Most folks here are focusing on Burry's comments regarding price-discovery. However there is another huge point: Liquidity risk. To understand his point, you have to know the gory details of how an ETF operates.

First: When you buy a ETF share for the S&P 500 (iShares, Vanguard etc), the share is not backed by all 500 S&P components. Virtually all the large-number component ETFs are using a sampling of shares to match the underlying index. (They would be buried by transaction fees otherwise.) The subsampling of the index is reasonably well-understood math, but relies on an assumption: That the buying and selling each component share will not be greatly affected by the ETF purchase or sale.

[Edit: I may be out of date - Some ETFs are full samples. Nevertheless, the bigger point that the ETF purchase/sale does not much affect the price stands.]

Second: The ETF uses a very clear process to keep the price of the ETF in equilibrium with the index it represents. Large players are allowed to go to the ETF adminstrator (say iShares) and turn in a bunch of the ETF shares, and iShares will transfer back the underlying components. So if the ETF price ever gets too cheap relative to the index, the big players will redeem the ETF share, and then sell the underlying shares they received, which results in a quick, nearly guaranteed profit.

Conversely, if the ETF price goes above the index, a large player will bring a basket of the underlying component shares to iShares, and iShares will give them corresponding ETF shares. So they buy the components cheap, sell the expensive ETF, again making a quick profit.

Now to what Burry is saying: Several components of the big indices are thinly traded compared to the amount of money in the index funds. In a large index drop, there will be disproportionate downward moves in those thinly traded shares: As large players will be redeeming the ETFs for underlying shares and then sell, these thinly traded stocks will drop further than you'd predict from the index. This will cause the index to drop further, which will cause more ETF shares to be redeemed, perpetuating the cycle.

I think his point should be better known than it currently is: The current wisdom that "you can't lose money in the stock market long-term" is reminiscent of "you can't lose money buying a house."

Yes, the liquidity risk seems the more interesting piece.

He seems to say that if you have trillions of dollars in ETFs, you should be seeing more volume in the shares in these indexes than we actually observe.

So some of this cash is going toward synthetics -- mathematical models that are supposed to mimic the underlying securities -- and not the actual stocks in the index.

In a general rout, the synthetics won't perform like you'd expect them to. Prices might eventually clear, but it's not "as good as cash" like many investors assume.

This feels like the most concise explanation of the underlying mechanics that I was intuiting from the article. Now the question becomes: how do I hedge out of this risk without going full day-trader?

> Now the question becomes: how do I hedge out of this risk without going full day-trader?

Here's anecdata from the past: I spent a lot of time during the housing bubble working on a similar strategy. I came to the conclusion that shorting the banks (with leverage!) would be a profitable way to make money.

It turns out that was a beautiful and correct strategy, up until the moment the SEC decided to ban shorting. We got out with profit, but it was stressful and certainly nothing life-altering as a consequence of the SEC action. (bastards!) If you have seen The Big Short, they had a similar problem: Because the CDOs stopped trading, Goldman and company unilaterally declared that there was no problem. Since there was no market, there was no mark-to-market. Burry and friends were able to wait it out, but you'll notice that Burry had to exercise some extraordinary clauses in the contract; Dealing with your investors after that must have been all kinds of fun.

The moral of the story is probably something like: When you are profiting from the system melting down, the system will invent new rules to impede your profit, so be prepared.

Edit: BTW, I don't think mark-to-market accounting has ever been fully restored, but it's been a while since I checked.

In what capacity did you do this? A trading firm?

My guess is that would be more expensive than what the index fund / ETF would cost you even in a worst case scenario. Read my comment where over the last 10 years Vanguard has only deviated by 1%, even after factoring in trading costs. A typical active fund is going to charge .5% per year, minimum, which adds up to 10% over 10 years, assuming a 7% annual return. A more typical 1% expense ratio is going to be 20%. Active management is extremely expensive. But trading yourself, unless you have a million, is going to be expensive, too. IF you wanted to DIY, $5 a trade adds up if you're putting money into multiple stocks every month. $1000 divided into 10 stocks a month is going to be a 5% expense before you even get started.

A large cap index fund wouldn't have the same liquidity problems, but it has the problem that if this were to happen, funds might have to sell their large cap holdings to cover outflows, driving down those prices. At least it would reflect the NAV, though.

You could buy a closed-end mutual fund since it won't be balancing its holdings in the same way.

You could buy a small cap fund and short a large cap fund, betting that small cap shares will get distorted in the positive direction if there's a liquidity crunch.

I guess I'm somewhat less worried about people not picking stocks because hedge funds, and really, anyone greedy, will always try to do that, bringing some amount of pricing to the market.

