WARNING: The Index Fund Bubble

What's up you guys, it's Graham here. So we got to sit down today and have the talk. And no, this is not the talk where I go and ask you to hit the like button, although we'll have that one a little later. Instead, we're gonna be having the talk about the potentially devastating index fund bubble news, which seems to appear in media and videos all warning about its upcoming collapse. And if that's the case, that could be a very big deal considering that half of all US fund assets are invested in, wait for it, index funds.

Plus, as someone who is part of that 50% who invests in index funds and believes in the long term, I thought it would be worth analyzing to really dive into it and figure out if this is really a bubble that could be ending in some catastrophic collapse, or if it's just an overblown hype from people who always believed the entire market is just going to be on a brink of collapse 24/7, like Ray Dalio. So to go to answer this, I spent like 10 hours researching absolutely everything to find out whether or not we're actually in a bubble, and what I found was actually pretty surprising.

But first, let me simplify exactly what this is and what's going on, and then also remind you to smash the like button for the YouTube algorithm if you've not done that already. And with that said, let's get into the video. So to start, an index fund is really just a big basket of stocks that you can invest your money into. And then by doing that, you own a small percentage of all of them. For example, you could spend about two hundred and seventy-eight dollars to own a small percentage of the entire top 500 publicly traded stocks on the US stock exchange.

This way, you're not just buying one stock in one company, but instead you're gonna own a small percentage of everything. And index funds really cover just about any investment that you could think of. Like, for instance, for twenty-eight dollars, you can own a small portion of every single international stock out there, or for seventy-eight dollars, you can own a small portion of the entire US stock market. This list just goes on and on and on as far as your imagination can take you.

However, the benefit to doing this isn't just in owning a small amount of everything for a very low price. Index funds are also profitable because historically they've outperformed actively managed funds, where investors are going in and buying and selling individual stocks, which means more money and more profit for you. In fact, several studies have suggested that 92 to 95 percent of professional portfolio managers could not outperform the market index over a 15-year period.

Keep in mind, a lot of those managers are Ivy League college graduates with a really deep understanding of economics and finance, who are the brightest in their fields, who do this full-time, and not even they can outperform a broad index fund long term. Warren Buffett also went so far to say that attempting to pick individual stocks to buy and sell is a mistake for 99% of the population. And then he put his money where his mouth is by betting a collection of hedge fund managers a million dollars that they could not beat the market index over a ten-year period. You could guess who won, and which one was the most profitable: that was Warren Buffett and the index fund.

Literally, an index fund outperformed the best hedge fund managers in the entire world. And if the wealthiest living investor is telling us to invest in index funds, then that is something I would certainly listen to. So given all this, we can't deny that index fund investing has seen a big boost of popularity and is going mainstream, with all the excitement and a lot of people finally seeing the advantages of low fees, high profitability, and the ease of diversification.

And because of that, index fund investing now controls about half of the US stock market. But wait a second, the real question is: if everyone all of a sudden is investing in index funds, then does that make them less effective? And could that pose a huge risk to our entire economy? Well, according to Michael Burry, the investor who predicted the 2008 subprime loan crisis and also featured in the movie The Big Short, says that index fund investing is artificially driving up the price of the stock market because people are driving up those prices through index funds.

And that's causing an imbalance between what a stock is now valued at versus what it's actually worth. Now it sounds complicated, but this is what all of that actually means: when you're investing in an index fund, you're really just investing in a big basket of stocks. This means that anything within the basket gets your money, and the more money it gets, the higher the price is going to go.

Basically, if everyone just starts investing all of their money within these stock baskets, then the stocks that are within the basket are constantly going to see money thrown at them just because they're lucky enough to be in the basket. So Michael Burry is warning us that index funds are pouring too much money into the stock market, artificially inflating prices and causing those to be overvalued, and leaving other companies not within that index fund as being undervalued.

In other words, index funds make money, which causes people to invest in them. Which then means that the demand for that fund goes up because it's making more money, which causes other people to want to make more money as well, which causes the price to continually go up. And then it becomes this infinite loop of it going up because people are investing their money into it.

