Transcript: Mike Green, Simplify Asset Management

 

 

The transcript from this week’s, MiB: Mike Greene, Simplify Asset Management, is below.

You can stream and download our full conversation, including any podcast extras, on Apple Podcasts, Spotify, YouTube, and Bloomberg. All of our earlier podcasts on your favorite pod hosts can be found here.

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This is Masters in Business with Barry Ritholtz on Bloomberg Radio.

Barry Ritholtz:  Hey, this week on the podcast, I have an extra special guest, Mike Green, and I have been chopping it up on Twitter, arguing over passive versus active. And I thought, well, why are we wasting this on Twitter as it circles the drain? Why don’t we just have a conversation in the studio about his beef with passive, why he thinks it’s a structural threat to the market? And the advice that he gave to David Einhorn about it that helped lead Einhorn to start really kicking the benchmark’s butt again for the past couple of years. I found this conversation to be both interesting and surprising. Some of the things Mike said about investing, like what would you tell your friends and family to put your money into? He says, it’s hard to argue against the low cost and the performance of indexing, but that doesn’t mean regulators should overlook the potential threat.

I’m kind of unconvinced by the argument. There have been a series of arguments over the years against passive. What makes the discussion with Green so interesting is he’s the guy that identified the, the structural problem leading to the destabilization of, of the vix. If you recall, back in 2018, vol Mageddon, he was on the right side of that trade, made hundreds of millions of dollars for his firm in identifying a structural problem that was about to blow up. Now, I don’t believe the market structure is subject to the same risks as a single inverse trading instrument, but he makes a really compelling case for this is important. We have to pay attention to this, and we have to understand why this is potentially a risky asset.

With no further ado, my discussion with simplifies Mike Green.

Mike Green: Barry, thank you for having me.

Barry Ritholtz: So let’s start out a little bit with your background before we get into your really interesting career, Wharton at the University of Pennsylvania. You’re also a CFA holder. What was the initial career plan?

Mike Green: Well, the, the initial career plan, actually, so I grew up on a farm in Northern California. My initial career plan was that I was gonna go into science. I actually studied physics as a young man, and then recognized that I was not actually nearly talented enough in physics to do anything of, of note. And so transition like many people did in my generation into finance. Similar,

00:02:48 (Barry Ritholtz) Similar story. I’m always fascinated when I hear people who were grade in, in high school at mathematics or physics and then go to university and say, oh, I’m only pretty good at that. I, I’m in the same camp. Yeah. Camp as you, you’ve had a fairly entrepreneurial background, not just in finance over the past decade or two, but you founded or co-founded value add software in the 1990s. Tell us a little bit about that experience. Sure.

00:03:14 (Mike Greene) So that was actually an outgrowth from my experience coming out of Wharton and you mentioned the, the, you know, the transition of people who tended to be skilled at math or physics into finance. We forget that there weren’t personal computers on everybody’s desk back then. We forget that most people didn’t have the skillset around Excel, et cetera. We did. Excel didn’t even exist when I started. It was VisiCalc and Lotus, right? And so in the 1990s, I developed the, the late 1980s, early 1990s, I developed a skillset around valuation, in particular discounted cash flow or residual income type models, along with a couple of peers out of the consulting industry. We built a company that was focused on valuation, initially, actually targeting corporate strategic planning departments. So working with companies like PepsiCo or others that were looking to either divest business units or to make acquisitions and needed to have some mechanism to think about the valuation of these.

00:04:02 That’s what value add software was originally. It also was the path for me into the asset management space, because coincidentally, Mitch Juli of Canyon Partners was researching on the internet in the early days of the internet for valuation engines and insights. Stumbled across our stuff and reached out and said, Hey, could you link this to the public equity databases like Compus stat so we could use it for valuing stocks? That actually is exactly what we ended up doing. We were one of the last to get what’s called a value added license to the compus stat database. And so that then led to the sale of that business in the late 1990s to Credit Suisse.

00:04:36 (Speaker Changed) And then you end up actually at Canyon Capital, previously, I, I had Dominic Neal as a guest, but you stood up, they’re an LA outfit, you stood up the New York office and ran about $5 billion for them. Tell us what it was like doing that a couple of years before the financial crisis blew up.

00:04:56 (Speaker Changed) Well, it was very tight to the financial crisis, and so I’ll tell you candidly that I thought there was a very reasonable chance that I was gonna be out on my, so the technical term in the, in the financial crisis, you mentioned Dominique Mills is one of the fantastically talented people at Canyon Partners. She was based out in Los Angeles. And from kind of that 1996 introduction to Mitch and Josh, they repeatedly tried to get me to go to work for them in Los Angeles. And finally, I think it was 2003 or four, I ran into Mitch on the street on, actually on 57th, just around the corner from where we are right now. And he, you know, said, Hey, you know, we’re thinking about opening a New York office. Is it US or is it Los Angeles? And the answer was, it was Los Angeles.

