Michael Burry Of The Big Short Fame Says This Is The Next Market Bubble

“This fundamental concept is the same one that resulted in the market meltdowns in 2008.” And when this trend reverses, “it will get ugly,” Burry says.

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For an investor made famous in a best-selling book and an Oscar-winning movie for being one of the first investors to call and profit from the subprime mortgage crisis, Michael Burry has kept a rather low profile in the last few years.

But now the hero of “The Big Short” is seeing a new bubble in passive investing. As money floods into exchange traded funds (ETFs) and other index-tracking products that skew toward big companies, Burry says smaller value stocks are being globally neglected. 

“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 Scion Asset Management oversees roughly $343 million, wrote in an email to Bloomberg News.

These passive investments are inflating stock and bond prices in a similar way collateralized debt obligations did for subprime mortgages more than a decade ago. When the massive inflows into passive vehicles reverses, “it will be ugly,” Burry said. 

“This fundamental concept is the same one that resulted in the market meltdowns in 2008. However, I just don’t know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be,” Burry said. “This is very much like the bubble in synthetic asset-back 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.”

Active managers have hemorrhaged assets in recent years as investors rebelled against high fees and disappointing returns, a trend that led Moody’s Investors Service to predict that index funds will outstrip active management in the U.S. by 2021. Passive investments have already taken over nearly half of the stock market as more investors shun stock pickers in favor of index funds. Equity passive funds alone have ballooned to a more than $3 trillion market over the last decade.

“The dirty secret of passive index funds—whether open-end, closed-end, or ETF—is the distribution of daily dollar value traded among the securities within the indexes they mimic. …Trillions of dollars in assets globally are indexed to these stocks,” Burry said. “The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.

This shift has coincided with a multi-year period of underperformance by value stocks and, more recently, by small cap stocks.

“There is all this opportunity, but so few active managers looking to take advantage,” Burry wrote.

Burry isn’t the only name sounding the alarm on the proliferation of passive investing. DoubleLine Capital CEO Jeffrey Gundlach has also said that it is causing widespread problems in global stock markets, calling it a “herding behavior” that has reached a “mania status.”

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