An inquiry into Index Funds and Trackers: Is there a Bubble?

Growth of Passive Investing:

(DiBenedetto, 2019)

The Index Fund market has grown five-fold since the global financial crisis of 2008, holding more than $10 Trillion worth of assets as of September 2019. Based on a report by Morningstar, Passive investment funds have seen an unbroken streak of growth, reaching parity with actively managed funds last year. However, various economists and financial experts like Robert Shiller and Michael Burry are warning us that these index tracking vehicles are causing more harm than good by inflating asset prices.

An Introduction to Mutual Funds, ETFs and Index Funds:

But before we delve deep into this world of index funds, let us first understand some key differences between a Mutual Fund, an Index Fund and an ETF.

A mutual fund is a company that collects small (or large) amounts of money from people, pools it, and invests it for them. These funds allow people to collectively have a stake in companies and securities they could never achieve on their own. Mutual Funds are great for diversification, and convenience. They help avoid the inefficiencies that plague investing on our own, like large brokerage fees, or having to constantly re-balance our portfolios.

Mutual Funds can be of two types. The first is an actively managed fund where you have professionals choose the composition of the portfolio, based on some pre-determined characteristics (i.e. the basic nature of the fund). These funds are rather expensive, charging approximately 1-2% of the amount invested per year, regardless of whether the fund makes a profit or a loss since client have to remunerate fund managers.

Tired with these high fees and sub-par performance, Jack Bogle in 1976 created something known as an index fund. An index fund would operate as a mutual fund, however, this kind of fund would simply track a market index (Like the SWPPX). It would do this, cheaply (0.2% fees) and efficiently allowing the average American investor (in the 1970s) to have a stake in the broader performance of their economy. Though initially labelled as “Bogle’s Folly”; the idea soon caught on when index funds began to beat the market over the long term, according to the BBC. It is important to remember that index funds are a type of passively managed funds but not all passively managed funds are index funds. There are different types of active and passively managed funds that track different sets of securities. An investor is essentially spoiled for choice when investing in these.

ETFs are similar to mutual funds but they’re not the same. Unlike mutual funds, that can be traded only once a day, ETFs can be traded like a stock. ETFs track the value of underlying securities, whether these are stocks, commodities or bonds; and maintain their value close to the Net Asset Value thanks to the no arbitrage principle. ETFs have to be dealt in large blocks known as “Creation Units”. You might get a slightly higher or slightly lower value than the Net Asset Value of the underlying securities because the demand-supply discrepancies of the ETF and the fact that they are dealt with in these creation units.

If an investor wants to track an index or a particular security, they can also simply purchase an ETF tracker for that security. For example, you could purchase a Vanguard S&P500 ETF (VOO for just around $300 as of 02/2020) and it would essentially do the same thing as a passively managed index fund.

What is the Index Fund Bubble?

Michael Burry who famously predicted the 2008 credit crunch and financial crisis has diverted his attention to Index Funds. In a recent Bloomberg interview, he compared index funds to CDOs and stated that people were only invested in them because they saw the index fund values go up. He said that “Passive Investing has removed price discovery from equity markets […] these [index fund investments] do not require the security-level analysis that is required for true price discovery.”

He said that this was very similar to synthetic CDOs where there was no fundamental security level analysis. In simpler words, big companies are buying large amount of stock in companies included in indexes simply because there is a demand for the index funds or index trackers. Not because the stocks deserve to be bought because of their fundamentals and this, over the years, has created a self-reinforcing bubble.

Burry goes on to point out the liquidity risk of these assets by stating that in the Russel 2000 (which tracks the bottom 2000 small-cap companies in the Russel 3000 index, an index which gives exposure to the entire US Stock market); 1049 stocks were traded less than $5 Million during the day. And of these, 456 stocks traded less than $1 Million. This brings us to the point that, a lot of money is thrown into companies that do not have too much demand for their stocks. These companies are only traded because they’re part of an index fund. Burry’s broader idea is (much like the synthetic CDO market) that there is more money betting on the performance of these smaller stocks than there is actively analyzing and trading them.

If everyone was to sell their stakes in an index fund one day, the larger companies could still be bought, but the smaller ones would simply sink. This also leads us to a parallel problem that stocks with a higher market capitalization would be bought far more thanks to their (higher) weights and this leads to their prices rising disproportionally above fundamentals as well.

Burry however isn’t the first one to bring this up. In 2017, economist Robert Shiller called Passive Investing a pseudo-science and argued that it has damaged markets more than anything else. He said the thought behind passive investing was that the market is “all knowing” but the market cannot be “all knowing” if no one is trying.

Synthetic ETFs:

Richard Coffin mentions Synthetic ETFs and how these could be the probable real threat in this situation. While these are just 2.9% of North American ETF assets, they form 35% of European ETFs; many of which trade on US markets. A synthetic ETF uses derivatives and leveraged products like options to replicate the results of an underlying index. For example, the Pro-Shares Ultrapro QQQ returns 3(x) times the performance of the NASDAQ 100.

If there was a downturn in the underlying, such ETFs could pose significant downward pressure on the assets Because they would actually have to deliver on their promised assets, exacerbating the current problems.

Alternate Ideas:

However, investors have been a bit skeptical of this view; and investing in index funds has continued to rise. The logic for this is that if a large company wasn’t performing well, and the earnings missed their mark; the stock price would see a fall regardless of their inclusion in an index fund. Index fund investing also form a very small part of the daily trade volumes (5% approximately). For an equity to be included in an index it has to be successful to begin with. Like in the S&P 500, the top 10 companies make up 22% of its composition. Generally, these types of funds don’t even buy the smallest companies in the index they track.

A report by SeekingAlpha analyzed stock market performance with respect to new stocks being included in the index. They found that prices (on average) rose sharply after it was announced that the stock would be included but subsequently fell over the course of the next two months once the stock had been included in the index.

So, this would mean that markets price in this inclusion over time; and it does not necessarily mean that there is an index fund bubble.

Additionally, when we talk specifically about ETF trackers, trading these among ETF holders (over a short period) is not going to affect the underlying unless the authorised participant creates or destroys some units of the ETF. Traders however argue that there are arbitrage opportunities that can be exploited in a small time period before the participant actually creates or destroys these units; artificially inflating prices – This area however needs more study.

I personally am not against passive investing, but I would be wary of its risks and try to read more about it and the underlying before I make a final decision. For the moment, all I can say is that it doesn’t seem to be as large an issue as the global financial crisis of 2008 and minor over buying and selling often adjusts itself in the long term; however this certainly is an issue worth tracking.

Sidhaant MEHRA

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