00:05:35 I didn’t wanna be in Los Angeles. My wife doesn’t like to drive. I actually came like within inches of accepting a Canyon Partner’s offer back in 1998. And then I’m going from dinner at Miss Juli house to the airport. It’s 11 o’clock at night on a Friday bumper to bumper, and it’s bumper to bumper traffic. And all I could think is, if I do this, I’m done. My wife is gonna leave me in about two and a half minutes. And so we just made a, a a a a meeting of the minds when they decided to branch out to, to New York City. It provided the perfect opportunity to transition to Canyon Partners. Initially I joined to help them manage their equity portfolio. My background in the asset management space was originally going to small cap value, and Canyon Partners really gave me the platform that allowed me to branch that out into multiple different areas.

00:06:18 (Speaker Changed) How, how do you morph from small cap value into things like derivatives and fx?

00:06:26 (Speaker Changed) So, my actual background was originally in derivatives. My first job on Wall Street when I was still at the University of Pennsylvania was trading crude oil futures to offset option positions for spear leads in Kellogg. So I, I had a background in derivatives. The opportunities to trade derivatives and be involved in the hedge fund space was something that really had not emerged, at least for me in New York until Canyon Partners provided that opportunity. But if you look at, when I sold my software company in the late 1990s, we had this huge disconnect where I’m a value investor. I’m somebody who’s focused on valuation and small caps and small cap value in particular, we’re trading at this incredible discount. And so I actually went into small cap looking at it from the same standpoint that a macro investor might and say, this is an area that has real resources and opportunity and the valuations are totally mispriced relative to what we’re seeing in the broader market. I get just got lucky candidly that the.com bubble broke about six months after I made that transition. If it had gone on for another two years, I might not be sitting here to talk to you today. Right.

00:07:28 (Speaker Changed) Hey, listen, smart is good. Luck is

00:07:30 (Speaker Changed) Better. Luck is better. Definitely

00:07:32 (Speaker Changed) True. Absolutely true. So after a successful run at Canyon, you stand up your own fund, ice Farm Capital, you’re seated by Soros Fund Management. So I met him once briefly, I think it was on his, at his apartment at Park Avenue for some event. But tell us what it was like working with the people at Soros.

00:07:52 (Speaker Changed) Well, so again, the Soros guys in particular Scott Besson had actually rejoined Soros as the CIO at that point. He was the lead analyst for Stan Druckenmiller. And so he was returning to Soros. He basically tried to build a stable of outside managers that he thought were interesting and, and presented interesting ideas initially. Same thing as Canyon Partners, basically trying

00:08:12 (Speaker Changed) To meaning non-correlated multi-strategy. Let’s spread it across a lot of different ideas, disciplines, approaches, and hopefully some of them are working most of the time

00:08:21 (Speaker Changed) A hundred percent. That’s exactly the idea. And so Scott actually approached me about joining Soros and I turned him down with the observation. I’ve already got a great job. He immediately picked up on that, that the word job probably came across, tapping into my entrepreneurial background. And he said, well, if you don’t want to change jobs, would you be interested in running your own firm? We’ll seed you. That’s what led to Ice Farm Capital. The, the name actually, funnily enough comes from a vacation property that I used to own. We sold it when we moved to California to, to following the rest of the career career. But I owned a 19th century ice harvesting operation, which sounds insane until you actually stop and think about all the characteristics of what the world would’ve looked like in 1900. ICE was very much a business like cable television back then.

00:09:10 You actually didn’t own your icebox. You leased your icebox from the ice company. The Ice Man cometh, right? The Ice Man was somebody who would deliver the ice on a regular basis alongside cheese and various other components. And believe it or not, that was the seventh largest business in the United States in 1900. Wow. And by 1935, with the invention of air conditioning and modern refrigeration techniques, primarily by carrier, the entire industry is gone and everything files for bankruptcy. And so we actually picked up a vacation property that’s just outside of a exciting vacation destination just outside of Scranton, Pennsylvania that was in the Pocono foothills. It was effectively a property that is between two 3000 foot mountains. And so in the Northeast it constantly stays cool. It was fed by five Artesian Springs. And so this was the fantastic, most perfect place to grow ice, right against the Ice Farm. And we had like railroad tracks that went to New York and Philadelphia, et cetera. They were all abandoned, you know, long since abandoned. But that was the genesis of the name. We were always looking for a name to run the Telan firm.

00:10:11 (Speaker Changed) No, that’s great there. And there’s, if you look at every Greek mythological creature or God, like all the names have been taken. Yeah, it’s all, it’s pretty, it’s pretty hilarious. So let’s talk about the next gig. You have Teal Macro. You’re managing the personal capital of Peter Thiel, which I found fascinating because people have a tendency to read into the politics of, of the investors. The New York Post famously does this all the time, but you know, the politics is capitalist capital, whether it’s coming from Soros management or Teal. Tell us a little bit about what it was like working with Peter Teal.

00:10:52 (Speaker Changed) Well, so those are pretty much the two extremes, right? One is certainly perceived as, you know, right wing in one way, and the other is perceived as very much left wing. I don’t care about the politics component. I act, I care a lot about politics per se, but I very strongly believe that we’re able to have our own opinions. There is a degree of discussion around those types of components in any setting, right? And so it is important that at least you’re able to entertain that. Peter is unbelievably brilliant, right? He is one of these people who I think has a very intuitive grasp of order in the universe and tries to take positions that exploit those underlying dynamics. His, you know, familiarity with Rene Girard and the dynamic of mimicry and, and people’s desire to imitate what other people have or to try to obtain what other people value, I think is kind of his underpinning philosophy and has proved to be really, really powerful in terms of identifying where the puck is going. You know, Peter had built a phenomenal pool of capital that it was a real privilege to have the opportunity to work with him on.

