I will try to interpret, but obviously it is just my interpretation (and personally I mostly agree with many theses Burry gave). First, he does not really talk about being a "good citizen" or not. His points are for "greedy citizens" who, in his view, should be worried (about his pocketbook) if he is heavily invested in passive index funds.

This is due to his "bigger and bigger crowds, same exits" analogy: individuals easily move through doors at will; but if a crowd rushes out through the same door, injuries happen.

His premise is that many stocks that index funds invest in have low liquidity (small door): half of stocks in SP500 trades less than $150M a day. This is tiny (he quotes total market cap of indices of $150 trillion). What happens if there is a small, but synchronized outflow for any reason? If customers ask for 1% of index funds to be sold, index funds have to sell 1% of their holdings in the exact ratios defined by the index, including stocks with low trading volumes. Which is a problem, as there may be no one to sell them to, so prices of those stocks may crash and create a big panic causing additional sales of index funds bringing down bigger chunks of the market.

That is the gist of it I think.

Burry's point is not that a lot of indexed stocks are relatively illiquid and thus index funds would have a hard time getting out of them in a serious downturn.

His point is that the index funds don't own the stocks at all; they trade derivatives like futures and CDO's that mimic the movement of the stocks in leveraged fashion, and the more people who dump their money into index funds without doing their own research, the more leveraged the funds become.

He's warning that in the next serious downturn, over-leverage may cause cascading collapse of index funds and the economy with them, like it did in the mortgage finance crisis.

> His point is that the index funds don't own the stocks at all

This is misleading, I think. Depends on the fund. Some seek to match the benchmark through a certain exposure to derivatives and synthetic things. Others hold the stocks in proportion.

The vanguard funds I'm invested in don't have much synthetics - they own the stocks

As far as I'm aware they also have flexibility in when they sell or buy stocks, so they don't need to buy them the second you move money in etc.

IWM, the largest of the Russel 2K ETFs with $38B cap has exactly 0.14% in cash/derivatives ($53.7M)

https://www.ishares.com/us/products/239710/ishares-russell-2...

> His point is that the index funds don't own the stocks at all

What? Where did you see that? Not only do the index ETF issuers own the stock but I believe they are legally obligated to do so.

"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."

The keyword there is "help". They use derivatives to handle the daily fund flows. They should be a tiny percentage of the whole fund value.

You only find out who's swimming naked when the tide goes out.

Burry's point is, whatever the percentage of leverage, it's reaching levels that are dangerous for the larger economy.

That doesn't answer markbnj's question. You elaborate why the passive market is in peril (because in the event of a sell-off, the ETFs will be forced to sell a bunch of low-volume stocks, crashing them), but that's just explaining in detail that the market is in peril because not enough money is flowing to people who do a poor job of managing it.

But, granting that Burry is right and you're interpreting him correctly, what is the average person with a couple bucks to invest supposed to do instead of passive investments?

Surely we can't recommend actively managed funds, funds that don't even earn back their fees. And, if not passive investing, and not actively managed funds, then…what, exactly?

Dollar cost average purchases of index funds, and slowly draw down your shares in retirement. Maybe rebalance every year or so as you get older. In other words, don't panic or try to time the market. Those are purely speculative and usually pro-cyclic movements that just introduce noise into price discovery. After all, when there's a market crash, did millions of machines in factories fall apart, or millions of workers in offices forget how to do their jobs? It's just a psychological overreaction.

As to institutionalizing this stability, it would be nice if index funds offered fund choices that prohibited selling or trading for one, two, three decades. Since you as the investor would be adding information to the market ("I'm not an index fund band-wagoner, I understand buy-and-hold and I will practice what I preach") you would be rewarded with better returns in exchange for signaling your intentions and acting as a cushion when everyone else is panicking.

> After all, when there's a market crash, did millions of machines in factories fall apart...

In 2008, the crash happened because suddenly Wyle E. Coyote realized there was gravity when he ran off the cliff. Mortgages were actually defaulting on a very high rate, but people put blindfolds on and didn't want to see. It wasn't just a "psychological overreaction" but real fear and panic as those same investors were trying to squeeze through the same exit door as everyone else.

There is still some reasonable fear in 2019 that large financial institutions will choose to make money at the expense of the economy.

If you were invested in the broader market, and didn't move your whole portfolio in our out of cash in 1 year,the 2008 worldwide economic collapse was barely a blip in long term performance.

So you're point is exactly what again? It's okay for banks to manipulate the markets because in the end it all averages out?

> It wasn't just a "psychological overreaction" but real fear and panic as those same investors were trying to squeeze through the same exit door as everyone else.

Panic is quite literally a psychological overreaction.

So if only people had acted rationally while they were losing billions of money, things would have been okay?

I think the only thing one should always do is actively update one knowledge and be ready to adjust strategy accordingly.

No strategy/advice last forever

There is no such thing as passive investing per se.

So instead of recommending fund, it's better to recommend them to learn of the fundamentals of investing instead.

