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Thread: Index Fund Bubble?

  1. #1

    Default Index Fund Bubble?

    I have the majority of my retirement sunk into various index funds. This article gave me pause. Thoughts?



    Is Your Retirement Fund Ruining Our Economy?

    In the mid-2000s, Michael Burry smelled trouble in the housing market, realizing that big banks were packaging shady subprime mortgages and reselling them as surefire investments. He concluded that it would lead to a spectacular collapse, made a huge bet against the market and, ultimately, tons of money. His story was dramatized in the book The Big Short by Michael Lewis and in a Hollywood movie in which he was played by Christian Bale.

    Burry recently told Bloomberg that he sees another massive bubble happening. This time, he says, it's in index funds. Instead of relying on financial experts to actively pick winners and losers, index funds buy everything in a market, passively going up and down as the entire market goes up and down. If you're saving for retirement, there's a good chance you're invested in at least one of them.

    In 1995, index funds represented only 4% of the total assets invested in equity mutual funds. By 2015, that had jumped to 34%. There is now over $4 trillion in passive funds indexed to the U.S. stock market, more than the market cap of Microsoft, Apple, Amazon and Google combined.

    Index funds make a persuasive offer. Don't pursue the expensive and risky strategy of buying and selling individual stocks. Don't pay brokers or mutual funds big fees to move money around for you. Instead, just park your money in these passive moneymakers, which offer lower fees, diversified risk and — as the data has made clear — better returns over the long run.

    It sounds almost too good to be true, and Burry is arguing it is. And he's not alone in expressing concerns about the astonishing rise of index funds.


    The price isn't right

    Actively buying and selling stocks and bonds provides a service to the market: It's called "price discovery." If something is overvalued, traders sell it. If it's undervalued, they buy it. That moves the price of the asset, and it is the crucial mechanism to make sure the price is right, signaling its true value.

    But index funds don't really discover prices. Investors just dump money into these investments, which mindlessly hold stock in companies whether they're doing well or not. Burry believes the fall of active buying and selling has led to overvaluations, and he's predicting a crash in the value of the large companies held in index funds. "I just don't know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be," he told Bloomberg. He's now investing in small companies, which he says are often ignored by index funds.

    Burry has not disclosed much about his data or methodology. And like any trader, he could be wrong. But, even if he is, concerns about index funds go well beyond bubbles.


    A specter

    Legal scholars Lucian A. Bebchuk and Scott Hirst recently published a working paper called "The Specter of the Giant Three." The vast majority of money flowing into index funds are run by three companies: Vanguard, BlackRock, and State Street Global Advisors. Their combined average stake in each of the top 500 American corporations (the S&P 500) has gone from 5.2% in 1998 to 20.5% in 2017.

    The market for index funds, Bebchuk and Hirst argue, naturally favors bigness. Managing a trillion-dollar fund is not dramatically more expensive than managing a billion-dollar firm. This means the big firms can use their larger revenue streams to offer consumers lower fees, giving them a competitive advantage. Innovations in types of index funds are also easy to copy, meaning that it's especially hard for small companies to disrupt the big ones.

    As more and more people put their money in index funds, Bebchuk and Hirst believe these companies will just continue getting bigger and bigger. And, unlike many other investors, Vanguard, BlackRock, and State Street reliably vote at shareholder meetings, which makes them even more influential when it comes to company decision-making. If trends continue, Bebhcuk and Hirst project these three companies could cast over 40% of the votes in every single one of the 500 largest American corporations within the next couple decades.

    "In this Giant Three scenario, three investment managers would largely dominate shareholder voting in practically all significant U.S. companies that do not have a controlling shareholder," Bebchuk and Hirst warn. They fear this could have drastic implications for corporate governance and competition.

    Another group of scholars, Eric A. Posner, Fiona Scott Morton, and E. Glen Weyl, argue these gigantic institutional investors are already posing a threat to a healthy marketplace. And they urge the federal government to adopt new rules that limit institutional investors from owning large stakes in multiple companies in the same industry.