00:11:53 (Speaker Changed) And, and he was an early investor. People sometimes forget, he was early in Facebook, he was early in, I think it was Uber. I mean, he was in the right place at the right time more often than we were talking about. Lucky at a certain point it’s like, Hey, you know, once or twice is a coincidence, but at a certain point there’s a certain set of insights and skills there.

00:12:12 (Speaker Changed) Yeah, I I, I don’t think luck plays nearly as much of a role as people would like to think. ’cause it relates to Peter. I do think that that a lot of the dynamics that we saw coming outta Silicon Valley, Peter was one of the first people to say, Hey, wait, let’s try to treat this like a business as compared to purely a scientific experiment. And so he was part of that early crop of venture capitalists in that late 1990s time period that I think started to think about it less on the pure technology front and more on exactly as I was referring to with Rene Gerard, the aspirational dynamics, like, what do people really want? Right? Very few people want to quote unquote, get onto a smartphone. They want to be able to connect with their friends, they want to be able to do math, they wanna be able to get their email, they wanna be able to do their work away from the office, et cetera. That awareness that that world was transitioning to the online space, I think is really what Peter’s key observation was. And now it’s interesting to watch him as he recognizes, I think, in a lot of ways that people want other things in life, not necessarily just technology.

00:13:10 (Speaker Changed) There, there’s a whole longer conversation about the, the evils of how we use tech. But before I leave the teal macro, I gotta ask you about the famous Vage trade in 2018. You had identified in advance that there were some structural problems with XIV. Yeah. And on behalf of that funds, you made a bet that, hey, this thing is gonna blow up. Tell us a little bit about that trade.

00:13:37 (Speaker Changed) Sure. So XIV, which has been reintroduced in various forms, was just an inverse of the VIX index.

00:13:44 (Speaker Changed) You can meaning when, when market volatility went down, that should

00:13:48 (Speaker Changed) Go up. It would go up, it should go up. The, the irony of course is is that like most of these trades that’s out there, it’s not quite what people thought it was, right? So the actual source of profitability in that trade is not the level of the vix, but the shape of the vol surface. Right? Just de

00:14:03 (Speaker Changed) Describe, define what you mean by that.

00:14:05 (Speaker Changed) So the, the structure of the vol surface is generally upward sloping, meaning that people are more uncertain and price greater uncertainty about events far off into the future as compared to events that are relatively nearby right now. When that inverts, when the VIX spikes on a risk off event, that actually means that you’re suddenly, if you’re inverse, right? So you’re shorting this dynamic, you’re shorting stuff that is low priced, is rolling up to high price, right? That’s really bad. On the flip side of that equation, in a normal what’s called a contango construction in the vix, if you are shorting six month volatility or two month volatility and buying it back as one month volatility, you’re typically selling it around 15 and buying it back around 12. That’s a crazy return when you think about it, that that’s happening every single month. You’re basically generating between

00:14:53 (Speaker Changed) 25%,

00:14:54 (Speaker Changed) Close to 25%. Yeah. Right. In that trade on a monthly basis, when you run that full strength, it gives the dynamics of something like the XIV, which rose 600% in 2017, right? Right. Now my observation was twofold. One was that because of the growth of this strategy, it had actually gotten so large that it was consuming all of the liquidity in the UX futures, the VIX futures, on normal trading days, it was about 70% of the daily volume was simply the rebalancing of these things. Wow.

00:15:25 (Speaker Changed) That’s huge.

00:15:26 (Speaker Changed) So the passive component of that, which we’ll feed into a discussion we’ll have later on, had just become so large that it relied on liquidity that was not necessarily gonna be there. Right? Ver

00:15:37 (Speaker Changed) Very similar to the financial crisis where people had long-term debts, but it was so much cheaper to to, to finance that with short-term paper, Hey, we’ll just roll it over every 30 days.

00:15:47 (Speaker Changed) A hundred percent. That’s exactly the same underlying dynamic. And by the way, the model for the trade that I built was actually going back and reading Paul Tudor Jones analysis leading into the crash in 1987.

00:15:57 (Speaker Changed) Portfolio was

00:15:58 (Speaker Changed) The portfolio insurance components, right? Huh? It was the exact same trade. So like down to the point the portfolio insurance was consuming somewhere around 30 to 40% of the, the volume on the s and p 500 on a normal basis. Paul’s observation, Paul Tudor Jones’ observation was that in an event that actually exacerbated volatility, the trading quantity that they would need was far greater than the market could supply. I had the exact same insight, exact same view, and simply pointed out that, look, look, there’s a misunderstanding of an inverse product. You think like a normal stock, it’s getting safer and safer and safer as it goes higher in price. But, but

00:16:37 (Speaker Changed) It’s the exact

00:16:37 (Speaker Changed) Opposite. It’s the exact opposite. And so what you were actually building was a bimodal distribution, meaning two humps to the distribution where there was a smaller and smaller probability that everything was okay and a bigger and bigger probability that all, I think technical term is all hell was about to break loose. Right? We basically came to the conclusion there was roughly a 95% chance it was gonna go to zero over a two year period. We ended up buying, this is one of the wonderful things about financial markets and degrees of completeness. There were options available with a two year time horizon that allowed us to express

00:17:08 (Speaker Changed) That trade. Wow. That’s amazing leverage. So how much, how much were you putting at risk at that, that moment that, hey, this, this analysis is correct and the timing, this should happen within two years?

