The contrarian investor gives passive index funds a thorough tongue-lashing -- and sees opportunity in small-cap stocks (that he happens to own).

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

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The Smart Indexes Are Even Worse Than The Dumb Ones*

You may have heard that the Dow hit 13,000 today before subsiding to a shameful 12,965.69. You may not have heard this, or cared, because the Dow is for morons, being a price-weighted index of thirty semi-random companies that, gah, aren't even "industrial" any more.** There are alternative theories but those theories are wrong: Joe Weisenthal in defense of the Dow has been noting its very high correlation with other, broader, more sensible indexes. I see this as further undermining the Dow's legitimacy. If it's very different methodology were leading to some kind of meaningfully different result, then we could perhaps argue that it's adding value in some kind of way. But instead what's going on is that the Dow's creators are hand-picking which stocks to include in the index specifically with an eye toward constructing an index that mirrors the other, better indexes out there. Apple and Google, for example, aren't in the Dow and aren't doing to get in any time soon because their very high share prices would skew the index in weird ways. This just goes to show that the Dow's creators already "know" the right answer (from looking at the S&P 500 and the Wilshire 5000) and then are trying to assemble an index to create the predetermined result. Maybe! An alternative theory is maybe suggested by [Occam's razor and] this piece from the Journal this weekend about index funds that I just loved and so am now going to inflict on you at unnecessary length: