Hedge fund manager Michael Burry is almost a mythical figure. His shorting of the US housing market before the great financial crisis was the inspiration for the Oscar-winning movie The Big Short.
So when he suggests that there is another bubble developing, people pay attention.
This is what he did in an interview with Bloomberg last year, when he argued that index funds, and exchange-traded funds (ETFs) in particular, are distorting asset prices in stock and bond markets. As more money flows into these products, he said, this distortion is only growing bigger, which means that the likely severity of the resulting crash is getting worse.
“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 any more,” Burry said. “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.”
A closer look
Burry’s argument appears to start from the premise that passive investing has grown too big. However, speaking in Cape Town recently, the head of exchange-traded products at S&P Dow Jones Indices, John Davies, questioned this assumption.
“There are around 8 000 exchange-traded products in existence globally,” Davies explained. “That is a lot. But there are 50 000 mutual funds.
And if you look at the percentage of assets in ETFs compared to the total mutual fund market globally, it’s still only 10%.”
This perspective is important. Last year, Morningstar reported that the value of investments in equity index funds in the US had surpassed the amount of money in active mutual funds for the first time. In total, funds tracking US stock market indices held assets worth $4.271 trillion at the end of August, while active managers were looking after $4.246 trillion.
This was a significant milestone, but even though $4.271 trillion is unquestionably a lot of money, it is only around 20% of the total value of the New York Stock Exchange. The amount of money in passive investments is therefore still relatively small, even in the market where it has been most widely adopted.
How big can it get?
How much this 20% can really influence the entire market therefore has to be questioned.
“Two years ago at the Berkshire Hathaway investor day, Vanguard founder Jack Bogle was asked how big can passive get, and what the impact would be,” Davies recalled. “He said that passive can get huge, and it would be disastrous. But he went on to say that it could grow to 75% or 80% of the market and it still wouldn’t be a problem. It would actually help price discovery.”
Bogle actually said that if “everybody indexed” there would be “chaos” and “the markets would fail”. In this extreme scenario, Burry’s fears would indeed be realised as there wouldn’t be any active investors left actually deciding what shares should be worth.
However, it’s difficult, if not impossible, to see this actually happening. There are two key reasons for this.
The first is that a rise in passive investing would never shut out all active managers. What it would do, is shut out the most unsuccessful of them. The active investors that are left would therefore be the ones most able to accurately price securities.
As Davies noted:
“If you think about the impact of money moving from active to passive, what is actually happening is that the mediocre active managers will diminish or go out of business, and you get an environment where you have true, high conviction active managers who can deliver true alpha.”
Secondly, the rising influence of passive funds on markets will inevitably create counterbalancing forces. As Vladyslav Sushko and Grant Turner from the Bank for International Settlements noted in a 2018 research paper:
“At some point, greater anomalies in individual security prices would be expected to increase the gains from informed analysis and active trading, and thus spur more active investment strategies.”
What is also vital to note is that index funds do not trade in their underlying securities throughout the day. They only buy or sell shares at specific times.
“If you look at when trading occurs for ETFs or passive funds, the majority happens at the daily market close and around rebalancing,” Davies explained. “So I disagree with some of the assumptions that passive investing is creating inefficiencies.”
This is because share prices are constantly moving throughout a trading session. Active investors are constantly influencing where they go. Passive funds, however, generally only have an impact once a day.
“Price discovery in markets is happening throughout the day and ETFs don’t trade throughout the day,” Davies said. “The ETFs themselves might be traded, but that is in the secondary market, not the primary market.”
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