Why Index Funds Are Like Subprime CDOs

[JamesR]

The article: https://www.bloomberg.com/news/articles ... prime-cdos

Some discussion about it: https://news.ycombinator.com/item?id=20877700

It's interesting to ponder the effect of the whole index funds movement (bogle, vanguard, and robo-investors, etc)

[Seppia]

Wouldn't his points be valid for non-market cap weighted indexes/ETFs, and/or fr those who use synthetic replication?
I can't see how what Burry says could be relevant for "random gigantic market cap weighted ETF who actually owns the shares".

Increased stock correlation, yes, liquidity issue? Not so much

[jacob]

What Burry is saying is not new(s). It's only news that he is saying it.

If you want to know more, see
viewtopic.php?t=9060
viewtopic.php?t=7650

Starting fall 2018 I eliminated companies that have a high degree of institutional holders in my buy screen.

[Seppia]

An interesting post by Ben Carlson
https://awealthofcommonsense.com/2019/0 ... bble-myth/

This part made me laugh loud:

“Yes, index investors are free riders, but this is the way most markets work. We don’t go to the grocery store to bid on prices of oranges against one another to set an equilibrium. The market does that for us.”

I was partially reassured (I am now 40% indexes on my total stock holdings vs 50% a while ago) but then I re-read both threads linked by Jacob and now I’m semi-worried again

[just]

There are some good in-depth articles on the topic at philosophicaleconomics.com:

- Index Investing Makes Markets and Economies More Efficient
- The Impact of Index Investing: A Follow-Up
- The Value of Active Management: A Journey Into Indexville


The initial paragraphs from the first article:

U.S. equity index funds have grown dramatically in recent decades, from a negligible $500MM in assets in the early 1980s to a staggering $4T today. The consensus view in the investment community is that this growth is unsustainable. Indexing, after all, is a form of free-riding, and a market can only support so many free-riders. Someone has to do the fundamental work of studying securities in order to buy and sell them based on what they’re worth, otherwise prices won’t stay at correct levels. If too many investors opt out of that work, because they’ve discovered the apparent “free lunch” of a passive approach, active managers will find themselves in an increasingly mispriced market, with greater opportunities to outperform. These opportunities will attract funds back into the actively-managed space, reversing the trend. Or so the argument goes.

In this piece, I’m going to challenge the consensus view. I’m going to argue that the trend towards passive management is not only sustainable, but that it actually increases the accuracy of market prices. It does so by preferentially removing lower-skilled investors from the market fray, thus increasing the average skill level of those investors that remain. It also makes economies more efficient, because it reduces the labor and capital input used in the process of price discovery, without appreciably impairing the price signal.

I don't remember the articles in detail. Maybe his argument is perpendicular to the issues you are concerned about regarding liquidity, given that he talks more about price efficiency? Very interesting articles, regardless.

[jacob]

What gets us into trouble is not what we don't know. It's what we know for sure that just ain't so.

[Freedom_2018]

So what is the average wannabe EREr to do besides some diversification into indexes, real estate, gold, questionable loan to cousin Vinny?

If most folks have to become investment analysts to achieve/sustain FI...might just be better to stay at work.

From a portfolio perspective probably hold a little more cash to deploy if and when indexing falters...meanwhile tighten belt further to decrease SWR?

From a practical standpoint at some point other things become more important than beating or meeting the market performance...just avoid situations of permanent loss of capital...most of that threat is a investors behavioral problem not primarily asset allocation.

Those who held through the housing crisis should know.

[Freedom_2018]

Also with CDOs...Burry was busy meeting banks and getting them to draw up individual contracts even while they were laughing behind his back and at his face.

Here he is talking about it. Big difference to me.

So does he have the conviction to short the index like he did the CDOs instead of picking low cap stocks ( although as a med intern his stock picking is what got him noticed) ?

He might be right about the index eventually but can he trade his insight? That's the thing.

[Dream of Freedom]

So, with the housing crisis you had the rating agencies giving high ratings to CDOs ignoring the risks. Subprime mortgages began to default. This led to institutions not wanting to purchase more as they realized they are risky. Since no one would buy mortgages banks didn't want to originate them. Without mortgages few have the ability to buy a house so sellers would have to deeply discount the home to sell it which drove down prices and created more defaults as people realized that they owed more than the house was selling for and the let it go to the bank.

