Introduction 

Money has flooded into the cheapest, largest passive index funds. In an interview with Bloomberg, Michael Burry, who successfully predicted the Dot Com Bubble and US Housing Bubble, says this has created an Index Bubble. In this blog, we explore some of his comments from the interview and see whether it describes an investment opportunity.

Who Is Micheal Burry?

Michael Burry has a huge amount of experience with financial markets. In 2000 he founded Scion Capital and he very effectively called the dot-com bubble. By shorting stocks he managed to make a profit even when the S&P 500 was falling, but most impressive of all, in 2005, he forecast that the real estate bubble would burst in 2007.

In 2008 he had returned over 22% on average per year to the investors of Scion Capital, but you probably wouldn't have heard of him if he hadn't been mentioned in Michael Lewis's book "The Big Short" which was then turned into a movie where Michael Burry's character was played by Christian Bale.

What is Burry's Point About Price Discovery?

In the interview Burry starts off talking about how banking regulations have reduced the amount of risks that banks can take and in turn that has reduced the liquidity of markets because those banks can carry less inventory. You can think of reduced market maker inventory like a supermarket with just one can of beans or just one bottle of milk.

Burry says that "..passive investing has removed price discovery from the equity markets" - Price discovery is the ability of markets to sort out the good companies from the bad companies, where good usually means profitable and able to return value to shareholders.

His point being, If you just passively follow an index then you are not looking at value at all. You simply buy companies in proportion to the size of the company. Therefore by removing the requirement for security level analysis, which active managers perform, he's saying that we're not going to get true price discovery.

James Seyffart from Bloomberg research has shared the two pie charts below. These compare 2013 with 2018 based on the amount of money which was run in active mutual funds versus passive exchange-traded funds and index funds. While active represented about two-thirds of the market in 2013 by 2018 it was roughly 50/50. Given the rapid growth of passive funds we are likely to have passed the point where passive makes up more than half the US market in 2019. 

Jack Bogle made a really interesting point about price discovery in 2017. He said that you could still have price discovery even if indexing was around the 70, 80 or even 90%  level as a proportion of total funds. The reason for this he said was that people would always be looking for value so active wouldn't have to be a huge proportion of the market in order to have effective price discovery.

Can you compare a CDO to an ETF? 

Many people have made that point about price discovery, but what is much more shocking is Burry's comparison of CDOs with ETFs. 

In the interview Burry compares what he calls the indexing bubble with the bubble in synthetic asset-backed CDO’s just before the Great Financial Crisis. But comparing an ETF with a CDO is a bit like comparing a cheetah with a hippopotamus, they're very different beasts!

What is a CDO?

A CDO is not something most of us are familiar with.  CDO stands for Collateralised Debt Obligation.

At the heart of a CDO is a pool of assets, in the case of the diagram below it is residential mortgage backed securities (RMBS).

They start with a  pool of assets out of which is created a set of CDO tranches which are based on the risk from the pool of assets. 

The word tranche comes from the French word for "slice" and the key thing here is that you are slicing up the risk.

When you sell these tranches to clients you have the low risk, low yield tranche at the top, which is supposedly AAA or very high credit quality. You only lose capital on the top tranche if all of the tranches underneath have been completely eaten away by default but because the top level is low-risk it will also earn you the lowest yield.

The next level is AA which gives more risk but also higher return. This continues down the CDO until you get to the bottom "equity" tranche (which is sometimes compared with toxic waste) but it also gives you the highest yield.

Source: “The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States”, page 12

What is an ETF?

An ETF is an exchange traded fund. The fund in the data sheet below is the granddaddy of all exchange traded funds the SPDR SPY fund. This was launched in 1993 and it tracks the S&P 500 US equity index and the contents of the fund are completely transparent.

You can see the top 10 holdings in the data sheet and also the weights held by the ETF. In effect this is just a portfolio of stocks which you can buy off the shelf and the price of the ETF is just a weighted average of the price of the stocks inside the ETF. If the weights of the portfolio match those of the S&P 500 then you also match the price movements of the S&P 500. That is why these are usually called trackers, because they track some kind of index like the S&P 500.

Simple Versus Complex Pricing

The primary difference between CDOs and ETFs becomes very apparent if you look at the pricing. 

To get an intuition of how you price a CDO we can use an analogy which is a medieval castle. Imagine you are selling insurance and you charge people a premium in order to insure the gold they stored in the castle.

The nasty guys are going to try and break into your castle by digging a hole under it, filling it with explosives and then blowing it up!

These people were known as Sappers. If they got it right and didn't blow themselves up first, they would blow up the ramparts (the castle walls) and then the invading army could stream into the castle and steal your gold.

Naturally castle builders built up a defence against this and this was called a concentric castle. A concentric castle is like a castle within a castle with two sets of walls.

Now you can charge two insurance premiums. The highest premium would be to insure gold stored within the outer ward because it is more dangerous and the lower premium would be for gold stored in the inner ward as it’s safer.

To relate this to CDOs we can just change the terminology. The field around the castle is called the equity zone, this is the most dangerous region as there's no castle wall protecting it.

The area within the outer wall is called a mezzanine zone and the area in the middle is called the senior zone.

Now where would you attack this castle? You can probably see the design flaw in the diagram below. The arrows are where the walls are very close together, so if a sapper breaches the wall at that point they could breach both walls at the same time.

To stop the correlation of the walls falling together you would move the inner wall away from the outer wall and in that way the sappers couldn't blow up both walls at once and that's why correlation is key to pricing a CDO.

