The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs
Thanks to Reed Stevenson for permission to quote and backlink to his September 4 article at Bloomberg.com.
The subject of the article, Michael Burry of The Big Short fame, says, “I am 100% focused on stock-picking.”
Burry believes there is opportunity in deep value small-cap and small Asian markets, and that we are in a passive index-based market bubble that is bound to pop in the future, and it won’t be pretty.
Burry, who now oversees about $340 million at Scion Asset Management, a California-based asset management firm, believes the strength of the ever-increasing index fund inflows of the last decade will eventually reverse. He thinks the inflows are distorting prices for stocks and bonds, reminiscent of the way CDO (Collateralized Debt Obligations) purchases distorted subprime mortgages and caused the financial crisis in 2008.
Burry points out “the vast majority of stocks (in the indices) are lower volume, lower value traded stocks.”
So, is that important? Burry seems to think so.
His overarching theory is that the passive index funds and ETFs we buy contain a disproportionately large number of equities that trade with low dollar volume. He calls it “The dirty secret of passive index funds….”
It’s not really a secret. It’s available information to anyone willing to do the homework.
Take the Russell 2000 Index, for instance. He cites “the vast majority of stocks are lower volume, lower value-traded stocks….” 1,049 stocks, over half the 2000 index, trade less than $5 million in value during the day, and almost half of those, 456 stocks, traded less than $1 million.
Burry believes it’s important since passive investing does not benefit from the security-level analysis that is required for true price discovery, and investor dollars routinely go into companies with lower volume, meaning less public interest, than the highly researched bigger companies. In essence, he is saying these companies are getting a free ride.
This is an excellent and provocative article that made me stop and think each point through, but rather than rewrite it or try to interpret every line, I’m going to take it in the direction of practical application.
While he doesn’t say it directly, Burry may be making a case for Equal Weighted Index funds over Cap Weighted Index funds. What’s the difference?
Cap Weighted
Market Cap weighted or Cap weighted index funds are weighted by market capitalization, and as a result they have a big cap bias, that is, more weighting goes to higher capitalization companies in the index. The vast majority of the value of the S&P 500 Index, for instance, comes from the top ten companies that make up the index. Cap weighted funds heavily favor the largest companies in the index, generally the dividend payers, and for that reason can offer more relative safety than an equal-weighted portfolio.
Because more money goes into the more stable large companies, the investor reduces risk, but also reduces the return potential of a portfolio that favors smaller capitalization stocks.
So is Burry right?
I don’t know. I’m not in the prediction business;
I’m in the business of helping investors become self-sufficient.
Equal Weighted
Equal weighted index funds don’t have the same big cap bias as market cap weighted funds. The same dollar amount goes equally into each of the indices constituent stocks, regardless of relative size. This effectively favors the smaller cap companies Burry seems to like at the moment. Smaller companies have the potential for greater growth than larger companies, but also carry greater volatility risk than the large caps, the market’s steady Eddie’s.
I call this the electoral college model, if you will, giving the smallest companies an equal representation in the index, which is not the case in a cap weighted index.
Stock-picker types seem to like equal-weighted portfolios that favor lots of smaller, cheaper companies for the potential gain they offer, but investor beware: small companies have a higher risk of failure.
So which is better?
That depends on your investment objectives, which should be based on your own risk tolerance and time horizon, but in my experience, it’s not an either-or question. Most investors find something to love in each approach.
So is Burry right? I don’t know. I’m not in the prediction business; I’m in the business of helping investors become self-sufficient.
But if you are legitimately concerned about what a bubble pop will do to your portfolio, is it time to dump all of your index funds and ETFs? I don’t think so. Pop or no pop, there are lots of things you can do right now which make sense in all market climates.
Click here for money management ideas to prepare for a recession.
We are near historic highs, take some profits. You have seen a pretty healthy run up since the so-called Big Short fiasco. It’s not a sin to take profits, even if you think there is more juice in the market. If the market goes higher after you sell don’t give it a single thought. You have an eleven year period of profit behind you. Take the gain, pay the tax, move on. You don’t go broke taking profits. Scrutinize your holdings. Raise some cash.
Reallocate to safer havens. Think more about risk and less about reward. Don’t dump everything. Scrutinize every holding and reduce some of your riskier equities and go for some risky positions, like preferred and dividend stocks. Look for yield. Dividends, dividends, dividends. Nuff said, click here.
Hedge your portfolio with real assets. Gold and silver never go out of style, and perform well in recessions and provide a hedge for your financial assets like stocks and bonds. Target a weightingting of 5% to 15% of your overall portfolio.
Borrowing rates are low. Real estate should benefit from low mortgages. Good time to refinance and take a look at the REITs.
In conclusion, many of us have lived through bubbles. The tech bubble, the mortgage bubble a mere decade ago, and so forth. They were tough. They took prisoners. We survived them. We moved forward.
In my opinion, we face other potential bubbles that will will prove to be more horrific than an index fund bubble: student debt will create a nation of young debtors who can’t afford to buy a home, exploding healthcare costs will destroy our aging population, and the bulging federal debt has the potential to take us all down.
Am I pitching armageddon? No, just preparedness. And, of course, self-sufficiency.