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According to a recent Bloomberg article, Michael Burry of "The Big Short" fame claims that

In the Russell 2000 Index, for instance, the vast majority of stocks are lower volume, lower value-traded stocks. Today I counted 1,049 stocks that traded less than \$5 million in value during the day. That is over half, and almost half of those -- 456 stocks -- traded less than \$1 million during the day. Yet through indexation and passive investing, hundreds of billions are linked to stocks like this. The S&P 500 is no different -- the index contains the world’s largest stocks, but still, 266 stocks -- over half -- traded under \$150 million today. That sounds like a lot, but trillions of dollars in assets globally are indexed to these stocks

I fail to see how this demonstrates a problem. Is he suggesting that there is more money indexed to the stocks than the stocks are actually worth? Well that should be quite obvious as one can easily track the real value of the fund based on its reports of which stocks it holds.

What is Burry trying to say here ?

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  • $\begingroup$ For what it is worth the top 234 companies of S&P 500 have weight of 86.3% and the bottom 266 companies have weight 13.7%, so most of the "trillions of dollars" are tracking the top, most liquid companies. But what we need to know is how many new dollars flow into the index every day, not the outstanding amount. And that, I have no idea, but it is not "trillions". $\endgroup$ – noob2 Sep 5 at 16:09
  • $\begingroup$ This fallacy is know as "confusing stocks with flows" ;) $\endgroup$ – noob2 Sep 5 at 16:12
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    $\begingroup$ In addition to the answers below, keep in mind that notional value traded during the day is entirely independent of inflows and outflows of an ETF. I.e., if I sell you 100 shares of SPY zero shares of the underlying securities have traded. $\endgroup$ – amdopt Sep 6 at 12:27
  • $\begingroup$ @amdopt yes but if a bunch of people like me keep buying, there are sellers out there who DO keep track of the price and will start selling if the price goes too high, bringing the price back down. That's why I don't see how this could ever be a bubble $\endgroup$ – CodyBugstein Sep 13 at 4:42
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Very easily, you don't actually need to hold those stocks as long as you own a portfolio of larger stocks that in the correct proportion can mimic those small stocks. These are called replicating portfolios. Given that those stocks that trade low volumes are also low market cap (highly likely), the tracking error of not holding exactly those is not that big.

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  • $\begingroup$ Given that those stocks that trade low volumes are also low market cap (highly likely), the tracking error of not holding exactly those is not that big. I find this sentence hard to understand $\endgroup$ – CodyBugstein Sep 5 at 13:20
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    $\begingroup$ If the benchmark is market cap weighted, consider what the impact of the returns of a tiny company is on the benchmark return. $\endgroup$ – Bob Jansen Sep 5 at 13:38
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The goal of the index fund is to have a small tracking error (not to replicate the index holdings exactly). They are aware that some stocks are less liquid than others and will use techniques such as sampling (skipping some small stocks entirely) or substitution of more liquid similar stocks to construct their mimicking portfolio. So far these techniques have worked well.

Also, indexes easier to track than Russell 2000 have been developed, such as CRSP Total Market Index, so Russell 2000 is not the best example of an index (it is outdated in terms of index methodology, and I don't recommend it).

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