And isn't the fundamental truth of investing: optimize returns based on your tolerance for risk? For the vast majority of the population, the optimal way to get the highest returns with the lowest risk is to put the money into either the S&P 500 or a total market index.

Every study has shown that people do not get rewarded appropriately for the risk they take on when they move away from diversification.

The fundamental as in you should know how anything generate value, what is index actually is, how the index work, why the index being recommended, how the stock market work, etc.

Maybe we are wrong about the fact that active fund managers do a poor job? In the same way that mathematical models failed to account for the <1% unlikely event in the 2007 crisis, and predicted everything was just fine, maybe our mental models are not crediting the fund managers with saving our investment from this particular failure mode of passive index funds.

Unfortunately it's not clear how to tell which fund managers would actually be able to succeed at this.

Maybe one answer is a new fund type that spawns smaller funds automatically at a certain amount of capital raised which invest variable amounts in a broader group of companies.

Can I sell you a mattress?

> What happens if there is a small, but synchronized outflow for any reason? If customers ask for 1% of index funds to be sold, index funds have to sell 1% of their holdings in the exact ratios defined by the index

That's pretty interesting.

In 2019, the average daily trading volume of Berkshire Hathaway (class A) was 0.04% of the total shares outstanding. If all people that held this stock were forced to sell 1% of the total shares outstanding, look out!

On the other hand, Roku has averaged 15.6% this year, with a standard deviation of 10. 1% of total shares isn't even going to be noticed.

Index funds can and generally should skip Berkshire Hathaway class A and just buy class B stocks without issue. It’s meaningless in this context.

The SP500 has a long tail 150M on a 20B dollar company, which is the median, is 0.75% per day that’s quite a bit of motion normally but you expect volatility to go up on a major sell off.

Anyway, if 1% of all money is removed from index funds on the same day whatever caused that is also going to cause the market is going to crash and crash hard. It would take something like an outbreak of Ebola in NYC to get that kind of a reaction.

If 1% of the money in index funds exited the market in any form (not just index fund withdrawals), it's going to be a bad day any way you look at it.

I think the fund managers know this and will collude to prevent it from happening. They are smart enough to know about game theory, it's not their money. So they can sit and not go on a selling frenzy.

Are they manually managed though ? isn't there an algorithm somewhere responsible for balancing these funds ?

My understanding is that the largest index funds use free-float weighting. This adjusts the weight of a stock in the index by the proportion of the stock that trades freely in the market. https://en.wikipedia.org/wiki/Capitalization-weighted_index#...

In the example you give, this should result in Berkshire Hathaway Class A to have a very small weight in an index fund weighted this way.

Looking at the holdings of VOO, as of July 31, 2019, It holds 806 shares of Berkshire Hathaway (Class A) (worth ~$249 million), but about 37 million shares of Class B, worth ~$7.6 billion.

https://investor.vanguard.com/etf/profile/portfolio/VOO/port...

That's an interesting point; it would seem like the stocks Michael Burry, the Big Short investor, likes would be in the same boat.

Or maybe he's counting on their low volume? :-)

If you are buying Berkshire with as a short term investment and you’re not a market maker, you are an idiot.

> If customers ask for 1% of index funds to be sold, index funds have to sell 1% of their holdings in the exact ratios defined by the index

I'd like to point out that while this may be the case for traditional mutual funds, it is not for ETFs. ETFs don't redeem shares for cash they redeem them for equities in the underlying index. So ETFs don't actually buy or sell any securities unless they rebalance.

That depends on:

A) the standard lock-up period of a fund, or

B) an ETF under strong selling pressure can be halted by the exchange. Some contracts presumably allow an ETF manager to halt sales if high outflows and low liquidity? Certainly can occur with funds.

And C) "There are some escape clauses in Vanguard's index funds: The fund may temporarily depart from its normal investment policies and strategies when doing so is believed to be in the fund’s best interest. ... Vanguard funds can postpone payment of redemption proceeds for up to seven calendar days." as per MathNerd314 https://news.ycombinator.com/item?id=20888999

One thing I am trying to understand . lets say there is a super flash crash and take Acme INC

Day 1: (before crash) price : 200$ S&P 500 weight : 2%

Day 2 :next day market crashes. Acme is very low volume so price crashes to 1$ .

what happens next ? do all the EFT that follow S&P have to sell all ACME for 1$ because it is not in the S&P 500 anymore.

Day 5 : ACME jump back to 200 $ and is back in the S&P 500.

So my question is what would have happen to a passive investor. if he bought 1000$ worth of ETF right before the crash. Will he still have a 1000$ dollars at the end of it .

The S&P reconstitutes itself four times a year. But, imagine that your scenario worked anyways -- the investor would have less than $1000 since the S&P index missed the recovery of Acme Inc. But considering the largest constituent of the S&P (MSFT) is only around 4% of the index total weight, the impact of Acme Inc's price decline would not be great.