    We now look back at the housing bubble with an astonishment at the mass delusion behind the idea that home prices could always go up and that more people like Michael Burry didn't see it coming. It's possible that someday, we'll look at the promise that everyone can just buy and hold pieces of an entire market and nothing will go wrong the same way.
    https://www.npr.org/sections/money/2...ng-our-economy
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  2. #2
    I've temporarily (past two years) paused my index fund saving because of these concerns. Disagree somewhat with the way they present the price discovery issue. Most people who invest in index funds do so in small increments over a long time, and should indirectly incorporate regular price discovery mechanisms over those time scales so long as the underlying assets do as well.
    “Humanity's greatest advances are not in its discoveries, but in how those discoveries are applied to reduce inequity.”
    — Bill Gates

  3. #3
    Have about three-quarters of my investments in four main index funds; US, UK, Asia excluding Japan, and the EU.

    The other quarter is in a higher-risk non-index fund.

    Had not heard of this bubble. What Burry purports makes sense and is concerning.
    Quote Originally Posted by Steely Glint View Post
    It's actually the original French billion, which is bi-million, which is a million to the power of 2. We adopted the word, and then they changed it, presumably as revenge for Crecy and Agincourt, and then the treasonous Americans adopted the new French usage and spread it all over the world. And now we have to use it.

    And that's Why I'm Voting Leave.

  4. #4
    Out of curiosity, why Asia excluding Japan?
    “Humanity's greatest advances are not in its discoveries, but in how those discoveries are applied to reduce inequity.”
    — Bill Gates

  5. #5
    Quote Originally Posted by EyeKhan View Post
    I have the majority of my retirement sunk into various index funds. This article gave me pause. Thoughts?

    https://www.npr.org/sections/money/2...ng-our-economy
    I read Burry's comments with interest when Bloomberg interviewed him, and I've heard similar arguments in the past. The question is how large a chunk of the market needs to be owned by indices before this becomes a problem? I suspect you'd need a lot more than a third. It's also smacks a bit of self-interested when active fund managers talk about how their role is so critical and index funds are screwing everything up - this has been an argument every since Bogle made his first passive investing push.

    The truth of the matter is that most of the market has been effectively passive long before indexing became a big thing. I don't mean passive in the sense that it was automated, but passive in that the managers of the money did not do a very aggressive job in either price discovery or, more broadly, oversight. That has always been the job of a small slice of the market that trades aggressively and actually has an opinion on most shareholder votes. Everyone else tended to own large sectors or classes of stocks with little attention paid to individual prices unless something was going really wrong (or right). So I'd need to see some fairly sophisticated math to make me really believe that this is a big problem right now. Obviously volatility might increase as the slice of the market that actually trades gets smaller, but I'm not convinced that's a huge issue right now. Indices in some niche markets - e.g. some emerging markets, some small cap markets - might have much more pronounced issues than, say, a total US stock market index.

    I've never been a huge fan of indices because they're generally market cap-weighted, which means you tend to be overweight in bloated stocks no matter what you do. The problem is that there aren't a lot of good alternatives - pretty much any active fund doesn't justify the expense ratio, and alternatives to traditional indexing like 'smart beta' funds and the like have not been well proven. Until there's a decent alternative, this is going to be an externality problem that won't be fixed by individuals minimizing their index exposure. I wouldn't worry too much at the moment.

    (FYI despite my critique of index funds, almost 100% of my various investment in equities are in various index funds. The exceptions are when specific offerings I'm looking for don't exist in an employer sponsored retirement plan.)
    "When I meet God, I am going to ask him two questions: Why relativity? And why turbulence? I really believe he will have an answer for the first." - Werner Heisenberg (maybe)

  6. #6
    Quote Originally Posted by Aimless View Post
    Out of curiosity, why Asia excluding Japan?
    When I set up the funds around four years ago, the company I chose to manage the funds, Fidelity, had two Asia-Pacific index-funds on offer; Japan, or Asia excluding Japan. I would have preferred Asia including Japan, but given a choice out of the two I went with the latter.

