The Index Fund Bubble - What They ARE NOT Telling You!

Welcome back to the Graham Stephens show. We got to talk about this because it's getting out of control. I'm talking about an index fund bubble. This for the last few years has been making its way around the internet because people are saying that index funds are in a bubble because people are just generically buying them because index funds are good. Individual stock picking is bad because so many people are just buying broad index funds without any care in the world as to what's within them. The index funds themselves are going up in value faster than the underlying stocks that you're buying. And if that sounds confusing, I want to talk about this video here. It's called the truth about the index fund bubble. Is your money in danger by the money guy show? So with that said, I'm going to link to their information down below in the description, along with their sponsor, Function Health, who we'll talk about a little later. But now with that said, let's begin. In 2019, Michael Burry, who was played by Christian Bale in the big short, claimed that index funds were in a bubble with prices exceeding their underlying value. But now in 2025, with years of additional market data available, we can re-evaluate whether these predictions have materialized and if they should concern everyday investors who are trying to build their financial futures, just like you. Here's the thing. With the mortgage crisis, what they were doing is that they were packaging these really bad loans. I'm talking about the loans that they just gave people off the street because they could make the dollar payment up front. But then like a year down the line, they'd have a balloon payment of like $100,000 and people were hoping that, oh, by the time I have to pay back that loan, my house is going to be worth so much more money. And then I could just refinance my house to pay back that $100,000 and then I can make even more money. But those loans were being bundled together. They were being sold off to investors as investors were buying them, thinking that they were buying like grade A quality stuff, when in reality, they're just buying horse manure. That's what they were doing. All those loans blew up. It came back on the banks and housing prices really fell by about 50%. So the comparison that Michael Burry is saying is that the same thing is happening now, but within index funds. And we'll continue because I do have some disagreements with this. And by the way, make sure to hit the like button and subscribe. I forgot to ask that earlier. You know what? It's really, I hate having to ask for it. It sucks. But every time I do, I look at the analytics and I see that just mentioning it drives likes by like 50%. It increases subscriber growth by sometimes more than a hundred percent. It's dumb. I get it. But just me mentioning it helps the metrics. And by helping the metrics, this video goes out to an even bigger audience and it helps the algorithm. So that's the way YouTube works. Unlike actively managed funds where managers try to beat the market by picking winners, index funds simply track the index. They are passively managed. This results in lower fees, better diversification and a more hands-off approach to investing. Here's the thing. Index funds so far have been phenomenal. I mean, if you want to go and invest in the stock market, you don't really have to go and pick individual stocks yourself because chances are you're going to lose money. Most actively managed funds, in fact, it's something like 97% of actively managed funds underperformed the market over a period of about 20 years. Now, here's the thing. In the short term, you could have some people that get insanely lucky or you have people that just correctly time the market. They buy the right stocks at the right times. They are correct. The issue is that when the market corrects and goes down in price, a lot of those people get wiped out or they just don't do as well as the overall market over the long run. So yeah, in spans of like three to five years, maybe three to 10 years, you can have some people who are just phenomenal stock pickers. But yeah, for most people who aren't spending 12 hours a day researching the markets. Index funds are the way to go. You just ride the market as a whole. And with something like the S&P 500, it's automatically weighted so that the best companies have the biggest exposure. And as a result of that, you get most of the gain. That's how it's worked so far. This is where Michael Burry sees a problem. He predicted that index investing was obscuring something known as price discovery and that as passive index investing increased, more and more investors would be buying investments based on what was essentially brand recognition. This process would cause the price of various index investments to increase beyond the true intrinsic value of the holdings that comprise them. So this is really interesting. I actually did a whole video on this years ago, and I did an analysis to see how much does the stock go up in price just from being added to the S&P 500? Because the thinking is that if a stock gets added to the S&P 500, automatically all these funds have to go in and buy that stock. If they're tracking the S&P and therefore the stock price is going to go up purely because it's in the index and people are forced to buy it. The reality is that most of the gain that a stock gets is from the announcement of going into the index and not actually being added to the index. Right. It's all priced in almost immediately. And then the funny thing is after about a few months, really, the price goes down to where it was before