Bloomberg: The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs

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Here’s an excerpt from an article at Bloomberg in which Michael Burry explains why index funds are like subprime CDOs:

For an investor whose story was featured in a best-selling book and an Oscar-winning movie, Michael Burry has kept a surprisingly low profile in recent years.

But it turns out the hero of “The Big Short” has plenty to say about everything from central banks fueling distortions in credit markets to opportunities in small-cap value stocks and the “bubble” in passive investing.

One of his most provocative views from a lengthy email interview with Bloomberg News on Tuesday: The recent flood of money into index funds has parallels with the pre-2008 bubble in collateralized debt obligations, the complex securities that almost destroyed the global financial system.

Michael Burry, who made a fortune betting against CDOs before the crisis, said index fund inflows are now distorting prices for stocks and bonds in much the same way that CDO purchases did for subprime mortgages more than a decade ago. The flows will reverse at some point, he said, and “it will be ugly” when they do.

“Like most bubbles, the longer it goes on, the worse the crash will be,” said Burry, who oversees about $340 million at Scion Asset Management in Cupertino, California. One reason he likes small-cap value stocks: they tend to be under-represented in passive funds.

Here’s what else Burry had to say about indexing, liquidity, Japan and more. Comments have been lightly edited and condensed.

Index Funds and Price Discovery

“Central banks and Basel III have more or less removed price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in interest rates anymore. And now passive investing has removed price discovery from the equity markets. The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies — these do not require the security-level analysis that is required for true price discovery.”

“This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.”

You can read the entire article at Bloomberg here – The Big Short’s Michael Burry Explains Why Index Funds Are Like Subprime CDOs.

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