I don’t normally link to scary stories in the media. But one in particular has generated a number of questions from advisors, clients, and even employees here at Commonwealth.
You might be familiar with a portfolio manager named Michael Burry, famous as “one of the first investors to call and profit from the subprime mortgage crisis” and who appeared in The Big Short. Burry claims that the passive investing boom of recent years has inflated the stock and bond markets like the mortgage debt markets were inflated in 2008—and with likely similar consequences. If true, this area is obviously something we should be paying attention to. But although he makes some valid points and notes things to watch out for, at a systemic level, the comparison just does not hold up.
What is passive investing?
To start, let’s define our terms. Passive investing is “an investing strategy to maximize returns by minimizing buying and selling. Index investing is one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon.” In other words, if you are a passive investor, you buy the companies in an index, in the same proportions as the index, and then update regularly.
Put that way, passive investing is pretty much the same as active investing, with a different mix of underlying holdings. If you buy the S&P 500 Index, for example, you own 500 stocks. An active manager would more likely own a subset of those stocks. You might be exposed to more risk, or less, from a passive approach. Either way, the risk comes from the underlying assets—not from the passive strategy.
2008 versus now
Taking a deeper look at Burry’s claims, we can find a primary discrepancy. When Burry made the call in 2008, he was talking about assets with little underlying value. As the housing market declined, the value of subprime mortgages collapsed, and so did the value of any assets based on them. Worse, there was no market for those mortgages, so there was no way to tell what (if anything) they were really worth. His call made sense, then. Now, however, the situation with most passive strategies is very different. The underlying securities of passive strategies generally have real economic value. For liquid securities, that value is discovered every day. Generally, Burry’s analysis does not apply.
We are not done yet, though, because Burry does make some useful points. The discussion above assumes underlying assets with clear values and liquidity. But what if that is not the case?
Here, Burry’s concerns might well be valid. For assets that are not liquid—like many fixed income securities, international stocks, or small-capitalization stocks—a passive strategy might make less sense because of those concerns. In fact, here at Commonwealth, we favor active strategies for assets like those. It just makes sense. It is in these asset classes, though, that passive strategies have the least market share. Because these asset classes are inefficient and illiquid, active managers can and do show more outperformance, and passive is less appealing.
In the areas where Burry’s concerns could do real, systemic damage, like we saw in 2008, passive investing does not really apply. And in the areas where those concerns do apply? We simply don’t have enough risk to have a systemic effect.
There is a second area where Burry’s concerns might be justified. When most people talk about passive investing, they are not just talking about the strategy or the underlying assets. They are also talking about the structures of those investments. ETFs, for example, are a relatively new development that is largely centered around passive strategies and that attracts a great deal of criticism.
Here, I am going to include some thoughts from my colleague, Peter Essele, on just this issue:
Has there been a large increase in index products? Yes. But for all intents and purposes, the largest holdings in most ETFs are the same holdings that are in most active mutual funds. As a result, an investor who owned a large-growth active fund two years ago who now owns the large-growth index has the same names in the underlying securities (Google, Netflix, Amazon, etc.) as he or she did previously. Has the ownership of those names changed or just the vehicle through which the investor owns them? I would argue it’s the latter.
What Burry is saying is that if everyone rushes for the exits, there won’t be enough liquidity to meet those redemptions. That is a risk with any security, but it is lowest with these large, widely held securities. More than that, you could argue that there is actually more liquidity to meet redemptions in ETFs than there was when a majority of assets were in active mutual funds. Why? Well, ETFs have two levels of liquidity. The first level of liquidity is the ETF itself, which is traded like a stock on an exchange. In a majority of cases, investors buy and sell ETFs to one another. The issuers (iShares, Vanguard, etc.) are not involved because there are enough buyers and sellers on the exchange to meet the orders. For instance, I put out an order to buy 500 shares of VTI, and your sell order of 500 shares is matched with mine. It’s only when there’s a large mismatch in buys/sells does a market participant step in and facilitate the transaction.
Okay, so back to the main point I’m trying to make. ETFs have the volume of the open market and then the added level of liquidity on the back end from the market makers and issuers who trade in the actual underlying names. If all investors hit the sell button at the same time and rushed for the exits, resulting in a list price well below the NAV of the underlying name, you better believe there will be market makers ready to step in and close the gap, as described in the scenarios above.
It's hard for me to envision a scenario where index funds somehow have a major disconnect from active funds, because at the end of the day, they all hold the same names, just in different weights. An index fund is merely a price reflection of underlying securities like Apple, Google, and Netflix, the same names that are held in active mutual funds. If those names go down in one vehicle, they’ll go down in the other.
Thanks, Peter. What we can conclude so far is that the underlying assets of most passive strategies are demonstrably valuable and that both they and the funds that hold them, whether ETFs or mutual funds, are as liquid as any other security. These are marked differences from the 2008 subprime mortgage security market and, overall, mean the comparison simply isn’t valid.
Will passive investing sink the system?
Burry raises some real points, and proper consideration can be very beneficial to your portfolio. But his headline conclusion simply doesn’t hold up. Will there be blowups? No doubt, especially in some of the passive products in the asset classes mentioned above. Will that be enough to sink the system? No.
We do have real risks out there, and we talk about them all the time here. But a systemic blowup based on passive strategies really doesn’t look like one of them.