Do you still remember the movie "the Big bears" that became popular all over the world? Michael Burry, the prototype played by Batman Christian Bell, is back, and this time he says the next one is ETF.

The purpose of this paper is to look at the market from the perspective of financial instruments and market characteristics. There are not many people who look at things at the bottom of their minds like Burry. Most pragmatic people despise other "realities" because they attach importance to the "reality" in front of them.

ETF is next to collapse.

He is a legend in the investment world:

Medical background

With an artificial eye.

Suffer from autism

He set up the Scion fund in 2000 and by 2008基The rate of return achieved by gold investors is 489% (after deducting fees).Over the same period, the s & p 500 returned just 3%.

One of the most praised is that in the last mournful financial crisis, he insisted on acting on his own judgment, betting on subprime mortgage defaults.In the end, it made $750 million for investors with a scale of $600 million.

He closed the fund permanently in 2008, and the second half of this article is an introduction to its past.

The former hedge fund manager, who accurately predicted a recession in the US housing market, has discovered another financial product that is about to trigger a crash: ETF (traded open-index funds).

He believes that passive investment represents the index fund and ETF will lead to the market crash.

This undoubtedly adds some new ideas to many voices betting against US stocks.

He believes that large inflows into index funds are similar to those of CDO before the 2008 crisis.

CDO:Restratify the cash flow of different assets (such as mortgages) and package them into financial products with different credit ratings for sale.

ETF's assets rose from $338 billion in 2004 to $5.595 trillion by mid-2018, 16 times that of the former.

Burry said:「一Some simple papers and models allow people to buy index funds or ETF and other mutual funds that mimic these strategies, but these passive investments do not require the security analysis required for real price discovery.。」

This is very much like the CDO bubble before the last financial crisis. Like most bubbles, the longer it lasts, the worse the crash will be. "

After consulting the relevant information, I found that Burry is not interested in passive investment for a long time.

As early as the end of the 20th century, Burry said on his blog that Vanguard's index funds were not worth investing in and that these index products would perform poorly in the future.

No one took Burry's opinion seriously before the last subprime bubble burst. What about this time?

In the past decade, the number of ETF holdings in the United States has risen sharply, making it a force to be reckoned with.

As Burry points out, a large amount of money is allocated to stocks without price discovery.

There is no good or bad. This is the structure of ETF.

The market is in a long bull market and everything is fine.But in a major sell-off, the ETF sell-off could trigger problems in illiquid stocks, which could exacerbate the market crash.

Burry said: "the bubble of passive investment has been blown up, this is not one of my views, but a fact." "

Why has ETF developed at such a rapid speed in the past decade?

In my opinion, there are three reasons:

1. The failure of most active fund managers to consistently outperform the market is the best advertising slogan for passive funds such as ETF.

Many active fund managers fail to outperform the market and tend to charge higher management fees than index funds such as ETF, making their funds even more ugly.

Even Berkshire Hathaway has lagged far behind the S & P 500 this year, and Buffett said in an interview earlier this year that Berkshire may not outperform the index by much.

2. ETF reduces the cost of investment index.

3. In addition, there is a force accelerating this trend.

Securities brokerage income has begun to shift from commission to wealth management, that is to say,These experts prefer to charge annual financial consultants' fees rather than rely on commissions on clients' daily transactions.

Wealth management experts will tell clients to stop worrying about stock picking. Buying an ETF allows your investment to allocate hundreds of stocks at once, with enough risk diversification to outperform most professional investors who study stocks every day.

Stockbrokers who used to hope that their clients traded frequently are now much calmer and can now charge their clients an annual consulting fee by allocating some passive funds.

ETF is a genius invention for the brokerage industry, which has a more stable income, does much less work, and better yet, customers take less risk.

In addition, there is a bias in some mature markets that retail investors who trade stocks are considered "poor" because it is a low quality of life behavior.

This series of reasons together promote the growth of the ETF industry.

So why did Burry say that ETF would collapse? Are there any problems that people ignore?

That's liquidity!

As before the subprime crisis, when house prices rose, there was no problem.

The past decade has also been a bull market in the United States.

At present, the voice of pessimism is getting louder and louder, and the internal and external environment of the United States may not be able to support this bull market to continue.

What happens to ETF if you turn around and go down?

For example, the Russell 2000 index, the vast majority of which have very low trading volume.

Take today, for example.Of these, 1049 stocks traded less than $5 million, and nearly half of them (456 stocks) traded less than $1 million.

However, hundreds of billions of dollars are linked to such stocks through indexed passive investment.

The S & P 500 index, which includes some of the world's largest companies, is no different, but there are still 266 stocks trading below $150 million today.

150 million dollars sounds like a lot, butTrillions of dollars of assets around the world are invested in indices compiled by these stocks.

The theatre is getting more and more crowded, but the exit door is not getting bigger.

(In a market with no price limit and highly developed algorithmic trading, illiquid stocks face the fate of panic selling.)

When everyone tries to sell the index, no one can close the deal at the market price, and the price will collapse because the market falls.

At this point, investors will hear a lot of reasons from wealth management experts, for example, this is a black swan, these are completely unexpected, no one can control, and so on, but only investors will pay the price in the end.

Take a look at other countries, where the market liquidity is even less liquid, and if something goes wrong, the consequences will be even more serious.

