Bloomberg's Reed Stevenson
reports The Big Short’s Michael Burry explains why index funds are like subprime CDOs:
For an investor whose story was featured in a best-selling book and an Oscar-winning movie, Michael Burry has kept a surprisingly low profile in recent years.
But it turns out the hero of “The Big Short” has plenty to say about everything from central banks fueling distortions in credit markets to opportunities in small-cap value stocks and the “bubble” in passive investing.
One of his most provocative views from a lengthy email interview with Bloomberg News on Tuesday: The recent flood of money into index funds has parallels with the pre-2008 bubble in collateralized debt obligations, the complex securities that almost destroyed the global financial system.
Burry, who made a fortune betting against CDOs before the crisis, said index fund inflows are now distorting prices for stocks and bonds in much the same way that CDO purchases did for subprime mortgages more than a decade ago. The flows will reverse at some point, he said, and “it will be ugly” when they do.
“Like most bubbles, the longer it goes on, the worse the crash will be,” said Burry, who oversees about $340 million at Scion Asset Management in Cupertino, California. One reason he likes small-cap value stocks: they tend to be under-represented in passive funds.
Here’s what else Burry had to say about indexing, liquidity, Japan and more. Comments have been lightly edited and condensed.
Index Funds and Price Discovery
“Central banks and Basel III have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in interest rates anymore. 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.
“This is very much like the bubble in synthetic asset-backed 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.”
Liquidity Risk
“The dirty secret of passive index funds -- whether open-end, closed-end, or ETF -- is the distribution of daily dollar value traded among the securities within the indexes they mimic.
“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. The S&P 500 is no different -- the index contains the world’s largest stocks, but still, 266 stocks -- over half -- traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”
It Won’t End Well
“This structured asset play is the same story again and again -- so easy to sell, such a self-fulfilling prophecy as the technical machinery kicks in. All those money managers market lower fees for indexed, passive products, but they are not fools -- they make up for it in scale.”
“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. However, I just don’t know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be.”
Bank of Japan Cushion
“Ironically, the Japanese central bank owning so much of the largest ETFs in Japan means that during a global panic that revokes existing dogma, the largest stocks in those indexes might be relatively protected versus the U.S., Europe and other parts of Asia that do not have any similar stabilizing force inside their ETFs and passively managed funds.”
Undervalued Japan Small-Caps
“It is not hard in Japan to find simple extreme undervaluation -- low earnings multiple, or low free cash flow multiple. In many cases, the company might have significant cash or stock holdings that make up a lot of the stock price.”
“There is a lot of value in the small-cap space within technology and technology components. I’m a big believer in the continued growth of remote and virtual technologies. The global retracement in semiconductor, display, and related industries has hurt the shares of related smaller Japanese companies tremendously. I expect companies like Tazmo and Nippon Pillar Packing, another holding of mine, to rebound with a high beta to the sector as the inventory of tech components is finished off and growth resumes.”
Cash Hoarding in Japan
“The government would surely like to see these companies mobilize their zombie cash and other caches of trapped capital. About half of all Japanese companies under $1 billion in market cap trade at less than tangible book value, and the median enterprise value to sales ratio for these companies is less than 50%. There is tremendous opportunity here for re-rating if companies would take governance more seriously.”
“Far too many companies are sitting on massive piles of cash and shareholdings. And these holdings are higher, relative to market cap, than any other market on Earth.”
Shareholder Activism
“I would rather not be active, and in fact, I am only getting active again in response to the widespread deep value that has arisen with the sell-off in Asian equities the last couple of years. My intention is always to improve the share rating by helping management see the benefits of improved capital allocation. I am not attempting to influence the operations of the business.”
Betting on a Water Shortage
“I sold out of those investments a few years back. There is a lot of demand for those assets these days. I am 100% focused on stock-picking.”
Dr. Michael Burry has gained notoriety after being brilliantly portrayed by actor Christian Bale in "
The Big Short."