being added to the index. And it found overall that being added to an index has almost no effect whatsoever to the underlying stock, even though people are going and buying it. Now, the reason why is because the S&P 500 is weighted by market cap. So you have really the top 10 companies that currently make up about 40 percent of the entire index. And then the other companies, the other 490 companies make up the other 60 percent. So when a company is added, let's say it slots is like number 150 on the list. Even then, it's only a fraction, a tiny fraction of money flowing into the stock. And that's not really enough to move the price. Both tranching and overly generous credit ratings obscure their true risk. Although, you know what? Before we go into that, this is a really good reminder that it's not only good just to optimize for financial well-being, but also your health. And this is me being real here. I've always been the type to avoid doctor's appointments. I just don't like the hassle. I don't like scheduling them. But a few months ago, Function Health reached out to sponsor one of my videos. And I thought, you know what? This is a good opportunity to check two things off the box. I could do a sponsor and I could also get my biomarkers checked. And no joke, I did it. And it was absolutely life changing. This test uncovered so much that I had no idea was even going on. And my doctors didn't even bother testing for any of this. Like, as it turned out, I had genetically high cholesterol. I was overtraining and under eating, contributing to a thyroid off balance. And Function Health gave me a clear plan to fix the areas that were out of range. Like, if you're curious, every day I now take magnesium, omega-3 fish oils, vitamin D and zinc. And I've been a lot more consistent with my sleep, stress management, training and eating the right amounts throughout the day. And no joke, I feel completely different. I have more energy. I am more focused. I work better. And none of that would have been possible without the sponsor, Function Health. And if you're interested, Function Health allows you to test over 100 biomarkers covering everything from heart and hormones to toxins, inflammation and stress. That is why top health leaders like Dr. Mark Hyman, Dr. Andrew Huberman and Dr. Jeremy London are all behind Function Health. Lab visits are also quick and easy at more than 2,000 locations across the United States. And the cost is just $499 a year or $1.37 a day for tests that would often be over $10,000 if you wanted to do them on your own. At the end of the day, whether it's money or your body, you can't improve what you don't measure. So if you want to see exactly what's going on, click the link down below in the description to sign up or use the QR code on the screen and make sure to use the code GRAM100 because the first 1,000 people who sign up get $100 credited towards their membership. So again, that link is down below. Thank you so much. And now let's get back to the video. See, here's the thing. That's exactly what I described earlier, but it could be the same thing today. I hate to say it. I'm going to get torn to shred in the comment. AI, okay? They're all investing in each other. It's like I'm giving Joe $100 who's giving Tom $100 who's giving me $100. And then I could report $100 of revenue. The other guy could report $100 of revenue. And we all report revenue, even though it's from the same $100. I just think with AI, I'm scratching his back. He's scratching my back. He's scratching that person's back. It's just, it's too circular, okay? And I think that that can only go on for so long until eventually just demand's not going to meet that. Now, the hope is that AI is just going to be so revolutionary that it's going to take over and continue doing well. And listen, AI is fantastic. I use it on a daily basis and I'm never going to go back. But the thing is, how much is that going to cost? How much does that make me? Right now, I believe ChatGBT is still operating on a loss. So it's like, it's a good deal for you guys because we could pay 20 bucks a month for ChatGBT, but like every search query is costing them on the backend, like a few dollars. So you could just rack up hundreds of dollars, if not thousands of dollars a month to these companies and you're paying 20 bucks a month. So that's only sustainable until they either just make a crap ton of money, have a huge application down the line, which I think they will. But I just, the valuations today just don't make sense to me. It just, it is what it is. It's just like, you could math it out. It just doesn't make sense. But we'll continue. Let's look at Barry's broader argument. Is it possible that the unprecedented rise in index fund popularity is somehow distorting market prices through reduced price discovery? No, that's a short answer. It's just an immediate no. The reason why is because if you have passive investing like this, inevitably, if there is price discovery, which just means the underlying companies are worth less or are, you know, it could also be worth more, but in this case, worth less than what you're paying for the index fund. You know what? It sounds confusing. Let me just back up for a moment. Okay. Let's say the basket, the index fund in here, all the companies combined are trading at $100. If you were to piece them out individually, you have a hundred dollars, but the price of this whole thing, if you buy the bundle is $110, that means you're paying a $10 premium to go and buy this fund here. Whereas the underlying companies are less than that. Okay. At a hundred dollars. So that's what Michael Burry is saying. If that were to happen, all