Is There a Passive Investing Bubble?

The same man who foresaw the 2008 crisis is making another bold prediction

Good morning everyone! One quick note before today’s newsletter, I now have a website. The name Time & Money was taken so I settled on The Money Priest. You can read all of my newsletters on my website, and I’ve also been posting extra articles that haven’t been sent out. Now back to the newsletter.

I read a headline last week that immediately grabbed my attention: Michael Burry Warns of Passive Investing Bubble. Michael Burry predicted the subprime mortgage crisis in 2008 and made millions, and his story is featured in the movie The Big Short. Burry is a very intelligent investor and has predicted bubbles before, so when he talks, people listen. But does he have a case here? Could there be a passive investing bubble that’s ready to burst?

Why does Burry think there’s a bubble?

Before we get started, we need to recognize Burry’s conflict of interest. He is currently leading Scion Asset Management, LLC, an actively managed hedge fund. So a man who runs an actively managed investment firm is not a fan of passive investing. Go figure.

I won’t let that discredit his claim though, after all he was right in 2008. So why exactly does he think there’s a bubble? To put it simply, Burry believes that the large amount of money flowing out of active investments into index funds and ETFs is artificially inflating the market.

To understand how that might potentially inflate the market, we need to understand how index funds work. When investing in an index fund, you are buying a small piece of every company included in the index. So if you invest in an S&P 500 index fund, you own a very small part of every single company included in the S&P 500. Index fund investors aren’t evaluating every single stock included in the index individually, they are making investment decisions based on the long-term belief that the market will go up. They are buying the market, not individual stocks.

The shift to passively managed assets could cause some stocks listed on major indexes to be overvalued. If the fundamentals of a stock are poor but the stock is included in an index, the price of the stock may be higher than the true value of the company, and thus the stock may be overvalued.

How do you determine if a stock is overvalued?

The price-to-earnings ratio is one of the most widely used metrics to determine the valuation of a stock and if it is priced fairly. The ratio is calculated by dividing the market price of the stock by the stock’s earnings per share (EPS). For example, if a stock is $100 and the earnings per share are $5, the stock would have a P/E ratio of 20. That means investors would be willing to pay 20 times the EPS for one share of stock.

By looking at current P/E ratios and comparing them to historical P/E ratios, we can determine if a sector of the market might be historically overvalued or undervalued. In the table below, the current price-to-earnings ratio of different sectors is represented as a percentage value of 20-year average price-to-earnings. For example, if the current P/E is 10 and the 20-year average P/E is also 10, the value is 100%. A value over 100% means the sector is currently overvalued when compared to 20-year averages, and below 100% means it is undervalued when compared to 20-year averages.

Current P/E as % of 20-year average P/E

Source: J.P. Morgan Guide to the Markets, 3Q 2019

So Burry could make a case that sectors of the market are overvalued, but that doesn’t necessarily mean they’re overvalued due to the rise of passive investing. Investors today might value certain sectors more than they did in the past. Even if certain sectors are “overvalued” when compared to historical data, that doesn’t mean there’s a bubble waiting to burst.

If there is a bubble, how big is it?

Imagine for a moment that an S&P 500 index fund (a large blend fund) is overvalued and currently about 106.8% of the price it should be, as shown in the table above. As I’m writing this, the S&P 500 is currently creeping towards 3,000 points. If we divide 3,000 by 1.068 (the amount of the overvaluation in this scenario), we get a “fair” valuation of 2,809. I wouldn’t consider a drop of less than 200 points in the S&P 500 to be a bubble bursting.

Of course the “bubble” might grow larger in the future, which is what Burry is predicting. Although if Michael Burry is correct, I will argue that we should already be seeing massive overvaluations. Back in 1998, passive equity funds accounted for only 11.2% of all U.S. equity funds, and the rest was made up of actively managed funds. In 2019, passively invested assets account for 49.9% of total U.S. equity funds, with the rest invested in actively managed funds.

The past 20 years has brought with it a dramatic shift from active investments to passive investments. If Burry’s theory is correct, I would expect to see a dramatic overvaluation of equities, particularly large-cap blend, but this isn’t the case.

The passive investing movement is huge for American retirement accounts, bringing lower expenses and better performance. Actively managed large-cap funds have expense ratios of 1.00% on average, while expenses for S&P 500 Index Funds are 0.15%. Furthermore, only 2-3% of mutual fund managers are skilled enough to cover their costs. With passively managed assets finally surpassing actively managed assets in the U.S., it’s not surprising to see active investment managers start to feel the pressure.