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the big shorts Michael burry explains why index funds are like subprime CDOs oh no this is so sad I love index funds and ETFs not them but Michael burry is very trustworthy you know this guy right from the big short made tons of money in 2008 because he saw what was going down and before that he was actually an investment banker on Wall Street but you know things got a little crazy so it didn't really work out for him so to make up for that he became Batman to glens all his sins and fight crime until he returned to Wall Street to make all that money in the crash and now he's saying that another 2008 style crash is about to happen with these ETS so he's saying central bank's in Basel I think that's how you say Basel 3 have more or less removed price discovery from the credit markets meaning risk does not have an accurate pricing mechanism and interest rates anymore and the basel 3 is basically this thing right here there was just regulations for banks so enhanced minimum capital and liquidity requirements and a bunch of other stuff to make banks safer but of course every rule and regulation you put in place has adverse effects such as screwing up the markets pricing mechanism like Michael is talking about right here so he's saying on top of that in the credit markets where things are all getting screwed up pass investing is also removed price discovery from the equity markets he says you got all these simple theses and models now to get people into sectors factors indexes and ETFs or mutual funds but these strategies don't require the security level analysis that is required for true price discovery so people aren't you know doing fundamental analysis and trying to pick stocks it's just a bunch of money flowing into a few models and the most popular model right now as you know is the passive investing model which is just buy and hold and it's not really worried about what stocks is getting into it's just worried about the fees how much are they charging as long as the low fees everybody's happy so they just pile their money in you said this is very much like the bubble in the CBO's before 2008 in that price setting in the market wasn't done by fundamental security level analysis but by massive capital flows based on noble approved models of risks that proved out to be untrue so in 2008 they thought CEOs were safe and we're a no-lose situation so they're just piling money in same thing with ETFs and passive investing now no one is thinking about the downside and another reason people stop thinking about the downside is when they have too much money and you know central banks have been keeping interest rates super low artificially low for a long long time so there's a ton of money in the system that creates a lot of wealth disparity because all that money goes back into the market so the top group of people are making more and more money because there's more and more fuel going into the fire but there's so much money that people aren't being smart about those investments they're just piling it in and it becomes a reflexive loop like Soros style where it keeps pushing everything higher but again there's risk to this stuff that people are just forgetting because too much money and it's got to go somewhere same reason why so much money was going into all these venture back companies and now they're all IPO and one by one with just like ridiculous fundamental is not making any money at all but they've almost been trained to not make money because they're getting so much money from this low interest rate environment anyway so the big problem with passive investing in all these ETS is liquidity so if you think about the Russell 2000 index for instance as he explains here the vast majority of stocks are lower volume lower value traded stocks so he counted a thousand and 49 stocks that traded less than five million in value during the day and almost half of those traded less than 1 million dollars during the day yep through indexing and passive investing in these ETFs hundreds of billions of dollars are linked to stocks like this these tiny little stocks and the S&P 500 is no different it contains the world's largest stocks but over half of them trade under 150 million dollars today now that sounds like a lot but trillions of dollars in assets globally are indexed to these stocks so he says the théâtre keeps getting more crowded but the exit door is the same as it always was and all this gets worse as you get into you in less liquid equity and bond markets globally so Michael burry is getting into the structure of these ETFs here and what ETFs do is match the performance of an index right but at the end of the day there's still financial derivatives they're created artificially so sure they work fine when the market is going higher and isn't too volatile because everyone just keeps buying and it's ok but what happens when the market turns around and goes lower for an extended period of time or that comes super volatile so you said it can be really bad because of the impossibility of unwinding the derivatives and make it buy sell strategies used to help so many of these funds pseudo match flows and prices each and every day so again these index funds are using derivatives and other things to match that index cuz they have to do it artificially right so he says this fundamental concept is the same one that resulted in the market meltdowns in 2008 so he doesn't know what the timeline will be for this one but like most bubbles the longer goes the worst the crash will be so here's a different article that explains how ETS actually work so Luigi has worked with etf market makers and these are authorized participants looking for arbitrage opportunities so when you're buying and selling they're taking the other side so they trade dynamically to balance the supply and demand for ETF shares and their underlying assets but if liquidity and underlying markets suddenly dried up market makers would likely