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Bram de Haas
Bram de Haas
Articles (439)  | Author's Website |

Burry Sees a Bubble in ETFs

Why the guru believes passive investments are overvalued

September 05, 2019 | About:

Michael Burry, of "The Big Short" fame, has come out of the woodwork in recent weeks and engaged several boards. Last week, I wrote about his involvement at GameStop (NYSE:GME).

He was also interviewed by Bloomberg. In the interview, he said the index and exchange-traded fund complex has parallels with the 2008 bubble.

"Central banks and Basel III have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in interest rates anymore. And now passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes or ETFs and mutual funds mimicking those strategies -- these do not require the security-level analysis that is required for true price discovery.

This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue."

It is obvious Burry is referring to central bank policies like interest rate settings and quantitative easing programs.

Basel is less often discussed. This is speculative on my part, but I think Burry is getting at the fact that under Basel III, banks have different capital ratio requirements based on assets held. Certain assets require the bank to have much more equity capital. The table below, which is straight from the regalatory framework's website, shows how capital requirements vary. A lower percentage is more attractive to banks. A framework like that can influence which credit risks bans will want to underwrite and also result in a systematic avoidance of certain credit risks that an unconstrained rational person may have wanted to underwrite.

Proponents of passive investing will argue the remaining active managers set prices and indexes or ETFs have a free ride. There is a large element of truth to that. However, critics like Burry, Murray Stahl (Trades, Portfolio) and Steven Bregman argue there are serious problems as well. I divide these into two categories:

  1. Problem of systematic discrimination against certain securities.
  2. Liquidity mismatches.

ETFs and indexes charge low fees. They make money only when they gather lots of assets. Therefore, they get put together a certain way. For example, when you initially market them, you need a historic performance based on a backtest of the strategy you are selling. Only ETFs with great backtests will be successful and, therefore, strategies with great historical performance get put together. ETF creators are really incentivized to make sure their "strategy" includes huge winners like Amazon (AMZN). Amazon is included as a top holding in an insane number of ETFs. That includes ETFs with strategies that you would think are on the opposite end of the spectrum.

ETF designers know they shouldn't include stocks with very low liquidity. One category of stocks that get systematically avoided are those where insiders, a family or founder owns a large amount of shares. This decreases the free float of stock, making it less eligible to be included. I question whether that is a systematic tilt an investor would want. I know I don't.

Small-cap stocks, which Burry specifically labeled out as a category that is being left behind, have two issues that deter designers from building around them. You can't scale an ETF where small- or microcaps are top holdings. If your ETF is very successful, it can't scale up because there aren't enough shares to hold. Due to liquidity issues, a popular ETF with a large allocation toward a small cap could also have a severe market impact. If your product has a severe market impact, it will hurt its own performance, which ultimately always leads to failure.

Proponents of ETFs will argue that liquidity is tested and it is sufficient. But critics point out that in some markets like corporate junk bonds, that is very unlikely to hold up. Some of these ETFs trade with each other to find liquidity. But that becomes harder if there is a sustained one-directional move of money out of corporates (corporate junk is just an example). Those who have been in the market during crises also know that liquidity can totally evaporate. In some areas, banking regulation has also changed, making it harder for those parties to step in to the market at certain times. If critics are right, a holder of a junk bond ETF could see his losses accelerate as others jump ship and bonds get dumped into a void. The last one to jump ship may take the worst losses because liquidity is exhausted and, consequently, this induces a run on the bank effect.

In Burry's words:

"In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those --456 stocks-- traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this.

...Potentially making it worse will be the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day. This fundamental concept is the same one that resulted in the market meltdowns in 2008. However, I just don't know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be."

But Burry also sees value in this strange ETF-focused world. For example, in Japan:

"It is not hard in Japan to find simple extreme undervaluation -- low earnings multiple, or low free cash flow multiple. In many cases, the company might have significant cash or stock holdings that make up a lot of the stock price."

And in small-cap stocks:

"There is a lot of value in the small-cap space within technology and technology components. I'm a big believer in the continued growth of remote and virtual technologies. The global retracement in semiconductor, display, and related industries has hurt the shares of related smaller Japanese companies tremendously. I expect companies like Tazmo (TSE:6266) and Nippon Pillar Packing (TSE:6490), another holding of mine, to rebound with high beta to the sector as the inventory of tech components is finished off and growth resumes."

Burry also observed that in Japan, companies are often trading below book value and are loaded with cash. Corporate governance is often an issue, but the Japanese government desires change.

In regard to his activism, Burry told Bloomberg he only became active in response to widespread deep values. His intention is to improve the share rating by helping management see the benefit of improved capital allocation. He does not try and fix operations as some activists try to do.

Disclosure: No positions.

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About the author:

Bram de Haas
Bram de Haas is managing editor of The Special Situations Report and Founder of Starshot Capital B.V.

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