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Index Funds Are The Biggest Bubble of Our Time

 

Index Funds Are The Biggest Bubble of Our Time


INTRO: 

The S&P 500 is often hailed as the crown jewel of personal finance. If you want to reliably grow your money and you don’t want to go through earnings reports or experience extreme volatility, the S&P 500 is usually the top recommendation. 

Everyone from YouTubers like Graham Stephan to deca billionaires like Warren Buffett is massive fan of the S&P 500, and this is for good reason. 

The S&P 500 not only gives you a chance to be invested in the leading American companies but also an opportunity to diversify amongst hundreds of companies. 

In other words, as Warren Buffett says, investing in the S&P 500 is basically like betting on America. And for the past few hundred years, that’s been an extremely successful bet. 

However, a few notable investors like Michael Burry have actually been warning us that index funds and passive investing, in general, is one of the biggest bubbles of our time. 

Now, this probably doesn’t mean that you should sell everything and go into cash, but it’s also likely a good idea to look at why exactly Michael Burry believes this. So, here’s the index fund bubble theory. 

SHORT HISTORY: 

One of the biggest factors people cite in favor of the S&P 500 is its long history. You hear things like, the S&P 500 has returned an average of 10.5% for the past 100 years. 

Such statements make you think that the S&P 500 has been a staple investment for basically a century and that it has performed strongly even through events such as World War 2 and the cold war, but this isn’t exactly true. 

While the S&P 500 and the Dow Jones have been around since the early 1900s, they were never popular investment choices. In fact, there was no easy way to even invest in the S&P 500. 

If you were a retail investor, you had gone out and bought 500 different stocks. It wasn’t until 1976 that John Bogle, the founder of Vanguard, launched the first US index fund that was available to retail investors.

This means that for the majority of the 1900s the S&P 500 was simply an indicator like the RSI or the MACD as opposed to an actual investment. 

Also, it’s not like the S&P 500 just took off as soon as John Bogle launched the fund. In fact, interest in the fund was horrendous. 

John was hoping that $150 million would flow into the fund at IPO, but in reality, only $11.3 million flowed in. 

Not only did the fund perform poorly from a financial perspective, but it was often the laughing stock of Wall Street. 

The S&P 500 was generally associated with unsophisticated investors who couldn’t even beat the market. 

Now, it should be noted that active funds themselves were often not beating the market, but this didn’t matter. 

The vast majority of people bought into the narrative that active funds were superior and that only losers who didn’t have access to active funds invested in something like the S&P 500. 

This was the overwhelming sentiment up until the early 2000s when we saw the dot-com crash. 

A lot of tech-heavy funds got obliterated or completely wiped out while the S&P 500 held up decently well. 

Now, it should be noted that the S&P 500 itself was down about 50%, but this was far better than a lot of internet companies that were down 80,90,95%. 

This led to more interest in index funds and consequently, more index funds and ETFs were launched. 

But, it wasn’t until the 2008 financial recession and Warren Buffett’s famous bet against active funds that index funds really took off. 

Just take a look at this graph showcasing the assets under management by ETFs. In 2003, this number was just $200 billion worldwide. Today, this number stands at over $10 trillion and much of this growth has happened within the past decade. 

So clearly, index fund investing is not some tried and true strategy that has been around for 100 years. Really, it wasn’t till the last two decades that index fund investing become a popular strategy. 

And this short history opens up index fund investing to a massive slew of problems starting with asset inflation. 


ASSET INFLATION: 

While active investing often gets a lot of slack nowadays for not even beating the market, when you really think about it, it’s actually active investing that made index funds so great in the first place. 

The reason that index funds were able to post such great numbers throughout the 1900s was that index funds were basically a conglomeration of active investors' favorite stocks. 

For example, if a lot of active investors really liked Coca-Cola, the stock would go up and the market cap would go up, and it would be included in the S&P 500. 

Conversely, if a lot of active investors didn’t like Coca-Cola, the stock would go down and the market cap would go down, and it would be kicked from the S&P 500. 

So, it was really the active investors that indirectly determined which stocks would be in the index, and the index was basically a consensus of the active investors. 

With the rise of passive investing, however, this is no longer the case. Many of the companies in the S&P 500 receive massive amounts of buying pressure simply because they’re part of the index. 

For example, have you guys ever heard of Nielsen Holdings, Zions Bancorporation, BorgWarner, or Pinnacle West Capital? I doubt any of these stocks have massive active investor bases. 

However, they boast quite a bit of volume. BorgWarner boasts an average daily volume of 2.16 million shares and Nielsen holdings boasts an average daily volume of 10.72 million shares. 

This usually correlates to tens of millions of dollars if not hundreds of millions of dollars on a daily basis. And much of this volume is buying pressure from passive investors who simply invest a set amount every day or week. 

These guys aren’t looking at the company’s PE ratios or revenue growth or profit growth or any of the factors that determine whether the given company is a good investment. 

Despite this, they continue to buy in on a regular basis just because it’s part of the index. I don’t think I need to explain how this leads to these stocks being inflated. 

Over time, this leads to bad companies sticking around in the index for much longer than they should, and it prevents great companies from entering the index when they should. 

