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.