There is a range of active - passive even within ETFs that are trying to perform like an index. An example of this in Canada is say Horizons vs Vanguard that's "fully" passive. You pay higher fees for someone else to do the hedging (= protection from having your money in a passively managed ETF that has underlying assets that don't have a high trading volume) for you.

> ..."you can't lose money in the stock market long-term"...

Put in a large enough number of years in that "long-term", and it is true. But many people don't have the time horizons of institutional investors, so what is "long-term" to an re-insurance company might be "lifetime" to an individual investor.

Now, if we could only resolve the principal-agent problem for institutional investors to the benefit of individual participants that make up the institution's backers...

There are a number of stock markets that went down significantly and never recovered. I think Japan was one example.

I think the contrast is between active and passive funds.

If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets.

A passive fund adds money into the system, but it doesn't add any intelligence - it relies on the intelligence of the current market participants.

As more and more money switches from active to passive, we have more and more money relying on less and less intelligence. This means that the market is becoming less and less efficient, and prices are deviating more and more from where they should be.

Passive investors are essentially leeching returns off the work of the active investors.

This article suggests that the effect will be ultimately catastrophic, where I suspect that it'll just result in money slowly swinging back the other way as active funds take advantage of the situation to start to make more money than before. That's pretty much what the article says he's doing.

He seems to be implying that the naive idea of passive funds of actually holding a basket of the indexed stocks is not the reality and that there are various financial shenanigans going on analogous to the issues seen in the run up to the last financial crisis.

He points to a mismatch between the daily trading volume of various of the smaller components of these indexes and the amount of money globally indexed to them. The suggestion as I understand it is that some of the indexed money is not directly holding the indexed stocks but is using financial instruments to track the indices indirectly and that in the case of another global financial crisis those instruments could break down and you'd potentially see significant divergence between the tracking funds and the actual indices.

That's just my layman's interpretation though, I'm not an expert on this stuff.

> This article suggests that the effect will be ultimately catastrophic, where I suspect that it'll just result in money slowly swinging back the other way as active funds start to make more money than before.

This makes sense to me - I would see returns to active investors increasing gradually, as there are fewer of them. At which point, more people take their passive investments and give them to the active investors. At some point you maybe reach some sort of equilibrium.

Why would it not be a well-functioning feedback loop like this?

> If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets.

Also, worth noting that it's beneficial for the market, not necessarily (and probably not likely) for the individual investor, who will pay higher fees and may underperform the market.

> Also, worth noting that it's beneficial for the market, not necessarily (and probably not likely) for the individual investor, who will pay higher fees and may underperform the market.

Excellent point. Indeed, I believe the academic view is that due to decreasing returns to scale, funds flow in and out of active funds, with an equilibrium only when any alpha (performance above the norm) is entirely swallowed by fees.

>As more and more money switches from active to passive, we have more and more money relying on less and less intelligence.

That's assuming that the mutual fund managers who are being moved away from are all contributing their own unique information to the market, as opposed to repeating textbook business analysis techniques. If the fund managers that survive are smarter than the ones being replaced by indices, the intelligence of the market will improve.

Or, if the fund managers that survive aren't smarter - but are luckier than the ones being replaced by indices, the intelligence of the market will remain static.

Anyone can go all-in on red five times at the roulette table. One out of every 33 players will see 3100% returns from this investment 'strategy'!

The problem with that interpretation is the following:

Each active investor gets some return and contributes some movement to the market. If there are enough active investors, the aggregate move of the market matches the actual value movement of the stock in a company. Then, on the sidelines, over some time period the market's moves are copied by the index (a balancing of the index). If, however, there are too few active investors, the index funds will be causing feedback into the system by being the only source of liquidity in a stock. If active investors then attempt to capitalize on this "failure", they will be the movements of the market. Then the index funds will copy them in the next round of balancing. In the end, there is a level where the market is not something the active investors can get a good return in because all the momentum is in the index and nowhere else. If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well... Right?

> If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well.

Passive investors are copying the average of the active investors. Just as you would never have a situation where all active investors are outperforming passive investors, you would always expect there to be some active investors outperforming the average. The big question is the extent to which individual managers can keep it up over time (and as more AUM flows into their funds) and the magnitude of their out-performance.

And you're right - as active investors find new opportunities and make money out of them, they will improve the average and hence the performance of the passive investors.

You can add up the performance of all active funds and see how they are doing as a whole. My understanding is that at the moment, the sector as a whole is doing OK, but almost all of the returns are from the top performing funds, so an active fund chosen at random is likely to be destroying value. However, this could change as more mispricing opportunities arise in the market.

