Is Passive Investing a Bubble?

Within each industry, there are certain topics that divide participants and make them battle each other with religious fervour. Among programmers, the topic might be Windows vs. *nix. Among physicists, I’ve heard of dissent against string theory.

There are several topics that similarly divide financial professionals. One such topic revolves around the issue of whether passive investing is harmful or beneficial to financial markets. Passive investing, in contrast to active investing, involves an attempt not to pick individual stocks. Instead, it diversifies as much as possible, owning every stock in an index.

Until today, it seemed as though the vast majority of knowledgeable investors believed that passive investing was good, or at least neutral. However, there’s been growing dissent to this widely accepted opinion, and debate erupted recently when a highly respected investor went so far as to call passive investing a “bubble”.

The investor in question is a man named Dr. Michael Burry, who became famous as a result of being profiled in Michael Lewis’ book, “The Big Short”. Burry was one of the very few investors who predicted and profited from the subprime mortgage bust. It was therefore disconcerting when during a recent interview, he compared passive investing to Collateralized Debt Obligations (CDOs), the instrument he bet against during the subprime bubble years.

The reaction to Burry’s interview was swift. Cliff Asness, who runs a $200 billion investment giant, hit back by claiming the worries are “silly”. Ben Carlson, who runs a popular investment blog called “A Wealth of Common Sense”, quickly put out a blog post arguing against the notion that passive investing is a bubble.

But after reading the responses to Burry’s interview, it struck me that none that I’ve read so far has seemed to directly address his central concern. I think this is because although Burry heavily hinted at the concern, he was never explicit, perhaps because he assumed others would naturally arrive at the same conclusions he did. But seeing how that’s not the case, I thought I would help explain the concern.

To understand Burry’s point, it may first help to understand Burry himself. Burry is an extremely detail oriented investor, who likes to dig in to the exact mechanics of how investment vehicles work. When he bet against subprime CDOs, he did so after spending countless hours poring over legal documents that govern the mechanics of these CDOs. He may have been the only person to dive into such granular detail. So when he makes a big statement about passive investing, you can be fairly certain he’s thinking about the mechanics of index funds.

The chief concern Burry raised in his interview concerned liquidity. On that topic, this is what he had to say:

“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.”

Let’s unpack this statement. The Russell 2000 holds roughly the 1000th to 3000th largest US stocks. The bottom half of these stocks (the 2000th to 3000th stocks) have market caps that range from roughly $50 million to $150 million. The Russell 2000 is a market cap weighted index, and the allocation to each stock in this bottom half range from 0.01% to 0.03%. This sounds like a small fraction, but it’s really not.

As Burry states, hundreds of billions of dollars are linked to the Russell 2000. I don’t know the exact number, so let’s assume that $200 billion are linked to the Russell 2000. That means the bottom half of Russell 2000 stocks have between $20 million and $60 million invested by index funds linked to the Russell 2000, which amounts to roughly 40% of these companies’ market caps.

But, as Burry says, these stocks don’t trade that much. Almost a quarter of them don’t even trade $1 million a day, which means that Russell 2000 index funds own at least 20 times the daily trading volume of their smallest constituents.

This poses a big problem if there’s a rush to sell Russell 2000 funds. Let’s say that for whatever reason, investors decided to sell 10% of Russell 2000 index fund holdings in a single day. That means the funds themselves would need to sell between $2 and $6 million of the bottom half stocks in a single day. But the problem is, there’s not enough trading volume to handle such huge sell orders. Many of these stocks trade less than $1 million a day to begin with, but once investors see a deluge of sell orders arriving, chances are these investors will refuse to buy those stocks until the selling appears to ebb.

If a traditional active fund faced the prospect of wanting to sell stocks for which there were no buyers, the fund would probably decide to pause selling. Once the selling stopped, the prices of the small stocks would have time to recover, and a market crisis in general would be averted. But such is not the case with index funds, and there lies the rub.

Index funds, unlike actively managed funds, must follow a strict rule. If an investor buys a Russell 2000 index fund, exactly 0.02% of that money must go towards buying a stock with the index weight of 0.02%. The opposite is true as well:when an investor sells the fund, the fund must sell 0.02% worth of the aforementioned stock.

This can therefore lead to a situation where there are literally sell orders for stocks with no corresponding buy orders. We’ve had a taste of this scenario during the flash crash of 2015. For a brief period during the crash, buy orders for Accenture stock completely dried up, and the price went from over $40/share to literally $0.

Now, I’m not suggesting that such an extreme scenario is likely. There may be some stock market mechanisms that would prevent hundreds of stocks from going to 0. It’s also possible that there’s virtually no scenario under which investors would stampede out of index funds. I’m therefore agnostic about whether passive investing is a bubble or not.

That said, I do think it’s important not to dismiss out of hand Dr. Michael Burry and other investors’ concerns around passive investing. As I’ve said, I have yet to see someone convincingly argue against the problems regarding liquidity. Until then, I think it’s right to be cautious about passive investing.