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Parallels Of Index Funds To Subprime CDOs

by: KCI Research Ltd.

Michael Burry, one of the protagonists of the Big Short, recently stated why the bubble in index funds is similar to the bubble in subprime CDOs.

Many scoffed at the comparison.

Here's why the analogy is accurate, and what it means for your investment portfolio.

I will go to my grave... believing that really loose monetary policy greatly contributed to the Financial Crisis. There were obviously problems with regulation, but when we had a 1% Fed Funds rate in 2003 after, to me, it was pretty obvious that the economy had turned (up) and I think the economy was growing at 7% to 9% nominal in the fourth quarter of 2003 and that wasn’t enough for the Fed. They had this little thing called "considerable period" on top of the 1% rate just so we would make sure that their meaning was clear. And it was all wrapped around this concept of an insurance cut… I’ve made some money predicting boom-bust cycles. It’s what I do. Sometimes I am right. Sometimes I am wrong, but every bust I had ever seen was proceeded by an asset bubble generally set up by too loose policy...- Stanley Druckenmiller


Michael Burry, one of the famed protagonists of Michael Lewis' The Big Short, made news recently when he opined that the building bubble in index funds was similar to the bubble in synthetic CDOs (collateralized debt obligations).

Here were his prescient words, from my vantage point, in a Bloomberg interview (emphasis added is mine).

Central banks and Basel III have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in interest rates anymore. 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.

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.”

Personally, I have written extensively about this topic, specifically focusing on the fact that price discovery has taken a backseat to momentum and trend following strategies.

Burry's fame is bringing increased attention to the topic that index funds and passive ETFs are a bubble, and this is something I'm going to explore more here in this article, and write more about generally, as the lack of price discovery, specifically the lack of fundamental analysis, is at the heart of the everything bubble, which is the biggest bubble in modern market history.

The Birth Of The Index Fund

My birthday occurred recently in August, when I turned 42 years young. My kids think this is ancient, particularly the pre-teens and teenagers, however, most of us reading this know how fast time goes by.

In that context, the first index fund, the Vanguard S&P 500 Index Fund (VFINX), which mirrored the holdings of the S&P 500 Index (SP500), was launched on Aug. 31, 1976, roughly a year before I was born, making the Vanguard 500 Index Fund 43-years-old roughly a week ago. From one August birthday boy to another, happy belated birthday.

When it was launched in 1976 the Vanguard S&P 500 Index Fund was not received warmly, as Morningstar (MORN) reminisced about in 2011, with an excerpt below (emphasis added is mine).

For those unfamiliar with the history of index funds, Bogle's Folly is the Vanguard 500 the world's first index mutual fund. On Aug. 31, 1976, it launched as the First Index Investment Trust with little fanfare but soon attracted much derision for its central premise: That just buying and holding the broad stock market would provide better results than trying to beat it by picking stocks. Though many academics and practitioners had been promoting the idea of a market portfolio for years before Vanguard founder Jack Bogle made the 500 available, much of the investing establishment at the time dismissed it as a recipe for average results and even called it un-American.

From humble beginnings, index funds have come to dominate the investment management business, as never before.

80% Of The Stock Market Is Now On Autopilot

JPMorgan Chase (JPM) made business news headlines in June 2019 when the banking giant opined that 80% of the market was now on autopilot. Here was a quote from that article.

Passive investments such as index funds and exchange-traded funds control about 60% of the equity assets, while quantitative funds, those which rely on trend-following models instead of fundamental research from humans, now account for 20% of the market share, according to estimates from JPMorgan.

From my perspective of being an active, value-focused investment manager the past two decades, where it has been extremely difficult for roughly the past seven years, with the notable exception of 2016, I think fund flows are even higher tilted towards passive, ETF, and momentum trend following strategies.

The Shift Toward Passive Investments Has Created An Epic Bubble

I'm in agreement with Doubleline Capital CEO Jeffrey Gundlach, who said the following about passive investing in December of 2018 (emphasis added is mine).

I’m not at all a fan of passive investing. In fact, I think passive investing ... has reached mania status as we went into the peak of the global stock market,

I think in fact that passive investing and robo-advisors ... are going to exacerbate problems in the market because it’s herding behavior,

I wouldn’t advise anyone to be a passive investor,” Gundlach said. “My strongest advice is to not invest in passive U.S. equity funds.

Vanguard responded, saying in the following in a statement to CNBC:

While Mr. Gundlach may enjoy pointing fingers, the data simply does not support his claims. Index funds own a modest 15% of the value of all global equities, and the strategy accounts for less than 5% of the exchanges’ total trading volume.

From my perspective, I can see both sides of the argument, however, I side with Gundlach, partially because of what Michael Burry illustrates about liquidity, which he said in his earlier linked Bloomberg interview.

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.

In summary, while Vanguard has a point about the absolute size of index assets (though I would dispute some of their claims, however this is a topic for another article), which are still not a majority of the market yet, this point can be refuted for the scope of this article for two reasons.