Where do robo-advisors like Betterment fall into this? It seems like they combine a variety of different funds; do they typically stick with only passive funds or a mixture?

Thank you, this clarified so many things.

Other replies were good. But I'll add my two cents.

Index investors are basically free riders off the information and research generated by active investors. Indexing basically works pretty well because the market's efficient.

An index investor just comes in and just pays whatever the current market price is and allocates in proportion to whatever current market valuations are. He doesn't even need to know anything about the underlying companies. "Microsoft? Never heard of it. But the market says it's worth 3.8% of all major American stocks, so I'll put 3.8% of my money in it"

Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.

And the reason it does work is because the active managers compete so fiercely with each other. They end up showing all their cards to the market. And all the information they have, and the research and the analysis winds up reflected in the publicly available stock prices. In effect active investors pay their managers big fat salaries to analyze stocks, and passive investors get nearly all the benefits without any of the costs.

> Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.

Well, what also works fine is picking (enough) random stocks and buying them for an equal amount of money.

That index funds base the allocation on market share is (in my understanding) not a method to increase performance, but to greatly simplify any rebalancing of the stock allocation. If the price of a stock changes, an index fund does have to do anything. The allocation will always automagically reflect the market cap of the stock - more or less by definition.

Every other allocation (e.g. equal weight) would need to rebalance every now and then to return to the initial allocation. This can be complicated and/or costly. However, it might still perform better than the market cap index: https://www.realizeyourretirement.com/comparison-sp-500-inde... (of course it might perform worse in the future).

The harsher reality is that most retail and professional investors have no business trying to be active investors.

Throwing darts is cheaper and safer for them.

Index investors are only really messing with the market if there’s more capital chasing fewer goods than there otherwise should be if they were being “active”, which isn’t proven.

I'll try. Price discovery means finding out the value of a stock by people bidding to sell and buy it. Historically, beating the stock market is hard to do, so one strategy is to just go along for the ride, buy a little of everything. This is what ETFs do. You're not bidding your guess of the value a company should have, you are just saying "hey, I'll pay what that other guy is willing to pay". Now, thats not a problem necessarily, but if the majority of people are not placing their own bids, and everyone is just saying I'll take what the market rate is, then the price of a stock isn't really tied to anything. This is the world we are in today. ETFs have become so massive, some of them are starting to be the majority shareholder of the companies in their portfolio. Now let's say our dear leader really tanks the economy and everyone rushes to sell their ETFs. The companies most effected by whatever policy fuckup are not the only ones that go down, the whole market will go down. Scary stuff.

> This is what ETFs do

ETFs aren't necessarily index funds

https://www.forbes.com/sites/rickferri/2014/01/16/etf-does-n...

Much of the market gain is around handfuls of stocks like FAANGs. And our leader has issues with 4 of those.

So there is a very closely coupled lever to the market.

I wonder if there are high speed shorts triggered by twitter already.

> I wonder if there are high speed shorts triggered by twitter already.

There are: https://www.marketplace.org/2019/08/29/meet-the-algorithms-c...

Amazing. Would it be insider trading if twitter held his tweets for 5 seconds and sold early rights to the content?

Twitter Flash Trade Platform?

The more sophisticated part of the argument is that indexes require overexposure to thinly traded stocks and that in a market sell off the assets linked to the index would see outflows, which require selling the underlying(s), which would cause a material price hit in illiquid stocks, which could cause a partial feedback effect as the index would then slip more.

If one believes this to be true, one necessarily believes that illiquid index constituents are overvalued today relative to their actual enterprise value and will, at some point in the future, be sharply undervalued as a large number of computers controlling trillions of dollars attempts to implement a for loop shoveling money at you.

When people invest money into index funds, then the funds must spend all that money buying the shares of the underlying fund companies. So that creates tons of buy orders for the underlying stocks, which creates the buying pressure, which makes the prices rise. As long as more money comes into the index funds the prices of underlying stocks will keep rising. But the higher the prices of the underlying the more money needs to come in to buy them at those prices.

What eventually happens is that there's not enough new money coming in for index fund buy orders to maintain the bottom of the underlying prices, which means that the prices start drifting lower, the popular financial press goes nuts, CNBC/FoxBusiness/WallSt Journal/etc blast it in the headlines and the same way goes the other way. People start selling their index funds, which makes the index funds sell the underlying which creates a massive wave of the sell orders creating a downward pressure, which in turn puts brings the indexes lower which makes press go screaming more which causes more people to want to "protect their test egg" by selling the index funds they had.

