The wide and growing popularity of index funds, and passive investment strategies more generally, has many investment professionals worried. Michael Burry, a hedge fund manager and contrarian who gained notoriety a decade ago as one of the few players who bet against the U.S. housing market in the run-up to the Great Recession, recently added his voice to a growing chorus of concern in a Bloomberg interview. Burry is particularly concerned about the potential for a breakdown of two key market mechanisms, price discovery and liquidity, in the event of a significant market shock.
Of course, not everyone shares Burry’s bleak outlook. Ben Carlson, a CFA charterholder and portfolio manager for Ritholtz Wealth Management LLC, is not convinced. In an entry published Thursday on his widely followed investing blog, A Wealth of Common Sense, Carlson argued that Burry’s fears amount to little more than Chicken Little-esque scare-mongering.
The price discovery mechanism is still intact
Critics of passive investment fear that the price discovery mechanism may be compromised by the overbearing presence of passive assets in capital markets. Passive investors are obviously free riders, reacting to price changes and active investors’ flows. Carlson acknowledges this much, and rightly so. However, he is unwilling to agree that this represents any meaningful challenge for the price discovery mechanism:
“Active management will never completely go out of business because it’s far too lucrative and tempting for type-A personalities to prove themselves. But people worry that as index funds continue to gain market share, the price discovery mechanism could become fragile. This is nonsense. There’s plenty of price discovery going on in the markets. In fact, you could probably make the case there’s too much of it these days. Fifty years ago or so, the entire New York Stock Exchange saw trading volume for all listed stocks of 3 million shares. Today, Apple has an average trading volume of roughly 26 million shares a day. Facebook turns over more than 16 million shares a day, on average. Even the biggest stock market ETF (SPY, Financial) averages nearly 70 million trades a day. Active managers will always set the prices, no matter how many there are. Charley Ellis wrote in his book, The Index Revolution, that indexing accounts for less than 5% of trading, with the remaining 95% or so done by active investors. This will always be the case, no matter the amount of money flowing into index funds.”
Carlson contends that trading volumes have not abated as a result of more passive players. Rather, he points to today’s market as being in rude health, with far higher trading volumes than in years past. In other words, price discovery is not only happening, but it is doing so more actively than at any time in history.
Yet, while the price discovery mechanism may have proven itself relatively robust over the course of this long bull market and global economic expansion, they have simply not been tested in a real-world crisis scenario. Carlson’s satisfaction with index funds’ behavior to date is based on a very limited set of market conditions.
Feared liquidity problems are much exaggerated
The risk of a liquidity problem is far more worrisome than any potential index fund-induced degradation of the price discovery mechanism. When the liquidity of the market comes under pressure, a real risk emerges that passive money flows will magnify any problem. Yet, Carlson is convinced that this fear is also unfounded:
“When an index fund investor sells, they’re technically selling their holdings in direct proportion to their weighting in the index. So there is little market impact involved. Again, index fund investors are simply owning stocks in the proportion that all active investors own stocks. Plus, index funds never lever up your holdings. They never receive a margin call. They don’t put 30% of your holdings in Valeant Pharmaceuticals. And no index fund has ever closed up shop to spend more time with their family. There will always be investors that panic, regardless of the type of fund they’re invested in. Why would index funds or ETFs be any different than any other fund type or security in that respect?”
While Carlson is on fairly firm ground when criticizing Burry’s fears about price discovery, his confidence in the liquidity of passive vehicles is not well defended. Carlson argued that, unlike many actively managed funds and portfolios, index funds are not going to blow up or get destroyed by leverage. That much is true. However, Carlson missed the point when he said, “Index fund investors are simply owning stocks in the proportion that all active investors own stocks.” While technically true, it merely sidesteps the real issue, namely that index funds have more exposure to stocks than there are shares on the market. Burry has explained what this means in the context of the S&P 500:
“The index contains the world’s largest stocks, but still, 266 stocks -- over half -- traded under $150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”
Verdict
Carlson made some solid points in his effort to “debunk” concerns about a potential passive asset bubble. He is certainly not wrong about the incentives of active managers to attack indexing and its ilk. There are plenty of complaints from lackluster asset managers, financial advisers and the like who are worried about the prospect of losing out to such cheaper alternatives. But the real concerns run far deeper than mere self-interest.
On balance, we must conclude that Carlson fails to alleviate many of the fears involving the rise of passive vehicles. He attempted to discount the possibility that mechanisms, especially liquidity, could be hampered by a crisis, but offered little in the way of evidence to back this up. Of course, those investors and economists showing increasing levels of concern are also operating from a position of ignorance. However, they at least understand that the perceived normalcy of today could easily be undone in short order.
Investors would be wise to move with caution. The computerized infrastructure of, and the unprecedentedly high levels of passive participation in, modern capital markets could well fail to live up to Carlson’s high hopes.
Disclosure: No positions.
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