When correlation is high then all of the tranches could default at the same time. The pricing of all three tranches converges on to the same expected loss but if the correlation is lower there is a divergence between the equity tranche which is the most risky and the senior tranche which is the safest. 

To be able to price a CDO you do need to do some fairly hardcore maths or at least Monte Carlo simulation to price it accurately.

This is a far cry from an ETF where the price is just the weighted average of the prices of the stocks.

What is the impact of leverage on an investment?

Another huge difference between CDOs and ETFs is leverage. 

Leverage basically means investing borrowed money. This has the effect of increasing your profits in good times but it also has the effect of increasing your losses in bad times. In other words it amplifies your risk and your return.

In the Financial Crisis Inquiry report, which went through the reasons for the financial crisis, it outlined how leverage and CDOs go hand-in-hand.  

The CDO’s introduced leverage at every level. Firstly a mortgage for a home loan is itself leveraged,  particularly if you make a low down payment because most of your investment will be borrowed money. Next the mortgage-backed security which packaged up those home loans adds more leverage. Then in addition the CDOs into which they were placed produce further leverage because they are financed with debt.

This is even more complex with synthetic CDOs, which instead of containing bonds contained credit default swaps which amplified the leverage further.

The vast majority of ETFs we look at tend to move up and down one for one with the index that they track. That is why ETFs are sometimes called "delta one" products, they have this one-to-one movement with the underlying index. This is shown below in the left hand graph where the index value on the x-axis is plotted against the value of the ETF.

In leveraged assets like a CDO,  if the underlying index increases the asset value will increase by more and in the case illustrated in the right hand graph below this is by almost twice as much.

Leverage is yet another reason why a CDO is very different and much riskier than an ETF.

Liquidity

Now let's move on to Burry's point about liquidity. In investment terms liquidity just means how long it takes to sell an asset to turn it into cash.

In the interview Burry says:

“The dirty secret of passive index funds - whether open-end, closed-end, or ETF - is the distribution of daily dollar value traded among the securities within the indexes they mimic.” 

However, this argument could also apply to any fund,  whether it's active or passive, as long as that fund is benchmarked against some kind of index.

One way to measure liquidity is to look at the difference between the buying and selling price and in the diagram below I've plotted this along the y-axis. A big spread along the top of the graph means that a stock is illiquid and a low spread at the bottom means that the stock is liquid.

On the x-axis I've plotted  the average daily turnover which is how much of the stock changed hands every day averaged over the last 25 days. You will see that large caps are on the right and small caps on the left, illustrating a really clear relationship between large caps having higher liquidity and small caps having lower liquidity. 

In the interview Burry went on 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. The S&P 500 is no different - the index contains the world’s largest stocks, but still, 266 stocks - over half - traded under $150 million today”

“That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”

He is correct that if everyone tried to get out at the same time then there won't be room in the market,  but this is already a well known fact so that micro-cap stocks usually have huge bid offer spreads as they tend to be very illiquid.

If you look at the bid offer spreads in the morning they're typically worse than they are in the afternoon. This is shown in the data in the diagram below, from Brian Livingston, where there are two orders of magnitude difference in the bid offer spread between the smallest and the largest stocks on the US stock exchange.

ETFs have found a way around this which is called sampling. Instead of buying all of the stocks in the index in the same weight as the index, you only buy a subset of them. You then adjust the weights and through clever mathematical calculations you continue to track the index as closely as possible.

The stocks you miss out are the ones which are least liquid and that would typically be the smallest stocks in the index.

For example if you're tracking emerging markets stock indices, which tend to be less liquid than developed market stocks, you are likely to use one of these sampling methods. You may also use it if you're tracking a huge index like MSCI World where it may not be practical to buy all of the stocks in the index. 

I've Illustrated sampling below with a really simple example. The blue line is the S&P 500 and the red line is a simple portfolio with just three of the biggest stocks in index and of course the approximation isn't very good.

I have used 30 stocks in the graph below and you can see that the approximation improves.

In practice you would use hundreds stocks if you're trying to replicate an index for a real ETF but this does illustrate that you can match the index very closely and you don't need all of the stocks in the index to do that.

An ETF which uses sampling is shown below. This is the iShares FTSE 250 tracker, where the index obviously has 250 stocks in it, but if we look at the number of holdings in the ETF there are only 237 and that's almost certainly because they will have avoided the smallest and least liquid stocks.

A CDO is not an exchange traded security so it can only be traded over the counter. This means if you wanted to buy or sell one you would have to contact a counterparty and trade with them directly.

The way you buy and sell ETFs and CDOs is a bit like the difference between buying a bespoke suit from tailor and buying one off the rack from a high street shop. The high street shop bought suit (ETF) is not tailored exactly to your shape but it is a lot cheaper and easier to buy and sell.

We have seen that in terms of pricing, leverage and also the liquidity, of not just the asset itself but also its constituents, you really can't compare ETFs with synthetic CDOs.

Orphaned small cap value opportunity

In the interview Burry makes and interesting point about orphaned small cap value.

“The bubble in passive investing through ETFs and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally.”

It’s ironic that there are now many ETFs which are designed to harvest this small cap value risk premium. Strictly speaking these are not passive funds they are active funds but they are still wrapped up inside an ETF. The key thing is that they have forced down the fee that you would have to pay to get exposure to this type of factor. You won't have to do the single stock screen yourself you can get the ETF to do it for you.

While in the UK we don't have many of these  small cap value ETFs, Vanguard has created a global liquidity factor ETF and again this is designed to harvest that liquidity premium for less frequently traded shares and those tend to be the small caps.