Are Index / Passive Funds the New Subprime CDOs?

(image via the Federal Reserve Economic Data)

Someone on Quora asked if index/passive funds are the new subprime CDOs, perhaps implying that there could be an index fund asset bubble. My answer? Absolutely not. CDOs (collateralized debt obligation) are rather opaque, whereas index funds are much more transparent, particularly exchange-traded funds (ETFs).

(image via MoneyControl)

In addition to the flawed assumption behind tranching, the value in subprime CDOs was hard to determine because investors could not directly assess default risk. The lenders were the ones who interviewed the borrowers and ran their credit checks to decide whether to approve them for a mortgage loan.

CDO investors had to rely mostly on the word of the lenders, but leading up to the crisis, the lenders faced incentives to downplay default risk to make the CDO more attractive to investors. Along with yield (the mortgage interest the CDO investors gain as income), low default risk is how CDOs compete for investment money.

In contrast, ETFs have to publish their holdings, so you can easily find out what companies are in them (for example, you can look up a fund on ETF.com, find the list for “Top 10 Holdings”, and then click “View All” to see the complete list). Mutual funds aren’t required to publish their holdings as often as ETFs, but indices don’t change their holdings too often, so those should be fine as well.

Furthermore, as these companies are all publicly traded, they in turn are required to publish their financials regularly. Index funds following the same index are going to have very similar performance, so they compete for investment money largely on cost (aka expense ratios).

(image via Dreamstime)

Index funds (especially ETFs) are also very liquid, with most of the broad market ETFs trading with very high volumes that on national exchanges with millions of transactions a day (as high or higher than many popular stocks). CDOs are more thinly traded, which is part of why they so easily and quickly became toxic assets when their secondary markets dried up during the financial crisis.

Also, it is easier to spot a stock market bubble than a housing market bubble because one popular and simple value metric for a stock is the price-to-earnings (P/E) ratio, and you can calculate it for a whole index. It’s a lot harder to tell if a house is overpriced because the biggest factor affecting the house’s value is the value of comparable houses.

Update

Regarding Michael Burry’s claim, which I had not read at the time I wrote the above, keep in mind that he was the subject of The Big Short because he is a short. I wouldn’t be surprised if he has a significant short position or plans to open one, meaning that he has a vested interested in helping cause a bear market or at a correction. I stand by my above answer that the two investments do not parallel each other very much at all. Those selling actively-managed funds have lost a lot of assets to index funds in the past several years and have long tried arguing this exact line of argument before, and thus it’s not surprising to see some of them agreeing with Burry here.

Also, Burry wasn’t really “the hero” of the book. He was just trying to make his shorts pay off and was not above trying to convince other large investors that the price should go down. As I recall, the one painted as being the crusader was Steve Eisman. Note, I’ve read the book but have not seen the movie.

Originally posted at Quora

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