First, current funds flows, as described earlier are 80% attributed to passive and quantitative strategies.

Second, if you include closet indexers, which are the substantial majority of the rest of the assets under management (surviving active managers have had to closet index to an extent to survive), then the passive weights become overwhelming.

If you are not convinced about the closet indexers, think about it this way. What active manager would survive the past decade managing money if they were significantly different than the dominant indexes other than being overweight the best performing index components?

Passive Investments Craze Gathering Momentum

Building on the narrative, more and more esoteric ETFs employ passive strategies, which has grown by leaps and bounds from 2011, when Morningstar illustrated the problem back then with the following comment (emphasis added is mine).

Index funds may not have anything to prove anymore, but new challenges have come with their success. A lot of suspect investments and strategies are trying to ride the coattails of the indexing movement. Particularly among ETFs, there's been a profusion of narrowly focused, more-expensive niche index funds tracking obscure asset-class slices such as corn, Andean companies, lithium miners, and battery makers. In the past decade, even Vanguard, a bastion of broad-based indexing, has launched sector index funds and ETFs, albeit more-diversified ones than other ETF sellers have introduced. There's also been an explosion of leveraged index funds and ETFs that promise to produce two times the return or the inverse of their benchmarks. Their purveyors pitch these products as tools for active index investing - an approach that can involve trying to beat the market by tactically trading chunks of it, which is hard to make work over the long term.

The above quote was written in 2011, and look where things have gone since then, with an explosion in passive and ETF assets that defies the imagination, and many articles focused on trading these ETFs, with an almost careless disregard for the underlying components of these indexes. Said another way, in a famous Wall Street axiom, the ETFs have simply become trading sardines.

Quality Is Overpriced

Somewhat ironically, one of the chief beneficiaries of the passive movement is quality companies, who similar to the sovereign bond market, have become historically overpriced because everyone wants to own these companies, particularly against the backdrop of economic uncertainty.

13D Research is a terrific resource that I recommend most investors peruse, and in a recent article titled, "The risks grow that the passive and algorithmic transformation of equity markets could lead to a crisis," they highlighted a pervasive trend in the market today, specifically that investors anticipating a downturn (which is worthy of a whole separate article, specifically almost everyone is anticipating a recession...what if this does not happen?) have turned to quality companies.

Anticipating a downturn, investors have flooded into low-volatility funds. The iShares Edge MSCI Min Vol USA ETF (USMV) and the Invesco S&P 500 Low Volatility ETF (SPLV) have seen inflows of roughly $8 billion this year, only slightly trailing the $8.33 billion in inflows to the biggest U.S. ETF, the Vanguard S&P 500 ETF. As a result of this crowding: “Low-volatility stocks are trading at almost three standard deviations above the mean. That means low-vol is more expensive than it has been nearly 99% of the time, relative to the mean, since 1990,” according to the Leuthold Group.

For reference, here are the top-ten holdings of the iShares Edge MSCI Min Vol USA ETF, and the year-to-date percentage gains, with the SPDR S&P 500 ETF (SPY) higher by 18.8% YTD.

  1. Newmont Goldcorp (NEM) - Up 22.3%
  2. Visa Inc (V) - Up 38.4%
  3. Waste Management (WM) - Up 36.9%
  4. Coca-Cola (KO) - Up 19.7%
  5. McDonald's Corp (MCD) - Up 24.5%
  6. Republic Services (RSG) - Up 25.7%
  7. PepsiCo (PEP) - Up 27.9%
  8. Verizon Communications (VZ) - Up 6.8%
  9. Yum Brands (YUM) - Up 29.8%
  10. NextEra Energy (NEE) - Up 31.4%

Frankly, several of these names surprised me, including Newmont being the top weighting, with both Barrick (GOLD), whose shares are up 47.6% YTD in 2019 (I recommended Barrick in a public SA article last year and then in a follow-up on precious metals that captured the capitulation last year very accurately), and Newmont benefiting from the flight to quality in 2019. However, many of these are the usual suspects.

Personally I run valuation models for quite a few of these companies listed, including KO, MCD, PEP, WM and V, and I think the quality favorites like Coca-Cola, Johnson & Johnson (JNJ), McDonald's, Procter & Gamble (PG), and PepsiCo are historically overpriced.

Looking at the top holdings in the Invesco S&P 500 Low Volatility ETF and their year-to-date performance, the top-ten holdings are surprisingly different, given the similar mandates of the two ETFs.

  1. Republic Services (RSG) - Up 25.7%
  2. Ecolab (ECL) - Up 41.1%
  3. NextEra Energy (NEE) - Up 31.4%
  4. Arthur J. Gallagher & Co (AJG) - Up 23.4%
  5. Coca-Cola (KO) - 19.7%
  6. Entergy Corp (ETR) - Up 38.1%
  7. Eversource Energy (ES) - Up 28.7%
  8. US Bancorp (USB) - Up 16.5%
  9. Waste Management (WM) - 36.9%
  10. WEC Energy Group (WEC) - Up 44.1%

The best performing stock in the top 10 of the Invesco S&P 500 Low Volatility ETF is WEC Energy, a utility headquartered in Milwaukee, Wisconsin.

