I'd like to read someone's debunking of this debunking.
I gotchoo boo. Gonna need to get into the weeds first, though.
A few basix for the quiet kids in the back:
- an equity is a stock and a stock is an equity. That's a tiny fraction of a company and only that company. You buy Google stock and you are buying a piece of Google, nothing more nothing less (for purposes of this discussion).
- A mutual fund is a pool of money that owns stocks and bonds and shit but mostly stocks. Importantly, the price of a mutual fund changes once a day. At the end of the trading day, the value of everything in it is added up and that's what the fund is worth for that day. From an eTrade perspective they're very boring. They reflect what they say on their prospectus, which they put out every year. Mutual funds are basically someone's idea of how to make money and that someone can change their mind if they tell everyone who owns or wants to buy the fund.
- An index fund is a kind of mutual fund that tracks some index (as in, a named and acknowledged list of stocks, like the S&P500 or the Russell 2000 or some other Magic Brand Name). The makeup of that index fund reflects the makeup of that index at the end of the day. Raise your hands if you see the problem.
So. Index funds, like mutual funds, have a price at the end of the day. Meanwhile whatever index they're tracking has had an instantaneous price all day long. Let's say I have KBIF, the kleinbl00 Index Fund. It tracks two stocks, each worth the same amount of money, and KBIF holds 50% of each. At the end of a particular trading day, KLEIN is up five percent. BL00 is down five percent. My fund is now imbalanced. The value of KLEIN in my fund is at 52.5% instead of 50% and the value of BL00 is at 47.5% instead of 50%. So in order to balance at the end of the day, I have to sell enough shares of KLEIN and buy enough shares of BL00 to get them both back to 50%.
This is where the fund managers make their money, and why they exist. Yeah, lower fees. Yeah, no active management. But there's some guys there who are allowed to trade all day long and their job is to get back to equal by the end of the day so they leverage the time scale they're working at vs. the time scale you're working at to make their money. It's like how UPS used to hold onto your COD for a week, not for security, but so they could pump it into an interest-bearing account and make an extra three cents off your $400.
An aside: "day-trading" does not legally mean "I spend my days playing eTrade." Day trading is a defined and protected IRS activity that exists for purposes of simplifying investment taxes: in order to legally be a day trader you have to start the day at zero equities, finish the day at zero equities, and do whatever buying and selling you want such that you hold no stocks overnight. Hold 'em overnight and you're a "short term investor" and that puts you on another tax schedule. So. Day trading means "I give no fucks what the long-term health of this equity is, I care not a whit about its management, I don't even give a rat's ass what this company does, I'm just betting the stock will go up four cents in the next hour so I'm going to borrow money to own 400,000 shares between 1pm and 3pm so that a shift from $12.37 to $12.39 will make me eight grand without requiring me to have five million dollars in the bank to play with."
Awright. So ETFs. An "exchange traded fund" is a mutual fund or an index fund that has an instantaneous value. It doesn't shift at the end of the day, it's live and hot. What's in it rebalances every night, and the companies that make up that ETF have to buy and sell to rebalance every night and make their money the exact same way. You, the retail investor, the eTrade ninja, are buying and selling the ETF. The smart money trades "creation units" back and forth at extremely high speed, leveraging tiny fractions of trade. It's noteworthy that ETFs have exploded since 2001, which is when the SEC made stock markets count value in pennies rather than fractions - when your smallest unit is a sixteenth of a buck you have six and a quarter times as much movement for every blip of the needle than you do when it's a hundredth of a buck.
BUT WAIT THERE'S MORE
You buy an ETF because you want to buy a sector, not a company. You don't know which pharmaceutical manufacturer is the bestest and you don't care to learn - after all, there are 587 publicly traded biotech stocks on the US markets. So you buy a pharma ETF. You like Vanguard because of course you do. So you buy VHT like everyone else.
VHT has 390 stocks in it. Remember - the biotech industry only has 587. This isn't perfect overlap, but holy shit. VHT also has a market cap of $9b. The biotech industry has a market cap of $700b. So okay, shit. That one Vanguard fund is trading more than 1% of the biotech industry every time it trades. And it's not trading just the good stuff, it's trading the bad stuff and nobody is paying any attention to the individual stuff anymore. More than that, 43% of VHT's holdings are in ten stocks (the other 57% is the other 380 stocks). Which means the little stocks are no longer influenced by what they are or how they're doing, they're influenced by the big stocks. Full stop.
My daughter owns some AIMT. This is the company that makes the peanut powder she takes that has effectively neutralized her epipen-grade peanut allergy. And about eighteen months ago they published the results of their trial indicating that they'd effectively neutralized peanut allergy for a big percentage of kids, whereas their two competitors had skunked out and given up.
But the stock went down fifteen percent.
