ETF, e.g. SPY, owns the underlying in proportion to the SP500, yes? And if I buy 1 share of SPY, do they then use my $ to buy the proportional underlying? Instantly? At the end of the day? Do they hedge? I never own any mutual funds or ETF so never bother to study their prospectus. Thanks.
Actually you as an investor can "create" a share of SPY by depositing a basket of stocks with them. Effectively institutions arb ETFs when demand for the ETF exceeds supply and create new shares in that manner (and can also do the opposite). So unlike a mutual fund, the ETF sponsor isn't out buying and selling underlying (for SPY at least). Detailed explanation in the prospectus.