A Series of Unfounded Claims

Michael Burry’s words reported in a Bloomberg article caused a good deal of commotion and may even have shaken some investors’ confidence in passive funds. In my opinion, the article delivers three negative messages about index funds without offering the slightest proof. Let’s take a closer look.

Wrong message # 1: Index funds are similar to CDOs.

Quote:The recent flood of money has parallels with the pre-2008 bubble in collateralized debt obligations …”

Reply: As discussed in my recent blog, the CDOs that contributed to the 2008 financial crisis were characterized by their complexity, very low quality underlying assets and lack of transparency, along with the role played by credit-rating agencies, which failed miserably in estimating risks. None of these characteristics apply to most passive funds.

Mainstream exchange-traded funds (ETFs) invest only in publicly traded stocks and bonds. These underlying assets are subject to severe public disclosure standards and are relatively liquid.

 

Wrong message # 2: Investors who choose passive funds are birdbrains who haven’t done their homework and, as a result, stock and bond prices are significantly distorted.

Quote: “… passive investing has removed price discovery from equity markets.”

Reply: Despite the phenomenal growth of passive funds over the past 10 years, the great majority of financial markets are controlled by actively managed capital. The latest figures (Morningstar Direct, July 2019) show that the worldwide market share of index mutual funds and ETFs is 26.5%. Another report, by CREATE Research, assigns a market share of 34% to index funds among the pension funds considered. That means that at least two-thirds of capital is actively managed. On top of that, stock and bond prices aren’t decided by individuals like you and me: they depend on large institutional investors, who account for the majority of transaction volumes. For example, Canada’s top eight public fund managers (Caisse de dépôt et placement, Canada Pension Plan, Ontario Teachers, etc.) probably use passive management for part of the assets they hold, but most of their assets are actively managed, as shown by the fund managers’ annual reports. And I’m not even talking about investment banks like Goldman Sachs, which are constantly on the look-out for a good deal. Saying that share and bond prices are wrong — is just wrong.

 

Wrong message # 3: Seeing that investors who choose index funds haven’t done their homework, they’re so ill advised that they’ll probably sell all their investments at the same time.

Quotes:  … index funds inflows are now distorting prices of stocks and bonds …”, followed immediately by “The flows will reverse at some point and it will be ugly.”

Reply: The author doesn’t give any facts to back up this claim. Personally, I think that in many cases investors who opt for passive funds have done their homework. They’ve read the SPIVA reports, which document active funds’ underperformance not only in Canada, but also in the United States, Europe, Japan, and the list goes on. These reports also show that in the United States, only 16% of five-year first-quartile funds managed to stay in the first quartile for the following five years — a smaller percentage than you’d get from a random draw.

 

Wrap-up: A few questions

I’ve done my best in this text — based on evidence —  to show that the article published by Bloomberg is absolutely not backed up by facts. I find that it’s normal, given Michael Burry’s reputation, that investors ask questions. But it’s important to understand that passive funds’ strong growth is no bubble. Passive funds, especially high-quality ones, are chalking up phenomenal growth because investors realize increasingly that they do a better job of capturing capital market performance than active funds. It’s no surprise that higher-quality products increase their market share.

However, given the large number of passive funds currently available, investors and their advisors have to ask themselves some questions before investing. Here are a few suggestions:

  • What are the fund’s underlying assets and how are they structured?
  • How are the fund’s units created and redeemed?
  • Is the fund leveraged?
  • Are there derivative products? Do I understand them well?
  • What is the fund’s management method?
  • Why is this method likely to deliver satisfactory returns?
  • Is the information disclosed about the fund and underlying portfolio complete and updated at least once a month?
  • What is the issuer’s reputation?
  • Does the issuer answer my questions promptly, or dodge them if I insist?

By asking the right questions and keeping a critical mind, you can maximize your chances of choosing the ETFs best adapted to the situation and meeting your objectives.