What is an index fund

What is an index fund?

And is there an index fund bubble?

Michael Burry, the American investor who foresaw the issues which created the Global Financial Crisis and whose story was told in the Oscar-winning movie The Big Short, says the focus of passive funds on the world’s largest companies puts downward pressure on the stocks of smaller companies. Burry believes this has created a “bubble” that could burst.

Index funds have been grabbing a few headlines lately, and especially overseas, have experienced large inflows of investment funds.

What is an index fund?

An index fund is a type of investment fund with a portfolio passively constructed to match or track the components of a common financial market index, such as the Standard & Poor's 500 Index (S&P 500). An index fund usually provides diversification and low operating expenses without trying to ‘beat’ the market. This means index funds follow their benchmark index no matter what is happening in the markets.

Popularity of index funds

Especially overseas, index funds have gained a lot of popularity, along with being a huge favourite of international financial advisers (in New Zealand they’re a lot less popular, mainly due to; a lack of choices, tax reasons, and because our investment market itself is less sophisticated).

What does Michael Burry have to say?

Professional investor Michael Burry, whose story was featured in a best-selling book and an Oscar-winning movie, ‘The Big Short’ has been in the news speaking about index funds. While our wealth management advisers are usually the first to tell people to ignore headline-grabbing talk of bubbles (or for that matter any other doom and gloom from the media!), let’s take a closer look at the logic behind Burry’s comments.

Burry predicts a bubble. He recently told Blomberg News: “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.”

Burry explains that there has been a surge in popularity of such funds for two main reasons:

1. Lower cost fees due to their passive nature, and

2. Outperforming ‘active’ managers in the last few years since they track the index but have significantly lower fees.

Burry (who made a fortune by identifying the US housing bubble in the years before the Global Financial Crisis he mentioned above) said that “All those money managers market lower fees for indexed, passive products, but they are not fools -- they make up for it in scale.”

Burry went on to identify that index fund inflows are now distorting prices for stocks and bonds in much the same way that complex financial products purchases did for the US home mortgage market more than a decade ago. The flows will reverse at some point, he said, and “it will be ugly” when they do.

Basically, Burry said it’s a good idea to keep investing actively and invest in funds that are not closely aligned with the index. The good news for New Zealand investors is that we don’t have a large concentration of index funds anyway, so it seems that continuing to work with financial advisers who select appropriate actively managed funds may be the way to go.