00:17:20 (Speaker Changed) So we were actually ultimately limited by the liquidity in the space, but it was large enough that we were able to put a sizable amount of premium amount it was meaningful and, and make a meaningful amount of money.

00:17:28 (Speaker Changed) So you, you made this trade on behalf of Teal macro, put any of your own capital into it also.

00:17:34 (Speaker Changed) Well, that’s one of the funny things everybody discovers is you go through this industry is is that when your compensation is tied to the outcome of the trade, you can absolutely express components of it. But the reality is, is that we’re all massively under-invested, right? In things like equities, et cetera. Because

00:17:49 (Speaker Changed) So much of your income is that, you know, I’ve had that exact conversation. Yep. Hey, why don’t you own more common stocks? You talk about passive investing, this and that. I, I don’t know how about 95% of my net worth is tied up in market related investments? It’s, you’re in the

00:18:03 (Speaker Changed) Same place. It’s a hundred percent. And it it, it’s hard for people to understand that. So it’s great to have the opportunity to actually share that. Yeah. I mean, our industry tends to be among the most conservative investors out there. Precisely because we look at it and we’re like, wait a second, if this risk goes wrong, not only do I lose my assets, but I lose my job.

00:18:19 (Speaker Changed) Right? It’s, it’s double concentrated risk. There were lots of rumors about that trade at the time. Some people said it was 50 million, a hundred million, 200 million. I don’t know what you’re allowed to talk about, but it’s safe to say this was a big eight or nine figure profit, right? This was a giant win. Yeah.

00:18:39 (Speaker Changed) The notional amount of the trade was about a quarter billion dollars. And we did, well,

00:18:44 (Speaker Changed) I’m gonna guess you don’t, you don’t have to sit, you don’t have to admit or deny the following, but if the, if that was your notational a hundred isn’t a ridiculous profit margin. That’s Barry saying it. That’s not Mike. So any compliance people listening, I’m just spitballing here. Couple of months ago I had David Einhorn on and he, and he made some news basically saying passive has broken the markets and kind of snuck by after he dropped that bomb, was he credited you with helping him understand how passive has changed market structures and forcing him to become as a value investor, more of a, let’s call it a deep value investor? Yeah. And his performance has since rebounded. So given that Einhorn has credited you with this insight, tell us how you came about to this belief.

00:19:38 (Speaker Changed) Sure. So the, the XIV trade was actually part of a broader research into the dynamics of passive. And if I’m gonna run through that language and, and help explain it, the single biggest contributor to that research was actually a 2016 paper by Lace Peterson, an A QR brilliant individual who wrote a paper called Sharpening the Arithmetic of Active Management. Right? That paper refers back to the foundational literature of Bill Sharp, who wrote the famous paper in 1991. The arithmetic of active management, which is the source of any statement that you hear, which is active, simply owns the same stocks as passive because it charges less, therefore passive will outperform over time, right? The argument is very straightforward. There’s an assumption of completeness in markets. What lase pointed out in his paper was that passive had to transact during periods in which there was index rebalancing.

00:20:33 And so in that period they ceased to be passive investors, they became active investors, and that became an opportunity for outperformance. Now, the reason that that became interesting to me was I recognized one additional feature that Lae had not highlighted, which is that passive investors are always transacting because of the dynamics of flow. So you get your paycheck, you put that’s right, 6% aside, that flows into various Vanguard funds. They’re transacting on a daily basis. And just put it in perspective, over the past couple years, Vanguard has averaged somewhere in the neighborhood of $300 billion worth of inflows every single year. That’s the equivalent of a large hedge fund every single day having to deploy its capital into the market. And so when you think about this dynamic of, is passive, actually passive, it’s really important to understand that the definition of passive, as it stated, and this is true for the XIV, it’s true for the s and p 500 in any form of index fund, the definition of passive is somebody who never transacts. If they transact every single day, then they’re actually a different animal. So let,

00:21:37 (Speaker Changed) Let me push back on that definition a little bit. ’cause I don’t want us, ’cause you and I are gonna disagree about some things, but I want us to have some fundamental agreements. My definition of passive is rather than trying to time the market or pick specific stocks or have a concentrated portfolio, meaning a, a high active share, so you don’t look like the index, you’re just gonna default to a broad index, whether it’s the s and p 500 or the Vanguard Total Market, which I think is 800. And then there’s an even larger one that’s a few thousand. And I’m gonna own the whole market. And what that will allow me to do is have minimal trading costs, minimal tax costs, and avoid all the behavioral problems that comes with active management. And so I’m gonna own this in a 401k, it’ll be a mutual funds in a taxable account. It’ll be an ETF and I’ll let that run. So I, I don’t think you’re that disagreeing with that definition or how far off is my definition from yours?

00:22:39 (Speaker Changed) Well, the only difference in our definitions is actually the process of how you get to hold it. Right? So the, the natural conclusion that you’re making is actually consistent with sharp’s paper, right? Which is the idea that passive investors hold every security. The problem is how do you get into hold those securities and how do you get out when the time comes to sell them?