Index changes don’t happen like that and a drop that large would freeze trading.

There is no market rule that prevents a single stock from dropping 99% in a day. LULD only halts trading for a few minutes, then there's an auction that could result in any price.

There is no market rule that requires a single stock from not being halted.

Please show me a one day 99% drop on a stock. Trading would be halted well before that to prevent manipulation or errors.

The rules are covered here: https://www.sec.gov/oiea/investor-alerts-bulletins/investor-...

LULD is the one that applies to single stocks. It only results in a five minute halt, as I said.

The market-wide circuit breaker can halt the entire market for a full day, but only in response to a 20% move in S&P500, not a single stock.

If it were a straight drop of 99% - say it is trading at $100 at tick_1 and at tick_2, it is trading at $1, trading will be halted at point which happens to be after a 99% drop. In reality, stocks gap downwards in a series of shallow steps which are unlikely to be 99% in one tick.

More info on the 10% trading halt rule: https://www.nasdaqtrader.com/Trader.aspx?id=TradeHalts

> If customers ask for 1% of index funds to be sold, index funds have to sell 1% of their holdings in the exact ratios defined by the index, including stocks with low trading volumes.

Index funds generally aren't super rigidly defined in terms of 1% Company A to 1 % Company B to 3% Company C, etc. which grants them leeway to precisely not have to sell off their assets in precise ratios to maintain a certain portfolio composition.

Index funds do not seek to perfectly replicate whatever sector/market they're seeking to index, but rather they are trying to approximately track the overall change. You can ignore portions of the market while still tracking it to a very close degree (i.e. sampling a distribution).

Which is why it is weird he compares them to CDOs.

Indexes typically don't have a fixed set of underlying securities. CDOs do. Your index fund typically won't tank because one of it's holdings become unprofitable, the fund will adjust reducing shares of said fund and thus reducing risk.

That doesn't happen with a CDO. If you're AAA mortgage holder starts having financial troubles, you can't readjust the CDO to reduce exposure.

Take an S&P 500 index as an example. If company 500 starts having a crappy quarter and falls out, what happens to your index? You dump the old 500 for the new one.

This isn't too say they aren't without risk. Just that it is a completely different financial vehicle than a CDO. So different that trying to make comparisons isn't really prudent.

I may have read it wrong (or have a misunderstanding of how it all works) but I also took away that since passive investment is allocated evenly across the market that investors are not properly pricing risk. I take that to mean, if all investors are diligent then the allocation of capital shouldn’t be equal. Since there is so much capital now in passive it sort of distorts the market for investment dollars (of which public companies are consumers). It’s as though instead of having subprime homebuyers with easy access to capital we now have subprime companies with easy access to capital. Again my understanding of how this all works may be flawed but this is how I interpreted it.

But as an index fund investor isn't the dollar amount invested in those tiny market cap companies quite small? It's unclear to me if the cumulative effect of liquidity problems for the stocks of those companies would be enough to make a sizable dent in an index fund portfolio of someone not looking to panic sell.

So the result would then be something like the flash crash?

I share your understanding of the article, it’s not about “index bad active good”, it’s about, “is there a problem when a lot of investors have to move quickly”. I wonder if there is some analysis of this during the last crash.

It could be more serious than the flash crash (again, just an interpretation).

Flash crash gets resolved quickly and is transparent to non-participants because there is a lot of money willing to buy on dips. But fast trading money only buys and sells what they perceive to be highly liquid assets -- there are few things that scare them more than being stuck with an open trade.

The scenario Burry describes is akin to CDO crash. Naively, most CDO assets were not problematic and many/most of the problem ones had an underlying asset of some value guaranteeing the debt. What caused the crash was lack of liquidity that started a vicious circle.

Index fund scenario could be similar: less liquid stocks that are big components of major indices would crash with unknown systematic consequences. Even if only 10% of passive index investors heads for the exits we could see broad, long term damage. And they could: pension funds have been investing huge sums into indices and a targeted PR / a few headlines of the type "look what those financiers doing with worker's money" may nudge a lot of money out of stocks.

On the other side, it is easy to make conspiracy theories on any subject.

The fundamental reason this happens is that Index Funds aren't "real" stocks. You cannot really sell SPY. There is a bucket of shares owned by SPY. Those contain shares of the index' companies. There's an "owned by clients" bucket and there's a "share liquidity reserve" bucket (with shares of companies in the fund). There's also a (small) liquidity "bucket of cash".

And of course, that company can, subject only to it's own chosen limitations, "print" SPY shares and sell them. So there's never any shortage of those.

When people transact in SPY, the trades are satisfied from those buckets. The cash bucket for investors selling SPY, the reserve shares bucket for investors buying. Those buckets are then refilled by the firm behind SPY buying and selling shares so that their share reserve and cash reserve remain at useful levels.

