The “hero” of the movie “The Big Short”, Michael Burry, has made some claims recently about a bubble in ETFs and market risks. Here, I discuss his concerns, and provide an alternate perspective.
Price discovery
One of the risks Michael Burry identifies is so-called price discovery. He claims that index funds have removed price discovery from the equity markets. I must disagree with this claim. For example, when an investor buys an S&P 500 index ETF, they are agreeing to pay the seller some price. This transaction is an implicit agreement on the value of the underlying securities. So, this is the very definition of price discovery, where supply and demand are in equilibrium.
” Simply put, it is where a buyer and a seller agree on a price and a transaction occurs. “
Definition of Price Discovery, Investopedia.
Liquidity Risk
Michael Burry also identifies liquidity risk, which occurs when an investor has trouble selling an investment at a desirable price. Liquidity risk is very real. ETF investors often realize this risk during significant market corrections through larger bid-ask spreads.
“…liquidity risk stems from the lack of marketability of an investment that can’t be bought or sold quickly enough to prevent or minimize a loss.
Definition of Liquidity Risk, Investopedia
While I agree that there is liquidity risk in ETFs, there is also liquidity risk in just about any financial investment. For instance, homeowners often face liquidity risk. So, you may wish to sell you home next month to move for a new job, but may not able to find a buyer willing to pay your asking price. In stock and bond ETFs, liquidity risk also occurs during times of market corrections. But, this risk occurs whether you own the individual stock, bond, or a fund that contains them. Taking this risk is part of the risk-reward payoff. That is, by taking additional risk, the investor realizes the possibility of higher returns.
Conclusions about a bubble in ETFs and market risks
So, how should an individual investor treat this opinion? Michal Burry’s solution is to be “… 100% focused on stock-picking.” My choice is to stick with ETFs, thanks to their simplicity and efficiency. Markets corrections will occur, so it’s not a matter of if, but when they occur. If, as an investor, you are not comfortable with these market risk, perhaps you should re-evaluate your risk tolerance and move to lower risk investments.
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