Secondly, he also warns of what would happen if everyone were to sell their index fund at the exact same time, and also how that would negatively impact the price of smaller stocks within that index fund. We're just gonna be using these small candies from Aria casino in Las Vegas as an example of smaller companies invested into the basket of index funds. Michael Burry's reasoning is that there's a lot of money thrown in these index fund baskets of companies that are much smaller, that don't see a lot of trading volume, but do just because they're within the basket of index funds.

So if a large portion of people wanted to sell off their index funds at the same time, there wouldn't be a lot of buyers for the smaller companies out there, and that could cause a massive price crash for those smaller companies.

For example, the Russell 2000 is an index fund that tracks 2,000 small-cap stocks in the United States. Half of those stocks have a trading volume of less than five million per day, and one-fourth of those stocks have a trading volume of under one million per day. So a large sell-off could potentially devastate the smaller companies and lead to an overall much bigger price crash for the entire market.

But is there actually any truth to this? And really from a data-driven standpoint, Michael Burry is right: a lot of money has been pouring into index funds. Like in 2002, just 2% of the US stock market was held in an index fund, and now more than 17% of the entire stock market is held in, you guessed it, an index fund.

However, is he correct by saying that once a stock is within an index, that it's automatically going to have money just thrown at it? And because of that, it's going to cause the stock price to go up? And really to figure that one out, we have to look at the facts. But first, I looked at stocks that have just been added to an index to see if having money thrown at it causes it to go up in price, and then I looked at stocks that have been removed from an index to see if that causes it to go down in price.

And this is what I found: now before a stock is added to an index, it's announced ahead of time before index fund managers have a chance to go in and buy it. This leaves time for individual investors and speculators to go in and buy the stock, anticipating it being added to an index and trying to make a profit. Now, when all of this was researched, it was actually found that stocks do generally see a rise in price once it's announced that they're going to be added to an index. But then something interesting happens, and that once it's actually added to an index, the pent-up demand tends to slow down, the price drops, and then it returns to a new normal.

Long-term research shows that adding a stock to an index has absolutely no permanent effect on its price. And even more surprising was that any premium the stock did get from being added to an index usually wore off after about two months and returned to the price that was before it was ever announced it was going to be added to the index. And overall, here's the final nail in the coffin on this one: other studies have shown that stocks added to an index did not see any superior performance and demand over stocks which were not traded within the index. Likewise, it was also found that stocks being removed or bumped down from an index did not see any inferior performance, trading volume, or different price now that they were no longer being bought by an index.

Much of this is generally due to how index funds are bought and traded. First, to be a part of the index, you actually have to have the merits to be included in the first place. You have to be a successful company, you have to have the brand recognition, and you have to have the attributes and market cap to even be considered. Secondly, the way index fund investing works is that it's weighted towards the largest companies that have the biggest volume. This means that only the biggest companies within that stock market index get the most amount of money because they make up the majority of what's in that index fund.

It also means that smaller stocks within the basket make up less of that index fund money because they are a smaller component of what's in here. The third, once the stock is actually added to an index, it must actually perform well, and a lot of its price movement afterward is going to have to do with its earnings, ongoing developments, and new projects. Otherwise, if it doesn't do well, it's gonna get bumped, and the price will go down, and that's going to cause a small component of the overall index to go down with it.

But what about Michael Burry's warning that if we all sell our index funds at the exact same time that that could be potentially devastating and collapse our market? He compares this with an analogy that a movie theater is getting more and more crowded even though the exit door stays the exact same size. Well, like I said, index funds work by weighting the averages and buying every company in exact proportion to how big it is compared to the entire market. For example, just within the S&P 500, which has five companies within it, the top 10 of those companies make up 21% of its overall holdings. That means the other 490 companies split their way for the remaining 79%. That means the very smallest and last companies of the S&P 500, which would be News Corporation Class B, is only going to get less than 0.01 percent of your money if you invest within an index fund if it receives anything.