For example, in the past three years, passive investment funds have developed at an eye-popping rate in European countries, and everyone wants to maintain the value of their wealth in a simple way rather than increase it.

It is worth mentioning that Japan is better at this because their ETF is mainly held by their banks, so their performance will be more stable in extreme situations.

When an extreme situation occurs, even if it is highly unlikely, the impact of selling passive investment funds will be untested.

Burry also stressed thatThe sell-off of passive investment funds may also give rise to other risks, as so many funds use these products as part of their portfolios for hedging and other purposes, which may further trigger a chain reaction.

Therefore, it is time to consider the impact of extreme events at the far end of the normal distribution curve on ETF and financial markets.

Burry and his Story in the subprime crisis

This history is recorded in the book Big short, where a handful of people stood across from Wall Street before the subprime crisis, almost betting on the collapse of the entire US financial system. I believe that people who finish reading this book will be deeply attracted by the legend of Burry.

Burry lost his left eye at the age of 2 and has always been the object of ridicule by his friends, which makes him withdrawn, unwilling to communicate with others, and has few friends in adulthood.

At first he was just a doctor who graduated from UCLA and invested as an amateur.

In the late 1990s, when the Internet was just becoming popular, he often appeared in some stock forums to express his views.

Due to his excellent stock selection ability, his recommended stocks performed well, and slowly, many people became his fans. He was a big investment in the Internet era of PC in the United States.

He set up the Scion fund in 2000, and many fans became the first investors in his fund.

Burry was originally a follower of Graham, but as he studied further, he found that it was impossible to follow these investment principles to become Buffett, and he needed to establish his own approach, which was to find advanced "unusual opportunities that others were not aware of."

He once said, "The bulk of opportunities remain in undervalued, smaller, more illiquid situations that often represent average or slightly above-average businesses. "

The opportunities he is looking for are in cheap, unpopular, small market capitalization and illiquid "junk stocks".

Burry once said in his blogHis core strategy is to find heavily undervalued bargains, whether in a bull market or a bear market, with 100% compliance with the margin of safety.Then do not predict the direction of the market, because the market is always irrational.

Before the subprime crisis, he accessed a large number of mortgage repayment records and borrower data, and found that 50% of borrowers did not have any information, and there were a lot of defaults, especially adjustable interest rate subprime mortgages, as interest rates rose.

There were no shorting instruments in the mortgage market at the time, because no one thought it would fall.

Creating conditions without conditions, Burry carefully selected several types of subprime loans and signed CDS (Credit Default Swap) with investment banks.

CDS is the best tool to bet on subprime mortgage defaults. The analogy in the book is to "insure a house that is about to be engulfed by the fire, which belongs to someone else."

If you pay 1.5% of the premium every year, you can get an indemnity income equivalent to 30-50 times the premium in the event of a breach of contract.

Burry believes that this is an excellent profit-to-loss ratio investment, and do not have to wait a long time, within three years the risk of subprime mortgage is bound to break out.

But before the subprime mortgage really broke out, the premiums were all handed over, which is the net loss of the fund.

Burry began to increase in 2005, and the real risk did not burst until 2007, so the fund outperformed the index by a large margin in 2006.

In January 2007, Burry faced questions from investors: "Why did your fund withdraw 18% when the S & P 500 rose more than 15% last year?" "

People don't care that he earned 186% in the past, but question him for not picking stocks well and playing with derivatives instead.

He knew full well that he had to stick to it and that victory was ahead, but no one had the patience to listen to his explanation.

So he responded forcefully, freezing his credit swaps. At least half of the fund assets of investors are locked in.

Investors eager to get their cash back threatened to take him to court.

In the end, he was forced to reduce his valuable CDS position under pressure from his clients.

In the second half of 2007, when the subprime crisis broke out, Wall Street was miserable and Burry won, and that year he achieved a net income of 138%.

But this "investor-manager" fragile trust relationship led him to close the fund in 2008.

He took a commission of $100 million and became an individual investor.

Let's conclude by looking at his farewell letter again:

I met my wife on Match.com. My profile said, "I am a medical student with only one eye, an awkward social manner, and $145000 in student loans." She wrote back, "You're just what I've been looking for." She meant honest. So let me be honest. Making money is not like I thought it would be. This business kills the part of life that is essential. The part that has nothing to do with business.

For the past two years, my insides have felt like they're eating themselves. All the people I respected won't talk to me anymore except through lawyers. People want an authority to tell them how to value things but they choose this authority not based on facts or results. They choose it because it seems authoritative and familiar. And I am not and never have been "Familiar". So, I've come to the sullen realization that I must close down the fund. Sincerely, Michael J. Burry, M.D

My wife and I met on the dating website Match.com. My profile reads: "I am an one-eyed medical student who is not good at socializing and is saddled with 145000 dollars in student loans. She replied, "you are the very person I am looking for. "she means my sincerity. And now I'm telling you sincerely. Investing and making money is different from what I used to think. This business kills what I think is precious in life, and these things have nothing to do with investment.

In the past two years, my heart has been feeling corrupted. All the people I respect no longer talk to me, except through their lawyers. People want authority to tell them what is important and what is not, but people do not choose authority based on facts or results, they only choose people who look authoritative and familiar. And I will never become a familiar person. So I realized that I had to close the fund.

In good faith

Michael J. Burry

I would like to thank Li Zhen, a village investment fund manager, for his suggestions for this article.