Why The Big Short’s Michael Burry Is Wrong About Index Funds
September 19, 2019

Why The Big Short’s Michael Burry Is Wrong About Index Funds

Michael Burry set fire to investors’ worries when he recently said index funds will cause the market to collapse. He compared indexes to the sub-prime mortgage bubble in 2008, when he made a fortune shorting mortgage securities.
I’ve been investing for 30 years. Doomsayers have been predicting stock market crashes every week of every year since before I was born. And they’ll be predicting financial Armageddons long after you and I are dead. There’s a saying that Wall Street analysts have predicted 100 of the past 3 market crashes.

But Burry has a louder voice than most. He rose to fame in Michael Lewis’ book, The Big Short: Inside the Doomsday Machine. That’s why many people think he has a working crystal ball. Today, Michael Burry manages $340 million in assets at Scion Asset Management in Cupertino, California. In other words, he’s an active fund manager who hand-picks stocks.

Burry isn’t the only critic of index funds. In August 2016, Michael Blanding quoted George E. Bates in an article he wrote for Forbes magazine. Bates is a professor and senior associate dean for International Development at Harvard Business School. Bates said, “We are now in a situation where index investors are the major shareholders in most of the large and medium-sized public companies in the United States.” He says that companies’ management might become complacent if it doesn’t have to impress individual shareholders. If most of a company’s ownership comes from index fund investors, the company price will rise in proportion to its weighting in the index.

That’s also Michael Burry’s theory. In an interview with Bloomberg he said:

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.”

Here’s an example of what he’s saying. Consider a business that isn’t performing well. It’s customers are cancelling orders. It’s sales and profits are dropping every quarter. But Burry implies that if the stock were included in the S&P 500, its price might continue to rise if people poured money into the S&P 500 index. He fears that the same thing would happen in reverse. If investors were spooked enough to sell their indexes en masse, every stock on the index might fall in line with the index–even if the businesses were earning record profits.

But rabid selling occurred long before index funds existed. It happened in 1929. It happened in 1973-1974. When it happens again (and it will), index funds won’t be to blame. After all, when the stock market crashed in 2008, index funds performed better than actively managed funds. This means index fund investors kept cooler heads than most people think. According to the 2008 SPIVA Scorecard, index funds beat their actively managed counterparts in 12 out of 12 equity categories. That wouldn’t have happened if index fund investors stampeded for the exit. In fact, some index fund investors added money to the markets when active investors ran in fear. Such was the case with Dimensional Fund Advisors. In 2008, despite the market’s drop, DFA’s funds had a net in-flow. As a result, they didn’t contribute to the market crash. Instead, such inflows added money to stocks. That played a tiny role to stabilize stocks instead.

What’s more, index fund investors don’t represent most of money in the market, so they shouldn’t be blamed when the markets fall next. In a 2018 research paper, Vanguard says indexes, “represent just a small part of the global market. Registered fund assets made up only about 10% of the value of global investable securities and about 15% of U.S. investable securities as of September 30, 2017.”

And this isn’t just Vanguard’s data. Vanguard’s Chris Philips referenced Morningstar’s data when he said:

“Index funds constituted 14 percent and 3 percent of equity and fixed income funds, respectively, in market-capitalization terms. That means more than 85 percent of the equity market and more than 95 percent of the bond market were invested in some form of active management, be it individual securities, hedge funds or managed accounts.”

This might sound reassuring. But how do we know it’s true? To answer that, look no further than General Electric. It’s part of the S&P 500. The company has also disappointed active traders. As a result, its stock price dropped almost 50 percent between January 2018 and August 31, 2019. If the flow of money into index funds controlled individual stock prices, this would not have happened. In such a case, GE’s stock would have risen along with the S&P 500–despite the company’s woes.

Active Traders Cut GE In Half As The S&P 500 Gains 12.9%
January 2018 and August 31, 2019

Active Traders Cut GE In Half As The S&P 500 Gains 12.9% Chart

What’s more important, however, is to remember that nobody can accurately predict stock market movements. Plenty of people, like Michael Burry, have made a lucky market call. But most fall flat when they try it again.

Elaine M. Garzarelli famously predicted the stock market crash of 1987. But her crystal ball stopped working after that. On July 23, 1996, she said U.S. stocks could fall 15-20 percent from their summer peak. But 16 months later, U.S. stocks gained almost 50 percent. In 1997, she said U.S. stocks would fall again. But U.S. stocks soared 88 percent over the next three years. In 2007, she told The New York Sun’s Dan Dorfman that stocks would soar in 2008. We know how that turned out.

Gary Shilling, like Michael Burry, also predicted the real estate crash in 2008. Shilling said investors should also sell their stocks. In 2009, he proclaimed the S&P 500 would end the year between 500 and 600 points. But investors who listened to Shilling (even a broken clock is right twice a day) would have been disappointed. The S&P 500 soared. It ended 2009 at 1,115 points.

Meredith Whitney predicted the upcoming banking crisis in 2007. This made her famous when the markets collapsed in 2008. But in 2010, she said there would be hundreds of billions of dollars of municipal bond defaults over the next 12 months. But that didn’t happen.

Every week of every year, an “expert” predicts that stocks will fall hard. When a crash does occur, people sift through predictions to see who was, “right.” But it’s better to listen to Warren Buffett. He never jumps out of the market if someone claims to see the future. He always stays invested. He says, “Stock market forecasters exist to make fortune tellers look good.”

You can test this yourself. Find someone who has made a successful market call. Then track every prediction they make. It won’t take long. You’ll learn that Warren Buffett was right. Stock market forecasters really do exist to make fortune tellers look good.

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