Is Michael Burry correct that passive investing is the next bubble?

If you have read Michael Lewis’s The Big Short or seen the movie by the same name may recognise the name Micheal Burry. He is the guy (played by Christian Bale in the movie) who predicted the collapse of the CDO market in 2007/ 08 by actually looking under the hood of these products and seeing that they were built on a foundation of people with poor credit ratings and/or low incomes were getting mortgages to buy properties at discount interest rates. When these discounts expired and they went onto the real, sub prime rate, they would inevitably default and the whole thing would collapse. He shorted the market and his firm, Scion Capital ultimately recorded returns of 489.34% (net of fees and expenses) between its inception in November, 2000 to June 2008. To put that on context, the S&P 500 returned just under 3%, including dividends over that period.

In an interview with Bloomberg at the start of September, Burry warned about the impact that Index funds (passive investing) is having on the markets:

“(Passive investing) is very much like the bubble in synthetic asset-based CDOs before the Great Financial Crisis 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”

I have seen lots of commentary saying that Burry is wrong, that passive investing is not going to bubble like CDOs but I am not sure that is what he is saying. What he is saying is that those who purchase indexes don’t do any fundamental analysis of the price of the underlying shares, they just buy the whole lot. This distorts prices and and he is right. The MSCI World Index holds 1,600 stocks. Who knows what all of those companies are? A Google search doesn’t bring up the list of what is contained in the index, only the top 10, which you could probably guess anyway.

Why this isn’t a bubble like CDOs

There are fundamental differences between the CDO bubble of the Great Financial Crisis and

1. Active fund management. Not everyone is investing in ETFs & index funds. While passive investing is becoming much more popular and continuing to grow, active management still make 59% of all investing . Active managers still play a significant role in the investment landscape.
2. CDOs were created by banks to move on debt that the owned. They were certified AAA by the rating agencies based on who was selling them rather than by the quality of the underlying assets. The rating agencies income is paid by the banks, so there is a clear conflict of interest.
3. An index is created by companies such as MSCI or S&P. They are not restricted to packaging the debt that they own but has a universe of stocks to pick from and have clear qualifying criteria . For instance, Telsa are still not listed in the S&P 500 index.
4. The companies that create the indexes are paid by fund managers for their information. They are not paid by the actual listed companies to be included in the index.
5. CDOs were niche, investing in debt obligations. While some passive funds are region or industry specific, there are literally tens of thousands of passive funds with a much more diversified investment approach.

At Bluewater, we are a big believer in passive investing. For decades, companies like MSCI have designed indices that give a fair representation of the world stock market which gives investors a cheap way of getting access to the market. We will continue to recommend this approach to clients.

If you have any questions, send me an email at steven@bluewaterfp.ie

Steven Barrett

16 November 2020