Tesla, Burry, and a Passive Investing Bubble?

Tesla

At the start of May 2020, Elon Musk said Tesla was overvalued

and the stock subsequently fell 10% that day to $700 a share[0]. Anyway, this week it closed at $1546, to be worth $286bn, the most valuable car company in the world. On Friday alone it increased 10% (for seemingly no reason?), growing its market cap by more than Ford is worth ($24bn).

A 120% return for those who think they knew more about the company’s stock than its own CEO is either pretty good going or signs of a highly dysfunctional market.

12 days ago there was a post on r/wallstreetbets (yes I spend too much time there) speculating how Tesla could gain entry to the S&P 500 if it is profitable this quarter, and hence see a big run up in price as funds (both truly passive and ‘active’ index huggers) tracking the index are ‘forced’ to buy it. As of right now, that looks like a pretty good call.

But if a stock automatically goes up on (anticipation of) joining an index, does that indicate there is a problem in the world of investing?

Burry and the Passive Bubble

This is something Michael Burry (from the Big Short[0]) has been worried about for a while.

To summarise this, if passive money dominates, then the price discovery role of stocks is lost. People are no longer looking at the fundamentals of a company but just buying an index of the main stocks. The more passive money that goes into this (probably the single biggest investment trend of 2008-2020), the more stocks rise because of inflows, not fundamentals.

As ETF’s capture more and more of the market, and not just in market cap weighted ways, but equal weighted, or factor weighted, or a million other ways you can create a passive fund, then this could create problems that Burry is worried about. Let’s just use an example of S&P500 equal weighted funds, where 0.2% of the fund is held in each stock in the S&P500. Right now the smallest S&P500 company is Coty, which at a $3bn market cap accounts for 0.004% of the index (Microsoft is the largest at 6%). With an equal weighted fund, this means we are over-indexing on Coty by a factor of 50. These sorts of funds can therefore have a very disproportionate effect on smaller companies, buying or selling not because of news related to the company, but inflows and outflows of money into the funds. At the extreme end, if equal weighted S&P funds ever had assets of $1.5 trillion (highly unlikely) it would lead to the ridiculous situation where they would have to buy all of Coty just to give it a 0.2% weighting.

And on the other side, if there are outflows for any number of reason, then passive funds forced to sell could lead to huge falls in the companies. From the Bloomberg article above, this is how Burry describes the liquidity risk:

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. The theater keeps getting more crowded, but the exit door is the same as it always was.

That is the bear case, now for the counterpoints:

Not a bubble?

Arguably February and early March was the biggest stress test possible for this thesis, and after a shaky start, markets didn’t get into a cycle of falling lower and lower, but stabilised and then eventually rose to a few percentage points of their all time highs. If a global pandemic couldn’t trigger the selling wave that Burry fears, then what could?

Another reason not to worry is that the rise of passive investing has been a good thing for pretty much everyone. Individual investors can just buy an index fund and not worry whether there stocks will do better or worse. We are at roughly 50% passive right now, and as this FT article notes, this has been a good thing for consumers, paying less in fees for the same or more in performance than the active managers have been able to muster themselves.

Finally, hedge funds still control trillions of dollars themselves and are the most active investors there are. While they are painting themselves as the minnows in this argument, they still have the ability to move prices around. More passive money should make the market less competitive and thus easier for them to add alpha. Like many things, investing is moving to a barbell approach, where you have lots of money on the pure passive side, and then lots of money on the pure active side (hedge funds). Those in the middle lose out, but as pointed out above, the index huggers weren’t adding a lot of value to start with.

Conclusion

So while Tesla rising like crazy this week might be signs that Burry is onto something with the passive bubble, the bear case he fears never materialised at the height of COVID-19. Probably the best way to conclude this is that like seemingly everything else it does, Tesla is the exception rather than the rule.

Elon Musk Laughing Blank Template - Imgflip

Footnotes

[0] Even at $700 after Musk said Tesla was overvalued, it is still way above the $420 “funding secured” debacle in summer 2018, my all time favourite investment story.

[1] My favourite scene from the Big Short film, and how every bearish investor has felt since March

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