Johnson & Johnson, you see, had missed on earnings by a couple pennies so the markets punished the shit out of the stock. I think J&J was down 4% or some shit. J&J is in 287 index funds. AIMT is in 40. JNJ's market cap is $340b. AIMT's is $1.3b. So if you've got creation units that hold JNJ, to correct the 5% that JNJ goes down you're going to have to sell assloads of all the little shit in the basket.
At the end of the day, an ETF is a derivative - you aren't trading on fundamentals, you're trading on a strategy derived from those fundamentals. You are, mathematically, a degree removed from what is actually making money. We're at a place where any "tech" fund you own is not moving up and down based on nVIDIA or Seagate, it's moving up and down entirely on Microsoft, Amazon, Alphabet, Facebook and Netflix. The individual performance of the little companies that are innovating or languishing is no longer important.
THIS is what Burry is talking about when he calls indexing a bubble - nobody is indexing because they see it as a money saving option that exposes them to sector performance without needing to do the necessary research. People are indexing because the necessary research is actively detrimental to your profit potential. People are indexing because the liquidity in the indices swamps the liquidity in the underlying equities. There are 287 ETFs that hold JNJ. There are 136 for whom JNJ is one of their top 15 holdings. And the companies that are making money off of ETFs are making it by leveraging their timeframe (nanoseconds) over yours (however long it takes you to log into eTrade in a panic and dump VHT because you had too many beers at lunch and your friends spooked you).
Remember - you're not dumping VHT because of anything that's happening at J&J, or Fisher, or Medtronic, or Merck. You're dumping it because Trump tweeted nasty shit about healthcare. There is no fundamental connection between your action and the underlying value of the equities you're mucking with. And that means that as soon as someone successfully screams "the emperor has no clothes" it all comes crashing down.
You'll note that this was an oblique discussion of ETFs, not a "debunking" of Ben Carlson's article. This is because Ben Carlson's article reveals zero insight into the underlying mechanism of passive investing, zero insight into the mechanical problems of derivatives trading and zero insight into the criticisms raised by the Michael Burry article he's responding to. To whit, one of Burry's objections:
“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.”
When an index fund investor sells, they’re technically selling their holdings in direct proportion to their weighting in the index. So there is little market impact involved. Again, index fund investors are simply owning stocks in the proportion that all active investors own stocks.
Plus, index funds never lever up your holdings. They never receive a margin call. They don’t put 30% of your holdings in Valeant Pharmaceuticals. And no index fund has ever closed up shop to spend more time with their family.
There will always be investors that panic, regardless of the type of fund they’re invested in.
Why would index funds or ETFs be any different than any other fund type or security in that respect?
You'll notice that he misses the fundamental problem: a holder of creation units HAS TO BUY OR SELL. They can pick when, they can pick where, but they better pick by 4:30PM or they're in violation of the SEC. And remember - they're not making money on what's in the index - they're making money on making the index look the way they said it would look. If that fund goes from $100 to $30 they don't lose $70, they make or lose whatever money it costs them a nanosecond at a time to keep the balance the same. If they have to sell JNJ into a goddamn vacuum to get the numbers right, there is zero incentive for them not to. After all, they don't hold the index they just move the legos around.
Ben Carlson doesn't even get this. He can't even see the criticism. He is so blind to the fundamental nature of index funds that he can't even understand why they might worry certain people. He'd rather talk about something else:
Do you know what didn’t cause the Great Depression or Japan stock market crash or 1987 crash or 1973-74 bear market? Index funds.
Index funds also weren’t around for the South Sea bubble in the 1700s.
No. In all five cases, those crashes were caused by a shift in the perception of value. People thought things were valuable, then they decided they weren't, and everyone dumped as fast as they could in an attempt to not be standing when the music stopped. That is because what they were trading had a value well out of line with its fundamentals.
There are 215 ETFs that hold Netflix. There are fifteen that have NFLX in their top 15 holdings. Netflix, meanwhile, is spending $15b for content every year that, by the way, largely belongs to other companies:
They lose about $3b a year doing this. They are covering this by issuing junk bonds at fucking 6%. And if people suddenly realize that Netflix is now has been and shall always be a shitty online version of mid '90s USA Network, not only are $127b in assets in jeopardy but also 215 ETFs.
Friend of mine is a screenwriter. He told me a story once about "taking down the S&P500" by having a movie he wrote (Treasure Planet) do poorly enough that Disney had to restate its earnings, which prompted a 3% retraction in the markets that day. Now - there were a lot of steps between "bad script" and "market tanking" but ultimately, his execution of a task that had nothing to do with finance destroyed several billion dollars worth of market cap.
We now live in a world where a Ronan Farrow article about Kevin Spacey negatively impacts every ETF on this page.