Michael Burry Sees A Bubble In Passive Index Investing - Dealbreaker

When we last checked in with Michael Burry, he was making a ‘scarcity play’ on water. Well, he has since sold those investments. But now that his quest to become Immortan Joe is over, he has returned to the spotlight to do what human portfolio managers do best: scold passive index funds. 

On Wednesday, the hedge fund manager denounced the proverbial dart-throwing monkeys in an email exchange with Bloomberg News:

[P]assive 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.

Burry compared these passive funds to subprime CDOs:

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.

According to Burry, passive funds can inflate the prices of the underlying securities they represent, exerting upward pressure without introducing real liquidity (just like CDOs). As Burry wrote, “the theater keeps getting more crowded, but the exit door is the same as it always was.”

Burry also worried that the derivatives used to correlate stocks and indices could be very difficult to unwind should the market go into free-fall. In such an environment, traders seeking to arbitrage price differences between indices and their underlying securities could get their faces ripped off.

Burry particularly bemoaned the overrepresentation of large-cap stocks within passive funds, and identifies some tremendous opportunities in small-cap Japanese stocks:

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.”

Burry then proceeded to extol the virtues of several specific Japanese stocks, including Sansei Technologies Inc., which assembles elevators, Nippon Pillar Packing, which produces highly-prized sealants and gaskets, and Murakami Corp, which manufactures the best damn automotive mirrors the world has ever seen. 

Of the stocks Burry listed, his fund happens to own all of them. This is a coincidence, to be sure, but it does raise the question: is Burry decrying the dart-throwing chimps over his concern for common investors? Or because the monkeys never even considered throwing a dart at Burry’s amazing, rational, well-selected portfolio of Japanese small-cap stocks?

Interestingly enough, following his remarks, the stock prices of many of the stocks Burry listed went up by a significant percentage, some by as high as 11%. But don’t sell yet -- Burry’s analysts indicate they could go a heck of a lot higher than that. 

Follow Jack Farley on Twitter @JackFarley96