[Music] this is the rational reminder podcast a weekly reality check on sensible investing and financial decision-making from two Canadians we hosted by me Benjamin Felix and Cameron Passmore portfolio managers at pwl Capital welcome to episode 302 and today we have a very interesting and thought-provoking philosophical as well Guest someone that both you and I have followed for a long time on Twitter it's Michael Green uh online he's known on Twitter at least as Prof Plum 99 Mike is a chief strategist at simplify Asset Management he's a prolific researcher and writer and this is a uh
incredibly thought-provoking uh alarming for good reason and I think this is a an important topic for us to understand as best we can but it's so Interesting so Ben why don't you give a bit of the backstory because as as Mike said get this we're possibly setting ourselves up for the worst Financial experience of all time there's all kinds of caveats to that but if you just accept that as the point of the conversation and try to understand it it is absolutely fascinating yep so M Mike someone that I've been peripherally aware of for years
because he's written a lot and Speaks a lot about index funds causing some real big fundamental problems in financial markets and because we often talk about index funds being a good thing I often been sent to stuff like you should have you seen Mike green stuff have you seen Mike green stuff and so I didn't really take the time to dig into it until about a year ago uh started Ed reading his his writing more seriously listening to him on other podcasts watching the presentations that He' done and really started to to get it to
get what he's talking about as as the problem um and it's important to say that he's not saying you know this collapse is coming you know it's not it's not a doomsday proposition it's just structurally these are the problems that are being created in financial markets right now there's a chance we get a really bad out come that could be could be disastrous maybe not not a necessarily a prediction that it's going To happen tomorrow but in terms of the distribution of outcomes Mike Mike thinks that there's some bad stuff that could happen based on
the way financial markets are working right now largely due to the growth in uh in index funds so we wanted to make this episode a place where people could listen once because it took me a while to really get what Mike was talking about so we wanted to make this a place where people could listen once get the Issues get the arguments see where Mike is coming from and I you know I think he has I think he raises a lot of really interesting points and uh he's brilliant to talk to like he just speaking
with him is keeping up is uh is something but the solution is so difficult and so politically challenging because the narrative run index funds is so powerful so that this is this is the thing that I find really difficult to think about is that Mike is Raising potentially valid issues and articulating them very clearly yes and so you take it all in and it's like okay there's there's potentially a real problem here what do we do about it and we talked about this with Mike during the episode for the average investor investing in you know
Vanguard funds nothing you keep investing in index funds it's a it's a individually there's nothing anyone can do other than maybe exercise their Democratic power I guess um but even then like like you said Cameron no politicians going to run on a platform of shutting down index funds it would be a disaster for that politician so there's this potential problem where index funds are growing making financial markets more fragile but in investors should still continue investing in index funds potentially even more so because as Mike talks about in the conversation it Actually gets harder for
managers to beat the market yep as index funds grow yep um but at some point as Mike says the adults in the room someone someone has to do something or the fragility of markets could cause a real bad outcome for a lot of people and again Mike's not saying you know that's going to happen tomorrow he says during the conversation that um this problem the the inelasticity of markets due to index funds could drive valuations up way Higher than they are now so it's basically a matter of like at the individual level you shouldn't do
anything about this you don't go and start investing in actively managed funds because of the problem I describing you keep investing in index funds and if you want to beat the market you leave her up because you can't beat it other than uh other than by increasing your your beta and then it's Like someone has to fix this eventually but it may not even be in our lifetimes that the bad outcome actually happens so I don't know I mean philosophically it's a very hard thing to think about and I think Mike did a great job
laying out the the issues that he sees and and the arguments and how he arrived there but in terms of what to do and Mike does he gave us a a slide deck that we can reference that's on slide uh what did he say slide 32 in the deck um That people can see some of his kind of policy recommendations on where do we where do we go with this but it's not and I think Mike would agree it's not easy to fix um anyway so people can listen to this episode hear hear Mike R's
arguments on the problems that index funds may be causing in financial markets and what people should do about it which at the individual level is not much which is not what you expect when You hear them describe the issues all right pretty good setup with that let's go to our conversation with Michael Green Mike Green welcome to the rational reminder podcast thank you for having me Ben super excited to be talking to you all right so can can you explain Mike what effect do you think the growth of indexing is having on financial markets so
what you've done is you've increased the proportion of markets that are true the proportion of Market participants That are truly valuation insensitive right or Price insensitive is another way to think about it and as a result what you've done is you've actually increased the inelasticity of the market the ability for prices to change in response to relatively small changes in supply and demand that's really the primary Dynamic you removed that historical filter in which investors would react to higher prices by saying all else equal the information content That I've now received is that future returns
will be lower therefore I'm more willing to sell for Passive investors you actually receive the opposite signal as the price goes higher relative to other Securities it becomes relatively more attractive it's presumed that there's information content there and as a result you actually allocate more Capital to those names that have gone up the most so what does the ultimate bad Outcome for this issue look like well unfortunately the way this plays out is is that it looks like things are getting better and better and better and better it's very much like the turkey tor turkey
before Thanksgiving right where it looks like it's most robust where it looks like it's most richly valued where it's looks looks like the opportunity set is greatest is right before actually you end up seeing a net Redemption that plays the whole thing in Reverse right It just makes the market much more fragile in both directions that's really the definition of inelasticity right a market that reacts a a price level that reacts much more violently to small changes in Supply and yeah okay perfect that's what I was going to ask you to clarify so when inflows
are going in that's having an upward effect but when they go down it's going to have an exacerbated downward Effect exactly correct okay can can you talk about the XIV trade that strengthened your belief in this view sure so XIV had a couple of different components to it and I just want to be very cautious and saying it's not a direct analog there's rules around say the S&P 500 or broader market indices that didn't exist for the ux futures for example or for the vix itself um this was another really good example of exactly that
type of dynamic So you had the XIV was an inverse vix ETF in other words every time the vix went down in price it would go up in price um it really was more tied to the carry components associated with the vix curve and so as um forward volatility was priced at a premium because you're selling high and then buying it back low you're riding down that curve so there was a huge positive carry associated with that short volatility position um what was interesting about This was as the price of the vix pushed lower and
