October 4, 2019


A Few Quick Responses to Michael Burry’s Index-bubble Remarks

Burry: “This is very much like the bubble in synthetic asset-backed CDOs before the GFC in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.”

  • Is there any market in the which the ‘normal’ state is for the marginal buyer to be a value-focused fundamental securities analyst? Even long before ETF and index funds, we’re pretty sure that’s not how most markets ever functioned
  • Credit ratings agencies made a business decision to rate large swaths of the sub-prime and alt-A CDO market AAA, then used a useful model to justify that decision. We know of no models approved by Nobel prize-winners supporting the idea that home-prices can’t go down, or that mortgage defaults should be uncorrelated in all states of the world
  • Money being allocated to broad equity ETFs (or active managers, or equities generally) isn’t largely being driven by false belief in any particular model (faulty or otherwise) nor an idea that there’s no risk in equities, it’s being largely driven by cash real rates at 0 and investors making a knowing decision to take more risk vs holding cash

Burry: “And now passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies – these do not require the security-level analysis that is required for true price discovery.”

  • Active managers are still more than 50% of equity funds
  • Private-equity funds are larger than ever and can take under-valued public firms private
  • HF long-short funds are larger and more active then ever and can make market-neutral bets of almost unlimited size
  • If there was truly not enough price discovery, you’d expect large mis-pricings that sophisticated investors could capitalize on: so long-short funds should be having a field day, and private equity funds should find an incredible target-rich environment of great companies under-valued by the public markets. But neither seems to be happening
  • If passive vehicles were really distorting markets, you’d expect significant discrepancies between public and private valuations, and if there’s a public-markets bubble you’d expect the public market valuation to be much higher. But in fact, many companies are choosing to stay private because they’re getting higher private-market valuations, in an environment where in theory all the private investors are sophisticated securities-analyst types. By way of example, Wework’s latest private valuation was $47B, while now they’re talking about an IPO at more like $10B because the public markets are so much more skeptical of Wework’s fundamentals than the private markets have been

Burry: “In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those – 456 stocks – traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this.”

  • He seems to be arguing that investors in aggregate should hold a lot less of these small/less liquid stocks than they do, but doesn’t that seem to cut against the idea that these smaller, less liquid stocks are significantly under-valued because of passive investing?

Burry: “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.”

  • We have no idea what this means

Burry: “The bubble in passive investing through ETFs and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally,”

  • We’d think the proliferation of value and small-cap funds would make investing in smaller value-type securities easier and more widespread than it ever has been, far from orphaning them. Micro-cap names may be getting excluded, but it’s not like micro-caps were easy or common to invest in prior to passive investing either