But let's now say there's heavy selling, for whatever reason. Sells really exceed buys and ... the cash bucket runs dry. Well, now sales stop, potentially indefinitely. The company will try to refill that bucket quickly, but there's absolutely no guarantee they will succeed, and there's no timeframe. Because the price for redemptions is only determined when they refill the bucket, you have no control over when this price is determined. It could be days after your order went through. Most index funds also technically have the right to just suspend redemptions entirely, indefinitely. Because of the amount of money in index funds, this will exhaust liquidity on actual shares relatively quickly and the whole market will freeze (because: no buyers)

Burry's claim is that if this ever happens, and investors find themselves stuck in index funds with no way out, there is nothing that will resolve that situation. Buyers won't want in, because once in, no way out. Sellers will panic and REALLY want out. This situation will self-reinforce until the market is driven into the ground.

0. some random situation causes that sellers exceed buyers for an index fund enough to initially exhaust the liquidity buffer of that fund

1. liquidity buffer in an index fund is empty

2. because of this transactions in the index fund stop

3. this causes panic, meaning less buyers, more sellers

4. goto 1, with situation getting worse every iteration

It won't be a "flash" crash, you'll just be locked in your index funds until the crash is complete.

It's hard to argue that this situation is impossible, that it cannot develop. It also seems to me that his conclusion that if this ever happens, it'll self-reinforce is correct. That said, we are pretty far from this happening.

Mutual funds usually redeem in cash, but they can also redeem in shares -- if some component of the index becomes untradeable, and becomes a significant enough holding, the fund should just give the shares to people who want out of the fund.

I fail to see how that would ever happen. Authorized participants [0] are always in the market for ETFs. If an ETF share price is crashing out of line with the index it tracks, they will step in and buy shares, swap them with the ETF issuer for the shares of the underlying stock in the index, and sell those shares for an arbitrage profit.

Even if one of the underlying stocks becomes illiquid, a big enough price divergence on all of the other liquid stocks would make it profitable to eat the loss or hold the illiquid ones (risky, but remember, there are many authorized participants competing with each other so if there is some way to make an easy arbitrage profit, they will find a way). You'd basically need the entire market to become illiquid.

[0]: https://www.investopedia.com/terms/a/authorizedparticipant.a...

The market has built-in circuit breakers or collars to stop wholesale panic selling. It's basically a pause so everyone can stop and come to their senses.

https://www.cnbc.com/2015/08/24/when-do-circuit-breakers-kic...

Sounds good in theory, and I think that's more for automated trading. In practice if real people panic and are selling, no circuit breaker will stop it, each break will just build up massive pressure and every time it's removed, will result in more drop. If the market is frozen for a long time, all trust will be eroded since it will be seen as pure market manipulation which is what it is.

Sounds like it could be a self fulfilling prophecy once people start to believe it.

How is it different from any other crash?

Or, for that matter, a bank run?

> index funds have to sell 1% of their holdings in the exact ratios defined by the index

SP500 is a market cap weighted index. That would alleviate some of this hypothetical problem, no?

Aren’t index fund investors generally the folk who would just buy more during a huge exist anyway? That seems to be the “common wisdom” that goes with index fund advice.

Imagine there was a cookie market made up of two types of cookies, tasty and meh. An active investor in cookies would spend time determining which cookies are likely tasty and which are meh. They would pay more for the tastier cookies so they can savor the flavor and less for the meh ones they can binge eat in the shower when no one is home.... A passive investor comes along and says, I don't want to do all this research, I'll just assume the market was able to price these accordingly and buy any cookie at the market price. At the beginning, it is great. They just sit back and buy baskets of cookies, some tasty, some meh... but they always pay the higher price for tasty and lower price for meh, so it is fair. Over time, more people start buying baskets of cookies rather than spending time/money figuring out what to pay for them. At some point, no one is left to figure out which cookies are tasty vs meh, so the price of all cookies converge to a single price. Cookie manufactures notice this and figure might as well just make meh cookies as no one can tell the difference until after they buy them... and then we are stuck in a world with meh cookies. With some critical mass of active cookie investors, prices could be set fairly for all cookies. Too many active investors, and there is a drain on the system as there is likely a lot of duplicated work among the investors ( each one has to have a research team, back office cookie trading systems, etc, etc ). Too little and prices become less accurate.

"What if everyone became a passive investor" is like worrying "What if the entire ecology became defenseless herbivores?"

It just won't happen, because there's a negative feedback loop against it, leading to a kind of homeostasis.

> At some point, no one is left to figure out which cookies are tasty vs meh, so the price of all cookies converge to a single price.

Five minutes later someone says: "Holy shit, I can make a ton of money by buying loads of cookies, sorting them, and re-selling them -- except with the definitely-tasty ones at a higher price."

Everyone here doesn't mean literally everyone. It means enough of everyone. And he's arguing it's already happened. And I agree.

Well they will not be able to sell their over priced cookies to the uncaring masses.

At the limit of 100% passive, everyone agrees the system would break down. But that’s not a realistic endpoint. There are studies to suggest that as little as 1% active is enough to keep the markets functioning and we’re nowhere near that point.

