Is passive investing the greatest thing ever for investors? Or is the passive investing “bubble,” as some would dub it, a looming disaster that threatens to bring down markets and trigger a new financial crisis?

This is a real debate, and it’s been going strong for years.

Those in favor of passive investing make a strong case. We explained the benefits of passive investing in our tribute to Jack Bogle, the father of index funds, who passed away in January at 89 years old.

But some argue that passive investing has grown too popular, that funds flowing mindlessly into the major indexes have created a passive “bubble,” and that this bubble is dangerous and could lead to a market crash — possibly even on par with the financial crisis of 2008.

Those who fear the passive investing boom make some intriguing points. All in all, though, they probably overstate their case. There is also a potential confusion of cause versus effect. It would be hard for passive investing dynamics to cause a crash, for example, if the boom in passive investing is actually a resulting effect, not an originating cause, with a different set of causes creating crash risk.

The passive investing debate saw a surge of interest this month for two reasons. First, because the dollar amount of index-tracking U.S. equity funds surpassed that of actively managed funds for the first time, a head-turning milestone; and second, because a famous and brilliant investor put out a warning that passive indexing could cause a crash.

Bloomberg recently reported that in August 2019, the total dollar amount of index-tracking U.S. equity funds rose to $4.271 trillion, which notched out the $4.246 trillion in active U.S. equity funds managed by stock pickers. This led to new concerns that passive investing is taking over Wall Street, that active money managers are a dying breed, and that the art of stock-picking could soon be dead.

None of the “active management is dead” fears are warranted. The statistic is misleading, for example, because index-tracking U.S. equity funds still have less than 20% of the total market when all forms of stock ownership are included (not just passive funds versus active ones).

Outside of the comparison reported by Bloomberg, there is a much larger body of U.S. equities residing in the hands of individual investors, pension funds, large institutions, and so on.

It also remains true that active investors buy and sell with far greater frequency than passive investors, which means active investors, even as a shrinking group, still tend to set prices at the margin. All in all, it would take a lot more to see the passive tail wag the market dog.

Meanwhile, the “passive investing is a bubble” warning that caught people’s attention came from Michael Burry, a brilliant contrarian investor who received the hero’s treatment in “The Big Short,” a best-selling book by the celebrated author Michael Lewis and an Oscar-winning movie based on the book.

Burry made his name and fortune betting against the subprime bubble that built up during the mid-2000s housing bubble. Burry and a small handful of others saw the potential in shorting exotic instruments known as “collateralized debt obligations,” or CDOs, when the rest of Wall Street thought CDOs were safe because home prices would never decline.

Because Burry put his CDO short position on very early, he had to endure extreme pain as the housing bubble continued to inflate. Many of Burry’s fund investors grew angry and threatened to abandon him or even sue him. But Burry stuck to his guns, and when the housing bubble finally popped, his CDO short became one of the most celebrated trades of all time (hence his profile in the book and movie).

More than a decade later, Burry thinks passive investing is a bubble reminiscent of the CDO market prior to the housing bust, driven by the same kind of complacency that assumes prices can’t or won’t decline. “Like most bubbles, the longer it goes on, the worse the crash will be,” Burry told Bloomberg.

To condense Burry’s argument, he sees two disturbing market bubbles right now, both caused by price distortion and a disconnect from the underlying fundamentals of real asset values.

The first bubble Burry identifies is in credit markets, as a result of the bizarre monetary policy of central banks. According to this way of thinking, because interest rates make no sense — thanks to manipulative central bank actions — money is outrageously cheap, making credit values outrageously expensive.

The second bubble Burry sees is in stock market valuations, as a result of the tsunami of capital flooding into passive index products. As Burry told Bloomberg, central banks “more or less removed price discovery from the credit markets,” while passive investing flows “removed price discovery from the equity markets.” They bubbles are two sides of the same coin.

Burry’s fear is that, while the major stock indexes are used to benchmark trillions of dollars’ worth of investment assets, the stocks that make up the indexes have very low liquidity in terms of daily trading volume. This creates the potential for a stampede, and a vicious downward spiral, if hundreds of billions worth of sell orders hit the indexes all at once and fuel a self-fulfilling doom loop.

“The theater keeps getting more crowded, but the exit door is the same as it always was,” Burry says. “All this gets worse as you get into even less liquid equity and bond markets globally.”

Burry’s concerns are warranted, but we’re not sure passive investing is to blame. If stock valuations are highly inflated right now, it is arguably due to zero-and-below-zero interest rates and a perpetuation of “easy money” central bank policies for the past decade (as Burry himself points out).

Given the nature of cycles and recessions, it wouldn’t take a passive investing implosion to lead to a 40% drop in the major indexes and a mass rush for the exits by investors. A global recession and a bear market could create that result on its own.

Whether or not you agree with Burry, he has some useful ideas, and it is wise to protect against downside risk regardless of whether or not passive investing is a bubble waiting to pop.

In the useful ideas department, Burry is a fan of small cap stocks. He thinks small cap names haven’t seen their valuations inflated as much by the passive investing trend, thanks to being overlooked by the major ETFs and indexes. “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 told Bloomberg.

Many of the world’s legendary investors agree with Burry. When markets are crowded, the place to look for values is off the beaten path, in nooks and crannies where the crowd is not paying attention. This is a long-favored strategy of some of the world’s best billionaire investors. They execute it by finding and purchasing overlooked small caps.

You can get access to timely and attractive small cap ideas by following the picks of our Billionaire’s Club inside TradeStops. We update these picks every quarter via mandatory 13F filings, an SEC rule that requires large investors to disclose their long holdings. By combining the picks in these screens with our proprietary algorithms and software tools, you, too, can find opportunities away from the passive crowd.

In terms of the downside risk Burry sees, the answer there is smart risk management, regardless of whether it’s a passive investing bubble that fuels the next bear market or something else entirely.

Occasional bear markets, like recessions, are just a fact of life in markets and investing. But you can protect against downside with risk management tools like the ones available in TradeStops, and simultaneously find investment ideas that work in any market environment (there were stocks and industries that went up even during the Great Depression!).

On the whole, the passive investing phenomenon has been wonderful for small investors. At the same time, concerns are warranted, for reasons that may or may not relate to passive investing as a phenomenon. Either way, you can find great small cap ideas (an area where Burry is bullish) via our Billionaire’s Club, and also protect your downside via TradeStops’ risk management tools.

TradeSmith Research Team