“Big Short” Investor Michael Burry Explains How Index Funds Will Trigger The Next Crash

And in an interview with Bloomberg, Burry doesn’t disappoint. At one point, he shares his skepticism about passive investing, and the flood of money that has poured into index funds since the financial crisis. Burry sees similarities between these funds and the CDOs that nearly brought down the financial system in the run-up to the crisis.

Burry, who made a fortune betting against the CDOs, argued that these passive flows are distorting prices for stocks and bonds in much the same way that CDOs did for subprime mortgages. Eventually, the flows will reverse at some point, and when they do, “it will be ugly.”

“Like most bubbles, the longer it goes on, the worse the crash will be,” Burry, who oversees about $340 million AUM at Scion Asset Management in Cupertino, said.

That’s one reason he likes small-cap value stocks: they tend to be underrepresented in index funds, or left out entirely.

Here’s what Burry had to say on a number of topics:

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.”

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Liquidity Risk

“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. In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than $5 million in value during the day. That is over half, and almost half of those – 456 stocks – traded less than $1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different – the index contains the world’s largest stocks, but still, 266 stocks – over half – traded under $150 million today.”

“That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks. 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.”

It Won’t End Well

“This structured asset play is the same story again and again – so easy to sell, such a self-fulfilling prophecy as the technical machinery kicks in. All those money managers market lower fees for indexed, passive products, but they are not fools – they make up for it in scale.”

“Potentially making it worse will be the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day. 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.”

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BoJ Cushion

“Ironically, the Japanese central bank owning so much of the largest ETFs in Japan means that during a global panic that revokes existing dogma, the largest stocks in those indexes might be relatively protected versus the U.S., Europe and other parts of Asia that do not have any similar stabilizing force inside their ETFs and passively managed funds.”

Undervalued Japan Small-Caps

“It is not hard in Japan to find simple extreme undervaluation – low earnings multiple, or low free cash flow multiple. In many cases, the company might have significant cash or stock holdings that make up a lot of the stock price.”

“There is a lot of value in the small-cap space within technology and technology components. I’m a big believer in the continued growth of remote and virtual technologies. The global retracement in semiconductor, display, and related industries has hurt the shares of related smaller Japanese companies tremendously. I expect companies like Tazmo and Nippon Pillar Packing, another holding of mine, to rebound with a high beta to the sector as the inventory of tech components is finished off and growth resumes.”

Cash Hoarding in Japan

“The government would surely like to see these companies mobilize their zombie cash and other caches of trapped capital. About half of all Japanese companies under $1 billion in market cap trade at less than tangible book value, and the median enterprise value to sales ratio for these companies is less than 50%. There is tremendous opportunity here for re-rating if companies would take governance more seriously.” “Far too many companies are sitting on massive piles of cash and shareholdings. And these holdings are higher, relative to market cap, than any other market on Earth.”

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Shareholder Activism

“I would rather not be active, and in fact, I am only getting active again in response to the widespread deep value that has arisen with the sell-off in Asian equities the last couple of years. My intention is always to improve the share rating by helping management see the benefits of improved capital allocation. I am not attempting to influence the operations of the business.”

Betting on a Water Shortage

“I sold out of those investments a few years back. There is a lot of demand for those assets these days. I am 100% focused on stock-picking.”

Late last month, Burry sat for an interview with Barron’s, where he explained his reasoning for his latest long position in GameStop. The embattled video-game retailer was undervalued, Burry argued, because the next generation of video game consoles from Sony and Microsoft were likely to feature physical optical disk drives, meaning gamers would have to buy the games from a brick-and-mortar retailer if they wanted to play them that day. He added that the “streaming narrative” had led GameStop’s shares to be extremely undervalued, and that 90% of the chain’s 5,700 stores were FCF positive.