Of course at 1%, or really, any sufficiently small and centralized number, it becomes easier and easier to game the system...

I'm thinking specifically of attempts to artificially inflate crypto coin valuations for members, then quickly sell off before anyone catches on. Should be, I would think, impossible to do that across a large area of the market, but if everyone is investing in index funds, it might be, I would guess.

Nonetheless, for my situation, index funds are the best rational solution. That or hiding all my money under my mattress.

> At some point, no one is left to figure out which cookies are tasty vs meh

Except that there’s a lot of money to be made by figuring out which cookies are winners, and buying them cheaply to sell to the passive investors.

A merit of the passive approach is that the act of buying tasty cookies will increase the tasty-cookie price. The passive investors' existing tasty-cookie holdings will increase in value, too.

All the passive investors want is for their cookies (and new-cookie acquisitions) to be properly priced. No matter what, they have an average distribution of cookie-quality in their holdings.

The passive investors are not buying cookies at any price other than the market price. Whatever the clever-cookie-buyer is paying for cookies, they're paying the same. If a clever-cookie-buyer buys low, takes out an ad in Cookie Magazine, and sells high to a bunch of tasty-cookie aficionados, the passive investors win, too. If a too-clever-cookie buyer buys low and discovers that the apparently-tasty cookies have spoiled, the passive investors lose a little, too.

It is hard to bilk a passive investor. The first people to really figure out how will accumulate a lot of money (and ire).

This is confused

> All the passive investors want is for their cookies (and new-cookie acquisitions) to be properly priced.

No, they want the cookies they purchase to be under-priced, and consumed once their price has gone up. The cookie analogy fails here, but passive investors are exclusively seeking return, not an efficient market.

> No matter what, they have an average distribution of cookie-quality in their holdings.

That's not how passive investing works. The classic model is investment in an index -- say the FTSE 100 -- which attempts instead to maximize the quality of holdings, not the most accurately priced.

> It is hard to bilk a passive investor

Yes, but that doesn't mean it's hard to make money off one.

In theory. In practice the people who can control market pricing can force out even passive investors because passive investors still get valuation reports albeit on a less timely basis. Burry almost lost his shirt shorting sub-prime credit, as Morganchase and Goldmans mispriced his derivatives more and more egregiously as the market moved in Burry’s favor in a bid to get his investors to force him out of his/their positions using ignorant fear. Passive investors are generally not market savvy, that’s why they are passive.

Yeah I think the consensus is that 100% passive would be terrible.

Jack Bogle's view was that if the market is 50%+ passive indexed that would be bad news.

Some folks argue that the number is even more extreme, that passive indexing generally increases efficiency, and that as long as there are even a handful of active investors, the market will still be efficient: http://www.philosophicaleconomics.com/2016/05/passive/

The same author had another thought-provoking argument that the popularity of indexing has probably driven up stock valuations: http://www.philosophicaleconomics.com/2017/04/diversificatio...

> Jack Bogle's view was that if the market is 50%+ passive indexed that would be bad news.

According to this source, it already is [0]. HN discussion at the time [1].

[0]: https://qz.com/1623418/index-funds-now-account-for-half-the-...

[1]: https://news.ycombinator.com/item?id=20020997

What i understood was all investors are buying basket of tasty cookies and no one is buying meh cookies' basket or cookies. So tasty cookies are overvalued and meh cookies are under valued.

The quality of the asset has nothing to do with this issue.

In both cases the actual buyer is an intermediary, who is managing many people's money. Those people don't even know or care what is being invested in. If for some reason many of them decide to disinvest around the same time (say a recession) they may be hurting themselves due to the asymmetrical nature of the action.

At that point, an active investor can say that any losses by holding the stock an additional month would be eclipsed by selling immediately. A passive investment does not have that ability.

"And now passive investing has removed price discovery from the [cookie] markets. The simple theses and the models that get people into [cookie baskets] -- these do not require the [cookie]-level analysis that is required for true price discovery."

And the article says that is due to other factors in addition to passive investing, like central bank interest policies.

Where does the article say that? We may be talking about different articles...

I think the flaw in this analogy is that it's impossible to know beforehand whether the cookies are tasty or not. And a cookie that was previously tasty might not be tasty any more.

Not sure I buy the argument, but that's an excellent comment.

> The article seems to be saying we'd all be better financial citizens if we put our money into actively managed funds, or did our own investing.

The evidence shows that most of us suck at investing. Further, I think Burry's critique is more limited:

> One reason he likes small-cap value stocks: they tend to be under-represented in passive funds.

IMHO, the problem he's stating is that people are focusing on large-cap companies. Basically the S&P500. And the S&P500 index funds probably do hold most of the passively invested money. But to solve this (small- vs large-cap focus), the solution is not to throw away passive investing, but to change the focus.

For example, instead of buying Vanguard's S&P500 fund (VOO), to buy their Total Market fund (VTI) which uses the CRSP U.S. Total Market Index:

* https://en.wikipedia.org/wiki/Center_for_Research_in_Securit...