Obviously this is speculation but I will take a swing at the possible chain of events. With index funds you largely have people with no investment knowledge who don't understand the risks being told that an index fund is only way to go. Something bad happens. So the people who thought the stock market was a piggy bank realize that it is risky. There are massive redemptions. This overwhelms the volume on some stocks. In order to get buyers for low volume names they have to sell at deep discounts. With prices depressed people who didn't panic first are shaken and sell too.

Yes I see the similarities. I don't see the scenario as a given. It is more likely that there will be some reversion to the mean toward active management.

[Seppia]

Mark Twain quote

This is pretty much the reason why I would be uneasy with 100% indexes.
I hate 100% anything as a matter of principle.

[Jin+Guice]

O.k., so I get the concern about there being a bubble in index investing. So let's say that bubble bursts and the whole thing comes crashing down. Everyone pulls out and swears off index funds as a fad.

In theory, as long as the U.S. economy keeps growing and another bubble doesn't develop, would this make the indexing philosophy valid again?

[7Wannabe5]

It seems to me that the built in feature/problem with an index is that by definition it destroys information. OTOH, I think the analogy to Subprime CDOs is false (or more like "not so true"), because the bad math underlying each flavor of purposeful stupidity (letting other people do your thinking for you) is very different.

If more people would read biographies of 20th century mathematicians, they would realize that the cornerstones are crumbling.

[Jason]

The rise of index/ETF is due, or at least partly due, to their i.e. Vanguard's successful marketing campaign that paying for financial expertise does not make sense over the long term for the average investor. The rise of the Robos combines this with one generation's complete derision/suspicion of the previous generations ability in this area. It's not just that we (indexers) are lazy. It's that we were told its better to be lazy and that the one alternative for lazy people, paying someone to do the work for them, is not in their best economic interests. It's like being sick and the medical community saying you're not qualified to cure yourself but you will still be better off not seeing a doctor.

I invest in certain mutual funds where I believe in a "guy" Robert Doll. I also pay for stock picking services. I pick, I hunt. But I still feel safer resting in John Bogel's heavenly arms than anywhere else.

[jennypenny]

Is Vanguard 'too big to fail' now?

[Mister Imperceptible]

https://www.epsilontheory.com/the-indus ... ssary-egg/

[7Wannabe5]

It's like being sick and the medical community saying you're not qualified to cure yourself but you will still be better off not seeing a doctor.

Well, it is highly likely that more than 50% of medical research studies are not replicable.

[Jason]

If I understand you correctly, which by definition, would be utterly fucking miraculous, your point is moot, because although it might be easier for the layperson to pick a stock or set forth a financial plan than replicate a medical research project, it is still beyond their abilities in terms of expertise and time.

My point is that authorities within the financial community have created this conundrum. There is a well recognized and thought out argument promulgated from within the financial community that says its so called experts do not possesses a degree of competence that exceeds the average laymen. It's like The Harvard Law Review publishing an article "Why The Average Person Should Argue Their Own Case Than Pay for An Attorney" or the AMA releasing a statement "6 out 10 doctors think 9 out of 10 doctors are fucking quacks". Or the National Association of Pimps releasing a statement "It's better to self-pleasure than pay $10 for a car job" although I'm not sure they have organized themselves to that degree. But the point is that John Bogel who rose to as much respectability and admiration as any former CEO of Goldman Sachs essentially said most people in the financial industry don't know what they are doing and the average consumer would be better off buying the entire market than letting a third party pick stocks for them and on last google search those mofos have 5.3 trillion in assets. At this point, Ronald McDonald would having more success telling people its better for them to cook their own food and go the gym than eating a Big Mac than the financial industry telling people they are better off paying for investing advice.

[Jin+Guice]

It's not just that we (indexers) are lazy. It's that we were told its better to be lazy and that the one alternative for lazy people, paying someone to do the work for them, is not in their best economic interests.

This is the crux of the problem to me. This is a game we are all (eventually) forced to play, by the nature of our retirement system. If you believe that SS will fail and/ or not be enough and you believe you have to become a semi-expert in finance just to play the game, where does that leave the average person?

From an early retirement perspective the fact that you have to save >50% of your income for years AND work to earn at least the equivalence of a bachelor's degree in finance, makes the whole thing a lot less tenable/ appealing. The assumed payoff is a less than 3% annual return and the risk that at any moment you could lose it all.

[Jean]

If the time spent working at shit job to pay for the doctor is more than the time of healthy life the doctor will get you, it's in your intérêst not to see one.

[Jason]

What about working shit job in order to save up to see doctor in order to be euthanized in order to get out of both shit job and shit health?