Published on Dec 05, 2019 in The Index Fund Bubble
Last update: Dec 13, 2019
I’ve been a fan of index fund investing since I read A Random Walk Down Wall Street in high school. From 2011 through 2017 I put a significant portion of my investible assets into index funds, mostly via Wealthfront, which I’ve been a user of since 2012.
That strategy served me well as we’ve ridden a 10-year bull market. While I still think that on a historic statical basis, index funds have above average risk-adjusted returns, I started to notice cracks in the current foundation near the end of 2017.
Here’s the problem…
The conventional wisdom of the day has shifted from “find a good investment manager” to “invest in the general market and be patient.” This new conventional wisdom has worked well for the last 10 years, but I think that once the market stops its relentless climb up (which at some point it has to), people will show their true nature and panic–I think a lot fewer people will hold through the bottom than they say/think.
If you’re not familiar with Micheal Burry, you probably actually are. He’s the famous hedge fund manager who shorted mortgage-backed securities and made a killing in the financial crisis (featured in the movie, The Big Short).
I was recently reading through one of his letters to investors from 2001 that I think rings true again today.
Buy and hold becomes mantra at the end of a bull market. Buy and hold becomes anathema at the end of a bear market. Thanks to the raging bull for those 10 years, everyone is preaching buy, hold, patience. However, if you had invested in the market in 1969, you would be at a significant loss in 1983, especially given the high inflation of the times and the down market. In the early 50′s, the common logic was that stocks simply don’t go up, thanks to the doldrums market from the mid 30′s to the mid 50′s. Why can’t this market conceivably crash from these levels and not recover for 20 years? I guess I am just a bit of a contrarian.
I started exiting my index fund position in mid-2018 and I was relieved when Micheal Burry publicly stated in Sep. 2019 that index funds are the closest thing he’s seen to MBS since the financial crisis.
I think Burry and I came to similar conclusions.
The clearest parallel I see between MBSs and index funds is how they’re packaged–1000 mortgages vs 1000 equities–and also how they’re being promoted as the go-to financial asset. We saw in the financial crisis that a small number of mortgages in a MBS failing could cause the entire system to come down, and I think there’s a chance of that happening with index funds as well. There are record amounts of capital pouring into markets, and a lot of it into index funds. Economic times are high and index funds are the savvy place to be. People blindly buying index funds artificially pushes the prices of everything in the funds up.
This is where price discovery is lost. Markets are efficient at pricing when buyers and sellers are constantly making transactions based on the best information available. When everyone “buys everything,” price discovery is lost, and that puts the index fund in danger.
Let’s say 50 equities in common index funds were to get themselves in trouble. This isn’t too far-fetched considering corporate debt is at historic highs. And according to Anne Walsh, who manages $180B at Guggenheim Partners, lenders have never been more lax or had less control over corporate debt covenants than right now.
If the economy slows, if there’s a recession, all that corporate borrowing with almost no rules could mean lots and lots of companies won’t be able to pay their debts.
At some point the credit bubble will unwind and some of the companies who are surviving on cheap debt will go under. That’s the inevitable natural business cycle, it’s not market timing.
When the unwind happens, we could see a lot of forced selling on the entire market as a result–people will sell their entire index fund, they can’t sell just the individual equities that have gone bad. This is the same reason mortgage-backed securities almost brought down the financial system. It’s this packaging that makes index funds dangerous and could have unintended consequences.
The more people shift their investments to passive index funds, the worse the eventual crash will be.