    My main priorities were US and UK index-funds and a non-index higher-risk equity-blend fund. Asia-Pacific index was more of an afterthought and is my smallest fund. Until recently it was also the fund with the lowest annualised return of the four funds I have, but has now overtaken the UK fund in that regard.

    The US fund is streets ahead of the other three.
    Quote Originally Posted by Steely Glint View Post
    It's actually the original French billion, which is bi-million, which is a million to the power of 2. We adopted the word, and then they changed it, presumably as revenge for Crecy and Agincourt, and then the treasonous Americans adopted the new French usage and spread it all over the world. And now we have to use it.

    And that's Why I'm Voting Leave.

  7. #7
    Quote Originally Posted by EyeKhan View Post
    I have the majority of my retirement sunk into various index funds. This article gave me pause. Thoughts?
    Extend your retirement date by at least five years.
    Don't trust Vanguard, BlackRock or State Street just because they're "leaders" in the index fund market.
    Keep a large amount of cash in a savings account, just in case the markets blow up (again).
    Take a more pro-active role in your finances -- and ask more questions of your financial adviser.

  8. #8
    It's telling that the publication and wide dissemination of this argument didn't have any effect on the market.
    Hope is the denial of reality

  9. #9
    Quote Originally Posted by Loki View Post
    It's telling that the publication and wide dissemination of this argument didn't have any effect on the market.
    How do you know?
    "When I meet God, I am going to ask him two questions: Why relativity? And why turbulence? I really believe he will have an answer for the first." - Werner Heisenberg (maybe)

  10. #10
    Quote Originally Posted by wiggin View Post
    How do you know?
    Which part? I've seen a bunch of replies from finance people. They seem to be taking the argument seriously, even if none agree with it. As for the second question: the market has barely moved in either direction since this story was written. Neither have I read anything about money moving from index funds, even in small amounts (I assume someone smarter than me would have noticed such a trend). And yes, it's hard to attribute market movements to specific events, but I assume if people took this theory seriously, we'd see some serious shifts in the allocation of funds. Or at least of new money.
    Hope is the denial of reality

  11. #11
    Arguments like Burry's have been around for years. If they were going to have an effect on the market, it would at best show up as a slowing in the shift to passive investing, which itself is nearly impossible to see without the counterfactual. There isn't a well defined 'event' we can use as a signal.

    More broadly, you could view this as a problem of the commons. Burry's concerns really only matter if no one is doing price discovery work because they're all passive. So it's easy to imagine a situation where people take his concerns very seriously indeed but it still doesn't change allocations.
    "When I meet God, I am going to ask him two questions: Why relativity? And why turbulence? I really believe he will have an answer for the first." - Werner Heisenberg (maybe)

  12. #12
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    I seriously have no idea what to do. I'm looking at a situation where I will have a mixture of a state pension, a company pension and capital in rental properties. WRT the last I feel that in the long run that's going to be a bit too much of a hassle, but I simply see no alternative that will give me a a reasonable return.
    Greece shows us that there is a kind of politician worse than the ones that break their election promises; the ones that keep their election promises.

  13. #13
    No one over 50 yrs old really knows what to do. Even if they have pensions. It's scary because of the time constraints. Living longer can be the biggest liability of all....

  14. #14
    Quote Originally Posted by Hazir View Post
    I seriously have no idea what to do. I'm looking at a situation where I will have a mixture of a state pension, a company pension and capital in rental properties. WRT the last I feel that in the long run that's going to be a bit too much of a hassle, but I simply see no alternative that will give me a a reasonable return.
    Do you have anyone managing those properties for you? Less return, but no headache. I'd wait until the next recession, and then invest semi-conservatively in stocks/bonds. You could get an annuity depending on what you think is your life expectency.
    Hope is the denial of reality

  15. #15
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    Quote Originally Posted by Loki View Post
    Do you have anyone managing those properties for you? Less return, but no headache. I'd wait until the next recession, and then invest semi-conservatively in stocks/bonds. You could get an annuity depending on what you think is your life expectency.
    Not yet but I'm thinking about it. As for liquidation; very uncertain about when.
    Greece shows us that there is a kind of politician worse than the ones that break their election promises; the ones that keep their election promises.

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