
The idea of an index investing bubble might seem far-fetched, but it's a growing concern.
Index funds have become incredibly popular, with assets under management reaching $20 trillion in 2020.
This surge in demand has led to a significant increase in index fund creation, with over 7,000 index funds launched worldwide between 2010 and 2020.
As a result, index funds now account for nearly 30% of the global equity market.
Index Investing Bubble
Michael Burry, a well-known investor, thinks index investing is a bubble. He made his points clear in an interview, which was accurately summarized by a reporter.
Burry has three main arguments against index investing.
One of his key points is that index funds are like subprime CDOs. He made this comparison, suggesting that they share some similarities with the disastrous financial instruments that contributed to the 2008 financial crisis.
In Burry's opinion, index investing is a bubble because it's a large and crowded market.
Check this out: Is Crypto a Bubble
Risks and Concerns
The index investing bubble is a concerning trend that has been gaining attention. Many investors have been pouring money into index funds, which has led to a surge in their popularity and a subsequent increase in their prices.
The risks associated with this bubble are real, and investors need to be aware of them. As we discussed earlier, the S&P 500 index has seen a significant increase in its price-to-earnings ratio, reaching levels not seen since the 2000s.
Investors are taking on more risk than they may be aware of, as the prices of index funds are becoming increasingly detached from their underlying values. This can lead to significant losses if the market were to correct.
See what others are reading: Private Equity Investments for Small Investors
Lower Future Returns
Index funds that use derivatives can face significant challenges in times of financial stress, as seen in 2008 and 2009. The market for derivatives can break down, making it difficult for funds to mark to market or value their holdings.
Funds that use derivatives may not be able to accurately calculate their returns, which can lead to lower future returns. This is because derivatives can be complex and hard to unwind, especially in volatile markets.
In extreme cases, the use of derivatives can even lead to a complete loss of principal, as seen in some of the most troubled funds during the 2008 financial crisis.
High Concentration Risk
High concentration risk is a major concern in many industries, particularly in those involving hazardous materials. This risk is often associated with the storage and handling of large quantities of these materials.
In the case of chemical plants, for instance, a single leak or spill can release massive amounts of toxic substances into the environment. This can have devastating consequences for people living nearby and the ecosystem as a whole.
The risk of high concentration is also present in the oil and gas industry, where large volumes of flammable liquids are stored and transported. A single spark or ignition source can lead to catastrophic explosions and fires.
The consequences of high concentration risk can be severe and long-lasting. In the event of a disaster, it can take years for the affected area to recover.
Discover more: B Riley Preferred Stock
Liquidity Risk
Index funds can account for a substantial portion of small cap buying volume, as seen in funds like VTI. This can lead to problems if index investors sell en masse during a crisis.
Small cap stocks would likely get crushed if index investors sold their shares all at once. This is because index funds are forced to sell indiscriminately, without considering momentum or price movement.
Several total market index funds can account for a significant portion of small cap buying volume, making them vulnerable to liquidity risk.
Expand your knowledge: Healthcare Angel Investors
Price Discovery
Price discovery is the process by which markets determine the price of a stock. The more rational parties involved in price discovery, the more accurate the price.
Investors' rational opinions drive the market price close to the stock's intrinsic value. If 100,000 rational investors buy and sell a particular stock, the market price will likely be pretty close to its true value.
Index funds, however, don't weigh in on the value of the securities held in the fund. They simply buy each and every security on the list.
As index investing accounts for a larger portion of market activity, prices will deviate further and further from the truth.
If this caught your attention, see: Will Gold Prices Drop
Where Arguments Fall Short
Indexing makes up only 15% of the US stock market and 5% of the global market, so there's still a significant portion of active buying and selling going on.
The argument that indexing would hinder price discovery is based on conjecture, but it's hard to see how it would happen when 85% of the market is still actively buying and selling stocks.
Index fund investors shouldn't worry about price discovery suffering, as investing has come a long way since the last serious period of turmoil in 2008 and 2009.
Market timing doesn't work, and the path to the best investment outcome is a consistent, long-term strategy.
Panic selling during the next market event will likely happen, but thanks to the progress in the investment industry and available platforms, the door shouldn't get entirely jammed.
Investors with a time horizon of 10 years or longer shouldn't worry about short-term price fluctuations.
For another approach, see: Sell Shares of Stock
Index investors who plan to sell their funds soon should have a financial plan with an ample margin of safety to accommodate for such an event, and a healthy allocation to bonds.
Mainstream index funds like VTI and SPY don't use derivatives, so investors in those funds don't need to worry about additional risk.
You might enjoy: Buy Berkshire Hathaway B Shares
Expert Insights
Michael Burry, a well-known investor, thinks index investing is a bubble. He was interviewed via email, and his points were summarized by a reporter.
Burry has three main arguments against index investing. His position was accurately portrayed by the reporter.
One of his arguments is that index investing is a bubble. The article doesn't provide more information on this point, but it's clear that Burry thinks it's a bubble.
Burry's interview was conducted via email, and the reporter summarized his points. This suggests that Burry's arguments are based on his investment experience and expertise.
The article doesn't provide more information on Burry's second and third arguments.
Readers also liked: Gold Bubble
Conclusion and Next Steps
The index investing bubble is a complex issue, but one thing is clear: it's not going away anytime soon. The stock market is still a diverse place with tremendous volume from active stock pickers.
Currently, 85% of the market is making investment decisions on the merits of individual securities, which suggests that price discovery is still intact. It'll be a long time until the index investing trend takes over completely.
Just remember, the pendulum will swing again, and the issues that come with an over-reliance on index investing will become salient.
See what others are reading: Will Gold Prices Continue to Rise
Next Steps
The market is still a diverse place with tremendous volume from active stock pickers, making it a long time before price discovery really goes away. This is because 85% of the market is still making investment decisions on the merits of individual securities.
It's essential to be cautious and not make any rash decisions. The writer warns not to "run for the door when everything turns again", as the exit could be crowded.
The pendulum will eventually swing, and the issues mentioned will become salient. However, the exact point of this swing is unknown.
It's crucial to stay informed and adapt to market changes. The writer's advice is to be prepared for a potential shift in the market.
Final Words
It's easy to get caught up in the hype surrounding index funds, but it's worth remembering that they're just one tool in your investment toolbox.
Investors don't have to be bound by S&P 500 returns, and there's no need to stick to a rigid investment strategy that doesn't account for changing market conditions.
Active portfolio management doesn't have to mean trying to pick hot stocks or chasing blockbuster returns.
A patient focus on long-term investing can be a more effective approach, especially in overvalued slow-growth equity markets and low bond yields.
Mild adjustments to your investment strategy can also help you take into account unusual market valuations.
It's time to take a step back and reassess your investment approach, rather than getting caught up in the latest trends or fads.
On a similar theme: Value Investing Strategy
Sources
- https://www.lynalden.com/index-funds/
- https://www.abovethecanopy.us/is-index-investing-really-a-bubble/
- https://themarket.ch/english/is-the-passive-investing-bubble-bound-to-burst-ld.10021
- https://awealthofcommonsense.com/2019/09/debunking-the-silly-passive-is-a-bubble-myth/
- https://www.bogleheads.org/forum/viewtopic.php
Featured Images: pexels.com