lower and lower the XIV price was obviously being pushed higher and higher and higher most people are wired to look at a much higher price and say that represents a good thing that means it's safer that means it's in better shape right things are going better but because it was an inverse product where a 100% decrease in price could occur on a doubling in level that became mechanically easier and easier the lower The vix got in price itself right and really it's more ux Futures the vix Futures as compared to the vix which is not
really a traded instrument but the same underlying Factor remained the same the lower the ux Futures got the higher the XIV became and ironically the easier it became for XIV to go to zero right um now the market mispriced that was the simplest way to put it and so what I recognized was that under the conditions of crowding that had occurred That the potential for a spike in the vix on a relatively small change in the S&P had become magnified and the options pricing failed to take that into account and so really you know the
easiest way to think about it is in mathematical terms the distribution of XIV itself became very bodal right so it wasn't like a normal option which the most likely outcome is something near to its current price it actually turned out that the higher it went in price the Most likely outcome was that it went to zero I actually figured that there was roughly a 95% chance it was going to go to zero over the course of two years and as a result the option pricing should have been modified to reflect that really hard to do
right and so recognizing that mispricing we were able to put a fairly large position on and ultimately you know it ended up playing out the way that I thought it would H okay interesting so so markets become Less elastic because of the index fund issue and that caused xib to be mispriced or to have mispricing effecting its um its performance you saw that traded on it and it worked out worked out well yeah yeah that's the easiest way to put it um there's also like it is important for people to understand that there's always extenuating
factors right so just like I would not say that it was 100% probability that it was going to go to Zero you know there was roughly a 95% chance of the probability of it going to zero and that was being driven by a couple of factors one was the growing Reliance on the market itself to express trades in a short volatility manner right I would actually characterize that as very similar to the growing Reliance on the market that passive investing is quote unquote safe that it's the right choice for most people to make right um
in the aftermath of the global Financial crisis there were regulatory changes around how much Capital you had to hold against different types of Trades and so if you wanted to sell CDs for example in the aftermath of the global financial crisis that was obviously very risky right nobody would sell CDs and so you needed to hold a whole bunch of capital against it if you wanted to express a long Equity position as a Investment Bank right in particular foreign investment Banks you had to hold Relatively High capital Capital positions against set for the very obvious
reason that you know we' just seen equities fall significantly so you wanted to be protected against that potential risk there was a notable Arbitrage that existed in the capital regulations around short volatility is distinct from long equity and the two right you can think about the vix tends to behave inverse to the S&P and so it's actually quite straightforward to hedge A long S&P position with a short vix position right that's a relatively standard and relatively straightforward implementation um the vulker rule components what was called the secar provisions had a huge mismatch between the capital
that was required to be held against the short Vault position and the capital that was required to be held against a long volatility or long Equity position and as a result the street and once again in particular foreign Investment Banks UBS uh uh credit Swiss bank parba Etc gravitated their exposures to expressing trades in short volatility manner right on February 2nd 2018 the FED changed those rules and it dramatically increased the cost of holding short volatility positions and as a result on February 2nd knowing my positioning I started getting calls all over the place from
Banks saying hey would you be willing to sell volatility to us and I'm massively long volatility At this point and saying well that's a super interest request first the answer is no right and secondly what is actually going on and that actually is really what caused volmageddon was was a regulatory change that was unexpected and unanticipated that caused a scramble to buy volatility that in turn manifested itself as the start of a spike in the vix complex the ux Futures as those Banks tried to buy back that exposure and then the mechanical Implementation of XIV
kicked in because once you had a large enough move the volume that needed to be rebalanced within the systematic strategies like XIV really my position was expressed on something called svxy those actually took over and the market collapsed under the weight of its own illiquidity wow man crazy stuff uh okay so be beyond that beyond beyond the X uh the x that we just Talked about what other evidence do we have that index funds are causing a problem well when you define a problem right I mean a problem is typically thought of as a bad
outcome but in for the most part so far what we're seeing with indexing is a good problem it's forcing prices upwards it's causing markets to become more richly valued that in turn is leading to perceptions that saving is a great thing people are putting more money into these strategies And that in turn is causing prices to rise even further right so far there's no problem just like XIV represent Ed a magic money printing machine that attracted people into all sorts of investment strategies around short volatility um unfortunately there's a point at which you get so
high again the taleb turkey type framework that a relatively small and seemingly inconsequential event can start to magnify itself in the exact same manner We described with the XIV and so the problem that has occurred or the problem that is beginning to become quite apparent to many people particularly those who are following this very closely is that withdrawals or money coming out of a market is always a function of the asset level right and so as you push values Higher and Higher and Higher and you concentrate the resources in vehicles like the Vanguard Total market
index that carries no cash Whatsoever right it's $ 1.6 trillion doll fund that carries $80 million in cash if an active manager were to come into your office and say we're running a $1.6 trillion fund with $80 million of cash you would throw them out of your office and say don't ever talk to me again that's completely irresponsible right right but we look at that with Vanguard and we're like oh yeah of course this is the safe way for people to invest and so the problem Occurs when people try to take money out when they
try to take that money out Vanguard has no choice but to turn to the market for that liquidity the scale of these entities are now at the size that just like the XIV you could actually cause yourself to exhaust the order book and a crash to commence wow I have a market structure question for you Mike how are market cap weighted index funds different from closet index funds or large institutions With very low tracking ER budgets which have existed you know for a long time yeah so in some ways they're not right but remember that
a closet tracking fund always has the discretion to say yeah no we're not going to do that right and so like one of the Untold Stories of the crash of 87 was that the losses were actually born by um uh the clients of Leland O'Brien Rubenstein which was the firm that developed portfolio insurance so their Rules were very straightforward when prices fall you sell Futures to Delta hedge your underlying exposure right so as prices fell they needed to sell Futures as prices fell more they needed to sell more Futures at one point mark rubenstein's Trader
came to him and said Mark if we make this next sale we will send the market to zero and Mark said don't do it right that discretion is important and it doesn't exist in the passive Vehicles man uh so somewhat similar to that question how do we actually know that markets are getting less elastic over time and and maybe to ask it a slight different way how do we know that index funds have less elastic demand than the whoever the counterfactual security holder was in the absence of index funds well so part of it is
