Here’s Why Michael Burry Says Index Funds are Dangerous

Here’s Why Michael Burry Says Index Funds are Dangerous

Updated: April 1, 2020

Originally Posted: October 21, 2019

Michael Burry, the first investor to announce (and profit from) the subprime mortgage crisis and protagonist of Oscar winning movie “The Big Short” is seeing a bubble in index fund investing.

Bloomberg: The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs

And, to be honest, I DON’T THINK HE IS WRONG! Read on to understand why.

Here are Michael Burry’s 3 main points:

1. Passive investing distorts the prices of individual stocks, because we buy every stock in the index in a fixed ratio without considering the actual underlying value of each company. This causes an upward drift in indexed stocks as more money pours into passive management.
2. The exit door is small – there is a lot of money invested in companies whose shares are not frequently traded. So if we all tried to sell at once, we’d have way too many sellers and very few buyers. This would cause a massive price crash in the stock prices of these small companies.
3. Some index funds use exotic derivatives, things like options and swaps that can shatter under stress and cause massive losses and drive volatility.

Dr. Burry is right. There are some index funds that fall into each of the descriptions he put forth. There are a lot of them actually, from leveraged funds like SPXL, to inverse exposure like SH, to volatility products like SVXY.

But we will NOT buy those types of index funds as investments.

Will we be exposed to market downturns if his predictions come true? Yes, absolutely. Will that throw us off track? Absolutely not! Here is how to understand Dr. Burry’s arguments and apply them to your long-term investing:

Passive investing distorts stock prices

This is true to an extent. If everyone buys/sells everything no matter what, then there will be times when that pushes the market to extremes.

But the market has ALWAYS been pushed to extremes in the past, even before the dawn of the index fund.

(List of stock market crashes and bear markets)

You see, human nature is built into markets. And it will be until 100% of trading is completely automated. As long term investors, we don’t care about the fluctuations day to day. The market could drop 50% and I would continue investing. I would stick to the plan.

(Update 04/01/2020: Due to the Coronavirus crash, we have seen stocks drop over 30% from their recent highs. This has been the fastest drop in stocks EVER. But I can confirm that we continue to invest every week, no matter what, because we are confident in the US economy over the long haul.)

So while his first point is undoubtedly true, people buying and selling en masse does impact pricing, it always has and always will be true! That doesn’t stop us from investing.

Exit door is small

“Ahh but MDAS, when everyone else is selling the price of the index funds will go down and I will lose money!!”

Your funds will decrease in value when more people are selling than buying, but we aren’t short term sellers so why does this matter? As long as WE don’t head for the exit when everyone else is, then we can buy up the stocks that they leave behind for pennies on the dollar.

This is hard to picture when everything is hunky dory like it is right now. However, when everything starts going up in smoke, when prices are plummeting, that is when we should be buying the most.

As the great Warren Buffett says - “Be fearful when others are greedy, and greedy when others are fearful”

Of course, don’t overextend yourself and borrow money to be invested. Be sure you have a sound financial foundation so that it is possible for you to invest in even the hardest of times. I have said it before and I will say it again, in the event that every one of America’s largest businesses is worthless, there will be much more pressing things to worry about than paper money or the stock market.

Burry’s point #2 does not stop us from investing.

Use of exotic derivatives in Index Funds

Some funds - mostly those with leveraged or inverse exposure to the market, use derivative products like options and swaps to create the returns that they promise to investors.

We are not worried about this as long as we are buying non-levered, non-inverse funds with real ownership in the underlying shares. How can you check if a fund uses derivatives to manufacture its performance?

For ETFs, head over to ETF.com/VTI and ETF.com/SPXL

These two funds track the stock market, except SPXL uses derivatives to multiply the daily performance of the stock market by 3.

This means if the stock market increased in price one percent in a day, SPXL increases by about 3%. Similarly if the stock market declines by 1%, SPXL declines by about 3%.

I said ABOUT 3% in both scenarios because the tracking of performance is not perfect. This is due to fundamental workings of derivatives, which I won’t describe right now. If you are interested in learning about options, check out our Options 101 And Options 201 posts.

You can see if a fund uses derivatives by heading over to the ETF.com link and searching for the “OTC Derivative Use” section. We want to invest in funds where this says “NO”.

(For more info on ETFs, check out my intro to the stock market)

Any fund that uses OTC derivatives to manufacture its return is susceptible to crumble in bad times, just as Dr. Burry described.

So, as I said at the start of this blog post, Dr. Burry is right.

There are some funds that should be avoided like the plague as a long term investor. However, as long as we continue to invest in a disciplined, long-term fashion, with a focus on high quality businesses, we will be just fine no matter what.

Are there any other reasons you like passive investing over active? Are there risks you have thought about that others may have not? Let me know at the contact below or on my home page!

MDAS

If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!

P.S. New blog posts coming your way every Monday!

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