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Is index investing a bubble?

We've obviously come across Michael Burry's views and due to his popularity, there have been a lot of misconceptions about indexing.

Index investing, aka passive investing, is a method that consists in buying the stock market as a whole via globally diversified funds, avoiding therefore concentration risk and simply seeking to match the growth of the global economy. Consequently, by definition, a "bubble" isn't possible when one talks about that specific method of investing, as bubbles usually happen when concentration in one asset class reaches insane levels that do not reflect correct valuations.

However, this does not prevent index investors from systemic risks, which affect the global economy (like we're seeing right now), consequently affecting the state of the economy and therefore asset prices. And as no one as a crystal ball, no one knows when markets will pick up. This being said, the beauty of passive investing is that it is meant for long-term investors, that is those who do not believe in "timing the market" but rather focus on the time they spend in the market. Studies have shown that those who adopt a long-term strategy, who continuously invested no matter market conditions and who remain invested in globally diversified solutions, despite any event, will be winners overall. You just need to feel comfortable doing this.

The main argument against Burry's stance is that assets under management do not set prices; instead, trading sets prices. Almost by definition, index funds do not trade much. As a matter of fact, 95% of all trading happens by active funds. So there's still a lot of price discovery going on, leading to efficient markets.

Furthermore, passive investing is pushing bad active managers out of the market. Only the skilled active managers will remain. Getting rid of the rubbish active managers only makes the market more efficient.

Another point is that research shows that index funds make shorting stocks cheaper. Index funds hold stocks for long periods of time, which means they can lend out those stocks to shorters at a lending fee. And shorters also contribute to price discovery.

Finally, index funds still represent only 7.4% of total investments in the US, and this number is even lower in the EU. So even in terms of assets under management, index funds are still quite small compared to total assets.

So we don't agree with Michael Burry that money flowing into index funds makes markets inefficient by inflating the prices of stocks. The main argument is that price discovery is done through trading, and active investors still do the large majority of trading (95%). And that is not going to change, because by definition passive funds don't trade a lot.

Updated on: 03/03/2022

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