00:22:59 (Speaker Changed) So you and I are not disagreeing at all. You, you set up your 401k or you set up your investment plan and whether you’re making a purchase and putting it away, or dollar cost averaging in your 401k or in any other, my partner Josh calls this the relentless bid, the constant flow of money into 401k or IRAs ha have operated as a, a little bit of a floor on the market, you know, the.com financial crisis and pandemic crashes. Not withstanding, most of the time there you can count on positive inflows to equities.

00:23:37 (Speaker Changed) Well, yes. Right? I think that’s correct. And I do think you used a term that I think is really interesting, the relentless bid. Yeah, absolutely. Right. And so when you start thinking about each of those individual components that you’re talking about, first of all, just it’s really important to understand that all the literature that exists around active versus passive and the idea that passive doesn’t meaningfully change markets actually presumes that it’s simply a hold. That there is no transaction activity. It goes so far.

00:24:03 (Speaker Changed) I mean, other than I, I mean obviously it’s not like, okay, everybody in 1999 buys stocks and then no one buys stocks for the next 30 years. There’s a continual, the economy continues to grow. People earn wages, whether it’s a retirement account or a tax deferred account or just an investment account. The average mom and pop investor throws money into the market on a regular basis and takes money out of the market when it’s needed for other purposes.

00:24:32 (Speaker Changed) So the fascinating thing about that is, first, I completely agree, right? And I think that’s actually part of the language that gets confused and lost on this. And so again, anytime you’re transacting, you’re not passive. When you decide to buy with your weekly contributions, you’re not passive. What you’re actually doing is you’re transacting in a systematic fashion. So you are a systematic algorithmic investor that has a very simple rule. What do I buy? I buy everything. What price should I buy it at? Whatever price the market is offering me, that’s presumed to be the right price. Right now, anytime you buy, you’ve traded portfolios that are several hundred million to billion dollars in size. Anytime you attempt a transaction like that, you’re going to influence the prices, right? And that’s really what distinguishes the difference. That’s what David is highlighting. As more and more investors transition to this systematic algorithmic investment that simply says, did you give me cash?

00:25:27 If so, then buy. Did you ask for cash? If so, then sell. That starts to change the market behavior in a measurable and meaningful fashion. It actually causes two things to happen. One is it creates a momentum bid because what do I choose to buy? I choose to buy whatever the market is pricing it at. So things that went up since I, my last purchase I buy more of as a proportion of my assets. I buy less of things that went down, right? The second thing that it ultimately does is it creates conditions under which there’s a transition from cash rich portfolios that are ultimately option like in their characteristics. So I, as a discretionary portfolio manager, if you hand me cash, I can look at the market and say, you know what? Thank you for the cash. I’m gonna hold it in my portfolio. I’m going to use this as an opportunity for me to reduce my exposure to the market. Or I could choose to use it to buy something without having to sell something.

00:26:24 (Speaker Changed) Given that, what are the risks to the US economy and to the markets from too much passive investments flowing into equities.

00:26:35 (Speaker Changed) So the key risk ultimately lies in that very simple language, right? Did you give me cash? If so, then buy. Did you ask for cash? If so, then sell. And I just wanna pause for a second and go through a little bit of financial history here. ’cause I think it’s really important for people to understand this. Things that we think of as having always been there, things like 4 0 1 Ks and IRAs are actually very recent inventions and there have been dramatic changes around their implementation within your investment career and my investment career, which are roughly similar in duration. Yeah, it,

00:27:05 (Speaker Changed) It actually predates us, but had not become popular like it had existed for about 20 years before people started to figure out, wait, I could put this money away and have it grow tax free. It really took a few decades before the market kind of came to grips with

00:27:21 (Speaker Changed) That. Yeah, I mean, so just very quickly, IRAs were actually created in 1972 to facilitate a key risk that nobody had ever imagined before, which is if you were a union employee who was fired in the 1971 recession and you received a lump sum settlement of your pension, you suddenly, that was treated as earned income in that year. You were subject to the 75% marginal tax rate. Crazy. It was absolutely insane and devastating to many individuals. And so the IRA was created to facilitate the rollover of those on a tax deferred basis so that you could maintain those assets even if you lost your job, right? The second tool that was introduced was the 401k, which refers to a specific provision of the tax code that created the defined contribution, right? If you launch yourself all the way back to 1981 and the start of the bull market, 1982, the start of the bull market in US equities following the election of Reagan, the total assets in those two were about a hundred billion dollars in each, right? Today, IRAs, I believe are around 17,000,000,000,004 oh one Ks are somewhere in the neighborhood of eight to 9 trillion, right? These are the single largest pools of assets on the planet is the American retirement system. The F, there is a subsequent change in 2006 called the Pension Protection Act. That one tried to push more and more people into 4 0 1 Ks, right? By making it what’s called an opt out framework as compared to an opt-in, right? You

00:28:51 (Speaker Changed) Can blame Dick Thaler and nudge for that

00:28:54 (Speaker Changed) A hundred percent the nudge dynamics and trying to create the ownership economy. And those have been on net quite positive components to them. But they have meaningfully changed the structure of how flows enter the market because

00:29:06 (Speaker Changed) Of the qs, right?

