Michael Burry's Warning for the Index Fund Bubble in 2023

Do you happen to own index funds as a part of your stock portfolio? I do. My YouTube buddies do. My accountant does. Heck, even my old school friends do. Well, what if I told you the famous market tracking index fund might be fueling a massive stock market bubble? Recently, that's exactly what legendary investor Michael Burry said on Twitter.

Quote: "The difference between now and 2000, also known as the crash, is the passive investing bubble that inflated steadily over the last decade. All theaters are overcrowded, and the only way anyone can get out is by trampling each other. And the door is only so big."

But what does he mean by this? Then could the innocent market tracking index fund actually bring down the entire stock market? Well, let's find out.

As a very quick refresher, by buying a market tracking index fund, you're essentially buying a stock that represents diversification across the whole market. For example, the biggest index fund in the whole world is SPY, which is an S&P 500 index fund. So by buying into SPY, those shares will actually represent a very small ownership in the largest 500 companies in the United States. The idea here is that by buying the market, you'll get the same return as the market over time—a return which history tells us is not too shabby. It's around 10% annually for the S&P 500 over the long term.

Because of the, quite frankly, amazing historical annual return of this strategy, but also the simplicity and ease of actually implementing it over the past few decades, passive investing has gained a lot of popularity. A study by Bloomberg Intelligence recently found that, on average, more than 20% of the share of each company in the S&P 500 were held by passive instruments. For context, back in 2003, roughly 3.3% of the market was held by passive structures. These kinds of numbers have now started raising questions as to whether this dominance of passive investment is actually a good thing for the market.

Michael Burry certainly thinks it's cause for concern. But what's interesting is that despite mentioning the passive investing bubble recently on Twitter, this actually isn't the first time he's raised the issue. In fact, back in 2019, he did an email interview with Bloomberg on exactly this topic where he noted, quote: "Passive investing has removed price discovery from the equity markets. The simple thesis and models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies do not require the security level analysis that is required for true price discovery."

What this means is that over time, as passive investing becomes more popular, more and more shares of these big companies are being held not because the investor actually likes the company, but simply because they're in the index. What this leads to over time is an overinflation of stock prices. The buying of shares is no longer simply driven by the fundamental performance of these businesses; it's, in fact, being driven because they happen to be in the right index. And that right there—that's a bubble.

You know, when the price of an asset inflates for a reason other than its underlying performance. So the question is, could the popularity of passive investing cause such a bubble that it could pose a threat to market stability? If investors en masse start moving out of index funds and back into cash, well, the answer, as per usual, isn't clear.

For example, let's revisit how stock prices actually move. I mean, it's pretty simple. Stock prices move based on supply and demand. So if a lot of investors want to buy shares, but only a few investors are willing to sell, then the stock price will move up. On the flip side, if there's suddenly a lot of investors trying to sell but there are not that many buyers, then the stock price will fall.

Now for every stock, they have a typical daily trading volume, aka how many shares on average change hands each day. The thing to know about daily volume is that unless the daily volume is suddenly heavily disturbed, then the share prices, they don't really move all that much. But, for example, if the market is crashing and there's widespread selling, then occasionally there can be such a flood of volume trying to get out that it can very rapidly kill the stock price.

There won't be very many buyers, but there will be a lot of people trying to sell, thus the price will be set by the most desperate player that's trying to leave until more buyers arrive to settle things down. This is what Michael Burry is talking about when he says all theaters are overcrowded, and the only way anyone can get out is by trampling each other.

The door is only so big. This is a reference to a classic stock market example that explains daily trading volume. The example goes that you're in a cinema with, you know, 100 people, and the only rule of this cinema is that to get out, you have to find someone else to take your seat.

So, in normal conditions, that's okay. Usually, there'll be someone that wants to come in and watch a movie. But what would happen if the theater suddenly caught fire? All of a sudden, you'd have a hundred people trying desperately to get out but not a lot of people wanting to come in and watch the movie while the theater burns. That's what Michael Burry is worried will happen in the stock market.

