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The Big Fuss - Bursting the Index "Bubble"

Macro Focus Photo of a Bubble

As passive investing becomes more popular, there's growing concern around indexing and its impact on the integrity of the stock market. Michael Burry, portrayed by Christian Bale in The Big Short  for famously predicting the 2008 collapse, went as far as calling it a "bubble".

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

These concerns stem from indexing's lack of price discovery. Unlike active trading which involves analysis, passive investing simply buys stocks relative to their size in an index.

Trading sets prices, each trade is a vote for a stock's value. Critics fear that passively investing based on relative size will drive up the price of larger stocks and suppress the price of smaller stocks.

Luckily, ETF trading doesn't necessary equal stock trading. Most ETF trading happens in the secondary market (ETF shareholders trading between each other). These trades do not involve trading the underlying stocks, so there is actually no impact on stock prices. 94% of ETF trading is done on the secondary market.

The remaining 6% happens on the primary market. Primary market trading only happens when an Authorized Participate (AP) needs to creates new ETF shares (which results in the buying of the underlying stocks) or redeem existing shares (which results in the selling of the underlying stocks). An AP does this whenever there is excess ETF demand or supply, respectively.

Index strategies only account for 5% of total stock trading. An overwhelming majority is still done by active managers. Active managers are the ones setting prices.

Yes, indexing is growing. However, in terms of total stock holdings, they're still a small player. Only 17.5% of stocks are owned by index strategies. Critics flag that this is only the beginning and indexing will continue to grow (which is likely true), but this shouldn't be cause for concern. Remember, trading sets prices, not asset size. As long as the majority of trading is done by active managers, there will be sufficient price discovery to keep markets efficient.

The self-correcting nature of markets make it hard to imagine a time where all trading is passive. This would lead to inefficient markets. Inefficient markets create opportunities to profit. These opportunities attract active investors. Active investors create efficient markets. Perfectly balanced, as all things should be.

Index funds are not creating a "bubble". Be mindful of where these claims come from. Most are from underperforming active managers who are losing business to passive strategies. This is actually an argument for indexing making markets more efficient. By weeding out poor performers, only the highly-skilled remain, which leads to even better price discovery. Ironic, I know.


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