actually answered in your own question right so you just asked me about the Dynamics of what's the difference Between discretionary index trackers and systematic index trackers right by definition somebody is less elastic if they can't change their rules right so we actually know that to be the case now the academic Community has done a tremendous amount of work on this you're familiar with the work of Valentine Hadad for example how competitive is the stock market we've talked through these Dynamics before and they are identifying that the Eon that The market itself has become increasingly inelastic
now I could share with you a couple of slides some of which are actually quite dated one of the interesting things about the presentation that I shared with you is very few of these slides have actually changed in any meaningful way over the years but one of the slides I just draw your attention to is slide 14 which shows you the Market's reaction to fundamental events on earnings reports We're seeing a significantly greater level of price change associated with earnings reports um I have kept this chart in part because I love the description on it
that it's showing against an average something that's clearly trending is being shown against an average as if it's going to somehow mean revert in the future um I don't think that's the case obviously I think that it's becoming less elastic and again I would encourage people to check Out the work of Valentine Hadad which is on slide 15 talking about these underlying dynamics of market capitalization relative to elasticity their tests show that the largest companies those that make up the top of the s&p500 or the NASDAQ 100 paradoxically are the least elastic right and as
they become larger and larger in the index becomes concentrated amongst those names the Indices themselves the markets themselves are becoming significantly less elastic yep yeah I think I can't remember if it's from their paper or from talking with you but the intuitive explanation of that is basically that anyone who cares about tracking relative to an index has to hold those largest stocks so they're going to be less elastic correct that's I mean that is the easiest way to think about it right Is if I buy the S&P 500 theoretically I could statistically sample and say
I don't really need Delta Airlines it's not a very big company it's not going to have a meaningful impact on the index but I have to own Microsoft I have to own Apple I have to own Nvidia right h why are flows into a cap weighted Index Fund different from flows into you know the overall aggregate of active which obviously holds the market well so first of all that's not obviously true right So the second part of your statement that all active managers match all passive managers in aggregate is an untrue statement that's pre that's
predicated on the idea of fully complete markets with no regulation uh that doesn't have requirements around diversification Etc so that's honestly just a a a misframing of the reality um that unfortunately gets repeated over and over and over again right and remember look at some of the most Successful Investments until very recently would be entities like the tiger funds right that were very active in nonpublic equities there's non-public equities There's nonpublic real estate there's non-public companies there's non-public debt right and none of those can actually be represented within the indices and so it's it's really
quite disingenuous to actually use the language of Bill Sharp and say that they just the same thing because they're Not um the second component is is that it's not really so much that you're waiting on the basis of market capitalization although that does have a disconnect and this is again under the academic work of JP bod Who highlights that liquidity does not scale with market capitalization it scales with volume and volatility so market cap is only peripherally related to volume and volatility if I look at the number of shares and quantity of trading for Microsoft
for example relative to Delta Airlines while their Market capitalizations are roughly a hundred times different their trading volumes are only about five times different and that's actually a byproduct of Market structure how trading activity actually occurs if I'm a market maker I have to put Capital up against trades to facilitate those trades the profitability of that capital is determined by the spread between the bid Ask and the quantity of shares that are being traded right if there's only five times as many shares being traded on Microsoft and it has a tighter bid ask spread than
Delta Airlines then it's less profitable for me to put Capital up against Microsoft in proportion to its market capitalization and as a result it actually becomes less liquid or more inelastic is the easiest way to think about it when you try to shove through Trades in the size that you have to for a market cap weighted index it overwhelms and actually causes those names to rise more than they otherwise would would be expected to H yeah really really interesting you you explained it you explained it well um I did I did want to mention we
have uh I was just emailing with Valentine Hadad he's gonna come on to talk about his research later this year which should fantastic I mean Valentine hadad's work Is great there's only one major error that he made which is the Assumption of 15% market share for Passive vehicles and so if you actually properly scale his work on the basis of the far higher share of passive that you can derive from the work of mar Marco salmon and Alex Chinko um again that's you know the the academic Community is starting to rapidly recognize these underlying characteristics
um then you actually come pretty close to the right answers In terms of the impact that it's had it's just you know Valentine didn't do that because he didn't realize how large passive had become yeah interesting the the the Marco salmon paper you're talking about that's where they they measure passive based on trades right yeah so they what Marco sammon and Alex Chinko did this is actually in response to a challenge that I gave them as I was reviewing another of their papers where they had made a Similar uh statement as to Valentine Hadad in
terms of the share of passive they' alluded to it at 15% simply adding together the share of State Street Vanguard Black Rock basically um I challenged them and said no that's wrong and the reason it's wrong is it's missing all of the things like separate accounts that are mimicking right so to a certain extent Cameron's question right so you have separate accounts that mimic you have uh Collective Investment Trust commingled Investment Trust cits I'm sorry I'm blanking on the name of them um that rep you know that that represent a sizable fraction but are not
captured under traditional mutual fund 13fs uh you have individual corporate exposures you have total return swaps you have Futures Etc all of these are ways option trades on the indexes Etc all of these are ways in which indexes must be used at far higher scale so to come back to the point on on The Alex Shinko and Marco samon paper the way they chose to test this was they went and they looked at what fraction of chain of shares had to change hands and were traded on index reconstitution events and so this is the most
restrictive definition of passive index tracking those who trade within the very first day of an index reconstitution their conclusion is the number is somewhere around 35 % hit that hardest definition of passive if you expand it To a five day window it climbs to about 45% passive yeah that's a that's a cool way to cool way to look at the passive share it makes sense like uh well we know it's not 15% right we wouldn't be sitting here talking about it if it was 15% because it's become so omnipresent within the industry so again it's
it's one of these challenges where the entities that are most directly involved the vanguards black rocks Etc are being Very disingenuous in their presentation of information yeah I want to ask more about that later I want to come back real quick to the flows into aggregate active versus passive because I know we we asked our podcast audience what kind of questions they wanted us to ask you um and and this was one that a lot of people said they they really wanted to hear you talk about if we forget about non-public active does that does
that Change anything not sure what that means well you said it was it was disingenuous to ask to to frame it that way because there's lots of assets that are nonpublic and can't be included in an index but if you just look at aggregate active public markets does that not look kind of like passive not really and again it boils down to the regulatory framework so there's something called the 40 act Which I know you're deeply familiar with that governs the amount of diversification that's required within funds um the index providers are largely exempt from
