Michael Burry sounds warning bell on ETFs

Michael Burry of The Big Short fame, has sounded the warning bell around ETFs - and in particular around large cap ETFs. He compares larger ETF index funds and CDOs pre-GFC. Burry seems also to be bullish on a number of opportunities, like smaller-cap ETFs and individual equities, and Korean equities, given the innovative nature of Korean companies. I'd love to hear the group's thoughts. I'm pasting the more relevant components of the letter from Burry to Bloomberg below.

“The bubble in passive investing through ETFs and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally,” Burry, whose Cupertino, California-based firm oversees about HK$2.67 billion, wrote in an emailed response to questions from Bloomberg News.

Active money managers have bled assets in recent years as investors rebelled against high fees and disappointing returns -- a trend that prompted Moody’s Investors Service to predict that index funds will overtake active management in the U.S. by 2021. The shift has coincided with a multiyear stretch of underperformance by value stocks and, more recently, by small-caps.

**Smaller U.S. stocks have underperformed large-caps
**
“There is all this opportunity, but so few active managers looking to take advantage,” wrote Burry, who was played by Christian Bale in the film version of Michael Lewis’s book on the collapse of the U.S. housing bubble and ensuing financial crisis.

**Read more on the shift to passive from active funds
**
While Burry is best known for his bearish wagers, he said his passion is “long-oriented investing in undervalued and overlooked situations.” He said he’s turning to activism in some cases because there’s not a “critical mass of smaller value-seeking active managers like me” and to help companies make themselves more attractive to investors.

This month Burry petitioned GameStop Corp., a video-game seller, and Tailored Brands Inc., a menswear retailer, to buy back stock. Shares of Tailored Brands climbed 7.6% and GameStop 4.9% in New York on Wednesday. Scion also recently increased its positions in two South Korean small-cap companies -- Ezwelfare Co. and Autech Corp. -- and disclosed its intention to engage with management at Autech, a delivery truck and ambulance maker in which Burry’s firm now owns a nearly 10% stake.

Burry said he’s also “watching” developments at CJ Group, a South Korean conglomerate, without providing more details in his email to Bloomberg. Listed preferred shares of CJ Corp. rose as much as 2% in Seoul on Thursday morning.

“Korea has so much potential,” Burry wrote, citing the country’s technological prowess and high education levels. “Yet Korean stocks are almost always cheap, and management teams are to blame because they do not treat shareholders equally as owners.”

**Korean stocks trade below book value, less than half global level
**
While activists including Elliott Management’s Paul Singer have recently pushed South Korean companies to boost stockholder returns, the market still trades at one of the most depressed valuations worldwide. The benchmark Kospi index has dropped about 5% this year, compared with a 16% gain in the S&P 500.

“I have seen the mistakes Americans make with activism over the years, especially in Asia,” Burry said. “My first instinct is friendly advice. It may occasionally evolve to a more hostile situation, but that is not what I want. I most want a productive conversation.”

 

i would like to Read more on the shift to passive from active funds pls

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Here's what I don't get about Burry's bubble logic. And this comes from a guy who's no fan of passive investing.

Inflows into assets don't necessarily create bubbles. Especially when the inflows are only a fraction of the total liquidity.

Say a bunch of fools rush in to buy an ETF tomorrow. Lets just say its a small ETF, so the rush of liquidity will temporarily raise the price intraday. Lets say the fund goes from $5 to $10 intraday . . clearly a temporary bubble.

To take matters further, lets say the trading in the ETF pulls up prices of the underlying stocks with it. Traders start buying up the underlying shares to bundle them into the ETF. So now, temporarily, you've got every stock in that ETF now trading 2x its value.

That's already an extreme and unrealistic scenario but let's say that happens.

Here's my question: if that happened, how long would you expect the mispricing to last? I would say not very long at all. Days at most. More likely hours. Why, because all it takes is two fundamental traders to come to agreement on a roughly fair price for something. So the ETF buys can theoretically double an underlying stock price, but as long as a few active funds know something about that stock, someone will short it and someone will be on the other side of that short.

Not saying he's necessarily wrong, but I'd like to know how he thinks stock prices remain artificially high over extended periods of time when all it takes is a small number of active managers to reset them.

 

Issue is that assumption is rather weak. Liquidity is not evenly spread, so in your example say for an equity etf you’d need on every stock which is part of the index; 1) enough borrow stock such that price to short isn’t prohibitive 2) enough willing investors to take other side (in which case where are they getting their money from)

Temporary imbalance causes a bubble, more pronounced the more esoteric or illiquid you go.

To make the extreme point, say it’s not stocks, say it’s bonds, or vol, or gold, or even hedge fund managers etc

 

Agree with you on illiquid markets.

For equity ETFs, it seems a lot of them are low turnover vehicles like Vanguard/Blackrock that make their underlying shares available to borrow. So in those cases there would be plenty of borrow available to short cheaply.

Burry is a guy I don't question lightly, but even with the caveats you lay out it seems that it would be hard for liquid stocks to run far from fundamentals simply because of ETFs buying them.

 

People are worried about the number of "active voices" vs "passive voices" in the marketplace. When the market was 99% under active investment by high fee money managers, there were a lot of leeches getting by on other people's work. Now it's closer to 55% active, 45% passive, and people are freaking out that "we're losing the market makers when 'everyone' just follows an index".

Which is ludicrous. Like, the right answer isn't 100% active just like the answer isn't 100% passive with no hedge funds or quant guys sending the signals. You only need a couple sharks to direct the path of the schools of fish, it's people that want an analogy to 2008 so they look at trends, extrapolate to the point of ridicule, and write an article.

 

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