Deflating the Index Fund Bubble Argument

Back in September, Bloomberg released an interview with hedge fund manager Michael Burry (link). Burry is famous for predicting the housing market bubble of 2008; he is even depicted by Christian Bale in “The Big Short” film, based on the book by Michael Lewis. In this interview, however, Burry expressed his concern that index funds were causing a bubble in stocks. 

Index funds, which come in both a mutual fund and exchange-traded fund (ETF) form, are investment vehicles that mimic an index, providing passive exposure to the market. These investments don’t analyze the stocks they invest in, instead simply allocating funds to a diversified pool of stocks deemed representative of a market segment. This means that they don’t contribute to price discovery, the process by which stock prices come to reflect their actual worth. Afterall, when a company releases bad news, the stock will typically fall in price, but if no one is trading based on analysis (i.e. if everyone used index funds), then the price would not change, even if the fundamentals of the firm were materially different now.

The crux of Michael Burry’s argument is therefore that, with index funds seeing massive inflows over the past decade, stocks are seeing their prices inflate without any fundamental reason for the higher price. This could then, in theory, lead to a bubble.

So, are index funds causing a stock bubble? Perhaps, but as you’ll see the situation isn’t as bad as it appears at first glance.

Firstly, if there is a problem, it is likely concentrated to the U.S. stock market, which has an above-average utilization of index funds. In America, for example, passive index funds recently surpassed active funds in terms of assets under management, meaning that more investors held index-like funds than actively managed funds. In Canada, however, roughly 90% of fund assets are still actively managed (turns out free health care isn’t the only benefit of living in the North!).

Secondly, even with over half of fund assets being managed passively, index funds still only represent around 15% of the U.S. stock market as a whole; there are plenty of assets held outside of these funds, many of which are actively managed (just like our own segregated accounts here at WDS).

Finally, even with passive funds holding a sizeable chunk of the market, only 5% of trading activity is estimated to follow index mandates. This means that active trading still dominates the price-setting mechanism of the markets.

All of this isn’t to say that stocks won’t experience a down turn in the future, nor that index funds couldn’t cause a problem in the future, but what it does show is that the problem isn’t as big as it’s been portrayed. It’s impossible to know when the next recession or bubble will hit, however monitoring stock valuations allows us to directly see how much we’re paying for a company; by sticking to high quality picks, investors should have no problem weathering future downturns if they focus on the long-term.