Or perhaps a fund that uses the the Russell 3000 or Wilshire 5000.

* https://en.wikipedia.org/wiki/Russell_3000_Index

* https://en.wikipedia.org/wiki/Wilshire_5000

It's just that the S&P (and DOW) have more name recognition.

But generally speaking, these decisions are micro-optimizations. Just put away a little every month and re-invest and dividends, and over the long-term you'll do well.

He's saying index funds are invested in companies big enough to be indexed, but too small for the stocks to remain liquid in a market with a lot of sellers.

By this reasoning indexes focussing on small caps would be even worse than the more popular funds.

The point of the article for me is that all of this capital in one place is bad for contagion, and there’s no backstop to even small fluctuations downward / sell-offs that will end up zeroing out the wealth of most index investors. In that way it resembles all the capital in CDOs - but this time instead of being held by banks that can get bailed out it’s being held by individuals. Woof.

Bottom line - they look low risk until they’re absolutely not low risk because of these properties.

As an average investor I’d say diversify is still a good strategy. Don’t just do US Market index funds. Global stocks, bonds, and other small-cap stock collections might help hedge risk of large-caps going bust. Most passive-style funds also have these options. Not an active investor. Just a dude playing a dude disguised as another dude. This is not investment advice.

The article is claiming that index funds are an overhyped bubble, so of course they'll out perform actively managed funds that have better liquidity.

Perhaps they have become that because of their publicity.

But when all the financial gurus are recommending investing in traditional securities (stocks and bonds), and millions of people wishing to get a leg up in life obey their advice, doesn't that turn the securities market in general into an "overhyped bubble"?

The market behavior and health of any investment, no matter how theoretically sound it is, will be strongly affected by investors' behavior around it. So the fact that index funds are popular (and thus perhaps inflated/overpriced) isn't a knock on the fundamental idea. It's merely an indication of a particular market situation at present.

I agree, I saw below in someone else's comment that the issue is with the attitude of "[index] stocks will always go up in the long term", which is similar to the attitude "house prices always go up in the long term" which caused the 2008 crash.

This short explanation put the reasoning behind this in the best context for me, but makes me wonder more about the dissimilarities.

Are there other factors like in the housing market of a decade+ ago? Is there a lot of risk for Joe Six-Pack? Are there people out there borrowing money from banks with poor underwriting practices getting into index funds when they should not be doing so?

I'd think if this is most peoples' 401k and surplus income at risk that there may be a huge market correction but it won't devastate the economy. If people take the long term view and if investors sit tight and wait for the cycle to move into recovery again they'll be OK. If however they need to live off returns on their investments in the present (like homeowners needed a place to live during the crash) then they're in trouble.

A lot of 401k providers have been pushing passive Index funds as "stable" late-life investments with higher return rates than actually stable securities such as bonds. So maybe there is a fear to find there that there is a lot more short term thinking and short-term investors in Index funds than there "should be" (and that market adjustment there could be disastrous to a lot of retirees).

Even basic investment courses, and any investment guru, will say any stock investment is not low risk enough if you need the money short term.

Sure, but 401(k)s have nicely~ distributed investment planning across the lowest common denominator worst case on both sides: banks with too much vested interest in cumulative commissions and fees on one side, investors with effectively zero knowledge and a large number of competing (mis)information sources with arguably little opportunity to discern proper advice versus zeitgeist and marketing.

I guess I'm not old enough to have thought through this already, but it was explained to me early on in my career that 401k plans should be divested slowly as one approaches the end of their career. Is this atypical compared to how it actually works in reality?

That's still almost the usual good advice: as much as possible with one's personal 401k you want to manage it as close to a classic pension as possible. Your best case will always be that you build it up enough over your working career that you only withdraw "passive income" (dividends/interest) from it as your "retirement salary" (and leave the bulk of it to continue generating passive income). Generally early in your career you can afford higher risk/higher reward investments, and as you transition through your career towards your inevitable retirement you rebalance from high risk investments (stocks) to lower risk securities with stable passive income (bonds).

Most "age-based" or "target-date" Active Funds that 401k providers sell are built precisely around managing this gradual multi-decade progression from mixtures high in stocks to those higher in bonds.

(You probably don't want to divest from the account before you retire because you'll pay heavy taxes on it. You simply want to manage the asset mix inside it. You generally want to avoid divesting as much as possible [and want to try to keep it as slow as possible] after you retire simply because passive income is more sustainable than asset liquidation in the long term.)

The reality though is that 401ks are individual accounts for better and (mostly, much) worse. Even when people follow the best advice, they rarely hit the right passive income numbers for a living wage. 401ks also wind up with more people gambling with such savings without thinking about the long term. Then there's simply the fact in the horribly messy transition between group pensions and individual 401ks that there are a lot of "short timer" 401k accounts out there among "Baby Boomers" and "GenX", that people will just cash out when the right retirement age happens to avoid tax penalties, or when the need is greatest (or anything in between), because there's no chance they'll ever make enough passive income and the account itself at that points for most purposes is merely a tax shelf.

