“The Big Short” investor Michael Burry, who successfully bet against subprime CDOs before the financial crisis, now says another trend is signaling a financial meltdown, per a detailed Bloomberg report. 

The investor, whose story was made into an Oscar winning film and best-selling book, now oversees about $340 million at Cupertino, Calif.-based Scion Asset Management. One issue of major concern for Burry in the current environment is the flood of money moving into passive index funds, holding an estimated $4.3 trillion in assets. Burry argues that the popularity of passive investment strategies could bring about a similar event as the massive pre-2008 bubble, which was the result of a crash in rotten securities known as collateralized debt obligations (CDOs)

Passive Investing 'Distorting' Price of Stocks and Bonds

While investors' full-scale move into passive funds and ETFs is seen as less risky than placing money in actively managed funds, Burry says index fund inflows are now distorting prices for the stocks and bonds that they are designed to track. He draws parallels to how a surge in CDO purchases distorted subprime mortgages preceding the last major market crash. 

“Passive investing has removed price discovery from the equity markets,” he said. “The simple theses and the models that get people into sectors, factors, indexes, or ETFs and mutual funds mimicking those strategies -- these do not require the security-level analysis that is required for true price discovery.”

Just like funds were quickly pulled out of the system over a decade ago, the investors expects major outflows from passive investing, yet did not offer a time frame. He is certain, however, that “it will be ugly.” 

“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,” added Burry. 

This comes as passive investing funds have nearly caught up with those managed by active equity funds in the U.S. stock market, at $4.305 trillion as of April 30, versus $4.311, per Quartz. “The trend toward low-cost fund investing has gained momentum,” explains Morningstar analyst Kevin McDevitt. 

What’s Next? 

“Like most bubbles, the longer it goes on, the worse the crash will be,” Burry told Bloomberg in a detailed interview.

He recommends investors look at small-cap value stocks, since they are typically under-represented in passive funds. In particular, he likes technology and technology components companies, indicating that he is a “big believer in the continued growth and remote and virtual technologies.”