price that risk into their ETF quotes so in effect ETFs track not only the performance of their underlying assets but also the liquidity of these assets so etf's targeting illiquid instruments like corporate bonds and leveraged loans would present greater risks and investors trading on the premise that ETFs are more liquid than their baskets might find that results fall short of expectations in a stress environment so ok this problem would be the biggest with specific sector ETFs like the hyg high-yield bonds or something because there's a lot of money trading on that ETF but not as much supply of actual bonds especially if liquidity dries up as when people don't want to buy and sell those bonds anymore the people trying to get out of the ETF might get screwed because of the person managing the ETF can't even buy or sell their gonna reflect that in the price of the ETF so you might wake up one morning and it'll be down huge and it's not even matching the index and another scary thing is that these ETF market makers these authorized participants if I'm understanding this right it's a little complicated but they don't even work for the ETF company meaning that they don't have to trade with the ETF so they don't have to take the other side of your trade so if something really bad happens all those authorized participants they could disappear then you have no one to sell to and then you see a huge huge price drop so that's another structural risk with ETFs and these index cons is just all about liquidity and these things haven't really been tested before because we've had such an easy market and we've never had this amount of passive funds all in these index funds we're like at the height of the bubble right now I think the stat that I saw said that pass investing is gonna pass active investing as far as total AUM by 2022 so whenever things swing way too far to one side in the market they always swing back it's like a pendulum so yeah we've been in a long period of active investors underperforming the market which has pushed people into passive because they're like you know why am I gonna pay for you you suck you can't even meet the market where I could pay just a tiny tiny fee and get in this index file they'll do great it'll just match the market at least which is much better than what most active managers were doing but it's all about the environment right so we're Michael burry was saying that price discovery isn't happening anymore well if that's not happening the managers aren't gonna do as well right because they make money on finding those discrepancies between what the market is pricing something at and what it's actually valued at but if there's just this wave of money coming in and everything is just floating up together then what's the manager supposed to do and I remember in Stan Druckenmiller interview on real vision he was talking about the same thing all these price signals are getting washed out but this will only happen for so long until this all falls apart like Michael burry is talking about there's way too much money and passive and then you get the washout and crash and then everyone wants to go active again because it starts working again it's just long long-term cycles that people can't handle so what does this mean though can you not use ETFs anymore no that's not true I'm still using ETFs in my systems I was just talking to Keith today for Marquis gage my mentor the guy billed with all these systems with and what he was explaining to me is that this doesn't even matter the bigger problem is that so many people are just in passive in general which is just a bad strategy because there's no risk control so even without these index funds and ETFs if you're just passive you're gonna take that huge haircut when it comes anyway and what you should have is risk control in place so in one of our systems we use ETS like spy and TLT but we have stops there we have a stop below our entry in that system of like 6% or something well when this crash happens in the ETFs it's not gonna happen all in one day even in 2008 the crash didn't happen all in one day it took a period of time well if you have risk control in place with your stops they should get you out of the market before the huge huge crash happens like I said in our system if we got to stop at 6% we're gonna get out at 6% and then we're gonna be fine we're gonna be in cash because this whole structure of pom with the ETFs that I'm talking about that won't trigger at just a few percentage points down it's gonna trigger once everyone starts selling at the same time and that happens when there's true panic which should happen after the market falls lower than 60% it's just the thing starts cascading and it picks up steam after a certain point because of the way all this money is grouped in together now so feel free to still use ETFs but be careful you need that risk control in place not only to protect you from the natural market crash but also from how these things are structured they're all financial products which are never created a hundred percent correctly with no risk there is always risk with financial products but okay if you have any questions put them down below and also let me know what kind of videos you want to see from now on we're trying to get some ideas about what you like so let me know in the comments and we will make those videos and by the way if you comment on one video with your suggestion and we don't make that video it's okay just keep commenting so we see it again we got like this running list and things get moved you know but if you keep commenting we'll be like oh they really want this okay if you haven't already make sure you subscribe to this channel and hit that notification bell so you get an email notification whenever our new videos come out we are publishing all the time all about margins in business so subscribe and I will see you in that next video stay fallible out there bye
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