00:29:07 (Speaker Changed) So qdi is what they’re

00:29:09 (Speaker Changed) Talking qds,

00:29:10 (Speaker Changed) I’m sorry. So the qualified default investment alternative, if you’re going to default somebody into participating, you no longer leave it up to them to say, Hey, what do you want to buy? You actually have to select something that you’re going to put them into. And so the Pension Protection Act also introduced this idea of qualified default investment alternatives that provided a liability protected mechanism for HR managers or CFOs to declare this is where we’re gonna default people into. Initially those were balanced funds. So this is part of the key growth of pimco, which had skillset in both, in both equities and fixed income. So the growth of balanced funds was a real, really key characteristic of that 2006 to 2012 market. And then in 2012, they changed the QDIA to what’s called a target date fund. Right? Which is what about 85% of Americans now default into in their retirement assets,

00:30:00 (Speaker Changed) Right? What the way it used to be is you would start at a company, even if they had a a match, you had to go out and do the paperwork. You had to go out and choose a fund. Even if they said, as joining a company you automatically get a 401k cash would just pile up in there if you didn’t give some form of default direction. Yeah. So, so essentially what was designed to say, Hey, you gotta get off your butt and do something, we’re gonna make it, we’re gonna make sure you’re investing in something. It’s up to you to go in and change it to what you want. It’s kind of shocking and, and in some ways, just reminding us of the strength of behavioral finance, that people are so lazy, just like, what’d you put me in? Okay, great. And they don’t even think twice about it

00:30:48 (Speaker Changed) A hundred percent. And that actually is exactly what we see. So it’s also a very bifurcated experience where those who were older and who already defaulted into 401k plans and made the choice to go into those 401k plans, they typically would choose from a universe of active managers, right? That’s the world that largely existed prior to 2006. The passive share at that point was still quite low. When I entered the industry, when I first started, you know, cutting my teeth on this stuff, it’s hard for people to remember, but passive was still roughly 1% market share. In 1992,

00:31:20 (Speaker Changed) Vanguard formed in 1974. They didn’t get to a trillion dollars till pretty much after the financial crisis. I have a thesis that have said, you know, from the nineties implosion and then a, just a raft of scandals, the accounting scandal, the animal scandal, the IPO spinning scandal, the just go down the whole list, and then Bernie Madoff and then the financial crisis. My general sense has been lots of mom and pop investors have said, we just don’t want to get involved in that mess. Just let me buy the market and forget about it. And, and for those folks, it’s worked out. And those folks are very often my clients. So let me pose this question to you. If you are having a discussion with a fiduciary who runs a few billion dollars in client assets, convince me to shift those accounts away from either broad indexes or passive generally to something more active. Why should I move their accounts elsewhere?

00:32:23 (Speaker Changed) Quick answer is you shouldn’t. And that’s actually a part of the problem is that the individual choice should be to bypass passive, right? The problem is, is when all of the individuals buy passive, we actually change the structure of the market. And so it no longer represents what it historically did.

00:32:39 (Speaker Changed) And by the way, let me interrupt you and just say, we obviously have huge swaths of fixed income and muni bonds as part of the that portfolio. And we also own a variety of non- passive holdings. Some with a value tilt, some with a momentum tilt, some international. So it’s not like, all right, we’re gonna charge you a fee and just load up on the s and p 500. It’s obviously a lot more significant than that. But given what you’re saying that fiduciaries should be looking for low cost, at least in a current satellite setup, how do you go about reducing the risks to what you see as as market structure problems caused by a simple default to passive?

00:33:23 (Speaker Changed) So this is actually the core of the issue, and it’s part of the reason why I spend so much time talking about it. And it’s part of what I made David aware of in that conversation to go back to it, is there’s very little the individual or the individual RIA can do to change this. This is a regulatory framework and it is controlled by the Vanguards and BlackRocks who are spending far more on lobbying than the rest of the industry combined, right? So part of what’s really happening is the political choice to push you into these vehicles, the political choice to make it the only acceptable alternative under the rubric of offering safe, low cost investments to people is totally understandable. We all want that desire. Certainly that’s your desire as well.

00:34:04 (Speaker Changed) I mean, is it an overwhelming amount of academic literature that says, you know, some active managers manage to outperform, but by the time you get to 10 years and take in taxes and costs and and fees, you would’ve been better off in, in passive. The more people who find their way into passive vehicles, doesn’t that create more opportunities for people like David Einhorn? Isn’t the greater the percentage of passive ownership the more inefficiencies there are and therefore, shouldn’t we see active sort of reassert itself perhaps at a lower fee than in the past, but aren’t there more and more opportunities for people who have a skillset to identify inefficiencies wherever they pop up?

00:34:50 (Speaker Changed) So I’m really glad you asked me that question ’cause this is the traditional model and the way that people think about it. And it’s exactly what I focused on with David, right? The immediate reaction to the idea of the growth of this non thoughtful entity passive right, makes it seem like those who are thoughtful should have an advantage. The problem is, is in the theories that lead you to that articulation. So what you’re referring to is broadly called the Grossman Stig Paradox. The dynamic that the more people choose not to put in effort into the market and divining prices, the greater the incentive and the opportunity set is for those who are choosing to put that into the market. It’s what they call the impossibility of perfectly efficient markets. The problem, again, goes into the details of the assumption of the model. So really what Grossman Stig is all about is the wisdom of crowds.

