Famous Investor Calls Index Funds Including the TSP a Bubble, but is it True?

Recent claims have said that index funds might be the next investment bubble. Should federal employees be worried?

Although no investment platform is perfect, the Thrift Savings Plan remains one of the most elegantly simple and cost-efficient investment platforms in the world compared to most alternatives. And as feedback pours in over the years, they improve some of the shortcomings, like the new upgrade to withdraw options

However, the model does have some detractors. 

Readers that have seen the acclaimed movie, The Big Short, might remember Christian Bale’s character, as he played a version of the real-life fund manager Michael Burry who shorted the housing market at the top of the 2007 subprime mortgage bubble and made a ton of money for himself and his clients. 

Well, the real-life Burry recently came out with a big claim that index funds are possibly the next bubble, due to overvaluation and a mismatch of liquidity. It was reported by Bloomberg and then re-reported and discussed throughout the financial media this month. 

All funds within the Thrift Savings Plan except the G Fund are index funds, so should federal employees be concerned? This article takes a look at the details. 

Index Fund Bubble Claims

Burry is the most recent in a long string of famous investors that have argued against the proliferation of index funds. Ever since index funds were created by Vanguard in the 1970’s, active fund managers who charge high fees have been critical of their lower-cost automated competitors, and for good reason. In the decades since they were invented, index funds have developed a strong track record of outperformance (due to lower fees) and have taken market share from high fee actively-managed mutual funds that fail to beat the benchmark. 

A small minority of skilled fund managers have been able to outperform passive investments, but they have been the exception rather than the rule. For the most part, investing is a zero-sum game compared to a benchmark, like the S&P 500, and active managers as a whole roughly match the benchmark before fees. After typical fees up to 1% per year or more are factored out, most of them underperform. 

Many 401(k) plans in the United States, including many contractors working within federal agencies, are still performed by high-fee actively-managed mutual funds that fail to outperform low-cost index funds.  

Fees of 1% per year may seem insignificant, but compounding your money at 8% per year for 40 years grows your investment by over 21 times the original sum, while compounding at only 7% per year for the same period results in less than a 15-fold increase. When hundreds of thousands of dollars in contributions are added over decades, fees make a big difference. 

However, as index funds make up a larger and larger portion of U.S. financial assets, criticisms from Burry and others are worth consideration. Burry’s argument against index funds focuses on two primary issues: potential overvaluation and liquidity mismatches. 

Potential Overvaluation

Most index funds, including the TSP funds, are weighted by market capitalization, which means they put more weight into the largest and highest-priced companies. For example, both Apple and American Express are part of the C Fund, but because Apple’s market capitalization is about 10x larger, its weighting in the C Fund is also about 10x larger. 

Burry’s concern is that if trillions of dollars flow automatically into index funds without enough analysis of the individual stocks, it could overweight the biggest companies and cause them to become overvalued. In particular, Burry thinks that large-cap growth stocks are generally overvalued and small-cap value stocks are potential bargains in the current financial environment. 

This is a valid concern to some extent, but has occurred throughout stock market history even before index funds became popular. In 1929, the U.S. stock market reached such a high peak that after the subsequent market crash and Great Depression, it took 27 years to reach new market highs in inflation-adjusted terms. Similarly, the market took 24 years to reach new inflation-adjusted highs after the 1968 market peak, and 14 years to reach new inflation-adjusted highs after the 2000 peak. 

The main defense against this risk is diversification. The TSP Lifecycle funds, for example, hold U.S. stocks, foreign stocks, and bonds, and automatically rebalance themselves, which helps them avoid concentrating too heavily in areas of capital concentration. 

In addition, many TSP investors have an IRA or other accounts, and can complement their TSP with other investments or asset classes like factors, real estate investment trusts, precious metals, emerging markets, and more. For example, there are many exchange-traded funds that let investors emphasize a specific area. The SPDR S&P 600 Small Cap Value ETF (ticker: SLYV), for example, lets investors allocate specifically towards small cap value stocks.     

Liquidity Mismatches

Burry’s second big claim is that there is a mismatch in liquidity (trading volume) between the funds and the underlying stocks. Many stocks only have a few million dollars in typical daily trading volume, but there are trillions of dollars invested in index funds that hold those stocks. If a massive number of investors sell their index funds at the same time (due to algorithmic trading, or TSP investors all deciding to shift towards something like the G Fund during a market decline, as some examples), it could cause a situation where sellers dramatically outnumber buyers for some of the less-liquid stocks in the fund, which could then result in big gap down in pricing. 

This is a reasonable concern. The most notable historical example is that the S&P 500 lost over 22% of its value in a single day in October 1987 due to liquidity and valuation issues happening at once, but it wasn’t tied to index funds back then. 

The good news is that there are stock market exchange safeguards to mitigate potential liquidity-driven price issues like that, ever since the 1987 fiasco. If stocks fall 5% or 10%, for example, most of them trigger a “circuit breaker” that temporarily halts trading. This gives fund managers time to figure out what’s going on, and for dip-buyers to potentially step in. 

Plus, TSP investors often have other accounts which they can use to diversify if they wish. For example, I have always used a blended approach of index funds and some individual stocks within my various accounts, because I like to know some of the details of what I own and to pick some potential bargains from stocks that index funds haven’t favored. Each investor has a different level of interest and time commitment that they are willing to spend on their investment accounts. 

Final Thoughts

The Thrift Savings Plan provides investors with a formidable set of index funds to build a relatively diverse portfolio, including large and small U.S. companies, foreign companies, bonds, and special G Fund Treasury securities. While this might not cover quite all asset classes, it historically does a good job for investors, and there’s always the option of using other accounts for further diversification for those that desire to do so. 

About the Author

Lyn Alden is an investment researcher with a background that blends engineering and finance. Her work has been featured on Forbes, Business Insider, Kiplinger, and other media. She has a master’s in engineering management with a focus on engineering economics.