Are Index Funds a Bubble?

This article will discuss index funds . The article will start by explaining what they are, the positives and negatives, and end by asking whether they are the next bubble.

What are Index Funds?

An index fund is a mutual fund or an ETF (exchange-traded fund) which follows a certain set of rules in order to track some major financial market indexes such as ‘Standard and Poor’s 500 (S&P 500)’ is known as an ‘Index Fund’.

An index-linked ETF or index fund, therefore, is a very similar financial instrument, despite some small differences, in terms of fees and performance.

When you make an investment in an index fund, you actually own a percentage of the underlying asset. But after investing, the investor gets his profits based upon the actual performance of the whole asset instead of just the fraction he owns.

Index funds are known to be the best kind of investment because they require very little time, easy to understand, simple to manage, etc. That’s why they have been called by the name ‘Passively Managed Fund’.

It follows implementation rules which include minimization of tracking error, tax-management, trading strategies for maximized tracking error and minimized market impact costs, broad market exposure, minimized operating expenses and portfolio turnover, etc. 

Usually index funds beat the performance of actively managed funds. Investors can save a huge amount of time because they won’t have to manage each stock individually to earn profits. About a huge percent of investors (including skilled and experienced investors) found it very hard to beat the performance of the S&P 500 Index. 

Some Indexes like that of Dow Jones (which provide up to 130,000 indices) have strategic and systematic methodologies that are harmonized within the index families.

Advantages of Index Funds:

Index Funds provide various advantages to investors. Some of them are:

  • ‘Lower Costs’ – The costs involving an index fund are comparatively low than that of actively managed funds. Hence, investors can reap the benefits of having lower costs when it comes to investing in an index fund instead of investing in a mutual fund.

Actively managed funds involve in higher expense ratios which affect the overall returns. Whereas the index funds require lower expense ratios in which case higher overall returns can be expected than that of the actively managed funds.

For example, The expense ratios for an index fund range between 0.10% for U.S. Large company indexes to 0.70% in the case of emerging market indexes. According to the costs based on 2015, the expense ratio for a large-cap actively managed mutual fund is around 1.15%.

Here the average expense ratios in the case of index funds is about 0.20% to 0.50% while trading in some of the cheapest index funds. The expense ratios for actively managed funds can be around 1% to 2.5%.

Managers of index funds usually charge lower transaction fees and commission while investing in index funds. This is due to the unneeded services from research analysts and other staff who would be required while trading with an actively managed fund.

Here we can observe the relatively lower costs for index funds when compared to actively managed mutual funds.

  • ‘Lower Turnovers’ – The process of selling and buying securities by the fund managers is known as turnovers. Selling securities often results in capital gains taxes for investors from certain jurisdictions. These capital gains tax charges are usually received by the fund managers.

Even if there aren’t any taxes applicable, turnovers include implicit and explicit costs. Due to these, returns are reduced.

Index funds being passive investments have lower turnovers than that of actively managed funds.

  • ‘Easiness’ – Index funds are often considered to be very simple and easy to be understood by anybody. An investor can be able to determine the securities held by an index, once he gets familiar with the target index of the index fund.

The investor can easily manage his index fund holdings by rebalancing the investment every six months instead of doing it regularly. Index funds can easily be understood even by beginners.

  • ‘Style Drift’ – When the actively managed funds are not following their described style in order to increase the returns, it is known as Style Drift. Portfolios with diversification as high priority are hugely affected by this.

Risk is maximized when style drift occurs as the style drift can reduce the diversity of a portfolio. Style drift does not occur while dealing with index funds. Hence, index funds can be considered advantageous when this category is primarily focused.

Disadvantages of Index Funds:

There are not a lot of disadvantages but a few exist such as:

  • ‘Disadvantage for Arbitrageurs’ – Arbitrageurs are the investors who gain their profits by investing in the market inefficiencies. In order to match the changes in prices and market capitalization of the underlying securities indexes they track, index funds require to be rebalanced periodically.

Algorithmic traders possess the index re-balancing information, which makes them spend huge amounts in these arbitrages a few seconds (a few microseconds in many cases) before other arbitrageurs in order to gain the profits.

This causes lesser investor returns for those who are dealing with index funds as arbitrageurs. 

They don’t try to protect you from falls – an index fund focusing on stock markets doesn’t try to protect you from market falls. This isn’t a disadvantage if you are long-term because you can see the crisis through.

2008-2009 was a great example. It only took markets 3 years to recover from the crisis. Bond funds, moreover, tend to increase as index funds fall.

Therefore it is highly recommended that an investor picks both index and bond funds, and rebalances those funds yearly, when one component outperforms.

They are used incorrectly – the rise of DIY investing has caused many people to use the index funds incorrectly. The founder of the low-cost Vanguard company, Jack Bogle, warned about index funds being used incorrectly in the past.

“Now you can trade the S&P500 in real time”, he commented after index-linked ETFs were added to index funds. “What kind of nut job would want to do that!” he ranted.