00:35:41 You’re familiar with the Michael moan examples of these, or the articulation that we’re all familiar with. You go to the county fair, there’s a giant jar of jelly beans and you’re supposed to guess how many jelly beans there are in there, right? Any individual has a very low probability of success. But when we aggregate all the guesses and we take the mean of that, it tends to be pretty darn close to that answer. And that’s composed of absolute nerds like me who are like, well, what’s the diameter and how big is a jelly bean? And all that sort of stuff, right? And people who are making just total wild guesses, right? The problem is that model, the wisdom of crowds actually requires everybody to have what’s called equal endowment or the same number of votes. And that’s actually what Grossman Stig relies on as well, is the idea that the wisdom of crowds is caused by the dynamic of each individual making those choices and the market in its totality, being able to guide towards that. And so that incentive where prices get pushed off, if I am the same size and I have the same number of votes as everybody else, I can guide the market back to that. That’s the opportunity set. Why?

00:36:45 (Speaker Changed) Why wouldn’t that work in equity markets where people with more votes, more dollars have a greater incentive to get the number of jelly beans? Correct?

00:36:55 (Speaker Changed) So that’s actually exactly what isn’t the case. So what’s actually happening is we’re giving more and more of a vote to somebody who doesn’t care, right? As a result, Vanguard and BlackRock, because of their daily transactions, the size of those transactions has gotten to the point, even though they’re not actively trading on a day-to-day basis, that relentless bid that your partner refers to is actually changing the structure of the market. It’s changing that price behavior. It’s the same thing as if we went to the county fair and they said, everybody guesses, and then the mayor gets to guess 10,000 times. Hmm, whose vote’s gonna count?

00:37:32 (Speaker Changed) So I did a lot of prep work for this. You and I have had disagreements on Twitter about passive versus active. I, I think our disagreements are less than I previously realized. I, I think we both understand the advantages of low cost indexing, but, but let’s talk about some of the recent data that’s come out. I know you’re a big fan of a lot of research that’s out there. Last week, Eric Unis, who’s the ETF wizard at Bloomberg Intelligence, put out a report, passive investing worries appear overblown as active as in control. And his key take takeaway was when you looked at the s and p 500 stocks and you broke them into Quintiles with the most or the least passive ownership, the least owned quintile beat all the rest over one, three and five years. So if that’s the case, doesn’t that prove that active managers are still doing okay and the struc market structure is behaving as it should?

00:38:37 (Speaker Changed) So it’d be nice if that was the case. Unfortunately, the analysis was deeply flawed. I pointed this out in responses to Eric. What you discover if you actually dig into that analysis is, is that the least passively owned stocks are the apples, Microsoft, Nvidia is, et cetera, the world, the largest companies, meaning

00:38:54 (Speaker Changed) The active managers are buying those big, magnificent seven stocks,

00:38:59 (Speaker Changed) Except they’re not. And so the reason why that disconnect comes is because,

00:39:03 (Speaker Changed) Wait, hold on. I have to, I have to stop you there. Sure. Every concentrated portfolio I’ve looked at, every active manager you have to really go down the list to get to people who don’t have some combination of Nvidia, Microsoft, Netflix, go, you know, go down the list of the top 10. They all seem to own United Health. Now, if they’re not closet indexers, if they don’t own 300 stocks, maybe they stop after 10 or 20. But those big, big cap, dare I call them nifty 50 stocks, they seem to be the favorites of the active managers make the other case.

00:39:42 (Speaker Changed) So it actually turns out that the active managers, and this is almost exactly why we see some of the dynamics that we talk about. Active managers skew towards smaller stocks simply by definition, right? The Russell 2000 has 2000 out of the roughly 3,500 stocks available publicly traded. It’s about 4% of the total market cap. So somebody has to actually go out and own that. And we know it’s not vanguard, we know it’s not BlackRock, they’re not owning it in any different proportion or any meaningfully different proportion to what they’re owning. Everything else through a total market type index. There are some wrinkles around that. But in rough terms, that’s the case. You are absolutely correct that there is representation of Apple or Microsoft, but that actually hits on a slightly different component, which is if you are going to compete with the s and p 500, paradoxically, you do have to own those names. You don’t have to own Delta Airlines, nobody cares, right? But you do have to have exposure to the apples, Microsofts, et cetera world, but almost no active manager can carry them in the size that a passive vehicle can because of concentration limits. Why,

00:40:43 (Speaker Changed) How, how much is Tesla in the s and p 500 or Netflix or nvidia? None of them are more than 10%. Did didn’t the s and p and the NASDAQ 100 change those rules like 10, 15 years ago?

00:40:57 (Speaker Changed) So 10 to 15 years ago they changed to market cap from market cap weighted to float adjusted weights. I think that’s what you’re referring to, right? But actually, interestingly enough, this is part of the dynamic and where regulation plays a role. Entities like the s and p 500 growth fund are far more concentrated than is legally allowed by the 40 act, by which they’re governed. They are too concentrated relative to that. They’ve been given dispensation by regulators because they’re index investors. And this is where the analysis that Eric was highlighting is flawed. Because what’s actually happening when you see the high levels of index ownership for an individual name, what’s happening is, is that you’re picking up a sector fund, for example, this is very notorious in REITs. It’s also very clear in things like a technology index, the XLK for example, or the XLE in the energy space, XLE is I believe 40% ExxonMobil, 40% Chevron, right? Nobody can actually run an active portfolio that looks anything remotely like that.