His opinion is that if conditions continue to deteriorate, that will trigger a lot of passive investors to try and leave the market and go back to cash. But if everybody does this in a panic, then it will crash stock prices. The thing is, usually this happens to isolated businesses when things go wrong. But what happens if passive investors, which, you know, actually own a little bit of everything, all decide to leave at once?

Well, I guess it crashes everything, right? All the stocks in the index will cop the same effect. However, there is one factor on the flip side of that coin, and that is that despite a lot of trading activity occurring in and out of these passive funds, this actually doesn't translate to a massive amount of trading volume in the underlying companies that make up the index.

How could that be? Well, it's actually because most of the trading of ETF shares happens on the secondary market, aka it's passive investors simply trading back and forth with themselves. I want to give a huge shout out to Ben Felix, who actually made a great video on this topic three years ago. In that video, he quotes two really, really interesting pieces of evidence.

The first is from Vanguard, and this shows the percentage of ETF trading that is either on the secondary market or that actually affects the trading volume of the underlying securities. They found that 94% of the time, the trading was conducted on the secondary market. In other words, for all of that ETF trading volume, 94% of it didn't even touch the underlying stock positions that make up the ETF.

But what about if there's a lot of demand for an ETF or, on the contrary, a lot of selling all at once? In those cases, ETF units do get created or destroyed, and that does cause trading in the underlying stocks. But interestingly, even when you consider the normal activity of creation and redemption, a study conducted by BlackRock in 2017 shows that, well, that's still a very small fraction of overall trading.

In fact, they described a case of Apple, which was at the time the largest company in the world. They noted that in July 2017, quote: "A month which saw large inflows to ETFs, 65.9 billion of Apple stock was traded." Although Apple was held by 331 ETFs globally, we found that at least 95% of the stocks trading volume in July 2017 was not directly related to ETF flows.

So in reality, despite ETFs becoming a larger and larger holder of the market over the last few decades, they have quite a minimal effect on the trading volumes of the underlying securities they hold. But could Burry still be on to something? Because, well, quite frankly, Michael Burry is expecting stock market Armageddon over the next few years, and if you think that's going to happen, then maybe he still does have a point.

Because in the case of a stock market crash, you do see panic, and when you see genuine panic in the market, then wild selling cycles can emerge. You know, a drop in stock prices can cause a wave of investors to panic sell. But that panic selling increases the selling volume, which causes the share price to fall further. This can then start a negative feedback loop and can crash the stock price very, very quickly.

So, Burry's thinking is if we do get a genuine panic moment in the market where market tracking ETFs are being panic sold en masse, then there probably is a chance that that selling and destruction of ETF units could amplify the crash of stock prices.

On this topic, he thinks the stocks at highest risk of coping this effect are the smaller, less traded stocks that still make it into a lot of these big indexes. He said in 2019, quote: "In the Russell 2000 Index, for example, the vast majority of stocks are lower volume, lower value traded stocks. Today, I counted 149 stocks that traded less than 5 million in value during the day. That’s over half, and almost half of those—456 stocks—traded less than 1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this."

The S&P 500 is no different. The index contains the world's largest stocks, but still, 266 stocks—over half—traded under 150 million. Today, that sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.

So it's a very interesting perspective and does make you wonder how these smaller cap stocks in large indexes will fare if a lot of passive investors move out of the market during the next big crash. You know, normally, we cheer when a smaller company finally gets included into the index, but this is an interesting example where, in fact, maybe index inclusion isn't such a win.

But with that said, definitely let me know what your thoughts are on the chances that passive investment vehicles will have a large impact in the next big panic moment of the stock market. I’d definitely be interested to hear what you guys have to say. Let me know that stuff down in the comment section below.

Of course, leave a like on the video if you did enjoy it. Subscribe to the channel if you'd like to see more. But guys, that will just about do us for today. Thanks very much for watching. I'll see you guys in the next video.