those requirements now due to the effects of lobbying the SEC to obtain exemptions things like the S&P 500 growth fund or even the NASDAQ 100 really at this point are far too concentrated to qualify for what's called Diversified fund status technically they shouldn't even be Bought by anyone other than um uh I'm totally blanking on the term here uh sorry I woke up early and drove all day today um accredited investors right so you know they shouldn't be buying these things but they can buy them with the click of amounts likewise if you want to
flip that around and take it even a step further we're now enabling people who have never obtained a margin account never actually obtained option trading authorization to replicate that type of Experience by using things like triple lever dtfs right so like we we've allowed the markets to become far more risky while pursuing a a a theoretical ideal of complete markets and can I think that we're ultimately going to pay a penalty for it right yeah what what that's that's a we might have this later well whatever I'm gon to ask you now one of the
things that came up when we were talking to our podcast audience about This is like so you just talked about the the penalty are we talking about like is there going to be a bad event where where there's a lot of volatility um or is it is it something worse than that so unfortunately I think it's something worse than that I mean that's really like I wouldn't be out here and you know raising the alarm if I thought the problem was that we'd see a 4% correction in the S&P right like who who Cares right
um that's not the issue the issue is that we have effectively allowed a system to persist that mechanically inflates valuations inures us to that process allows us create all sorts of narratives around both why it's happening and what the degree of wealth that is being created is and then we rely on that wealth for our future consumption expenditures right and so when you have an aggregate something like a baby Boomer demographic or a passive penetration strategy that starts to run in reverse and the passive investors become net Sellers and require liquidity from the market the
market can't provide it that's the XIV event right and unfortunately when you run simulations around how this plays out in the S&P it looks very much like the Chinese stock market crash in 2015 in which the market fell 85% in a matter of months okay so not just a little bit of Volatility no per and that's a permanent decline well I mean the real risk is that you just end up shutting the markets I realize that sounds insane but remember that you have you know 100 million Americans and Untold number of people around the world
who believe that their deposit in the S&P 500 are safe right take that away from them they try to take that money out and suddenly the world changes in a quite you know dramatic fashion what about stuff like Uh and this is a off-the-cuff question but like circuit breakers and Marcus does that help 100% absolutely circuit breakers that's part of the reason why I I I highlighted that at the start the behavior of the S&P would be almost certainly quite different than the behavior of the XIV which could fall 85 to 90% 95% in a
single day that's obviously not possible with the S&P but the problem is is that you create the Dynamics of a Bank run right and a bank run effectively can only be solved by shutting the bank man yeah that is that's wild uh okay so we've talked about the S&P 500 just now how big of a deal is this in other countries like we're in Canada you know is is the TSX exposed to the same kind of issues so it's not as much and this is kind of one the interesting features so if you look at
the behavior of us markets and you look at the market Share gain one of the charts that I would draw people's attention to and this is we're going to skip around and you'll you'll have access to the full presentation and I encourage people to check out other you know um podcasts where I've given the full presentation but I just want to show you a very quick chart uh which is slide 11 how does a market transitioning from active to passive behave the chart on the right hand side um actually shows the Exponential feature of the
growth of passive strategies and how that actually becomes a exponential curve in terms of rising valuations right um the reason why that matters is because when you think about the US which had a head start in passive investing and it's far further along in passive investing than any other market around the world this helps to explain why we ultimately continue to gain share versus the rest of the world while the Rest of the world is moving towards passive and is adopting it their share of passive is lower and as a result they're constantly basically you
know it's a red queen effect from Alison Wonderland right they're running really fast to try to just stay in place we're running just a little faster right so we continue to gain share relative to Global Market capitalizations even though our GDP really doesn't suggest that that should Be happening there's a lot of debates around the quality of the companies you're looking at antitrust lawsuits against you know each one of our largest entities and yet we continue to price them more richly than ever oh I know I want to ask you about that but I we're
going to keep going on indexing for a bit I I'm but I'm very excited to ask you about us expected returns later um so how does systematic firms like dimensional or Avantis the Tilt Away from cap ways fit into these Dynamics you talk about well so they they're playing a slightly different game right and um when you think about what's ultimately happening with strategies like dimensional fund advisors where they're engaged in systematic value strategies is really they what they're well known for um it actually turns out that really what that is is just a a
volatility sale so it's a portfolio construction Technique where you agree in advance that you're going to sell stuff that goes up and you're going to buy stuff that goes down right mechanically that's the same thing as saying I've sold call options and I've sold put options right I should capture a premium associated with that volatility short this is why the value factor is so so closely correlated with short vola volatility in general right when volatility spikes the value Factor tends to underperform quite Significantly so like they're interesting and that they have different exposures and I
I do want to emphasize I don't have it in this presentation I have it in another one uh I could send a copy of it afterwards and if you wanted to share the slides you could but remember the part of what you're looking for in a robust Market is diversification in terms of the participants and so actually there's nothing wrong With a passive strategy a quote unquote passive strategy and I do think it's actually really important let me pause for a second and just make sure that your investors or your listeners understand what the academic
definition of a passive investor is right the academic definition of a passive investor is somebody who never transacts they simply hold and if you actually read the original literature behind the idea of passive investing is Put forward by Bill Sharp in his 1991 paper the arithmetic of active management which is what Cameron's referring to when he talks about all passive managers are the same as all active managers again I don't think that's actually true for reasons I've talked about but the part that's equally less true is the idea that passive investors can simply hold because
they can't they have to get into the market and they ultimately have to get out of The market in order to realize their gains and as a result there is no such thing as the academic definition of passive investors it's so perverse that in Bill Sharp's paper in footnote number four it actually refers two transactions theoretically happening in the limal hours when the market doesn't actually exist right like that's awesome I mean a little bit of magic in your life is a wonderful thing right it's not a great thing in your expectations for Retirement but
it's a wonderful thing in thinking about markets right and I would actually go so far as to suggest we've kind of hit that Arthur C Clark point where you know any sufficiently advanced technology is indistinguishable from Magic if you ask most people how markets go up they're like well it's kind of magic right just happens right um so that is really the definition of passive investing that was highlighted by Los Peterson in his 19 sorry 2016 Paper called rethinking the arithmetic sharpening the arithmetic of active management in which he noted this footnote number four and
said hey wait a second on Index reconstitution this is exactly the Marco salmon approach they have to transact my observation was something slightly different than that and I pushed L hard on this he fully acknowledges it that passive investment as we Define it today transacts every Single day Vanguard takes in about a billion and a half dollars every single day that is a large hedge fund every single day yep right so the idea that they're not transacting in the market that they are somehow passive investors is primy absurd right what they have been is contributors