In September 2006, I was working at PSP Investments as a senior investment analyst in the Asset Mix Group and started doing research on the issuance of CDOs, CDOs-squared and CDOs-cubed.
Needless to say, just looking at the total issuance, you knew something was going to crack in the credit markets but nobody knew how bad it was going to get.
I discussed my findings with my boss, Pierre Malo, and my colleague, Mihail Garchev. Pierre asked me to call Goldman and find out how to short a popular credit default swap (CDS) index.
So I did, picked up the phone and called Ramsey Smith who was covering us at Goldman back then. Ramsey had a conference call with me at a couple of his colleagues who were perplexed: "Why would you want to do that? The US housing market is extremely strong."
Note, this was two years after I
met Bridgewater's founder Ray Dalio and pressed him on deleveraging and deflation where he pushed back and put me in my place: "Son, what's your track record?".
Goldman never got back to us on how to short CDS. Ramsey Smith went on to
found ALEX.fyi which "works with financial advisors and individuals to navigate the financial challenges associated with longevity" (he's actually a very nice guy).
In October 2006, I had breakfast with Gordon Fyfe, then president and CEO of PSP to share my findings and why I was very concerned with the credit risk PSP was taking back then. Gordon warned me that I was being "too negative" and pissing off some senior managers. Later that month, I was out of a job and the rest as they say is history.
Of course, I wasn't portrayed in Michael Lewis's
The Big Short and neither did I deserve to be. I was a lowly investment analyst at a large Canadian pension fund who irritated the hell out of people and didn't make hundreds of millions of dollars shorting the market back then.
Like Ray Dalio says, "What's your track record?". Talk is cheap, show me your track record and if you made a gazillion dollars, then you deserve a place in Michael Lewis's book and a spot on CNBC and Bloomberg blabbing away your views on the market.
By the way, as an aside, my favorite hedge fund manager of all-time whom I never met,
Andrew Lahde, made a killing shorting the market during the 2008 meltdown (866% net return that year) and then had the wisdom to book his profits and walk away from the industry for good.
Before he did, however, he had a few choice words for "the low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA" in an
open letter where he basically told the world "Goodbye and F**k You".
Lahde wasn't portrayed in Michael Lewis's book or the movie, probably because he told Lewis to "f**k off" and leave him alone (I'm speculating but not everyone wants to be portrayed in a book or movie).
Anyway, back to Dr. Michael Burry and what he sees as the next subprime CDO crisis, the astounding rise of passive investing, aka indexing.
Welcome to the bandwagon "Dr. Burry", it's so nice of you to join the chorus of active managers blasting passive index strategies
as they continue to severely underperform their benchmark.
To be sure, Burry raises a lot of great points, he's not an idiot, far from it, but what a lot of people don't know is the great American economist,
Paul Samuelson, once warned that while he loved the indexing strategy Burton Malkiel extolled in his seminal book,
A Random Walk Down Wall Street, he
feared what would happen when everyone adopted this strategy.
Capiche? Everything works well until everyone jumps on the bandwagon and ruins it for everyone else. Burry is right, bubbles last a lot longer than you think. Keynes famously warned investors:
"Markets can stay irrational longer than you can stay solvent."But when it comes to passive indexing, it's not as simple as Burry thinks, especially now that central banks are "all in" trying to fight deflation, actively buying stocks in hope of raising inflation expectations (good luck with that strategy).
Basically, if you're claiming there's a bubble in index funds, which there may very well be one, then you also have to prove to me there's a bubble in central banking and that's where you'll lose me.
As Simon Lamy, a former bond portfolio manager at the Caisse, recently told me: "Unlike you or I,
central banks have no P&L, they can keep creating money and hitting the bid."
Burry talks about how the Bank of Japan owns a huge chunk of Japanese equities and that insulates them from this bubble he's warning of but who is to say the Fed and ECB can't follow in the BoJ's footsteps? They're already doing it covertly and sometimes openly or through the Swiss National Bank.
