Do physical ETFs possess the same problems as CDOs?

Question

Today Michael Burry explained to Bloomberg that ETFs are comparible to subprime CDOs, in that investors are buying securities that aren't backed by any real value:

Passive investing has removed price discovery from the equity markets...

... 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.

The S&P 500 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.

-> Michael Burry (https://www.bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos)

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My question is: does this apply to physical ETFs (e.g. iShares CSPX) or is Burry only refering to synthetic ETFs and other derivatives?

Answer 1

Yes, I believe Burry's concern applies to physical ETFs as well as synthetic. The increasing popularity of passive investing via index-tracking funds means - according to Burry - that companies that form part of an index are inherently overvalued, relative to smaller companies that are not part of a major index. Consider for example the NASDAQ-100 index, which is weighted by market capitalization so that MSFT, AAPL and AMZN alone comprise 30% of the index. As money flows into index-linked funds (such as QQQ) that track this index, the fund manager necessarily invest proportionately in these companies regardless of their inherent value.

Answer 2

My question is: does this apply to physical ETFs (e.g. iShares CSPX) or is Burry only referring to synthetic ETFs and other derivatives?

Metaphorically, he means all the ETFs and derivatives.

Nevertheless, I think Michael Burry simply exaggerate the topic by using the subprime-CDO metaphor.

CDO is a derivative that hides the risks with complicated structure and it is NOT a zero sum game. In fact, subprime CDO doesn't much value, because it is targeting people that are not afford to buy a house, and it also creates a property bubble, which potentially thanks to the popularity of Robert Kiyosaki "Rich dad, poor dad". That is bubbles price in one.

On the other hand, the index fund is based on the stock, and stock trading is a zero-sum game. Unlike CDO, Index stock will never fall indefinitely and it is difficult to hide a huge amount of non-collateral leverage on index stock speculation.

Ironically, for the serious investor, subprime-CDO is bad, but the stock bubble is good. Overpriced stock means there are lots of people speculating on the stock. When the bubble burst and causing panic sells, the patient investor will come in and scoop them up.