But this doesn't seem to have anything to do with index funds. Wouldn't the same thing happen regardless of the way people are invested into the stock market?

It is directly related to the index funds. They are now marketed as the "correct" way of invest into the market where they in fact invest into a very small number of companies creating an artificial wave of the buy orders.

Actively managed funds have choices in what they invest, and how much they put into any of the companies. Index funds do not.

https://www.etf.com/SPY#overview

for an example.

So, a normal decade in the markets?

A bit more exciting probably since the market is higher now which means that the oscillation will be more impressive.

The rest is chicken little - we got into that mess before because neither CDOs nor CDSs were liquid which means that as long as they were not trading banks were able to continue book them at the nominal value and since to trade them one needed to have banks that were on a hook for them to do the trade nothing was moving. That's the biggest issue with those kinds of instruments.

Nothing of sort could happen with the index funds because both the derivatives and the underlying are sufficiently liquid, so the drop won't be 100->20 but rather 100->99.9->99.8->99.7->....->20.1->20 which in turn would re-balance everything.

Someone that knows more than me: how is a correction going to happen on index funds?

Retail investors are told to shovel money in and keep it there. Who's going to be selling to pop the bubble? Do investment banks have a lot of index funds and their derivatives bought? Does there have to me some major re-allocation within the fund that causes investors to sell?

If a single stock is valued incorrectly, how is that going to bring down the entire index?

I think https://news.ycombinator.com/item?id=20879296 answers this by saying "The big players making money on the spread"

That's the essence of it.

I can explain the analogy at least, though I think there's a serious flaw in his reasoning.

CDOs are collections of mortgages with rules about how they pay out. During the last bubble they were sold (and rated by supposedly respectable third-party arbiters) as among the safer investments available. This was because the CDO had a safety feature where a certain percentage of the mortgages were expected to default, and so you didn't need all top-quality mortgages, lousy ones were okay, too. Thus the sudden availability of "NINJA" (No Income, No Job, no Assets) loans, which were completely inexplicable to basically everyone. No one would have lent their own money to poor credit risks, but the CDOs would buy that loan and stick in in their security in a heartbeat. The problem came that once the expected maximum level of default was breached, the CDO started paying out very little or nothing, and the value fell to near zero.

So his analogy is that the same thing will happen to index funds, which invest on the principle that you don't need to pick top-quality stocks, that you just buy all of them. As far as it goes, there is a significant similarity with CDOs. As an index investor, I don't try to find my own good stocks, I don't even need someone skilled in stock picking. I'm relying to an extent on financial engineering and the rest of the market to make sure that I'm not grossly overpaying for the lousy companies that are in the index. He notes that there is a huge multiple on many of the stocks, such as the 266 that have less than $150 million in daily trades, but represent trillions held by index funds. Trading is the "price discovery" mechanism of the market, and lightly traded stocks are subject to all kinds of manipulations and volatility, to be sure.

But there are several places where I think he's making a major stretch with this argument. First, the CDOs were sliced into "tranches", so when you bought a CDO you didn't get the underlying assets, just the right to a payment stream. The index fund sticks very close to the current market value of its assets; you get what you would have gotten if you just bought all 500 stocks individually, without any financial magic. For instance, on a $10K investment the Vanguard S&P fund trails its index by about $100 over 10 years. There's no daylight for shenanigans there, so I think the financial engineering argument is categorically false.

It also doesn't bother me that the stocks are thinly traded relative to the assets, because one of the big advantages of passive investing is that you're not trading all the time. Again looking at Vanguard, they turn over less than 4% of the stocks in a given year. But that's what you should do if you don't want to get killed by trading fees. Buy and hold and all that. For there to be a problem you'd have to see that those stocks were getting volatile, or that the index funds were constantly buying at a disadvantage. It is true that there is a certain amount of trying to beat the index funds to the punch; kind of hard to keep from telegraphing your investment choices when they're literally written into the name of the fund and you need to buy for a half-billion dollar fund. But these are tiny in magnitude. If anything, things are much more efficient and rapid then they were before computers took on most of the trading.

Finally you get to the thing I worry he has a point. If 100% of the money was passive, there would be huge opportunities to exploit. There's no law that says passive investing is going to be better than active. It's been true so long that maybe it's taken as gospel when it shouldn't be. Nothing is forever, and anyone who argues "it's different this time" is probably wrong, eventually. But there's still a ton of money out there in active funds, hedge funds, pensions, etc. If they saw a good opportunity, they would take it. There's too much money to be made by sharp-eyed investors to let the market as a whole get to the point where bad stocks and good stocks are treated the same.

https://investor.vanguard.com/mutual-funds/profile/portfolio...