There's something else, you should all read Josh Brown's recent blog comment,
The Real Bubble Has Always Been in Active Management:
Michael Burry joins the chorus of people referring to indexing and passive investing as a bubble. It’s not his main point – which is that value small caps are being ignored, which is true – but it’s a point we now hear tossed off on a daily basis as casually and nonchalantly as though the speaker were simply saying that water is wet or LeBron James is good at basketball.
Most of the people referring to passive investing as a bubble have not accurately described the way in which it represents a bubble. What they’re really saying is that it is popular. So is shopping online and using Instagram and eating Mexican food. These things aren’t “bubbles.”
The term bubble, in the financial vernacular, represents something that is highly speculative in nature and surrounded by so much unbridled enthusiasm and untempered greed that it is unsustainable and due to blow up spectacularly. This is a terrible description for the current preference for low cost funds and low maintenance investing strategies. People using the term “bubble” to describe the newfound humility among ordinary investors (and their financial intermediaries) are either bitter, deliberately trying to mislead or mistaken.
Michael Burry’s a brilliant investor and has accomplished something in the market that 99.99% of all other investors could not or would not be able (willing?) to do. He especially ought to know better.
The real bubble is in actively managed funds. But we’re nowhere near that bubble’s peak, which was in the mid to late 1990’s. It’s been slowly deflating since the Great Financial Crisis – the moment the Boomer generation truly fell out of love with investing as a pastime or a recreational activity permanently. There were no more star stock managers from that moment forward, as almost all of them blew up along with the indexes and averages. The investor class then said to itself, subconsciously, “Why bother, I’ll just own the indexes and averages.”
From 1987 through 2007, we had a twenty year bubble in investor preference for active managers and stockpicking as a sport and investing as a hobby. In 1989, Peter Lynch’s book “One Up on Wall Street” came out and Warren Buffett’s status as a crossover celebrity began to take shape. The iconic brands and corporations of the mid 1980’s – like Coca-Cola and Nabisco and AT&T and IBM – became revered by the investor class and owning their shares became a token of success, their logos the emblems of Yuppiedom. This led to the inaugural broadcast of CNBC, the mainstreaming of BusinessWeek and Fortune and Forbes, and, later into the next decade, the rise of TheStreet.com and Yahoo Finance.
And as the 1982-1999 bull market gained steam, stock-picking mutual fund managers became household names. Celebrities began appearing in television commercials for do-it-yourself online brokerages, promoting a message that even truck drivers could one day buy their own island and anyone who wanted to begin trading stocks could one day become rich. Movie stars, tennis pros, famous basketball coaches and even Jackie Chan appeared in these spots for Ameritrade, Schwab, Waterhouse, Olde Discount, ScottTrade, eTrade, DLJ Direct, Fidelity, etc.
And then it fall came crashing down as the millennium rolled over. Whatever enthusiasm the dot com bubble and bust didn’t destroy in 2000-2002, the credit bubble and subsequent Great Financial Crisis would finish off just a few years later. By 2009, the Boomers were ten to fifteen years removed from the heyday of enjoyable active management and they were done with it. Later generations had never truly experienced that moment in time, and so never became enamored with the idea of recreational trading (until Crypto and Robinhood, both creatures of the latter twenty-teens decade, both very far removed from anything even remotely representing “investing” activity).
The active management bubble produced massive asset management companies that have been shrinking every year, despite the rise of both the bond and stock markets over the last decade. They are declining in headcount, advertising spend, product offering, investor awareness and prominence among the Fortune 500. None of this is abnormal – they were mostly too big in the first place, the beneficiaries of a bubble environment that hasn’t existed for over ten years now.
The twenty year period from 1987-2007 was the real aberration. What’s happening now is a reversion to normalcy.