of liquidity to the market by providing wring an investment philosophy that says if you give me cash thank you for the billion and a half Dollars every single day then buy what should I buy everything what price should I buy it at whatever the last idiot priced it at that's that's interesting so that's like B basically saying that that Bill Sharp ignored flows is that yeah huh um okay you talked about dimensional and aventus what about just non cap weighted index funds more generally like I don't know F sure that really exists but again you
know you're Just talking about slight variations on it right so if I equal weight it am I removing some of the the misspecifications on liquidity versus market cap sure but I'm replacing them with others yeah okay that makes sense right I mean the real issue again and just go back to the diversification component right it's hugely valuable to have people transact for different reasons right you may want to buy a house Therefore you sell I may look at a valuation and say wow that's too high therefore I'm going to sell right somebody who has even
more conviction may say wow that valuation is so crazy I'm going to short it and synthetically make more shares available for people right that's what shorting really is right those divver that diversity creates robustness within the market and really all we're describing with the growth of passive and more importantly The regulatory support for the growth of passive is that we're effectively narrowing down the diversity and heterogeneity of the marketplace and making it more and more homogeneous into a group of strategies that basically boil down to did you give me cash if so then buy did
you ask for cash if so then sell interesting the regulation is like the uh I can't remember what it's called in the states the qualified whatever it is the auto Enrollment uh slight slightly differently but so under the pension protection act of 2006 we switched 401ks from optin Frameworks in other words you had to choose to participate to opt out Frameworks in other words you had to choose not to participate that was a substantive change in the market that was done under lobbying from primarily Vanguard and black rock um the second key change was the
designation of qualified default investment Alternatives so if you're going to default somebody into participating you have to put them into something it actually turned out that the vast majority of people or not the vast majority but many people when they chose to part partipate in their 401K would look at the plethora of choices available to them and say man I have no idea and just hold cash right right and so the qdia changed that it started to force people into the market right and Therefore led to far greater participation and then another and so interestingly
enough when that was done in 2006 that led to the explosion of the growth of firms like Pimco that could manage balanced funds that combined bonds and equities into a single product that was then replaced as the qualified default investment alternative qdia in 2012 by Target date funds and today I want to say the number is somewhere in the neighborhood of 95 cents of every Retirement Dollar in the United States now flows into a Target date fund H wow wow crazy yeah how how is we talked with this on Twitter a while ago how is
the the issue that we're talking about the elasticity issue that index funds create how is that distinct from market efficiency um well so this is actually a really interesting Dynamic right because this is one of those things where the Academic definition can really pollute the underlying information set right so the academic definition of efficiency is effectively how much of the price change can be explained by the release of fundamental events right so information is released the price changes if the price changes a lot then actually the market is theoretically quite efficient right and if the
market doesn't change in or if the security doesn't change in a substantive way Different from the market in other words you need to think about the behavior of a security is being idiosyncratic in its relation to things like an earnings release and systematic in its relation to Behavior with the market and so perversely the definition of efficiency is when there's not information released it behaves very much like the market when information is released it behaves very differently than the market right and so the irony is is that by making Securities less elastic you know more
in elastic right you're actually increasing the responsiveness to those fundamental events which can lead to the confusing articulation that the markets are becoming more efficient right things that we look for things like post earnings announcement drift or one of the metrics that are used to measure efficiency well those are diminished if the reaction to an earnings report is the stock Rises 100% right the proportion of movement that's tied to uh post earnings announcement drift becomes smaller and smaller right now most people are beginning to wake up to this and say wait a second it's not
at all efficient for the stock price to rise 50% on a you know trillion dollar market capitalization on an earnings report clearly there's something wrong with the efficiency in terms of information diffusion that's going on most people Are starting to wake up to that most people are starting to recognize that it's not efficient for a company to Triple or quadruple in its price post bankruptcy announcement right right so like we're starting to actually say hey wait a second that's a stupid definition even if I understand why you arrived at it so now we're actually starting
to recognize markets are becoming less efficient even as that elasticity is leading to many of the academic measures Of efficiency to be like hey nothing's ever been better man super interesting um one of the other big measures is active manager performance uh how how does this situation affect the ability of of active managers to beat the market well so perversely what it does is it creates a drift in the marketplace that penalizes holding cash or being quote unquote safe right maintaining the optionality of cash but It also perversely corrupts measures like the sharp Ratio or
Alpha um in its behavior and so again jumping to a slide and this one has to be a little bit interactive I apologize to your listeners uh if you jump to slide 25 in my deck um this is titled when time becomes a proxy for Passive penetration Alpha vanage vanishes for active management and what I'm pointing out here is that the historical model of how stock prices behave or how markets Behave is that there's a central tendency equities return 8% a year and then there's cyclical variation around that when you introduce something like passive this
is the pale blue line the the um convex curve that you see when you introduce something like passive that pushes valuations up over time it actually changes that underlying return function from a flat line to a convex line right now this is where it gets really tricky and I apologize for your Listeners that there is math involved right the solution sets that we use in finance we're all very good at math right but Alpha is actually just the intercept on a linear equation the behavior of your portfolio is equal to its beta times the market
return plus some idiosyncratic measure we call Alpha yal MX plus b right if you use a linear Cur a linear solution to a curved surface over time mechanically your Alphas get pushed Lower right it's just math and it's a function of the fact that we're really not as good at math as we like to talk about being right we're just using the wrong metrics and so then if you flip to the next slide you can actually see the impact that this has the theoretical model you looking at Alpha in this context and the impact of
passive is identical to the empirical data H so Alpha's going Alpha's going Down more than because of the growth of passive it's not because active managers have a harder job or because there's fewer idiots out there Etc there's plenty of idiots just look at GameStop right but what we're actually experiencing is a market that is being distorted from the growth of passive as that becomes larger over time it creates this exponential curve of rising valuations that in turn forces mechanically the alphas lower for active Managers which causes us to fire the active managers because they're