Reality is full of a lot a 401k accounts that are managed only so well as the account owner and maybe the interests of the bank involved in holding the account. Which is also why the world is full of a lot of bad 401k advice and advice managers, because we've distributed that cognitive load across almost the entire populace. (As opposed to classic group pensions that could afford full time managers with CPA degrees.)

A lot of the possible "mismanagement" advice lately is a Boomers in particular were sent a lot of advertising / clickbait / thoughtpieces on how much Index ETFs are generally better than Active Funds for the simple reason of Fees. An Active Fund, especially one such as the age-based or target-date funds, charges higher fees than a passive fund like an Index ETF. In the same magic that creates passive income, compound interest, whatever you save on fees multiplies greatly over time. Unfortunately for the Boomers, while this is potentially great early career advice [1] when the age-based/target-date active funds are most active (higher stock mixes), passive funds are still a higher risk late career than the usual bonds and similar securities such funds push to late career.

(Which returns to the topic of the article at hand, this is why Burry, as at least one investor, is worried about this over-sale of Index ETFs. Index funds in the last few years have generally done better than both traditional securities [not really a surprise] and active funds [possibly a surprise; Burry describes it as an unstable bubble, but may be hyperbolic], so there's been a lot of short term investors in that game. There probably are enough Boomer 401ks alone that are in "short time" mode ticking time bombs full of Index ETFs that should they all start coming due and trying to liquidate/divest, we might see if passive Index ETFs can handle the trade volume the hard way, which is what Burry is worried about.)

[1] Depending on your investment management time, of course. The majority of people with 401ks already have at least one full time job and likely don't have time to also become their own personal pension fund manager.

> so of course they'll out perform actively managed funds that have better liquidity

I don't get this at all. So why aren't active fund managers investing in the same stocks the index funds are buying in order to take advantage of the price increase for their investors? Isn't that their job? And what do you mean by "better liquidity?"

Index funds aren't CDO's though, they are quite well established and their outperformance of active management goes back decades (IIUC).

There is an interesting idea when index funds are taken to an extreme in that if no one is manually playing the market or managing investments then everything is invested in at the same or similar rates. Index funds need active traders to trade and set pricing within the market.

My analogy would be if we are all buying tickets to the big game and sit in the stands until it's over, there's no one to yell and shout and drive the energy of the crown or possibly no one to even compete on the field therefore why are we even showing up?

It's definitely the extreme - active trading isn't going away any time soon but fears of a only a limited group playing the market and managing or controlling stock prices for their gain isn't 100% unrealistic.

But the wisdom of the crowd, the price signal, only works if professionals look at the stocks. And it requires only a few [hundred] of them (with big enough leverage, so their position shows up).

For the top 500 stocks there are enough people (and algos) going over every bit released by the corresponding companies.

That's a contradiction. It's not the wisdom of the crowds if only a few hundred people are really looking at things. The whole point of that expression is that you need a crowd, to avoid groupthink, capture etc

Not really, because passive funds just piggy-back on the price finding results of the market.

And the active market is very sensitive. Especially if someone is so confident that they are willing to use drastically leveraged positions.

The more interesting question is, if there is an index fund crash, will the actively managed funds benefit from it, or crash right alongside the index funds? How much are actively managed funds contaminated by stocks that are in index funds? (That probably depends on the type; a small-cap or emerging markets managed fund will probably be mostly clean of the indexed stocks, but a managed large-cap is probably full of them.)

There’s a clear narrative in favor of actively managed funds: they analyze the underlying stock and avoid stocks that are overvalued according to their fundamentals, and buy those that are undervalued.

The consequence would be near total avoidance of the S&P 500 as a good strategy for the long run. There would be exceptions for those stocks that are quite undervalued, or so overvalued that they are worth shorting (despite the tailwind of index funds).

Don’t worry, strategies like these have predicted 12 out of the last 5 asset bubbles.

Right. Which begs a question... are the large-cap stocks that dominate the index funds overvalued relative to their fundamentals? That should be easy enough to determine, and we should see a lot of "hold" or "sell" from the analysts.

And if they're not overvalued, are index funds really a bubble?

> and we should see a lot of "hold" or "sell" from the analysts.

That's not how that works... Sell-side analysts have a systematic bullish bias, that's what they are paid for.

https://www.bloomberg.com/opinion/articles/2017-01-20/wall-s...

The concept of "overvalued" assumes a valuation model that everyone agrees on. Large companies are complex organisms and equally complex to value. It follows, with ample evidence, that simple reductionist valuation models based on P/E, book value, and other easy-to-obtain numbers are going to be inadequate. And most valuation models are terrible at incorporating myriad risks.

