‘The Big Short’ Whiffs On Indexing

The man who sounded the subprime mortgage alarm more than 10 years ago is now sounding a new alarm—index funds are the next collateralized debt obligation (CDO) bubble. In a recent Bloomberg interview, Michael Burry explains his logic.

Burry argues that passive indexing removes price discovery because an index fund must go out and buy all the stocks in the index. They don’t require the security-level analysis that is required for true price discovery.

‘Same Story Again & Again’

Burry says that “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.”

Burry also claims there is liquidity risk, noting that just over half of the Russell 2000 stocks trade less than $5 million a day. Thus, when investors exit, there won’t be enough liquidity to sell the shares. It won’t end well, says Burry, stating: “This structured asset play is the same story again and again.”

Burry says: “It is not hard in Japan to find simple extreme undervaluation: low earnings multiple, or low free cash flow multiple.” He states there is a lot of value in small caps. Burry concludes: “I am 100% focused on stock-picking.”

Why He’s Wrong

Before you sell your index funds and recognize large capital gains taxes, consider this: The largest U.S. stock index fund on the planet, the Vanguard Total Stock Market ETF (VTI) has more of its assets invested in the top 10 stocks (18.9%) than the entire Russell 2000, which represents a bit more than 7%, according to a Vanguard spokesperson. These largest 10 holdings are the most liquid stocks on the planet, far more liquid than the small cap space Burry claims is undervalued.

As far as the lack of price discovery goes, tell that to holders of GE stock who have been so badly punished, or to Boeing after its 737 max jets were grounded.

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

Market volatility is a sign of vigorous price discovery as well. While a bit of an exaggeration, I agree with financial theorist William Bernstein, who says, “I’m often asked how many active participants are necessary to maintain market efficiency: ‘Two dentists having lunch in Lubbock.’” Price discovery is alive and well.

Ignoring Index Asset Stickiness

Burry is right that investors generally exit after poor performance. But he fails to mention they do this far more in active funds than in index funds.

Index funds are geared toward longer-term investors, and index funds owned in target date retirement funds are particularly stable. This Vanguard research paper shows that index funds account for only about 10% of the global investable market, and 5% of daily trading volume.

One brilliant call isn’t a track record.

I accord Burry all due credit for being perhaps the first to expose the AAA-rated subprime derivatives that would trigger the Great Financial Crisis. I also give credit to Gary Shilling, who made 13 gloomy financial predictions for 2008, with every one being right. That proved to be a tough act to follow, however, as, after he was discovered and widely followed, all of his 13 gloomy 2009 predictions were wrong.

Meredith Whitney also made a brilliant gloomy call in 2007, and then followed up with a horrible prediction in 2010 stating there would be hundreds of billions of dollars of municipal bond defaults over the next 12 months, which, of course, never happened.

My View

I’ve been concerned for a while that so much money is pouring into stock funds, and that index funds are the largest contributor. But that’s a risk to the stock market as a whole.

A more than 10-year old bull market isn’t likely to last another decade. So when I advise people to sell some of their index funds, it’s to rebalance to a target asset allocation rather than any flaw in index funds. Index funds are nothing like CDOs!

For my stock allocation, I’m 100% focused on broad, low-cost index funds.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.