Hedge fund training 101: go after indexing to get attention for your fund

Frank Koster and Josh Kruk are going to have serious fun. Sporting a combined 50+ years in the financial industry, they're opening a Shelburne, Vermont One Day In July office. They know how the "sausage is made" in the industry, and they plan to unmake it. That's the fun part! If you are in that area, or if their backgrounds appeal to you, give them a call. Their pages are here and here, and Josh likes to write extensive "deep dive" articles on finance and indexing as well, which everyone may appreciate. For example, check out Mutual Funds vs ETFs.

Investing has the advantage over baseball in that you don't have to swing at a pitch. You can just stand at bat and wait for something appealing to float through the strike zone. We do this all the time on the investment side. Normally, on the media side, we ignore most of what the pundits say, preferring to watch the baseballs fly by.

But today I have to dust off the bat, because hedge fund manager Michael Burry, of The Big Short fame, threw a pitch at indexing. This broke through to the national media, and many of you have been asking about it.

In case you missed this corner of Internet theater, Burry claimed indexing was a bubble akin to 2008 subprime real estate.

Let's talk about what he didn't mention first. He runs a hedge fund. Hedge funds need assets, and for many hedge fund managers, indexing is putting them under intense pressure as those assets bleed away from their high fees. Consider it a win for the people.

Publicity helps hedge fund managers raise money, and Burry isn't exactly running a large fund. That's why they go on CNBC. That's why I generally ignore them, because they are hoping for a response. But Burry confused enough people that I have to swing at the pitch. Some items to consider:

First, there is a difference between indexing in general and buying the S&P 500. Burry conflates these two concepts erroneously. Most people who index do just buy the S&P 500 - and that may be high at the moment (but then again, maybe not). But the process of indexing is not tied to one asset class.

Second, the idea that indexers are crowding out price discovery is silly. Price discovery is what active investors do. They study stocks and bonds and try to figure out what is expensive or cheap, and the average of that activity turns into the price of a stock or bond. The index swoops in and says "thank you for doing all of that work at your expense, we will now ride your coattails at almost no cost," and follows along.

But trading on the New York Stock Exchange has surged by a factor of over 20 times since the first index fund was released in 1975, and 95% of trading today is done by active investors (1). Price discovery leaves its fingerprints in trading volume, and it is alive and well.

Finally, it got lots of media attention for Burry, but indexes don't carry the risks that CDO's and derivatives did in 2008. Most are not leveraged. They don't receive margin calls. They will not require the United States Treasury to bail them out. In fact, one of the beautiful traits of a well-constructed index is its simplicity - you can understand what you own.

This doesn't mean that asset classes, whether indexed or not, won't have bubbles or slumps. They will, and in fact at One Day In July that pattern is important, as our models rely on the concept of reversion to the mean. But that is a long, long way from what happened in 2008, unless you're trying to raise the profile of your hedge fund.

Dan Cunningham

(1) Source: NYSE.com

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