idiots and replace them with the oo efficient passive investing which further exacerbates the problem man so it active management is getting harder as indexing grows harder to generate Alpha exact opposite of what most people think yeah it's wild so so so how should or should investors Change their strategy in response to uh this current market structure well this is where it gets really hard Cameron because what we're describing is the same phenomenon as the Chuck Prince you know Soliloquy and in the lead into the global financial crisis right I just showed you it's impossible for
active managers to beat passive and it becomes harder and harder as passive gains larger and larger share yeah so the answer is you invest Passively right but that then exacerbates the societal risk that we face when ultimately we try to take that money out the music is playing we still got to dance right but that is the society you know significantly less than optimal response to these underlying conditions and so it really unfortunately relies on the grown-ups in the room I would include raas and asset man you know asset Managers and investment advisers to begin
to communicate this and can L Vanguard and black rock should be taking the lead and saying oh man we've really screwed this up we need to start unwinding this but their paychecks depend on not revealing that information so we're really trapped unfortunately I want to ask about that like why their paychecks I want to ask about that like why their paychecks rely on on on things being the way that they Are but like their paychecks are going to go down if the market crashes 85% why wouldn't Vanguard and black want to do something well the
simple answer is one I just don't think the people at Vanguard are that good right it's a cult organization um and so I'm not convinced that Vanguard really understands this although I know I know for a fact that ENT that individuals within their organization do know some of these elements Black Rock I think is a little You know let's just be honest they're they're you know true capitalists they just want to make money and I think part of the irony is is that you're starting to see the signs that they are aware of this right
what has Larry fin now come out and done he's replaced his ESG fixation with Americans are not saving enough for retirement we should adopt the super annuation systems of Australia that's possibly the only system that is more aggressively moving passive than The US system so what he's really saying is I Larry thinket Black Rock want to do the same thing I did in the aftermath of the pandemic I want to be tapped by the US government to manage all assets I want to solve the high yield problem right I'm going to be the guy who's
t to go out and buy all this sort of stuff so even more attractive than managing 15% of a market that is you know up 100% would be managing 100% of a market that's down 85% that's a great Gig uh just on the topic of active being able to beat or strategy being able to beat the market with the way it's set up now is there anything cross-sectional like like momentum uh or I don't know is there a way to measure elasticity and and select Securities based on that no it's super interesting so I mean
guys that you and I both know right like Ralph Ken at Chicago he's developing some tools and systems that allow you to effectively Predict uh the behavior and elasticity around individual Securities um I have a ton of respect for the work that he's doing in that area um others I think certainly are aware of this right and so part of what you're referring to is almost like the Andrew low adaptive markets hypothesis right people are going to respond to this unfortunately the easiest answer is hey I just recognize that this is happening I can't stop
it and therefore I become Even more venal in my prosecution of it um a really simple example of that would be the nonsense around smci and its inclusion within the S&P 500 right um among the most profitable businesses out there for the multistat hedge funds like Millennium or de Shaw or others is index inclusion Arbitrage and so recognizing that something like smci having exceeded the 12.5 billion do threshold for the S&P 500 was going to be included in the S&P 500 they're able to buy as many Shares as they want effectively pushing it further into
the S&P 500 and guaranteeing them themselves exit liquidity when the event occurs right so that's one of the strategies that works the other one I would argue is that the public is starting to wake up to the Dynamics of momentum and quote unquote technology in the same way that they did in the late 1990s where a similar phenomenon happened um Cameron this actually goes Back to one of your points we used to have market cap weighted indices we don't actually just to be very clear we have we have float adjusted market cap indices right the
irony is is that the dot was version 1.0 of this Dynamic so in the in the 1990s the unique features of the market where that you had companies that had gone public that were relatively large market cap but had many of their shares held by insiders companies like Microsoft Cisco Dell Etc Right um there was a very substantive change in the passive rules and regulations in 1994 where they moved from trying to statistically sample or buy every individual share to increasingly relying on futures for replication that shifted the problem away from the risk of Vanguard
having tracking error to the Dynamics of tracking error existing in Futures Merchants who refus to accept accept it right because that's where their profits Are generated from um that meant that every time that you went in to buy shares of Microsoft in proportion to its market capitalization you were effectively trying to buy twice as many shares this would otherwise exist we used to call this The Insider ownership effect it led to outperformance it was the single best performing factor from roughly 1995 soon after the adoption of those Dynamics until 1998 when of course people started
to wake up they're like Hey wait a second um it's not really Insider ownership that matters it's technology and it turned out that the single best correlation to Insider ownership was a relatively recent IPO and so the street began to manufacture all sorts of these things that people suddenly wanted right we called them technology IPOs that's what the dot cycle was um now perversely we're at the same stage we bought ourselves capacity by Changing the markets from cap weed to float adjusted cap weights um but now we've exhausted it and so we're seeing the same
underlying behavior and people are of course waking up and saying hey this whole value thing boy that was stupid I should be a momentum investor I should be a technology investor just get me some of that sweet sweet AI stuff and I'm Gonna Be Rich like cesis right now ironically all they're doing is accelerating the termination Point right but that's what's underway right now so you're a portfolio manager how do you incorporate your views on on passive into your investment strategy so again that's one of the wonderful things about adaptive markets right so in the
past couple of weeks you've been treated to all sorts of individuals who have identified different ways to do this David Einhorn who I spoke with and identified these with he was one of the Early people I spoke to figured out that he was going to approach markets in a totally different way than I chose to approach them his has worked out really really well in in some ways um my view was very straightforward that you ultimately wanted to stay exposed to the large cap indices that you wanted to participate in this and candidly if you
can you want to actually leverage that exposure so doing things like buying call options which historically had Delivered significantly negative returns now actually largely offer positive returns because the market has shifted in that drift feature um that would be one way that you incorporate it you embed long-term or you embed call option type strategies that capture elements of this drift and are candidly not properly priced for those underlying Dynamics the other way that you identify this or you deal with this is you recognize that the information content that we're receiving On the health of the
economy and the health of um individual Securities is actually wrong right it's just it's being corrupted by these underlying Dynamics that's trickier because it effectively requires you to start saying you know where do I start to bet against this where do I think this starts to unwind now my models would suggest that what this largely means is that markets are increasingly reliant on employment right that contribution from 401ks and ultimately that you start unwinding this process again it is really tricky because there's multiple levels to thinking through how this plays out right one way in
