Bursting The Passive Investing Bubble

This week Bloomberg put out an article focusing on Michael Burry’s criticisms of passive investing and how, in his opinion, it mimics the bubble in synthetic asset-backed collateralized debt obligations prior to the 2008 financial crisis. Burry, one of the protagonists in Michael Lewis’ book “The Big Short” who correctly called the financial market collapse in 2008, centers his arguments around what he believes is the absence of price discovery and liquidity inherent in passive investing vehicles. While Burry is a well-known asset manager given his “Big Short” fame, there are a few main points that he misses with his arguments. Collectively, trading in exchange traded funds (ETFs) only makes up roughly 30 percent of volume in the United States, so there is still plenty of price discovery going on with single stock selection by active managers. As it pertains to liquidity, the creation and redemption process is the secret sauce of the ETF product that facilitates ample liquidity. When an ETF investor goes to sell their holdings in a market capitalization weighted ETF, they are selling their holdings in direct proportion to the weighting in the index, so there is no adverse market impact. In more esoteric ETF products, the liquidity in the underlying securities could be an issue, but those products are nowhere near the size required to spur contagion in other areas of the market. For a more fulsome discussion around debunking the passive investing bubble myth, Ben Carlson wrote a lengthy piece on the topic this week.