Generally, most index funds won't even bother trying to buy the smallest companies within the index because it's not worth their time or it's not worth the transaction fee. So Michael Burry's argument that index fund investing is going to cause a liquidity issue is somewhat a moot point. Index funds really just track the broad market, and even in the event of a sell-off, each stock is really only bought in direct proportion to how big it is in comparison to the overall index. Plus, in the event of a mass sell-off of index funds or some catastrophic crash of the overall market, that would just create a massive buying opportunity for outside investors to come in, buy in at lower prices, and eventually just drive its price up to the normal baseline.

So any drop in price is really only going to be temporary. Overall, however, here is what I think: an index fund is really just an investment that tracks the overall market performance. And it's been shown that a stock actually being included into that index does not add to a long-term boost in price. That, to me, is far from a bubble. Even if people are just blindly and passively throwing money into an index fund and holding it long term, regardless of the individual company's performance, this is not 2008, where people are leveraging their money and borrowing what they can't afford and expecting prices just to go up forever in order to make a profit.

Today, if people are investing the money they actually have in a broad diversification of companies which actually have an underlying value, these are companies with assets, productive capability, intellectual property, and a service market purpose, you're still going to get something from it even if the returns you get are not going to be astronomical. That also means that as more people invest passively in index funds, that should open the door for active traders to find and exploit undervalued companies to then try to beat the market. And then as that happens, I'm sure more and more people will try to exploit those opportunities to the point where again it shifts back to index fund investing coming out the winner.

In addition to that, Michael Burry's warning could very much just be a false scare where investors and news outlets start an issue added nowhere that ends up amounting to nothing. For instance, if people start talking about a recession and we expect it to happen, investors might start pulling their money out of the markets and saving cash. But by doing so, maybe they've actually prevented a recession from happening because they've already pulled their money out, and that was already included and factored into the current price. That's just something interesting to think about.

But let's just go a step further and assume what would happen if everyone invested in index funds. Well, if that happens, stock prices would never drop even if the companies did poorly or never had any earnings; they would stay exactly the same. Conversely, good stocks would not see a rise in price even though they're making a lot of money just because they've had the exact same amount of money injected into them. That would make a very interesting dynamic and opportunity for people to go and find those companies, invest their money into them for a very big return, further drive up the price of those companies, and therefore the entire market would just balance out. All of this is really just supply and demand, and there will always be people out there to exploit the opportunity where there is one.

So given all of this, no, I personally don't see this as any sort of sign of an index fund bubble. And from all of the research I've done, I don't see anything to confirm there's any cause for concern. However, as with anything at any point of the market cycle, I do recommend always having a few preparations ahead of time, no matter what. And this is what they are:

1. Have a three to six month emergency fund in cash at all times, held in a high interest savings account.
2. Only invest money that you aren't planning to use or need in the next 10 to 20 years.
3. Do not panic sell anytime something drops in price; all you need to do is hold on, stay the course, and continue buying at lower prices.
4. Always diversify your investments, whether it be through index funds, real estate, bonds, individual stocks, or smashing the like button; doesn't matter.
5. And then lastly, you may have figured this one out, but no matter what you do, always smash the like button.

So with that said, you guys, thank you so much for watching. I really appreciate it. As always, if you've not already hit the like button, make sure to destroy the like button, subscribe button, and notification bell. Also, feel free to add me on Instagram; I post here pretty much daily, so if you want to follow me there, feel free to follow me there. And then lastly, if you guys want free stocks, all you got to do is use the link in the sign-up for Weibo. Deposit $100, and when you do that, they will give you two free stocks. One of those stocks is going to be valued up to $1,000, so my recommendation is just go on Weibo, deposit a hundred bucks, get the two free stocks. If you decide you want to use it after that, great; if not, just sell it off, get a profit. It's pretty easy to do. I highly recommend it.

And oh, then one more thing: don't forget to add me on my second channel, The Graham Stephan Show. I post there every single day I'm not posting here. So that means, if you want to see a new video from me every single day, just go and add me on that channel as well. Thank you so much for watching, and until next time!