Prior to Peter Lynch’s books, the celebrity of Buffett, the all-day news channels and websites devoted to chronicling stock prices, etc, the vast majority of people were passive investors. But they didn’t realize it. The predominant form of retirement investment was happening out of their hands, and in the hands of the massive pension fund management and administration complex, all over America. You traded your best thirty years to a corporation or a union or a government agency in exchange for someone managing the money behind the scenes that would one day represent your retirement. You didn’t see your pension’s money manager face to face or have conversations about the stocks and bonds he was buying. You didn’t feel personal ownership over the investments themselves. You were merely a passive investor, awaiting your investments to turn into a stream of income upon retirement.
And if you owned individual stocks in the 30’s, 40’s, 50’s, 60’s, 70’s, it was because you were in the upper class or you had a very savvy parent or grandparent that had accumulated these investments. Often, they were in the form of stock certificates, held passively in an attic or a binder or a safe deposit box. Another possibility is you worked for a company that distributed shares as part of compensation or severance or to commemorate some long anniversary of your labor at the company. My wife’s grandmother had hundreds of shares from the various Baby Bell telephone companies she worked at in the 60’s, 70’s and 80’s. She was not an “active investor” simply because she held these shares individually as opposed to within an index fund. American households owned stocks individually prior to the aberrant period of stock market enthusiasm – but they weren’t operating under the delusion that they had the ability to trade against everyone else successfully, or that they ought to be spending their free time trying. They may have owned stocks, but they weren’t active investors.
Speculative bubbles in stock market activity and enthusiasm had come and gone since the beginning of our nation – first with canals in the early 1800’s, then with railroads fifty years later, then during the electricity and automobile boom of the 20’s, etc. But these were manias. They came and went. They had nothing to do with investing per se. They were gambling opportunities.
Pensions were the first form of investing that had ever caught on among mainstream American households. And their role in how these pensions were invested was almost non-existent – entirely passive. Once they were given domain over their own retirement funds in the shift from defined benefit pension plans to defined contribution 401(k)’s in the 80’s and 90’s, the brief dalliance with stock market fun and candy took hold, and an entire superstructure of fund companies and financial media had erected itself around them. What you are witnessing now is the slow and steady dismantling of this structure. It’s been over for a long time, but the realization has only become apparent in the last few years.
The popularity of passive investing isn’t new at all, it’s a throwback to the days of people focusing on their own work and careers, not trying to pick managers and become part-time market speculators. You can never have a bubble in humility, apathy and passivity, which had always been the status quo up until the ’87-’07 period and is the more natural posture for investors to adopt for the future.
Very well stated, Mr. 'Reformed Broker', and there's no doubt people are sick and tired of hearing about the market and which stocks to buy so the great majority just buy exchange-traded funds (ETFs) and forget about it.
In another critical comment, Ben Carlson of A Wealth of Common Sense
debunks the silly "passive is a bubble" myth, noting index funds hold less than 15% of shares in public companies. And according to former
Vanguard CEO Bill McNabb, indexing in stocks and bonds globally represents less than 5% of global assets (this would validate Josh Brown's point, the real bubble is in active management).
Ben also notes the following:
Benchmark huggers have always been around. Vanguard and iShares have experienced massive growth in the past 10-20 years, seeing trillions of dollars of inflows. But this doesn’t mean indexing is new. It’s just in a cheaper wrapper now.
Professional money managers have been closely tracking their benchmarks for decades now. That’s because those indexes are their benchmarks. Very few actively managed funds deviate much from those benchmarks because being different eventually leads to underperformance, which can lead these managers to get fired.
Career risk may be one of the greatest inefficiencies people never talk about but it’s there. And because career risk has always existed, closet indexing has been around for some time.
Plus there’s the fact that pensions and other large institutional investors have been creating their own index funds in-house using separately managed funds for years. We’re just seeing a shift from closet indexing to ETFs and other index funds en masse now that investors have wisened up.
Isn’t it a good thing investors are shifting away from expensive closet index funds?
