Passive Stampede?

Adam M. Grossman

INVESTMENT MANAGER Michael Burry made waves last week when he issued an apocalyptic forecast: Index funds, he said, are in a bubble similar to the housing bubble that ended very badly in 2008. Burry couldn’t say when the crash would come, but noted ominously that, “the longer it goes on, the worse the crash will be.”

Burry acknowledged that he’s “100% focused on stock picking,” so—at first glance—his criticism seems not unlike other active fund managers’ criticisms of index funds, sometimes referred to as “passive investing.” Competitors have been lobbing grenades at indexing since its inception nearly 50 years ago, when one active manager called index funds “un-American.”

But Burry isn’t just any ordinary stock-picker. He’s a cult hero within financial circles. A neurologist by training, Burry left medicine to start a hedge fund and was one of a handful of investors to predict the 2008 crash in mortgage bonds—and to profit from it. In The Big Shorthis book on the topic, Michael Lewis cast Burry as a central character. In short, Burry is exceptionally talented, with a track record that speaks for itself. It’s no surprise then that last week, when he issued his broadside against index funds, people listened.

In Burry’s view, the growth of index funds presents several dangers. First, they use derivatives, “the same fundamental concept that resulted in the market meltdowns in 2008.” He cautioned that index funds could face a liquidity crunch. “The theater keeps getting more crowded,” he said, “but the exit door is the same as it always was.”

That last line was the one that really got people. No one likes the idea of being stuck, especially when it comes to one’s finances. And no one likes the idea of getting caught in a stampede.

While I disagree with Burry’s doomsday forecast, I’d like to discuss a broader issue here. My peers Allan Roth and Ben Carlson have done, I think, the best job of responding to Burry’s comments point by point. Vanguard Group also addresses some of Burry’s criticisms in this paper. I recommend reading what they have to say.

The broader issue, in my view, is our propensity as humans to buy into narratives like Burry’s. As Jonathan Gottschall wrote in The Storytelling Animal, “We are, as a species, addicted to story. Even when the body goes to sleep, the mind stays awake all night, telling itself stories.”

Writing in Thinking, Fast and Slow, Daniel Kahneman says that, “The confidence that individuals have in their beliefs depends mostly on the quality of the story they can tell about what they see, even if they see little.” In his experiments, Kahneman has proved that most people prefer stories and intuition over facts and data.

This, in fact, is how people accomplish memory feats like reciting thousands of digits of pi. No one can remember all those numbers, but they can remember stories. They build mental images, and associate numbers with stories, as they walk through those landscapes in their mind.

In short, a story is a potent tool. And the more sensational the story, the better. Data is hard, but stories are easy.

In reading Burry’s warning about index funds, I’m not sure most readers would follow his logic. After all, it’s a complicated topic and most people don’t have ready access to the same data. But his image of the stampede at the movie theater? Everyone can understand that. Indeed, that’s why I think his comments got so much attention.

Stories aren’t necessarily all bad. But as an investor, it’s important to discern fact from fairy tale. Here are some tips:

  1. Determine if the story is even true. Especially today, with the ability to manipulate images and even video, your first step should be factchecking everything you hear.
  2. Even if the story is true, ask yourself whether it’s conclusive or just one data point. Anyone who has ever taken a statistics class knows that there are always outliers. Make sure that the narrative you’re hearing isn’t the dramatic story of one extremely unlikely case.
  3. If the narrative involves a forecast, ask yourself whether there are alternative narratives that also fit the same facts. That’s what I recommend in the case of Burry’s warning. I’m confident that his opinion is based on facts, but I also think those same facts could lead to a different conclusion.
  4. Beware of recency bias. Our minds are programmed to extrapolate. If the market has been going up in recent days, we’re more likely to believe that it will continue, and vice versa. Beware of stories that seem to fit neatly into current trends.
  5. Ignore credentials. By its own admission, even the Nobel committee isn’t perfect. Remember Ted Kaczynski? He has a diploma from Harvard. Don’t accept everything people say just because they seem smart or sound good.
  6. Diversify. Suppose Burry is right. I don’t think he is, but no one can say with 100% certainty that he’s wrong. Fortunately, there’s an easy solution: diversification. If you own cash and bonds, they’ll help you weather any stock market disruption. In fact, regardless of Burry’s warning, I’d always recommend diversifying like this.

Adam M. Grossman’s previous articles include Adding ValueThree Risks and Room to Disagree. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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Langston Holland
Langston Holland
3 years ago

I’ve been following scary index fund stories since the mid 90’s and speaking of telling stories, the WSJ is one of the best. A 30 Jan 1997 article complained about companies getting a (temporary) price bump with their inclusion in the S&P 500. The story: imagine a shopping mall where any new store opening guaranteed sales. My thought was fine, but the new store is required to prove worthiness for acceptance into the mall and if they don’t grow their business, they’re going to be displaced by someone that is.

The takeaway from the Vanguard article for me was that index fund investors are not monolithic buy-and-hold as assumed by the dooms day prophets, a large portion are using these funds for active strategies. Apparently human emotion is not going out of style. Something else not mentioned in the article is that even though the percentage of ETF’s relative to mutual funds are relatively small at present, they are growing at a much faster pace. ETF’s with their stock like trading characteristics are traded at higher velocities than mutual funds. I think we’re gonna have to perpetually post date the index fund apocalypse.

Rick Connor
Rick Connor
3 years ago

Vey well written. #3 is one of my favorites – making sure I stay open to other’s interpretations of the data.

terry gustin
terry gustin
3 years ago

Check out what MMM has to say about the ‘problem.’

2 years ago

Is there a follow up story to this about Michael Burry? Many naysayers continue to put down index funds. I’d rather index than follow the herd.

Jonathan Clements
Jonathan Clements
2 years ago
Reply to  Olin

Saying outrageous things gets Wall Street experts attention. But those experts are rarely called back later and asked to explain their ridiculous comments.

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