The Next Big Short?

Sep 07 17:09 2019 Print This Article

Bloomberg's Reed Stevenson reports The Big Short’s Michael Burry explains why index funds are like subprime CDOs:For an investor whose story was featured in a best-selling book and an Oscar-winning movie, Michael Burry has kept a surprisingly low profile in recent years.But it turns out the hero  of “The Big Short” has plenty to say about everything from central  banks fueling distortions in credit markets to opportunities in  small-cap value stocks and the “bubble” in passive investing.One of his most provocative views from a lengthy email interview with Bloomberg News on Tuesday: The recent flood of money into index funds has parallels with the pre-2008 bubble in collateralized debt obligations, the complex securities that almost destroyed the global financial system.Burry, who made a fortune betting against CDOs before the crisis, said index fund inflows are now distorting prices for stocks and bonds in much the same way that CDO purchases did for subprime mortgages more than a decade ago. The flows will reverse at some point, he said, and “it will be ugly” when they do. “Like most bubbles, the longer it goes on, the worse the crash will be,” said Burry, who oversees about $340 million at Scion Asset Management in Cupertino, California. One reason he likes small-cap value stocks: they tend to be under-represented in passive funds.Here’s what else Burry had to say about indexing, liquidity, Japan and more. Comments have been lightly edited and condensed.Index Funds and Price Discovery“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.”Liquidity Risk“The dirty secret of passive index funds -- whether open-end, closed-end, or ETF -- is the distribution of daily dollar value traded among the securities within the indexes they mimic.“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.”It Won’t End Well“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.”Bank of Japan Cushion“Ironically, the Japanese central bank owning so much of the largest ETFs in Japan means that during a global panic that revokes existing dogma, the largest stocks in those indexes might be relatively protected versus the U.S., Europe and other parts of Asia that do not have any similar stabilizing force inside their ETFs and passively managed funds.”Undervalued Japan Small-Caps“It is not hard in Japan to find simple extreme undervaluation -- low earnings multiple, or low free cash flow multiple. In many cases, the company might have significant cash or stock holdings that make up a lot of the stock price.”“There is a lot of value in the small-cap space within technology and  technology components. I’m a big believer in the continued growth of  remote and virtual technologies. The global retracement in  semiconductor, display, and related industries has hurt the shares of  related smaller Japanese companies tremendously. I expect companies like  Tazmo and Nippon Pillar Packing,  another holding of mine, to rebound with a high beta to the sector as  the inventory of tech components is finished off and growth resumes.”Cash Hoarding in Japan“The government would surely like to see these companies mobilize their zombie cash and other caches of trapped capital. About half of all Japanese companies under $1 billion in market cap trade at less than tangible book value, and the median enterprise value to sales ratio for these companies is less than 50%. There is tremendous opportunity here for re-rating if companies would take governance more seriously.”“Far too many companies are sitting on massive piles of cash and shareholdings. And these holdings are higher, relative to market cap, than any other market on Earth.”Shareholder Activism“I would rather not be active, and in fact, I am only getting active again in response to the widespread deep value that has arisen with the sell-off in Asian equities the last couple of years. My intention is always to improve the share rating by helping management see the benefits of improved capital allocation. I am not attempting to influence the operations of the business.”Betting on a Water Shortage“I sold out of those investments a few years back. There is a lot of demand for those assets these days. I am 100% focused on stock-picking.”Dr. Michael Burry has gained notoriety after being brilliantly portrayed by actor Christian Bale in "The Big Short."In September 2006, I was working at PSP Investments as a senior investment analyst in the Asset Mix Group and started doing research on the issuance of CDOs, CDOs-squared and CDOs-cubed.Needless to say, just looking at the total issuance, you knew something was going to crack in the credit markets but nobody knew how bad it was going to get.I discussed my findings with my boss, Pierre Malo, and my colleague, Mihail Garchev. Pierre asked me to call Goldman and find out how to short a popular credit default swap (CDS) index.So I did, picked up the phone and called Ramsey Smith who was covering us at Goldman back then. Ramsey had a conference call with me at a couple of his colleagues who were perplexed: "Why would you want to do that? The US housing market is extremely strong."Note, this was two years after I met Bridgewater's founder Ray Dalio and pressed him on deleveraging and deflation where he pushed back and put me in my place: "Son, what's your track record?". Goldman never got back to us on how to short CDS. Ramsey Smith went on to found ALEX.fyi which "works with financial advisors and individuals to navigate the financial challenges associated with longevity" (he's actually a very nice guy).In October 2006, I had breakfast with Gordon Fyfe, then president and CEO of PSP to share my findings and why I was very concerned with the credit risk PSP was taking back then. Gordon warned me that I was being "too negative" and pissing off some senior managers. Later that month, I was out of a job and the rest as they say is history.Of course, I wasn't portrayed in Michael Lewis's The Big Short and neither did I deserve to be. I was a lowly investment analyst at a large Canadian pension fund who irritated the hell out of people and didn't make hundreds of millions of dollars shorting the market back then.Like Ray Dalio says, "What's your track record?". Talk is cheap, show me your track record and if you made a gazillion dollars, then you deserve a place in Michael Lewis's book and a spot on CNBC and Bloomberg blabbing away your views on the market.By the way, as an aside, my favorite hedge fund manager of all-time whom I never met, Andrew Lahde, made a killing shorting the market during the 2008 meltdown (866% net return that year) and then had the wisdom to book his profits and walk away from the industry for good.Before he did, however, he had a few choice words for "the low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA" in an open letter where he basically told the world "Goodbye and F**k You".Lahde wasn't portrayed in Michael Lewis's book or the movie, probably because he told Lewis to "f**k off" and leave him alone (I'm speculating but not everyone wants to be portrayed in a book or movie).Anyway, back to Dr. Michael Burry and what he sees as the next subprime CDO crisis, the astounding rise of passive investing, aka indexing.Welcome to the bandwagon "Dr. Burry", it's so nice of you to join the chorus of active managers blasting passive index strategies as they continue to severely underperform their benchmark.To be sure, Burry raises a lot of great points, he's not an idiot, far from it, but what a lot of people don't know is the great American economist, Paul Samuelson, once warned that while he loved the indexing strategy Burton Malkiel extolled in his seminal book, A Random Walk Down Wall Street, he feared what would happen when everyone adopted this strategy.Capiche? Everything works well until everyone jumps on the bandwagon and ruins it for everyone else. Burry is right, bubbles last a lot longer than you think. Keynes famously warned investors: "Markets can stay irrational longer than you can stay solvent."But when it comes to passive indexing, it's not as simple as Burry thinks, especially now that central banks are "all in" trying to fight deflation, actively buying stocks in hope of raising inflation expectations (good luck with that strategy).Basically, if you're claiming there's a bubble in index funds, which there may very well be one, then you also have to prove to me there's a bubble in central banking and that's where you'll lose me.As Simon Lamy, a former bond portfolio manager at the Caisse, recently told me: "Unlike you or I, central banks have no P&L, they can keep creating money and hitting the bid."Burry talks about how the Bank of Japan owns a huge chunk of Japanese equities and that insulates them from this bubble he's warning of but who is to say the Fed and ECB can't follow in the BoJ's footsteps? They're already doing it covertly and sometimes openly or through the Swiss National Bank.There's something else, you should all read Josh Brown's recent blog comment, The Real Bubble Has Always Been in Active Management:

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About Article Author

Pension Pulse

Leo Kolivakis is an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. He has researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). He's also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system.

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