Are Index Funds in a Bubble?

Question


Hi Scott,

The financial guru from the movie The Big Short, Michael Burry, who made a fortune betting against the US housing collapse, is saying that the next big bubble is index funds and exchange traded funds (ETFs), and that things will get really ugly should the share market crash. Aren’t index funds what Barefoot recommends? How do you respond?

Steve

Scott's Answer


Hi Steve,

After the 1987 crash, governments around the world held at least six inquiries to work out what caused it.

There was no conclusive answer.

My guess is that investors were driven by their emotions:

First, by greed as they watched stocks going up (buy, buy, buy!), and then quickly by fear (sell, sell, sell!).

And, given human emotions don’t change, this behaviour will be what causes the next crash.

Faced with all this erratic decision-making, wouldn’t it be good to have a mechanical, unemotional, by-the-numbers way of investing?

Enter index funds (and Exchange Traded (index) Funds (ETFs).

They are simple to understand: you own, for example, a share in the 300 largest businesses on the ASX.

They have transparent investing rules: twice a year they rebalance the portfolio so it matches with the index (the market).

And, as a result, they have low turnover, low taxes and low fees.

In other words, they are the exact opposite of those actively managed funds that try and pick market swings and roundabouts.

In fact, we know that, over the long term, investors in these actively managed funds will end up with less money than they would if they’d invested in a simple index fund. (And repeated studies show that even those actively managed funds that do well in the short term often do so by luck rather than skill.)

Now, to your question: will things get ugly for index funds if there’s a share market crash?

Yes.

Yet it will be ugly for every investor, whether they’re in index funds or not. However, I still can’t see how owning a collection of the largest stocks on the market would put you at a greater disadvantage than other investors.

Steve, if you’re lying awake at night worrying whether you’ll be able to sell your investments in the event of a once-in-a-lifetime crash — rather than, I don’t know, making love to your wife — you really need to check yourself before you wreck yourself.

Besides, history tells us is that the day a market crashes is the worst time to be selling.

Scott