Everyone has probably seen the movie “The Big Short” based on the novel of the bestselling author Michael Lewis. The main character, based on true events, has made a prediction back in 2005, which increased the value of his fund by 489% when it was fulfilled. Now, the same person is making another big call- what can the private investors do to safeguard from possible crises?
The new bubble?
The biographical comedy-drama is telling the story of an odd hedge fund manager Michael Burry. His fund has earned $2.69 Billion during the collapse of the housing crisis in the U.S. and a start of the subprime-mortgage crisis of 2008. Sure, the movie is worth watching, if you haven’t yet, not only because of the star-crew but also because the same person, who predicted the bubble of 2008 is pointing us to another bubble! According to Mr. Burry, the new bubble is caused by passive investing through ETFs (exchange-traded funds)!
What is an ETF?
Exchange-traded funds, as the name suggest are traded on the stock exchange. An ETF can be dedicated to a special sector, geography, or big know index, such as S&P500. For marketing purposes an ETF can be called something like “big promising disrupting tech companies”, but in reality, an ETF is benchmarked to a corresponding index, such as “Dow Jones U.S. Technology Index”, for example.
An ETF aims to replicate the index by buying all stocks in the same proportion as the index in the subject. Consequently, private investors can buy an ETF, for a small price, which will give them an exposure to a particular industry or geography. The biggest advantage of ETF is the cost-competitiveness and accessibility to a large number of private investors. Because an ETF is simply copying the index, it is called passive investing, as opposed to active style investing.
Active investing is stock-picking by a portfolio manager with an aim to beat the market, whereas passive investing aims to copy the market. In order to “beat the market” the portfolio manager needs motivational commission and additional knowledge to do so, which translates to higher fees.
Evolution of passive investing
Late John C. Bogle is known as a “father of passive investing”. His vision was that investing should not be exclusive only for the rich, but it should be accessible for everyone. In 1975 he introduced the first-ever exchange-traded fund Vanguard 500, which aimed to copy S&P500. The launch was not welcomed enthusiastically, by the financial professionals. They thought it was silly and even “unamerican”. The fund attracted only $11 million, which was not enough even to buy all shares in S&P500. Today the fund’s value is $492 billion and it brought positive returns for 40 years.
Now, there are thousands of ETFs which cover almost every product, every risk appetite, and every duration. Their popularity is unprecedented and the reason is not only low fees. The minimal investment in actively-managed funds is usually very high and is not affordable by many people, which we believe is not fair. Investing should be available to anyone, who wants to secure his/her financial future.
Trading is risky
But what if an individual decided he/she wants neither- not ETF, nor actively managed fund, and decides to buy individual stocks? Well, this is not as easy as it sounds. First of all, you probably won’t be able to afford to diversify as well, as the fund, due to budget restriction. When you don’t diversify, risks are concentrated on one asset.
Moreover, what if, for example, you want to buy the share of Amazon Inc., the world’s largest internet company by revenue. You can try, but one share of Amazon costs a whopping $1,8131! If you are on a tight budget, but really want to own a bit of Amazon -you can choose between 221 ETFs2 which, among others, own shares of Amazon too. Take, for example, Fidelity MSCI Consumer discretionary ETF- it costs only $46 and allocates 25% of all its managed assets to shares of Amazon.
Passive vs. Active flows
According to Morningstar, passive funds attracted inflows of $428.7 billion over 2016, while actively managed funds saw outflows of $285.2 billion, a trend that has occurred for nearly 10 years. In September 2019 the flows to ETF reached $157 billion year-to-date. Moody’s Investors Service monitoring this trend predicted that index funds will overtake active management in the U.S. by 2021.3
Where is the problem?
As we described above- the passive investing, a.k.a. index following gained increased popularity. Almost every individual with an interest in financial markets is aware of products such as ETF. Everyone is cherishing the investing freedom that it has brought to masses. So, where is the problem? Well, if you think about the bigger picture- it becomes apparent.
The indexes, which ETFs are benchmarked to, consist of certain companies, with certain market capitalization. In other words, many exchange-traded companies with small market capitalization are never included in the index. These smaller companies may be very promising and successful, but because of their size, they are simply overlooked.
Active vs. passive investing
|Mandate||Outperform the benchmark through discretionary security selection or trading in anticipation of market turning points||Replicates the benchmark by holding proportionally each security in it|
|Benefits||informed active managers can earn above-market returns||low fees|
|active managers can be especially helpful during periods of market stress||returns in line with the market and lower risk|
|Cons||generates trading costs and requires compensation to active managers and investment in relevant information, which go hand in hand with higher fees||attractive and promising companies that are not part of the index can be easily overlooked by investing public|
|Statically, most actively managed funds tend to “underperform,” or do worse than, the market index.||making income inequality worse, as executives at companies with high common ownership were paid 25% more than executives in companies with lower levels.|
So, when the money flows are increasing into the ETFs, it means bigger-capitalization companies are getting these flows and it artificially can pump up the price. Put differently, the share is bought not because of its attractive valuation but because it was part of an index. This may dilute the financial picture and can have dangerous consequences.
What the hero of “The Big Short” is warning us about?
Despite the optimism surrounding the celebration of passive investing, Michael Burry is seeing a bubble. For the reasons described above- the large-capitalization companies have seen unprecedented demand due to their inclusion in the indexes and as a consequence bought into ETFs. Mr. Burry says that this is a tremendous opportunity to earn for active managers. He suggests buying small-cap companies. His fund, Scion Ventures already has made four very large long positions, that are known, in U.S. and South Korean companies.
Despite being known for his bearish views, Mr. Burry says it is the time to go long. In his famous bet, immortalized in the movie, he bet against the collapse of the market. In 2005 he sensed this opportunity and kept shorting mortgage-backed securities. This lasted for many months and required very large premiums to be paid, which made the funds’ clients unhappy. But he won eventually, not only in money terms but also its reputational terms. So, his current warning is taken very seriously this time.
When the investment visionary says it is time to be in active investing, many would love to follow his guidance. But, wait how an individual investor can afford to do that? We already said that the fees for actively managed funds or money manager are tremendous. To become an active investor yourself is also very expensive and risky. Moreover, it requires specialized knowledge, experience and time.
This is not really affordable nor accessible to masses, is it? Well, the good thing is- the P2P investing is developing very actively. You still can benefit from earning a stable income with no fees, and protect yourself from the dangers of the new bubble. We believe the democratization of investing was the major leap in society and it shouldn’t go back, so don’t hesitate and explore how p2p investing can help you achieve your financial goals.
- Prices are shown as at 10th of September 2019