I’ve read a few articles recently about the bubble in passive investing. It started with Michael Burry declaring that index investing is a bubble similar to the collateralized debt obligations (CDO’s) that brought down the global economy in 2007. The simple premise is that ETF’s mostly invest in larger companies, and small cap stocks are being thereby being “neglected”:
As money pours into exchange-traded funds and other index-tracking products that skew toward big companies, Burry says smaller value stocks are being unduly neglected around the world.
Burry – like every small cap value investor since the dawn of time – is saying that the market doesn’t appreciate the information he’s uncovered about his small cap value stocks, and that there are structural reasons why the market doesn’t appreciate that information.
He goes on to say the bubble is in the prevailing “always be buying” mentality that surrounds passive investment strategies. That strategy states - passive investing always beats active investing, that stocks always goes up in the long term, buying and holding for the long term without picking individual stocks is your best bet.
While this is true today, it may not always be true. Passive investment is not a way to shortcut independent thinking.
What is different about today’s stock market that didn’t really exist even 10 years ago is the volume of investment information and commentary (thanks to Twitter), and the ease of participating in the market (thanks to so many fintechs). At a macro level the narrative makes sense: that the contrarian path is to move away from passive vehicles, because everyone already knows that’s the best form.
To be sure, index investors are free riders. They do receive the benefits that result from active trading without bearing the costs. But free riding on price signals provided by others is hardly a flaw of the capitalist system; it is an essential feature of that system. In a free-market economy we all benefit from relying on a set of market prices that are determined by others.