Is it possible for passive investing to cause a market bubble? - Seedly

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Asked by Pat

Asked 2w ago

Is it possible for passive investing to cause a market bubble?

ETFs and index funds have become really popular even in asset managers' funds. Are big firms getting higher valuations without much review of their fundamentals due to this? Curious whether the recent comment by Michael Burry has raised any concerns amongst community members here!

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Michael Burry’s latest comment that he sees a bubble in passive investing has definitely grabbed headlines, but I disagree with his argument that index funds are like the subprime collateralized debt obligations (CDOs) that caused the 2008 financial crisis – i.e. passive investing will cause the next market crash.

Burry is saying that the whole stock market has become over-valued because of "blind" passive investing. However, the stock index is merely a portfolio of underlying stocks. Burry is implying that because it is put together as a passive index portfolio, investors are no longer valuing the underlying securities and are merely blindly buying and causing a growing misvaluation.

But wouldn't short-sellers, e.g hedge funds, take advantage of this by shorting the over-valued underlying stocks? Is he assuming there are no arbitragers in the stock market where "shorting" is relatively easily accessible?

What’s more, CDOs are highly leveraged while index funds, for the most part, are not. The underlying stocks of index funds are listed and can be easily traded whereas the debt securities and derivatives that underlie CDOs are more opaque and not so easily accessible to the general public.

My view is that is passive investing continues to be a solid investment strategy for most people. If you'd like to find out more, do check out our article here: https://www.syfe.com/magazine/everything-you-need-to-know-about-passive-investing/

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Eliezer Toh
Eliezer Toh

2w ago

I totally agree
Kenneth Lou
Kenneth Lou

2d ago

Interesting POV!

Theoretically possible but I think we're quite a distance from a bubble. But I do worry about the next recession because fund outflows from passive ETFs will be massive.

People who bought into the idea of passive investing and was told to just buy this and that ETF have no real clue what they're doing. The 'magic bullet' would shoot beginner investors in the foot.

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Kishor Bhagwat
Kishor Bhagwat

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Level 4. Prodigy
Answered 2w ago

CDOs and ETFs are different animals. The Burry logic is that when people are investing in ETFs, money is pouring into stocks "without any valuation or thought about liquidity" - money is been invested blindly - simply because a stock is part of an index. This is 'similar' to what happened with CDOs - money been put into instruments that are opaque and very illiquid.

This isn't true, because Active investing is still roughly 50% of overall investments - so there is enough pressure on valuation as well as liquidity.

Jack Bogle has acknowledged that 'at some threshold' passive investing may change the nature of markets - but that percentage is more like 70 to 90%. We're far from there.

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Harvey Tan
Harvey Tan

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Level 5. Genius
Updated 2w ago

In short, possible but unlikely. Market bubbles often come from speculation and guess who loves to speculate in the market? Active managers. The role of active managers/funds is to take active bets in the market on which securities will outperform and/or underperform the market. That form the basis of an active fund’s composition, i.e. on which securities to overweight and underweight.

However, I am willing to entertain the idea that in the event of a 100% market share of passive instrument and every market participants is blindly investing into the market, it may cause a market bubble. Having said that, active managers do have a place in the market, though their market shares are rapidly declining. Rightfully so, I guess. Considering that passive instruments own about 45% of the US market, it is possible that they will distort market behaviour if they continue to gain market share. For example, it will be more difficult to create a market for IPOs. If the market contains 100% passive instruments and/or managers, there will be no way to market IPOs, i.e. IPO cannot take place. https://www.cnbc.com/2019/03/19/passive-investing-now-controls-nearly-half-the-us-stock-market.html Hariz pointed out that outflows from passive instruments will be massive. Imagine what the outflows from active funds will be in a market downturn? Even bigger? Entirely possible.

Education and mentality play a big part. Whether an investor is investing in active or passive instruments, they are susceptible to the same human emotions/biasness; fear, greed, euphoria, etc. Active investors are not special human beings. If your investment horizon is more than 15-20 years, you should be praying for a market downturn as I do. A disciplined investor, regardless of active or passive, always take opportunities in the market when they arise.

As always, do your own due diligence. On a side note, I am starting a financial blog. Do check it out.

https://investment-blueprint.com

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I wouldn't bet against Michael Burry. Everyone laughed at him and everyone thought he was wrong at the time as well.

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