The point he was making is that “market timing” doesn’t work, nor does using passive investing to pursue an active strategy. In other words, selling the US Markets when Trump got elected, buying the UK after Brexit is sorted out and so on.

Many investors are “buying and selling and buying again” rather than just buying and holding. Many studies have shown that the average investors only gets 4%-5% per year, even when the S&P500 is going up by 10% yearly, for this very reason.

This isn’t a problem of the indexes themselves, but “human error” on the part of the DIY investor.

What’s the bottom line?

It is highly suggested by most people that on a long-term basis, index funds can reap more benefits than an actively managed can usually obtain. Many mutual funds are inefficient and cannot beat the performance of broad indexes. According to data of S&P Dow Jones Indices mentioned by the ‘SPIVA Scorecard’, it was declared that Five years returns of large-cap funds have acquired lesser returns when compared to that of the S&P 500 until the year 2018.

It is also true that Passively managing the funds can be highly progressive if done over the long term. Even over the long term, some good actively managed funds have been said to perform higher than that of the index funds. 

While S&P 500 has gained about 13.12% returns over a ten-year period, some have gained about 15-19%. These were significantly high even over a little longer-periods such as three years and five years. 

According to a survey conducted in 2018, it was said that about US$458 billion was invested in index funds whereas the actively managed funds only did a US$301 billion during that period.

Indexing Methods:

There are three types of indexing methods. They are Traditional Indexing, Synthetic Indexing, and Enhanced Indexing.

Traditional indexing is having an illustrative collection of securities that have the same ratio as the target indexes. The modification takes place only when an existing company leaves the target index or a new company enters the target index.

Synthetic indexing is the technique where a combination of equity index futures contracts and investments in low-risk bonds is used. It focuses on replicating the performance of an index with a similar overall investment in equities. Managing the future position involves higher costs than traditional indexing.

Enhanced indexing is more of actively managing the investment. The features of enhanced indexing include diversified enhancement techniques, trading strategies, lower cost, issue selection, yield curve positioning, positioning of call exposure, sector and quality, exclusion rules, timing strategies, etc. 

Index Funds as a Bubble:

‘Michael Burry’ – Michael Burry is a man of many things out of which he’s famously a physician, an investor, and a hedge fund manager. He made millions by making a bet against the subprime-mortgage bonds in the 2008 mortgage crisis. 

He was also the founder of ‘Scion Capital’. Scion Capital was a hedge fund that operated from 2000 to 2008. Later Michael closed it to focus on other personal types of investments.

A movie named ‘The Big Short’ was made to depict the incident where Michael was profited from the mortgage crisis and the character of Michael was played by the famous Hollywood actor ‘Christian Bale’. Recently, Michael made the anxieties and fears of passive investors even worse by saying that Index Funds are going to cause huge losses to the investors.

Michael Burry is an active fund manager who deals with his stocks by himself and he has 340 million dollars in assets at Scion Asset Management in Cupertino. He compares the position of index funds to that of the mortgage crisis in 2008 where he was able to gain huge profits. 

Recently he gave an interview with Bloomberg news channel stating that the overflow of the money into the index funds is similar to that of the position right before the 2008 bubble in CDOs (collateral debt obligations) which were the complex securities that almost caused the destruction of the global financial system.

As we all know that burry made millions by betting against the CDOs right before the crisis struck in 2008, investors should consider his words while making an investment in index funds as he has a good amount of knowledge in this type of things.

He states that the index flows are now playing a part with deceiving prices for stocks and bonds just like the CDO purchases played their part in subprime mortgages (where he made a huge fortune). He also quotes that when the flow of these gets reversed, it will be very ugly and Like most other bubbles, the longer the time period, the worse the crash is going to be. 

Michael Burry’s statements when he made a comparison between the index funds and subprime CDOs:

“This is very much like the bubble in the synthetic asset-backed CDOs before the Great Financial Crisis (subprime CDOs in 2008), in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on the Nobel-approved models of risk that have been proved to be untrue.”

Are Index Funds really considered a Bubble:

According to many people like Burry, prices representing the underlying securities can be inflated by the passive funds (index funds) while having an increase in pressure with a lack of liquidity (just like the CDOs). it is like having the people in the theater getting increased in the number, but the same sized regular exit door.

It is also stated that if the market were ever to experience a free fall it would become very hard for the investors to unwind the subordinates used to relate the stocks and indices mutually. If such a situation occurs, the underlying securities and price differences between the indices can become the worst nightmares of arbitrageurs.

Burry isn’t the only person who indicates that index funds are a very bad idea, George E. Bates who is a professor and a senior-level associate dean for International Development at the Harvard Business School actually thinks the same.

Bates says that when investments in index funds increase, there is no necessity for the company to impress individual investors as ownership of the company largely resides within the index fund investors and the respective company’s price will experience a rise which is proportional to its weight in the index.