WEC Energy, a staid utility, epitomizes the rush to quality in 2019, amidst record low interest rats, with utilities, as measured by the Utilities Select Sector SPDR Fund (XLU), outperforming the S&P 500 Index year-to-date, as measured by SPY, with a gain of 22.3% for XLU, and 18.8% for SPY.

How overpriced is quality today, particularly vs. the rest of the value universe?

This chart from JPMorgan provides perspective.

(Source: JPMorgan)

Digging Deeper Into The Quality Overpriced Narrative

Look at a long-term chart of a stock like McDonald's or Procter & Gamble, and then look at their respective underlying fundamentals.

For McDonald's, shares have exploded higher over the past decade, rising more than 5x from their 2008-2010 levels.

(Source: Author,

The fundamentals, however, tell a sharply different story.

McDonald's stock price trades for a trailing price-to-earnings ratio of 28.7 and a forward price-to-earnings ratio of 25.0. The enterprise value to EBITDA ratio for MCD is over 20. These premium valuations are attributed to a company that has seen its revenue decline the past decade, posting $20.8 billion in revenues for the trailing twelve months compared to $24.1 billion posted in 2010.

Net income for MCD has risen from $4.9 billion to $5.9 billion over this time frame, however, looking at the stock chart, with MCD shares up over 5x from their 2008-2010 levels, the fundamentals simply to not reconcile with the levitating stock price.

The levity in Procter & Gamble shares is perhaps even more egregious.

(Source: Author,

Procter & Gamble is a similar story with PG shares trading for a forward price-to-earnings ratio of 23.9 and an enterprise value to EBITDA ratio of 19, a premium valuation, even though PG's revenue has declined from $77.6 billion in 2010 to $67.7 billion over the trailing twelve months, and both operating income and net income have declined from their 2010 levels, yet PG's shares have gone up roughly 3x from their 2010 levels.

Looking at it from at distance, it seems like the markets have lost their minds, as investors are bidding up the price of perceived quality companies to premium valuations, even though these companies clearly have not grown at a rate anywhere near what most investors think they have grown, and in the case of McDonald's and Procter & Gamble, there actually has been no growth.

Building on the narrative, it makes the valuations of the large-cap technology leaders like Amazon (AMZN) Alphabet (NASDAQ:GOOG) (GOOGL), and Facebook (FB), look much more reasonable, as these companies are at least growing their respective businesses at a healthy rate.

What's driving this madness in the stock price performance of staid quality names?

From my perspective, it boils down to two things.

First, the underlying culprit are the passive and ETF fund flows, which are price and valuation indiscriminate.

Second, it is corporate buybacks, which also are price and valuation indiscriminate.

(Source: Deutsche Bank)

Ultimately, investors jumped on the wave of the passive fund flows, and the wave of corporate buybacks (with some smart investors front running these waves of liquidity), and collectively, these investors eschewed valuation and price discovery too, and focused on just quality, similar to the price insensitive buying of the passive investment strategies, further exacerbating the bubble.

Closing Thoughts - Avoid Passive, Go Active

With advocates like Warren Buffett of Berkshire Hathaway (BRK.A), (BRK.B), who has famously said that indexing is appropriate for most investors, even though he does the opposite, specifically focusing on value investing through security analysis, a lost art in my opinion, it's no wonder that so many have jumped on the bandwagon of passive investing.

Michael Burry, though, offers a contrasting viewpoint that I happen to agree with, succinctly illustrating this viewpoint as follows.

This structured asset play is the same story again and again - so easy to sell, such a self-fulfilling prophecy as the technical machinery kicks in. All those money managers market lower fees for indexed, passive products, but they are not fools - they make up for it in scale.

Potentially making it worse will be the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day. This fundamental concept is the same one that resulted in the market meltdowns in 2008. However, I just don’t know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be.

In closing, that's the dilemma investors find themselves in today, specifically do they dance while the music is still playing, hiding in perceived quality when it is historically overpriced, or do they get out ahead of the inevitable price discovery that's coming?

From my perspective, I think there is an alternative approach. Specifically, it's to go where the passive and ETF flows have not been, which is where I think there is historic opportunity.

Building on this narrative, embracing shunned economically sensitive assets, when almost all market participants are buying quality, front running the passive and ETF flows, and preparing for a downturn, is perhaps the perfect storm of a contrarian opportunity.

These economically sensitive equities include energy equities, which are historically out of favor, and which I have written about recently (extensively), with a public article on Exxon Mobil (XOM), an article providing a historical comparison of the natural gas industry in the United States, and another public article on Antero Resources (AR), with all of these articles providing perspective on the historic opportunity from my vantage point.

Disclosure: I am/we are long AR, GOLD, XOM AND SHORT SPY AND AMZN IN A LONG SHORT MARKET PORTFOLIO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.