which markets have continued to power higher is people have started saying well I don't want to buy the Vanguard Total market index or I don't want to buy a total market index just buy everything you know Cameron's observation of I'll just mimic the entire Market in said they're now Cheating right and so they're starting to buy technology funds again and they're starting to buy the momentum funds again and they're starting to focus on you know certain areas of the market effectively concentrating their Firepower and so the great irony is is we look at a fantastic
year like last year or we look at a year like this year in which the S&P is I think up somewhere in the 10% neighborhood forget where is it is after yesterday's ret I think Today we're just totally reversing it um you know but when you actually start thinking about that and you concentrate that Firepower that can push markets higher even as the median stock is actually down this year and was for the vast majority of last year people are loving the technology well it's it's a look it's a natural component right we are a
narrative species you you've asked me on To this show because I have a compelling narrative if I had an uncompelling narrative you'd be like all right that's a crazy guy sitting on a corner right but because I have a compelling narrative you want people to listen to it as a species we gravitate to compelling narratives we believe for thousands of years that the sun transited the sky pulled behind a golden Chariot right it's not unrealistic to tell people that the reason why stock Markets go up is because they can't go down certainly feels that way
right and once you tell them they can't go down then they start trying to figure out wow how can I gain more wealth relative to everybody else you know what I'm going to buy the stuff that goes up the most because that can never go down even more or right um who knows so that's an interesting question actually do you think and I I want to ask more about the US Market in general later but just on Tech do do you think that tech stocks have done well because Tech is doing well or because of
this whole Index Fund problem we're talking about what a question so I think there's a mixture of the two right I think one of the other components that of course comes out of this is if you recognize that what I'm saying is is that markets right are less elastic than we think they are and there's an entire you know paper written on this in 2020 By gaban kin called the inelastic Market hypothesis so I'm not you know adopting like any unique liter you know language or anything else right but if you accept that there is
more friction from flows than the theoretical models would suggest and just to parameterize that for individuals right the work of Gab and Coan suggests that a dollar into the market on average creates about five dollars of market cap the theory of Efficient markets right under which we rely on for the the insights of passive assumes that a dollar into the market because somebody had to sell you those shares only creates one penny of market cap right so gay and Coan would tell us that we've misspecified our theoretical models that underpin the growth of passive by
500 to one right now my math says it's much worse than that actually but that is a pretty bad measure right like that's not even good enough for Government workers I like to joke crazy that's back back to the sharp thing where the arithmetic of active management makes sense unless you account for flows and now we're saying that flows are even more impactful than what people thought previously yep yeah super interesting uh what who's you mentioned slightly I touched on it earlier briefly uh that raas should be communicating this but like who and and you
mentioned the adults in the room who Who actually fixes this like who who needs to step up and do something this is where I hate to say it but the answer is unfortunately regulation and so at the tail end of the presentation I've got a a series of recommendations for individuals or for Regulators um the simple reality though is it's not going to happen because Vanguard and black rock spend more on lobbying than all of the rest of the industry combined they control the Regulatory apparatus at this point they are the quote unquote good guys
because they're facilitating savings at very low cost right and it's worked out brilliantly so far and as a result they have a degree of Mind share that is almost impossible to overcome H it's a crazy situation the other a crazy situation now you understand why I'm so passionate about it yeah I I I I do I started to understand it because I started reading your reading your stuff And then yeah I think it's a it's it's worth it's worth people hearing um one of the crazy things though from the individual investors perspective and you said
this earlier is that like other than recognizing that that it is a societal problem they shouldn't do anything like the best thing to do is continue buying index funds yeah that's exactly right that's wild it is wild okay I want to ask about us expected returns um us Market's been on this like Crazy Run for the last 20 years I hear people all the time saying that the us is going to keep getting 10% returns forever um and that the other thing people say it's crazy is like who cares about the US market look at
QQQ it's going to keep getting 14% returns forever uh what's your outlook on us expected returns well I mean first of all that's that complex adaptive phenomenon that you're talking about right so a decade ago nobody would have Talked to you about QQQ um really a little bit longer than that you know 12 years ago if you remember David Einhorn again you know one of the smartest individuals I know in these markets was highlighting that nobody was paying attention to apple or Microsoft right now part of the reason that change was because the growth of
Target dat funds that mechanically pushed that money in but the simple reality was at that Point people were looking at the companies Themselves and saying hey wait a second these margins are largely unsustainable right now one of the great ironies is is that when you create this type of feedback loop that advantages the largest companies with a dramatically lower cost of capital I would actually estimate that it's a negative cost of capital for many of these companies they're able to do crazy things like subsidize the acquisition of the highest quality labor and talent through the
use Of stock options right those stock options in in turn actually need to be exercised that is effectively like them selling shares right those Shares are then mechanically bought by the index investors with no consideration as to Value right and so what it does is it actually becomes very much the Soros reflexivity Dynamic where Microsoft and Google and apple become endowed in a manner that the other lesser companies are not and so it actually consolidates Real resources into these entities and makes them more powerful than we think they than they really should be right it's
just like it's it's truly perverse right so again if you jump back to that slide that I showed you before and I want to be very clear I don't think that this is ultimately going to happen um because the volatility will become so extreme but if you jump back to slide 11 that shows that exponential curve that orange line going higher the Easiest way to think about that is as you get to somewhere in the neighborhood of 80% passive and remember we're only about 45% right now and around 80% passive the Schiller PE would be
somewhere around four to 500 H right man sounds great right what's the problem well you could more more easily see an 85% uh correction maybe when when PES are that high well so that's that that is ultimately one of the things That's really important for people to recognize is like you know I don't know how to say get out of the way of this thing when I can realistically look at it and say wait a second I think it could actually go up another four 500 600 700% simply on valuation wow right um now I
don't think that's going to happen because I think we're actually approaching the inflection point where passive has become so large that it creates its own enemy right and this is Where it gets super interesting because remember withdrawals are always a function of asset levels you think about something like a 401K in the United States you have a required minimum distribution and again under lobbying from Vanguard and black rock they've changed the rules to keep Assets in 401ks longer than they otherwise would have right so they're doing everything they can to stop this outcome from occurring
