> I'd have a hard time believing some niche hedge fund somewhere wouldn't make a killing off this by providing liquidity.

Typically the opportunists here would be stat-arb hedge funds. They bread and butter of their strategy is to isolate the non-explainable ("idiosyncratic") movement in single name stocks, then bet on that factor mean-reverting.

E.g. if Microsoft goes down 0.5%, but the market's up 1%, and the tech stocks are up 1.2%, and various other factors that move Microsoft don't explain it being down. Then they'll bet that the movement is driven by random noise, and buy Microsoft, betting that it will re-converge with where it's expected to be. They'll also use various techniques to isolate whether idiosyncratic movements are likely driven by company specific factors or market noise. Like NLP on a newsfeed to look to see if there are any breaking stories, or tracking recent analyst revisions on the stock.

Suffice to say that stat-arb funds in this day and age are very very good at this. In a liquidity unwind event, the signals stat-arb traders use would absolutely be lighting up. The biggest question would be whether stat-arb funds in aggregate have enough capital to counter the absolutely humongous flows that a potential index fund unwinding would release.

Another complicating wrinkle is that most stat-arb desks are no longer independent hedge funds, but units within larger multi-strategy funds (like Two Sigma or Millennium). There's good and bad. The good is that if there's all of a sudden massive opportunity the multi-strat fund can quickly reallocate more capital to the stat-arb desk.

The bad part is that stat-arb desks may be unwound due to arbitrary contagion in other parts of the market. If the multi-strat fund sees a big loss in another unit, it may pull capital from the stat-arb desk to meet margin calls or redemptions. For example this happened in August 2007 [0]. The subprime mortgage market blew up, then all of a sudden a bunch of esoteric stocks started behaving crazy for the next weeks. And that was largely because multistrat funds were pulling capital to meet margin calls on their mortgage portfolio.

[0] http://web.mit.edu/Alo/www/Papers/august07.pdf

The "smart money" would start buying, but I imagine the concern is that as passive instruments become the majority of the market, there wouldn't be a deep enough pool of assets held by "smart money" to provide offsetting liquidity in the way you describe.

No, I think in such a scenario active investors would wind up getting just as whalloped as passive investors. By definition active investors in aggregate have the same average exposure as cap-weighted indexers to any given stock.

Arguably, after the crash they might be able to take advantage of the opportunity. If they concentrate into the stocks with the biggest price displacements, then as those stocks return to normal, they may make up some or all of their initial losses. Passive indexers can't do this, because they don't have the mandate to deviate from their pre-defined allocations.

But I think the broader issue is that excessive amounts of indexing present potential systematic risks for everybody. Burry's hypothesis is more relevant for policymakers than it is for investors.

As an individual, long-term buy-and-hold investor, low-cost index funds are without question the best option for investing. The problem is behavior that's rational on an individual level, may produce irrational results at the collective level.

When I actively managed money for mutual funds, we had limits on both total % ownership and how many days of volume we could own. We were small cap growth, so sometimes we could be stopped from owning as much of a company as we wanted because it was too illquid. Passive doesn't care - it buys what it needs to replicate the returns of the underlying. Also, it's well known that if a hedge fund (or mutual fund) is in trouble, they sell more of what they CAN rather than what they want. That's one reason why we always knew who else owned the stocks we did. Index funds have no leeway here. They need to sell - whether there is liquidity available or not. My gut is, there will be much less liquidity available during the next crisis than you'd expect. A lot of "non passive" investment is quant driven, which ends up becoming very homogenous in nature across different firms. Many also have momentum factors in play, where they buy short term positive momentum and sell the reverse. Once again,vthey don't have a lot of leeway for humans to say "this market is different".

Average Daily Volume

yes, possibly. but i think that may feed back into some weirdness for the index funds

"i'm supposed to sell 500m of this small stock but i only got to sell 300m before it was frozen out...now my basket of holdings is slightly off from the actual index...hopefully i can rectify it tomorrow..."