Michael Burry, the same hedge fund manager that shorted mortgage securities, can see another bubble – but it may be an opportunity for small cap investors.

This bubble focused on passive investing, which is investing in funds that track equity indexes or sectors rather than actively seeking out or managing individual investments to beat the market.

This is especially manifested in ETFs. By 2021 it is anticipated passive investing will overtake active management in the US.

Moody’s Research has shown three index fund managers already manage over $US1.8 trillion ($2.7 trillion) in assets and they could control up to one third of all voting shares of S&P 500 companies eventually.

 

So what?

There are three fascinating insights that came out of Burry’s comments.

First, and most relevant for Stockhead, Burry argued this resulted in smaller value stocks being neglected. Prices fall not because the stocks are bad but because there is less demand for them.

“The bubble in passive investing through ETFs and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally,” he told Bloomberg earlier this week.

Second, this trend has happened due to investor discontent about lower returns and fees accordingly disproportionate.

Burry said he was taking the approach he was because there needed to be more managers like him. He called himself a “smaller-value seeking active manager”.

But he is hardly a radical activist. Stockhead spoke earlier this month with Regnan head of advisory Susheela Peres da Costa.

She said the way Rengen acted for their investor clients was through private conversations, sometimes even initiated by the companies.

Burry said his method was similar. “My first instinct is friendly advice,” he said. “It may occasionally evolve to a more hostile situation, but that is what I want, I most want a productive conversation.”

 

Be prepared

Third, some critics fear this could amplify any market sell-off. Some managers argued that ETFs could withstand market shocks on the basis of Decembers’ sell-off.

But as Oaktree Capital cochair Howard Marks noted last year, it was nothing compared to the GFC — this would be a real test of how passive investing stacks up.

But even ETF managers are preparing for market downturns. Australian ETF provider BetaShares reminded its clients this week it had three “bear funds” which were designed to go up when the equity markets went down. One of these funds returned 39 per cent during Q4 2018’s share market downturn.

“For investors seeking longer-term risk mitigation strategies within their portfolios, maintaining an appropriately diverse asset allocation calibrated to their risk-return preferences might be more appropriate,” said BetaShares’ chief economist David Bassanese.

Bassanese said he felt a doomsday scenario was unlikely in the near future. But he acknowledged investors were concerned with the trade war and slowing global growth.