Is there a bubble in passive investing?
Opinion is divided over whether indexing poses a huge threat or adds to stability
A scene from The Big Short (2015)
Michael Burry, the hero of The Big Short movie who became famous for his prescient bets against the US housing bubble, says financial markets are now facing another dangerous bubble – in passive investment vehicles. As more and more money pours into index-tracking funds, should investors be worried?
In the United States, according to fund group Morningstar, there is now as much money invested in passive funds as there is in active funds. That’s a major turnaround, given that active funds controlled five times as much money in 2000. The shift from active to passive investing is a “global phenomenon”, researchers from the Boston Federal Reserve noted earlier this year in a paper exploring whether the trend posed risks to financial stability. By late last year, there were more than 3.7 million indices globally, according to figures from the Index Industry Association. Burry, whose warnings have been the subject of much commentary in recent weeks, says this shift brings both opportunity and threat.
The opportunity lies in small value stocks around the world, with Burry saying they are cheaper than they should be on account of investors committing more and more money to index-tracking funds dominated by large-cap companies.
As for market threats, Burry says huge inflows into index-like vehicles are distorting stock and bond prices in the same way the rush into exotic financial instruments stretched subprime mortgages in the run-up to the global financial crisis more than a decade ago. In both cases, prices are being set not by “fundamental security-level analysis, but by massive capital flows” based on flawed risk models.
“Like most bubbles, the longer it goes on, the worse the crash will be,” says Burry, adding that it will be “ugly” when the flows eventually reverse. Trillions of dollars are indexed to stocks, many of which see relatively thin trading on a daily basis. That presents a potential liquidity threat. “The theatre keeps getting more crowded,” says Burry, “but the exit door is the same as it always was.”
Burry is not the first to warn of a passive investing bubble. Morgan Stanley has previously argued the “exodus from active to passive funds may be reaching bubble-like proportions, driven by an exaggerated critique of active management”. Last year, billionaire bond manager Jeffrey Gundlach said passive investing had reached “mania status”, adding it would “exacerbate problems in the market because it’s herding behaviour”.
Famously, passive investing was described as “worse than Marxism” in a 2016 Sanford Bernstein report warning that too much of this type of investing risked making markets less efficient.
Indexing advocates note such concerns aren’t new. “Worrying about index funds is literally as old as index funds themselves,” tweeted Bloomberg ETF analyst Eric Balchunas in the aftermath of Burry’s comments, pointing to a 1975 letter to the Wall Street Journal from Chase Investors warning of the danger posed by a proliferation of index funds.
Similar sentiments were expressed in 1991 by billionaire value investor Seth Klarman, who warned of a “self-reinforcing feedback loop” and an eventual “rush for the exits”. “Indexing is an odd risk to worry about,” says Ritholtz Wealth Management’s Ben Carlson, given that it saves investors money in fees, beats most active funds and is simpler to understand than most investment strategies. “It’s like worrying about a trend where everyone decides to eat better, thus hurting sales at McDonald’s,” says Carlson, who describes passive investing bubble talk as “silly”.
That’s echoed by his colleague Josh Brown, who says the word bubble has lost its meaning and is now bandied about to describe anything that is popular. There is nothing speculative about investors’ current preference for low-cost, low-maintenance funds, says Brown, adding that you “can never have a bubble in humility, apathy and passivity”.
Both Brown and Carlson argue much of the money making its way into actual tracker funds is coming from closet trackers that masqueraded as active funds.
For decades, most active managers have tried not to deviate too much from their benchmarks, they say, as this potentially leads to underperformance and the risk of being fired. “Money fleeing closet passive to actual passive” is not a big deal, says Brown. The media is “lazily” repeating Burry’s argument “because a lot of people saw the movie”.
Rush for exits?
Indexing advocates similarly reject the idea that the growth of passive funds will result in a mad rush for the exits when the bull market eventually ends, saying such behaviour is more characteristic of investors who are over-leveraged, undiversified and who have taken on too much market risk. Indeed, some evidence suggests index investors are more inclined to sit tight and hold tough during market declines than their active counterparts.
Index investors were net buyers during the last two major bear markets (the dotcom crash in 2000-02 and the global financial crisis in 2007-09), according to index fund giant Vanguard, with passive funds experiencing significant cash inflows on both occasions. According to the aforementioned Boston Fed paper, evidence indicates passive investors are “less reactive” to fund performance than active investors. Passive funds “may face a lower risk of destabilising redemptions in episodes of financial stress” so a “continuing shift to passive investing” may in fact bring “further stability benefits”.
On the other hand, certain passive strategies, particularly leveraged ETFs, have the potential to amplify volatility, the Fed cautions.
As for potential price distortions, opinion is divided. Vanguard says the impact of indexing strategies on trading activities is “minimal”; price discovery is driven by high-frequency traders, hedge funds and individual investors, with index funds only accounting for between 1 and 5 per cent of trading volumes. The Boston Fed says there is the possibility of “index-inclusion” effects, although it says evidence linking passive investing to co-movement – the tendency of individual stocks to move in line with the index – is “mixed”.
However, Vincent Deluard of INTL FCStone has found that indexing is impacting the valuations of individual stocks. In a report last year, Deluard noted that the average US stock is in 115 indices. The more indices of which you are a member, the higher your book value is likely to be. Deluard found stocks that are in more than 200 indices are 2.5 times more expensive than stocks in less than 75 indices.
Correlation is not causation, of course, although Deluard’s take is that the increased popularity of indexing may well be driving a valuation anomaly, with more commonly-indexed stocks receiving higher valuations than their less indexed counterparts. If true, bargain hunters willing to withstand short-term pain might like to seek out cheaper stocks that are “under-owned by the index crowd”, as Deluard put it.
That investment thesis echoes Michael Burry’s argument regarding the attractiveness of small value stocks that are underrepresented on market indices.
If this is the case – and it’s clear opinion remains divided, with many seeing anti-indexing arguments as mere scaremongering – then indexing may become a victim of its own success.
And, if stock prices are being distorted, active managers can seek to exploit those distortions, potentially increasing their profitability after years of underperformance.