Currently, I would argue that some large caps are clearly overvalued but others are also clearly undervalued, based on my own valuation model. The indexes are almost always a mixed bag but I buy individual large caps so that doesn't concern me much. It is rare for the entire market to become overvalued, in which case the smart move is not to buy in.

I wouldn't say simple reductionist valuation models are inadequate... just incomplete. Most of the time, a deeper analysis should be in line with rule-of-thumb tools like P/E. This is even more true for large companies that value not-losing over winning big.

If you can come up with a clever valuation mechanism that can reliably outperform the well-understood mechanisms, then enjoy pocketing the profits!

Well the argument, if I correctly understand, is that the less liquid stocks in index funds are getting pumped up because investor demand for passive stocks is outweighing active price discovery. This would exhibit a cyclical pattern where as passive outperformed, more investors switch over which continues to pump bad stocks and so on. Then in a downturn, even if you hold, as investors get scared and pull their cash out of the index fund, those less liquid stocks will get hammered by the double factor of their being already overvalued and also thinly traded, dragging passive performance way down.

Not saying I agree but, if he's right it makes complete sense that passive would outperform active right now, just that in the next downturn it would dramatically underperform.

The market is in peril because there are too few actors setting value based on the merits of the company instead of betting on other investors' behavior.

You want to help? Pull some, not all but some assets out of index funds and put them into individual companies you understand and believe have long term profitability. Sell those assets when you think they're overvalued by the market.

Trading less often is correlated with better performance (you are not an HFT)

There is some responsibility you have. Your money isn't going to just magically work for you, you have some obligation to research and understand what you are investing in. When nobody does it, the market is in trouble.

> put [your money] into individual companies you understand and believe have long term profitability

If anyone was able to do this, they'd be a successful money manager themselves. Yet few professionals actually manage to do this at all, let alone sufficiently to justify their fees, which is why index-fund investing is so popular in the first place.

The only real way to reduce the reliance on index funds is for professional investment services to become sufficiently competent that it makes sense to use their services. Asking the average person to "take one for the team" and throw their dart at the same dartboard the pros can't even hit isn't a great solution.

[EDIT: phrasing]

There’s a lot more that goes into the success of a business than the financials that investment services firms have access to. It’s entirely possible for someone that interacts with a company on a daily or weekly basis to have a better idea of how well that business is doing than professional investors, especially if they also bother to look at the public financials.

Gathering this kind of information may be too labor-intensive to justify doing it as a profession but rewarding enough for an interested amateur.

That assumes it's possible to retain a deep understanding of a company or industry whilst being outside of and focusing full time on "money management". It's the same school of thought that says corporate management is a generic skill that people can/should be taught and then they can manage anything.

I think his point is that most index funds are weighted towards large caps and ignore small ones. With more and more money pouring in, it creates an inflation in value there whereas the small caps get ignored. That is the most logical interpretation I can draw out of his statement (although I am a 100% index investor myself).

It seems like that point doesn't stand, though. In the boggleheads thread linked elsewhere several posters seem to show that there is actually more small cap diversity in the index funds.

Huh. I thought standard index fund advice was to split up you investments. I have 25% (of my investments) in a small cap fund. Does that count as ignored, or am I an outlier?

A total market index fund is proportioned by market cap. As the large cap gets larger, it proportionally becomes a higher percent of the pie. If large cap is overvalued, youre owning less small cap than "true price market cap."

Ah got it. So I by sharding my investment into several different different targeted funds (with auto-rebalancing) avoid that issue.... I think.

If, for example, you thought small caps were under valued, and you wanted to tilt small cap, you could keep doing exactly what youre doing, and just add a small investment into small caps on the side. So at Schwab, if you hold Schwab Target 2060 Index Fund (SWYNX) you can tilt by making sure Schwab U.S. Small-Cap ETF (SCHA) is 10% of your portfolio. At the moment, SCHA is 6.8% of SWYNX, so you would need an additional 3.2%. I dont know if you even need autobalancing for something so simple, just fix your allocation every time you make a contribution.

You’re trading one issue for another. By holding x% of a small cap fund, where x does not equal the actual market proportion for small cap funds, you’re choosing to over or under weight that asset class.

It’s all fine to say that active funds can’t outperform index funds... but if it’s a bubble and it crashes, then people in active funds will be having a field day while the people who bet it all on index funds will be left behind like the people who leveraged their 3 homes to buy 5 more during the “real estate always and consistently goes up” days of pre 2008.

The problem with bubbles is that everyone’s a winner and every indicator is confirming the everlasting increase.. on the way up.

This would assume that active funds exit at the right point in the crash. What if they wait to the bottom to sell? What if they sell during a temporary dip, then the market rallies (pseudo-bubble that never happens?)

> It’s all fine to say that active funds can’t outperform index funds... but if it’s a bubble and it crashes, then people in active funds will be having a field day

The CNBC article I linked claims that actively managed funds have been beaten by the S&P 500 for _nine straight years_. How long do the investors in actively managed funds have to wait for their big celebration?

This is my question as well.