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9/23/2019
9/23/2019
Last week a client asked me about Michael Burry's claim that index funds are about to burst. Michael Burry was one of the few major investors who correctly predicted the 2008 market crash. Should we listen to him? More than a few thoughts:
1. Take Market Guru Advice with A Grain of Salt
On any day, I can find two market gurus who give opposing statements. Michael Burry might be considered an investor and not a guru, but he's still producing news-worthy articles outside of a research body. One has to ask the question - are they trying to sell a product (even themselves as a product or their TV/Radio show) or influence the market in a certain manner? I'm always cautions - I try to base my views and recommendations on independent analysis. I've covered this before, and my view won't change. This isn't always possible, as some of the firms have larger research funds than independent bodies.
The Wall Street Journal tested a theory that a blindfolded monkey throwing darts to select stocks would do better than market pros. Apparently they didn't use actual monkey's for liability reasons.
2. Burry Doesn't Disclose Everything, and Not in Real Time
Take a look at a few articles following Burry's investments. One key area he doesn't disclose: his short positions! And note these are post-disclosures! Burry made his fortunes in shorting the US market, not finding companies which were going to grow. Thus, I'd really like to know these short positions. As a hedge fund manager, Burry can do pretty much anything he decides and disclose holdings later. As such, he can "hint" at his actions but keep his cards hidden. Will this hint influence the market? Maybe not, but if were a hedge fund manager and had an inside look at the economy, would you announce it for public information or for private motive?
https://whalewisdomalpha.com/michael-burrys-scion-13f-holdings/
https://whalewisdomalpha.com/michael-burry-scion-asset-management-q1-holdings/
https://finance.yahoo.com/news/michael-burrys-3-favorite-stocks-192030591.html
3. Passive Funds Don't Own the Market
While they own a good portion (nearly half US equities in 2019), active still controls the other half. If the passive funds did own a majority of the market, would this be of concern? I'd suggest not - did anyone raise these concerns when the active funds controlled 90% of the market? It is a different issue, but worthy comparison for this napkin-test (wait, this is longer than what would fit on a napkin).
4. Does the Tail Really Wag the Dog? Market Liquidity Issues? Passive only Generates Alpha? Efficiency?
The key question is will indexing itself influence the market, and if the market was 100% passive how would pricing matter, and does passive investing create inefficient markets? We are still a long way from that point - but yes, it could happen. At 100% passive, there would not be competitive market pricing. But that's what is great about the market - there's no way it will be 100% passive as someone will always be out there trying to beat the market. It is a shrinking population, but until that point. Some argue that indexing makes up only 5% of the market (as of 2016) - that's not enough to be of concern.
I'll buy into the liquidity issue in a few select time frames - if the market was mostly passive and all passive investors rush the market, there's a liquidity issue. Would the active managers have enough to purchase these (at this point low cost) funds? Perhaps. But one could argue that if passive indexing, particularly with dollar cost averaging and a "set it and forget it" mindset, was the norm, market liquidity would be better during a bear market. Someone needs to do a study on this...or send me one already done!
5. This Concern Isn't Old
Yet another hedge fund manager, Seth Klarman, said in his book back in 1991 that passive investing would be a fad. And what has happened in the last 28 years? Exactly.
6. Sales Technique from Active Fund Managers
Who's screaming this issue? That's right...always active fund managers. They have to make noise, as they are consistently under performing the market. Check the latest SPIVA data here: https://us.spindices.com/spiva/#/reports
7. A Major Economic Issue? Are We Headed Into a Downturn?
Finally, we come to the root issue. Has the massive growth in passive investing caused the market to be overvalued? Yes, this could occur, and yes, we could be heading towards a downturn. Is this a reason in itself to adjust back to active management? No, not a move to active, as if the market is overvalued, I still believe in the monkey stock selection vs. an active manager. I'm a 80% core advisor and investor, but that does leave some room for an active role.
The economic question is a larger issue than this blog post, but for a short answer: I concentrate on is asset allocation, risk, which some argue (and I mostly agree) over the long term predicts nearly all of your investment returns, and do not time the market, because no one can perfectly. Risk tolerance matters, as does time frame: are we investing for the next market cycle or for retirement in 20 years? This said, I often look into alternative investments for clients, everything from rental properties (who wants to buy a villa in the French East Indies...I'll happily manage it) to small businesses (storage units in my area are making a killing) and many ideas in between. I'm not an alternative investment junkie, but I do allow 20% of my assets to be in non-passive investments. Is the market overvalued? Yes, I believe so and conventional wisdom (i.e. most fundamental analysis) says so. Is this itself a reason to pull out? If we knew the timing, yes. But remember, even God can't time the market, and attempting to will do worse than buy and hold. Ok, maybe God can, as long as we are in monotheist.
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