‘Key Factors mentioned by Michael Burry in support of his argument against the Index Funds’ 

‘Risk of Liquidity’ – Michael Burry says that the secret behind the passive funds (index funds) is the distribution of the daily dollar value while making trade among the securities within the indexes they are trying to copy. 

Burry mentioned an example for this stating that about 1049 stocks which track Russell 2000 Index (most of the stocks are of lower volume and lower value traded stocks) have traded less than $5 million and even in that 456 stocks traded only up to $1 million, while through indexation and passive investing over hundreds of billions are linked to stocks of this category.

To support this, he mentioned the statement where he referred about the theater getting crowded and exit is still the same. This becomes even worse when the investor tries to get into global equity and bond markets with even lesser liquidity.

‘This is not going to end well’ – He says that this type of structured play is repetitive and goes on again and again in the same manner. It is very easy to sell and technical machinery is way too good. He says that the money managers charging lower fees for index funds will make up for it in scale.

This makes it very hard to unwind the derivatives and the buy/sell strategies which aid these funds to automatically match the flows and prices on a daily basis. This the same concept that caused the devastating global market meltdown in 2008’s CDO crisis. 

Burry says that he is not sure about how much it might take for it to crash, but the longer it is going to take, the worse the crash is going to be.

‘Japan Central Bank’ – the Japanese Central Bank owns most of the largest ETFs in Japan which mean in case of a global panic which denies the existing pattern, the largest stocks which track those indexes are very well protected when compared to stocks that of the US, Europe and other parts of Asia. 

This happens due to a lack of stability in their ETFs and passively managed funds (index funds). Therefore, the Japan situation can be considered as a Japan Cushion.

‘Undervalued Japan Small-Caps’ – It is very easy in Japan to find simple extreme undervaluation. Multiplication occurs for low earnings or low free cash flow will be multiplied. There exists a lot of value in tech and tech components when it comes to small-cap space. 

Burry says that he believes in the never-ending growth of the remote and virtual technologies. He says that the companies in the technology sector like the Tazmo, Nippon Pillar Packing, etc. can be expected to resume their growth in the near future.

‘Japan’s Cash Hoarding’ –  He also says “The government of Japan is likely to make these companies mobilize the unmoved cash and their other forms of trapped capital. The value to the sales ratio of these companies which have market cap trade value under $1 billion is less than 50%. If the companies start administration more seriously, there is a high opportunity for re-rating. 

There are a majority of companies that have been having trapped capital and shareholdings. These holdings are considered to be higher than many other markets on the earth.”

‘Shareholder Involvement’ – Burry says “He would rather be inactive and he’s just getting active as the deep value has risen with sell-off in the Active equities over the recent years.

Burry’s intention is to help the management reap the benefits of improved capital allocation in order to make the share ratings more effective. He says that he doesn’t try to influence the business operations of the company.

Why index funds are probably not a bubble

The biggest reasons why index funds are probably not a bubble is:

Rapid selling has always existed – index funds didn’t exist in 1929….that didn’t stop the worst financial crisis in history! So there will be rapid selling and buying in the future, but that is the reality of markets. They rise big time long-term, but fall hard occasionally

Index funds still represent a small percentage of the market – they do not represent over 50% of the market yet, never mind 80%. That is a misconception

Individual stocks are still falling as the market increases – Facebook’s stock is still slightly below its all-time highs at the time of writing, even though the markets and especially technology have soared. GE is down and so are many banks in the last 10 years, despite the market increasing. Some other stocks have beaten the market. The point is, there is no indication that Blurry’s thesis is relevant today.

Don’t assume the past will replicate itself – Why are many people interested in index funds? Well, today’s winners are usually tomorrow’s losers. Take eBay or GE. The same with critics though!

Peter Schiff predicted 2008, but has gotten 90% of his predictions wrong. Gary Shilling and the economist Nouriel Roubini also predicted 2008-2009, but both said “cash is king” in 2009. Stocks have since risen more than 300%.

So Michael Burry might have gotten 2008 right, but that doesn’t mean anything when it comes to future predictions.

Conclusion:

People have been predicting the demise of markets since they started, and on the day I was born. I am sure they will be doing the same thing on the day I die.

There is no indictaion that index funds have become a bubble. Buffett recommends that most investors park their money in the funds, and so do most academics.

People who get one prediction right, moreover, tend to get the next ones wrong. So it is natural some people take Michael Burry’s statements seriously because he got the last crisis right, but historically, one right prediction doesn’t make you a sage for the next one.

Ultimately, in recent years, despite the rise of indexing, individual firms have fallen as the market itself has risen, with GE being an obvious example.

We are miles away from being in Burry’s situation. In 30 years, if indexing becomes 80% of the market, his thesis could become more relevant, but it isn’t at this point.

Index funds do fall hard when the market falls, but long-term markets rise. The long-term investor, therefore, doesn’t need to worry about this aspect of investing, especially if they are in bond funds.

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