A recent prediction about Index Funds from Michael Burry warns investors about a possible bubble. Burry, who had correctly predicted the derivatives-based 2008 Financial Crash – and whose character was the star of the film The Big Short, a movie that made our must-watch list – has warned that Index Funds may be setting up a market bubble in equities, which may end badly for the large number of people now invested in index-tracking funds.

Let’s break down the scenario, how we got here, and the potentiality of an index fund-induced crash.

What is an index fund?

Let’s start with a definition and explanation for newbies to the markets. Most people know the American S&P 500 or Dow Jones, the European FTSE, CAC, and DAX, or the Asian Hang Seng. These are all indices that represent a portion of the overall stock market and by extension, the logic goes, the economy.

Since these are virtual assets – there are no official shares of FTSE or S&P500, only shares of companies included in the indices – there is an industry set up to mimic their movements. These are passive index funds. They’re passive because they do not pick winning stocks but simply mirror the index.

When an investor buys into a fund, whether it be a mutual fund or an exchange-traded fund (ETF), the fund will purchase a corresponding amount of stock, with weighting according to the index. Usually, stocks with more weight (that is, more dollars invested) will be more liquid, but small stocks will still carry some weight in the index and therefore in the index fund.

When an investor sells shares in a mutual fund or ETF, the fund generally liquidates part of its equity holdings, again in proportion to the weightings of the index, receives cash, and passes the proceeds along to the investor.

That’s pretty much all there is to it. If you are still unsure about how funds work, we have a full, detailed post explaining the four main types of funds.

Why are Index Mutual Funds and ETFs so popular?

There are multiple reasons funds are popular. The two most prominent are probably ease-of-investing and cost-sharing. Many people are involved in markets through retirement accounts or as sideline investors who do not really know much about investing. They’re uninterested in the finer points of investing or don’t have time to learn how to perform due diligence, check their investments every day, and understand how company management, financials, products, and macroeconomics interact with each other. Indices, and by extension index funds, allow these investors to partake in broad market upside without needing to understand everything about markets. For non-index funds, there is still usually a target sector or group, which an investor may like but not want to actively trade himself or herself.

The other main reason, cost-sharing, allows one to diversify without excessive cost and tied-up capital. Indices like the Russell 2000 track 2000 different stocks, which is great for diversification. Investors with little cash cannot purchase one share each of 2000 companies, though. Moreover, the transaction costs for an individual would be enormous. Even at $5 a transaction, a single investor would spend $10,000 just to purchase a uniform distribution of Russell 2000 stocks, which completely ignores the weightings. However, when funds regularly move into and out of millions of dollars of stock, $10,000 isn’t so bad.

Finally, index funds in particular are quite popular because of two pieces of widespread financial advice. One, invest in the overall stock market, because it always goes up in the long run. Two, active funds – those in which the fund managers choose stocks instead of copying the market – often have little extra return but carry more risk and higher fees. This advice is heeded by many, and, when coupled with the ease-of-use and cost-sharing in funds, index funds do quite well.

How the situation can be dangerous

Michael Burry’s concern is twofold: too much money is in funds to allow for an orderly exit from markets and the price discovery mechanism is breaking down.

The logic for the price discovery mechanism part is as follows. As index funds become more popular, more money flows into them, causing them to purchase more shares in companies in the indices, pushing up the price. Since these funds simply mirror the indices, they do not seek true prices but act mechanically to purchase shares as demanded by fund investors. Since many fund investors are not performing due diligence thoroughly and simply “buying the index”, as advised, they are artificially pushing up the prices. With few active funds countering this trend, the price moves away from its true value.

Now, because there is so much money attached to these funds (on the order of hundreds of billions of dollars in net assets for the largest funds), any downturn causing even a fraction of fund investors to sell will in turn force the funds themselves to sell large blocks into the markets, placing strong downward price pressure on the held stocks.

Burry is also worried about liquidity because some of the equities in small-cap stocks that are part of large index-based mutual funds will feel significant pressure from even a tiny selloff, wherein funds must offload assets of even small-cap companies whose daily dollar volume numbers in the low millions.