but you're entering into an Environment in which a 4% Redemption from a 401k that is appreciated 3 four 500% overwhelms any contribution that people could make and so ironically actually 401ks went negative in terms of their net contributions back in the fourth quarter of 2018 now we immediately changed the rules to address that but ultimately we can't fight it that much because of this Dynamic of withdrawals being tied to asset levels while contributions are always going to Be a function of income right so when you talk about like what are the returns I I have
to make it completely conditional and say do we see outflows if we see outflows then unwind a massive fraction of what we've seen so far and returns will probably be the most negative in history right on the flip side of that if we don't get to that point and they continue to change the rules and they suddenly say you know hey wouldn't it be a great idea if we Actually had the government put an additional 5% into retirement savings into the S&P 500 for every American well then the answer is of course we're going to
see much higher returns and fantastic returns right so it really is flow dependent and that's a very like it's super complex communication what what if we you you've got you've had I've seen some some of your really good commentary on US economic fundamentals If We Hold flows Neutral just forget about flows what do you think about us Market expected returns based on economic fundamentals well so so this is you know unfortunately I think there's a a whole host of separate issues as it relates to US economic fundamentals um tied to the pandemic and the behaviors
that we have around the p pandemic and then more broadly to a discussion of what societal wealth really is right so when you think about Societal wealth it's very easy to add up the dollar value of all the buildings and all the companies and all the cars we own and the dishwashers we own Etc right those are all you know certainly contributors to our quote unquote wealth but remember that's just an accounting entry right a car is worth $30,000 well I mean that's true until you have to you know you're dying of thirst and then
you're willing to trade your car away for a glass of water right so these are All just you know simply accounting entries the real value that exists across the world is in human capital and every corporation gives lip service to this our most valuable assets go down the elevator every day right now we negotiate against them as much as we possibly can we try not to pay them reasonably and in fact if you're Apple we're going to engage in outright you know um collusion with our peers to make sure that our employees are underpaid Relative
to the value that they're creating and we of course forgive that but you know that human capital is really the value and unfortunately because we don't measure that in any way shape or form I'd suggest that almost every metric that we have is deeply distorted if I look at that human capital component I would suggest that both in the United States and Canada we're seeing a significant dumbing down of the general population as our Educational institutions increasingly fail we're looking at an Inc an increasing failure in terms of our Health Care Systems and our ability
to keep people alive and healthy and in good spirits for an extended period of time we're seeing a society that is becoming increasingly fractured in the United States and Canada across multiple metrics right and so all of those should ultimately play into the valuation that we ascribe to assets and yet ironically We don't include those so we're not thinking about that underlying Dynamic on that basis I would simply point out that like the US is far less stable than it's been at periods in the past and as result you should be applying a country discount
versus history we're doing the opposite man yeah so PE people people investing in US Stocks like they they shouldn't get out on the either the index fund or the economic fun fundamentals piece like still be an Index investor I guess but maybe don't count on the recent returns repeating forever when you think about your future yeah I mean look that is the core issue right and and most people have kind of woken up to the giant joke you can't allow a retirement system to fail and the US markets have become our retirement system right and
so the US government is going to be forced to intervene now ironically if we know that the US government is going to be forced To intervene that makes us more comfortable investing therefore we push prices up higher which in turn means a larger selloff is required for the US government to intervene right and how the game plays out and that moral hazard I got to be honest with you is beyond my IQ man I think it's beyond everybody's IQ no kidding that's a big one okay can you briefly talk about why Bitcoin is not the
solution to all of our monetary and Fiscal policy problems uh geez um okay so the the easiest way to to think about this is and it should be very clear from what I just said that that at the core of any value system has to be belief in the value of human beings and human Innovation right the interesting thing about the gold standard which is really very simp similar to what bitcoiners would propose as a new monetary system that places meaningful constraints on The power of government right you can't magically create gold unless you happen
to have control of a a supernova right um You can create gold in a supernova that's awesome um but you know like then it ceases to work it's a b like the quantum calculations breaking Bitcoin right I'm not going to spend that much time worrying about harnessing supernovas yet right but what it does actually have is the advantage that everybody in Bitcoin talks about is the Opposite of an advantage if the price of gold goes up a lot suggesting effectively that there is a shortage of the underlying security the underlying asset human Innovation can be
directed to the production of additional gold to solve that problem to effectively bring the price of money down so that it's competitive with other assets or other things that you might want to spend your money on it's actually exactly what happened at the Tail end of the 19th century as William Jennings Brian and the cross of gold speech which Canadians will be less familiar with and candidly Americans who no longer really learn anything in high school or less familiar with but the simple reality is is that that cross of gold was solved through technology we
changed the methodologies that we used for extracting gold from gold reserves using the cyanide process that dramatically increased the quantity of Gold lowered the price of gold and was able to actually restore some level of normaly right Bitcoin doesn't have that capacity you can work as hard as you want it's under a fixed release schedule and as a result there is no reward to human Innovation and that actually is a really messed up system that's the easiest way to think about it and so if you actually mechanically run through the gameplay of Bitcoin it actually
consolidates down to An autocratic system in which one entity has all the wealth that's not a good system and that's such a interesting way to to explain it and think about it how have the Bitcoin ETFs changed the nature of Bitcoin well I think the actual irony is is that the Bitcoin ETFs expose the true fragility and lack of value in Bitcoin and I know that sounds like I'm you know effectively searching for the right Answer but remember that you know gold ETFs own roughly 1% of the global share of gold Bitcoin ETFs already own
about 6% of all the recoverable reserve reserves of Bitcoin and you only managed to get the price to go up about 60% stop and think about that for a second that means that all the other bitcoiners had to dump their assets onto the unsuspecting Boomers who bought into those Bitcoin ETFs in order to keep the price which should be nearly perfectly In elastic from rising to extraordinary levels right now I mean the great irony is you've got all sorts of Bitcoin proponents who have absolutely no hesitation to run out so I think the bitcoin price
should be a million dollars by the end of the year right and people criticize Bitcoin and the response is well it's the best performing asset of the last decade right like this is just silliness honestly like if anything the Bitcoin ETFs is remarkable as they have been from a flows standpoint are a testament to how unvaluable this asset actually is final question Mike how do you define success in your life oh you got define success in totally non-financial terms I've been incredibly lucky I've got a wonderful wife I've got three amazing kids and they really
are amazing I like to brag about them but they are absolutely incredible um I've been gifted relatively good health and the Rest of it I'm just not going to worry about awesome all right Mike this has been a great conversation we really appreciate you coming on the podcast Ben thank you very much camon it was a pleasure I appreciate you guys having me on yeah great to meet you thanks Mike [Music]
