Although the Thrift Savings Plan has been around since the 1980s, Index funds – like the TSP’s F,C, S, and I funds – have grown fivefold since the financial crisis according to The Financial Times.
This is worrying to many investors because of their potential impact on markets. The latest to signal his concern is Michael Burry, a fund manager best known through the movie “The Big Short”.
As a response to his criticism of index funds, Lyn Alden wrote an article Famous Investor Calls Index Funds Including the TSP a Bubble, but is it True? for FedSmith.com.
Respectively, I feel she failed to fully explain the concerns that Mr. Burry expresses over index funds, and I believe she understates the dangers inherent in current TSP funding options.
The issues
In email responses that Mr. Burry gave to questions from Bloomberg, he made the point that:
“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.”
“This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.”
What does he mean?
Price-setting
When you put your money into something like the C, S, or I funds, that fund then buys stocks in proportion to the index used as the benchmark for that fund. If Microsoft represents 4.3% of the index used as a benchmark for the C fund and Apple represents 3.7% of the index, then that is where your money goes.
Who decides how much each stock represents in the index? It is based on market capitalization, so as more money pours into the index, market capitalization grows.
Back in, say, 1990, when the C fund was young, there were lots of other investors, such as actively managed mutual funds, that were also making judgments about Microsoft, so the C fund had essentially a free ride. Fund participants could depend on analysts and others to be making judgments about Microsoft stock and affecting the company’s market capitalization by their buying and selling of shares.
The analysts weren’t always right individually, but collectively they set the value of a stock. Participants in the C fund (or S or I fund) could essentially trust those other market participants to create a fair valuation for any given stock. Analysts would consider both large and small stocks and buy and sell accordingly. The C fund participants had a free ride in that they could benefit from others’ research.
Over time, index funds have become so popular that they dominate buying and selling decisions. The people who still do perform analysis of individual securities have less impact on the price of a stock than the index based on the stock’s market capitalization.
With indexes all driving money into the larger stocks, there is relatively less funds going towards smaller companies that may have more value. Everyone buying indexes using the same benchmark (such as the S&P 500 for the C fund) are buying the same large-cap stocks without conducting analysis of the product and overlooking smaller cap stocks.
Lyn Alden is right that the S&P 500 has always been over-weighted towards some companies, but as an individual stock investor, I don’t have to buy the largest companies. I can choose my own diversification, but of course I cannot buy individual stocks using my TSP funds, and if I buy an index I have no decision-making at all except as to which index I want to buy.
The same is true for bonds and the F fund.
Liquidity Risk
“Trillions of dollars in assets globally are indexed to these stocks,” Burry said. “The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”
Mr. Burry is concerned that in the event of a downturn in the market, everyone will sell at the same time and drive prices too low because they are all invested in the same companies, as represented by indexes that mimic each other.
Think of it like a ballgame. People go to the ballpark at different times. Some get there early while others arrive later. After the game, everyone leaves at the same time and traffic jams result.
With index funds, when the market is rising, as it has been since the beginning of 2019, people flow into the index funds at different times. But if the market suddenly turns down violently for any reason, lots of people holding the same stocks in similar indexes will rush to sell those indexes. In turn, the indexes will need to sell the same underlying stocks as all the other index holders regardless of price. The result is a breakdown in the system. Everyone becomes a seller and no one is a buyer.
Beyond these concerns, I take issue with Ms. Alden’s summary statement where she says “and there’s always the option of using other accounts for further diversification for those that desire to do so. “
The whole point of the TSP is to allow participants to build their retirement funds within this investment vehicle.
Yes, you can and should have an IRA and a Roth IRA outside TSP, but suggesting that you should not maximize your TSP contributions is foolish. For many current and former federal employees, TSP is their main retirement vehicle, and participants have a right to believe that TSP should be able to meet their needs.
I have made the point before on FedSmith.com that the current TSP investment options are too limited.
More options, despite increased administrative costs, would encourage younger Federal employees to invest more with the TSP and that would help both them and the plan. No one should be forced to go outside TSP to fund their retirement.