Another issue in this situation, not mentioned by Burry, may be synthetically leveraged ETFs, which employ derivative instruments to amplify gains and losses in the underlying index. Because losses are amplified, skittish investors might drop out of these ETFs faster, initiating the downward pressure on markets which in turn causes unleveraged ETF and mutual fund investors to start selling, creating the main drop.

And a final sign is valuation differentials between stocks that are represented in indices and those that are not. This may be the most convincing evidence that indices are driving a capital inflow into stocks that may not be linked to the true value of those stocks. Why is it that similar stocks inside an index are valued higher than those outside? One ready explanation is that index fund investors are injecting cash and demand where it otherwise wouldn’t exist.

Rebuttals to the Warning

Because of Burry’s fame resulting from his correct contrarian prediction of the CDO debacle, people take his warnings seriously. However, there are rebuttals to his argument.

First, some people attack the pricing mechanism breakdown point. There is more liquidity and volatility today than ever before. High liquidity implies markets are able to move without concern for lockups. Volatility implies markets are very efficiently pricing assets by instantly incorporating new information and are constantly engaged in a tug-of-war between two evenly matched sides – presumably with the true price point between them.

Others attack the too-much-money-too-few-exits point, where even a small selloff by fund investors will start a cascading crash of the markets. Many passive fund investors are such investors because they are not interested in finance and are not so worried about the market’s short-term prospects. If they were, they would be invested in active funds or directly investing themselves. Many are invested for retirement and have time for markets to rebound. This means that there will be no panic-selling by fund investors, which never puts enough pressure on the market to ignite full-blown panic.

Are the rebuttals wrong?

The idea that liquid markets and high volatility implies efficient and robust markets that haven’t destroyed their pricing mechanisms has its merits. However, this argument may be missing a major force in markets today: high-frequency algotrading. Algorithmic trading makes up 80% of daily trade volume in the world’s largest capital markets (those of the United States). This indeed improves volatility and allows for near-instantaneous price discovery – but that discovery is only as good as the algorithms have been designed to find.

Machine learning algorithms seek out patterns in data, but just because a pattern exists does not mean it is the pattern we need. Moreover, this dominance by algorithms leads to pattern amplification, which is suspected to be the reason behind flash crashes. Undoubtedly some of this algotrading is not meant for profitmaking but for on-the-fly portfolio rebalancing. Nevertheless, it seems likely much algotrading is profit-seeking and even speculative.

Additionally, psychological finance is a major driver of the markets, even with the dominance of algotrading. So, Burry’s worry that investors will start to flee the funds, therefore fleeing the general markets en masse, is not simply dismissible.

Where is all this money coming from, anyway?

The bull run since the 2008 crisis is historic. The Western recession had less of an effect in other parts of the world (notably China and India, which continued with 6%+ GDP growth in their already sizeable economies), and the United States economy has rebounded recently, too. This lends support to real value creation in the global economy. But the bull run has partially been driven by historically cheap credit, too.

For the decade starting in 2008 and ending in 2017, the Federal Reserve maintained sub-1% interest rates – for a decade! The European Central Bank also maintained sub-1% rates, but since 2014 the rate has actually been negative, pushing capital into stocks, corporate bonds, and anything other than ECB deposits.

This itself supports the idea that assets are a bubble created by cheap credit. In the context of this article, that money doubly endangers the economy because regular investors now have more money pushed into index mutual funds and ETFs in an attempt to capture upside in this historic trend. There is also the fear that central banks have hamstrung one of their central tools to combating recession (lowering interest rates), exposing their economies to more vulnerability to any market shocks that may come in the future.

In Summary

Whether ETFs and Mutual Funds are attracting too much investment and therefore leading to market bubbles and an eventual crash will be played out in the future. A single prediction does not make a Nostradamus. But past performance sometimes is indicative of future results.

Should you get out of ETFs and mutual funds linked to indices? You need to consider the alternatives (where to put your money otherwise), whether you expect the bull run to crash down or just make a small correction, and whether you think index funds have really become too big or not.