it takes is one person to realize, wait a second, what's in here is worth less than the price for the whole thing. Therefore I can go in and pick and choose and do this and do that and make money. Eventually someone is going to come in, see the price discovery, see the variations and find a way to make money on it. That's what everyone does. Always. If people are passive investing, there's going to be someone else who says, I find an inefficiency there and I'm going to go in and make money off it. That's what ends up happening. And so I just think the market is efficient enough where if there is something to exploit, someone will exploit it. Trading volume is still dominated by active investment. The most recent analysis of this phenomenon came from BlackRock and they found that for every $1 of passive investment trading, active investors traded $22. That's true. And here's the thing too. Even if you wind up overpaying a little bit, okay. Realistically, it's not that big of a deal. And in the longterm, it balances out because there are going to be times where that fund is oversold, where the price is a little bit less and you get a deal. Over the longterm, it's just going to balance out. It really doesn't matter. But what if index funds did come to dominate not only asset ownership, but also trading activity? Might we be in trouble then? Well, to answer that, we need to look at something called the Grossman-Stieglitz Paradox. It's an economic theory that says markets can never be perfectly efficient. A perfectly efficient market eliminates price discovery, which would then create an imbalance between price and value. At that point, the market becomes inefficient again and re-attracts active investors to buy and sell to affect the price. That's exactly it. There's always going to be someone who thinks that they could outperform the market and a very small percentage will. That's just the reality of it. So otherwise, index funds for most people, I think are great. The problem I see that's happening right now is that people think index funds are the best way to diversify. When in reality, 40% of your money goes into the top 10 companies. This is the highest amount pretty much ever recorded in history. And all of those companies are pretty much reliant to some degree on artificial intelligence. So when you're investing $10 in an index fund, you're saying, oh, wow, this is great. I'm getting good diversification right now. Not really. Because again, 40% of that money is very reliant on artificial intelligence. That's the biggest risk right now. You're also seeing a surge in what's called leveraged ETFs because people have this mindset now that the market moves up long term. And so if the market always moves up by an average of, let's say, 12%, why wouldn't I just get a 2x leveraged ETF? And instead of making 12%, after fees and everything, I'm making 20% a year. That's even better. I could speed up my timeline by double. The problem with that is that I think it's going to attract a lot of money. But when the market corrects, that 10% to 20% loss is going to be a 20% to 40% loss. People are going to get wiped the F out. It is going to cause a massive sell-off. We're going to see huge losses in the market if it's propped up by leverage because a lot of those people are just going to get liquidated. So that's the biggest risk I see here is that a bigger portion of the market is done on leverage. More people than ever are on margin. People are expecting the market's going to continue going up. They are buying 2x to 3x leveraged ETFs, just expecting that that's going to make them more money. Sure, in the short term, it'll work. But once things turn, oh my gosh, we are going to see massive sell-offs because it's inevitable. It will happen at some point. The evidence suggests the diversified low-cost index fund strategy likely remains sound. No dramatic change is needed. Index investing lets you ride out the market cycles, smoothing the ups and downs on your way to your long-term wealth. So here's what I say, okay? As some dude making videos in a half-converted garage, I have no true financial qualifications other than just spending a lot of time on the internet. It's like this is my special interest. I do worry that the AI bubble, whatever you want to call it, I think we're pulling forward, I think we're trading at futures prices today. That worries me a little bit. I'm still dollar-cost averaging into the market, but I want people to be aware that when you're buying the S&P 500, you are getting less diversification than you were five years ago. As a result of that, I think it's very important to know that, number one, but then to also diversify outside of just the S&P 500 and the United States. For me, that means the S&P 500 a little bit. It means international stocks. It means emerging markets. It means a little bit of some tax-free muni bonds. It means a little Bitcoin ETF. And then if you do all of that and you have the right allocations for your risk profile, then you're going to be a little bit more insulated if the market were to correct in the future, or it might not, okay? I could also just be totally wrong and AI is just, it's going to 20X from here. I don't know what I'm talking about. So let me know your thoughts down below in the comments. I will do my best to read and reply to as many of you as I can. Don't forget to hit the like button, subscribe, check out Function Health, by the way. They are truly awesome. My wife, Macy, she just did her own tests and we're going to get the results really soon and see what that comes back at. So I would highly recommend them, genuinely. So thank you so much. And until next time.