This concern also carries over to the biggest companies in the index as well. For 9 in 10 companies in the S&P 500, their largest single shareholder is an index fund provider. 

This means that stocks like Apple, Google, Amazon, and Facebook receive extraordinary amounts of buying pressure from passive investors. 

Now, there’s no doubt that these are phenomenal companies, but it’s likely that even these companies would be valued much lower if they weren’t part of the index. 

For example, Apple might be worth $2 trillion instead of $3 trillion if it wasn’t for constant buying pressure from passive investors. This eventually leads to a much bigger problem than simply asset inflation. 

If passive investing gets big enough, which it might already be, index funds will start performing well not because the companies in the index are fundamentally performing well but simply because of supply and demand, and that’s a rabbit hole that we don’t want to go into. 

NOT DIVERSIFIED: 

Another major shortfall of the S&P 500 is that it’s not actually that diversified. But wait a minute, 500 companies is a lot of companies. 

If we split $100 dollars into 500 companies, each company would only get 20 cents. 

This means that you’re only risking 0.2% of your investment with any single company right? 

Well, this would be true if the S&P 500 was an equal weight index but it’s not. 

Apple alone accounts for nearly 7% of the index, and the top 50 companies account for over 50% of the index. 

This means that the other 450 companies don’t even account for half of your investment. 

This lack of diversification significantly accentuates the asset inflation problem. Also, not only do these top companies account for the majority of the S&P 500 in terms of weight, but they also account for the majority of its returns. 

In fact, just 5 companies, Facebook, Amazon, Apple, Microsoft, and Google have accounted for 40% of the S&P 500’s total returns over the past 5 years. 

Another way to put this is that 1% of the S&P 500 accounted for 40% of its success. If we just remove these 5 companies from the index, the S&P 500’s annual average return would drop from 9.68% down to 5.76%. 

Now, this is already quite substantial, but the contribution becomes even bigger if we consider the top 100 companies. To make this comparison, let’s take a look at the S&P 100 which is exactly what it sounds like. 

It’s the top 100 companies in the S&P 500. In this graph, the S&P 500 is the orange line and the S&P 100 is the candle. 

As we can see, sometimes the S&P 500 is winning and other times the S&P 100 is winning, but over the long term, they’re basically identical.

Over the past 32 years, the S&P 500 has only beaten out the S&P 100 by a mere 20%. This means that 98.3% of the S&P 500 returns over the past 32 years are from the top 100 companies in the S&P 500. 

Where things get really interesting though is when we compare both of these to the Nasdaq 100.

If you’re not familiar with what the Nasdaq 100 is, it’s basically the top 100 tech companies in the S&P 500. And if we add the NASDAQ to our graph, this is what we get. 

As you can see, the Nasdaq literally performed 5 times better than the S&P 500 over the past 32 years. And given that the S&P basically includes all the stocks that are in the Nasdaq, this means that the other 400 companies in the S&P 500 straight up to hold back performance. 

And this makes perfect sense when you consider that the S&P 500 includes stocks like AT&T, Citigroup, American Airlines, and General Motors which are down on a multi-decade basis. 

Fortunately, such companies account for a smaller weight of the S&P 500 than the top performers, 

but that doesn’t change that billions of dollars are flowing into such companies not because they’re top performers, but just because they’re part of the S&P 500. 

And as more people start investing in indices and grow their positions, this just becomes a bigger and bigger problem. 

TRUTH ABOUT INDEX FUNDS: 

At the end of the day, index funds may not actually be the safe haven that they’re often pitched as. 

Index funds have a relatively short history of actually being invested in and the rise of passive investing is likely leading to significant asset inflation. 

Not to mention, you can get far better returns by simply investing in the top performers of the S&P 500. 

This is why many top investors aren’t big fans of the S&P 500 or are straight-up calling for a full-on collapse like Michael Burry. 

With that being said, should you stop investing in the S&P 500? Well, this is not financial advice and I’m just some guy on the internet, but here’s what I think. 

While the S&P 500 does have the risk of being the centerpiece of a massive bubble, I strongly believe that the risk of not investing is way higher than the risk of investing in the S&P 500. 

The only thing that is guaranteed to go down in real value is cash, and this is more relevant than ever before given the sky-high inflation. 

And currently, one of the best ways we know to mitigate this risk is to invest in the S&P 500 which has thus far produced moderate yet reliable returns. 

Now, if you’re willing to stomach some more volatility, I think the Nasdaq 100 may be an even better choice. 

And if you’re willing to take even more risk you might consider investing in just the top 20 or 30 tech companies along with some bitcoin and Ethereum. 

But, as a base, I think everyone should at least have some exposure to the S&P 500. 

That way, your money is not just burning away in some low-interest savings account. But that’s just what I think. Do you guys think that the S&P 500 is just a massive bubble? 

Comment that down below. Also, drop a like if you’re a fan of the S&P 500. 


Also read:  IDFC FIRST Classic Credit Card 

Also read: How the risk and return trade off can be applied in real life

Also read: How to Identify Stock Trend Changes

Also read: What is a pattern day trader


 THANK YOU SO MUCH 

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