Active funds literally own the market. When you buy an index fund of the total stock market, you are literally buying the stock market in proportion to the shares held by all active investors. If you sum up the collective holdings of active managers, what you basically get is a market-cap-weighted index. Index fund investors are simply buying what the active investors have laid out for them.
Plus we have to remember that not every cent flowing into index funds is going directly to the S&P 500 or a total market fund. Most of the money is going there but there are also index funds for small caps, mid caps, value, growth, sectors, themes, and everything in-between.
Many of the worries about indexing really boil down to career risk in the asset management space. By taking themselves out of the game and buying index funds, there are now fewer suckers at the poker table for the pros to take advantage of.
Isn’t it a good thing most small investors have decided they can’t compete with the professional active managers who trade with one another?
I recommend you read Ben Carlson's full comment
here, its' excellent. I would also add Vanguard's founder, the late Jack Bogle, knew very well there's a
symbiotic relationship between active and passive investing; one cannot exist without the other.
Just remember what I stated above, when everyone is doing the same thing, it's great news for BlackRock, State Street and Vanguard, as long as markets keep rising and passive strategies continue to outperform active ones.
But when the music stops, and it will, there will be another "reversion to the mean" which Josh Brown and others will witness, the reversion back to active management to protect against downside risks and mitigate against
permanent loss of capital.
You can only short volatility for so long before you get your head handed to you. We have witnessed two major drawdowns in the S&P 500 over the last decade and trust me, we will witness a lot more.
Global pension and sovereign wealth funds know this which is why they're increasingly and frantically shifting assets out of public markets into private markets which aren't marked-to-market and aren't as volatile as public markets (in theory, in practice, they can swing hard too when it hits the fan!).
Then again, some astute investors think there's a bubble going on in private markets and private debt too and that will be the Mother of all bubbles.
Or maybe the real bubble is in global bonds as the record issuance of sovereign bonds with negative yields continues to wreak havoc on
markets and
pensions. Maybe but I agree with Gary Shilling, even with rates this low, it only takes a small drop to
generate big returns on longer-dated maturities.
And so I end my long weekend rant on the real bubble in markets. Truth is nobody knows which is the so-called "real bubble", we are entering the Twilight Zone again, central banks are doing everything they can to "save capitalism" from imploding and that makes it a lot tougher to discern whether or not financial bubbles are about to burst.
Will the music stop? Yeah, sure, it always does, but nobody knows when and at that point I'm afraid there will be much bigger geopolitical concerns to contend with.
Lastly, beware of those claiming
index investing beats having a well-governed defined benefit plan. It most certainly doesn't, especially over the very long run.
Below, Michael Burry shot to fame and fortune by betting against mortgage securities before the 2008 crisis, a trade immortalized in “The Big Short.” Now, Burry sees another contrarian opportunity emerging from what he calls the “bubble” in passive investment. Bloomberg Intelligence's James Seyffart
has more on "Bloomberg Markets."
Seyffart is right, the media has sensationalized Burry's views and blown much of what he stated way out of proportion. Maybe there's a
Big Short Bubble.
Also, watch Federal Reserve Chairman Jerome Powell
in discussion with Thomas J. Jordan, chairman of the Swiss National Bank, on the US economy and monetary policy. The discussion is hosted by the Swiss Institute of International Studies in Zurich, Switzerland.
Powell
discussed the Fed's various viewpoints. Listen to his response on all the different views on whether to cut 25 or 50 basis points.
Fourth, Jason Furman, professor at the Harvard Kennedy School and former Council of Economics Advisers chairman, Michael Strain, director of economic policy studies for American Enterprise Institute, and Jill Carrey Hall, senior US equity strategist for Bank of America Merrill Lynch,
join"Squawk Box" with their reaction to the August jobs report. The panel is also joined by CNBC's Steve Liesman and Rick Santelii.
Lastly, the
trailer of the movie The Big Short. Great movie even if it's a bit too sensational.
