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Michael Burry stars in the The Large Cap Bubble – the movie that never happened

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Could passive investing, as hedge fund manager Michael Barry of The Big Short fame has suggested, be causing a bubble in Large Cap stocks? Algo-Chain’s Allan Lane has his say…

I love over-simplification as more often than not it’s the only way to get one’s head around a topic that is impenetrable when presented with the full details. And so it was in 2007 when Michael Burry, the hedge fund manager made famous in the movie The Big Short, saw that the US housing market was in the final stages of a bubble that was about to pop. 

A number of years earlier I had been managing a team of quants, one group of which had been refining their pricing models as they attempted to put a fair value on Collateral Debt Obligations, better known as CDOs. If ever there was a time when the dark art of ‘rubbish in, rubbish out’ applied, this was it. Every time I hear the assured voice from The Masters of The Universe, that the best model to use was a Gumbel Copula, I afford myself a wry smile.

It took the keen eye of Burry who managed to spot that the mis-pricing of CDOs and the housing bubble were closely related. Fast forwarding to August 2019 and Burry has gone public with his view that passive investing is causing a bubble in Large Cap stocks. My first reaction was – you don’t say – but on closer inspection I realise that this is an oversimplification of a story that has several fascinating sub-plots.

Over the years, Burry has deserved the accolades that have been thrown his way. There are not that many managers who can talk in terms of delivering a return of close to 500 per cent in the wake of the 2008 crash. On this occasion I welcome the debate that his headlines have stirred up, as ever when the topic of ETFs comes into view, strong opinions enter the fray. Given the madness of crowds, I personally believe that the distorted levels of US equity prices can be attributed to the fact that that’s what happens in a bull market. Yes, passive investing does drive up the price of all stocks in the index, and thus temporarily mis-appropriating the efficient use of capital, but at the end of the day there will be a real company behind every single stock ticker, and in the long run if it is overvalued then expect the laws of common sense to kick in.

So here we are in September, the month of the year when market surprises often occur as aptly displayed this week with a 20 per cent temporary spike in oil prices as the Saudi oil operations were attacked. Not withstanding this, I don’t rate the chances that Brad Pitt will get the call from his agent asking if he wants to star in the next Hollywood blockbuster, The Large Cap Bubble. Let’s all accept that when it is time to take the punchbowl away, ETFs will be at the scene of the crime. Imagine a headline in 2008, “S&P 500 undergoes a severe correction, as the evidence suggests equity investors are identified as the culprits”. Need I say more.

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