00:41:56 (Speaker Changed) Is that, are they that big? That’s, that’s close. That’s crazy’s pretty close. Yeah. That, that, that, that’s absolutely ridiculous. So, so

00:42:02 (Speaker Changed) That’s, so just very quickly, that is actually what Eric is picking up. And I would argue that those are not actually what we’re talking about when we talk about passive precisely the definition you and I were talking about. If you’re a passive or systematic index investor, you’re not saying, well, I’m gonna overweight energy, I’m gonna allocate to an individual indus industry and sort of turn around and then say that those stocks that are most passively owned don’t exhibit this type of behavior is to confuse those two dynamics.

00:42:29 (Speaker Changed) So also within Eric’s research piece was something that said, Hey, we went back and looked at drawdowns of 10% or more of the components in the s and p 500. The stocks with the highest passive ownership didn’t, weren’t subject to greater volatility or larger drawdowns than any of the rest of the ownership, which is a big part of the argument that, hey, the structure is damaged and when it finally breaks, these passively owned vehicles are gonna be a disaster.

00:42:58 (Speaker Changed) So there’s two separate components to it. One is that, again, the issue is how you’re defining the passively held. So if by definition, I’ve already gravitated to saying the least passively held are the Microsoft Apples, et cetera of the world, I’m gonna come to that conclusion. But the, the unfortunate answer, right? Well,

00:43:16 (Speaker Changed) What about the most passively held?

00:43:18 (Speaker Changed) Those actually ironically, are the most passively held. And the reason that they’re actually the most passively held is precisely this issue of concentration risk. Most active managers can’t hold those names in the size that’s required. If I’m a small cap manager or I’m a diversified fund manager, I typically have to run with a hundred names in my portfolio, a hundred names in my portfolio to be equal weight to Apple, for example, in the index. It’d have to far outweigh everything else in my portfolio I offer as an active manager, typically very little value added to the insights on something like Apple. And so the institutional space, or most asset selectors, asset allocators are gonna look for managers that are trying to add value. Otherwise, why not just buy passive? Why not go with a low cost solution?

00:44:04 (Speaker Changed) So, so that kind of raises the, the question about what is the solution to this? I brought up unis, but I recall maybe it’s 10 years ago, he, he wrote a column that he eventually turned into a book called The Vanguard Effect. And he figured out that over the course of the previous 20, 30 years, Vanguard has taken about a trillion dollars in fees out of the market. Now, it didn’t all go to Vanguard, they got, took about a hundred billion dollars in fees, but it forced everybody else to compress their fees, to lower their fees in order to be competitive and ultimately saved, ultimately saved investors a trillion dollars. So the question is, how do we not go back to the bad old days of expensive underperforming active managers given the, the alternative that we’ve created? And keep in mind, Vanguard and BlackRock didn’t, you know, they weren’t born whole cloth into a vacuum. They came about following a lot of academic research and a lot of pricing underperforming active managers in the seventies, eighties, nineties. So how do we not go back to those days and yet still have an opportunity to fix the market structure?

00:45:27 (Speaker Changed) Yeah, I know. So there, there’s a, a whole bunch of different components to what you hit on. The first is this idea of cost savings associated with Vanguard. First of all, I absolutely agree with Eric’s analysis that the low cost introduction, the introduction of the mutual structure was absolutely part of the success of Vanguard. And the push towards lower fees has been absolutely critical. But remember the vast majority of the time that Vanguard was actually running 50 basis points would’ve been considered really cheap fees,

00:45:54 (Speaker Changed) Right? That’s

00:45:55 (Speaker Changed) Right. Right. And initially introduced, I believe the fees on the Vanguard funds were about 75 basis points, 0.75% as compared to most active managers who are between one point half and 2%, right? So that pulling down was absolutely critical. Today you’re at a point where the three basis point, candidly, it just doesn’t mean it’s

00:46:13 (Speaker Changed) Free. It

00:46:14 (Speaker Changed) Free, it’s effectively free. And one of the reasons that it’s able to be effectively free is because there are hidden subsidies within the industry, which ironically are affecting things like the CPI numbers that we see where securities lending is actually what’s paying for Vanguard, right?

00:46:28 (Speaker Changed) Allows meaning people wanna short stocks, they borrow it, they borrow it from Vanguard, paying avanguard, you go to the largest holders, right? You go to, you go to BlackRock and Vanguard,

00:46:35 (Speaker Changed) Absolutely correct. Those are the two that you go to those, but

00:46:36 (Speaker Changed) That’s, that’s, you know, it’s real money when you’re running trillions of dollars. But when you’re three or four basis points or five basis points, and don’t forget, Vanguard is about 30% active funds. BlackRock is a little more 40 something percent active funds. So, so they haven’t abandoned that space. And when you look outside of their core, you know, s and p 500 or for Vanguard, it’s VTI or VOO or you have a run of total markets or total global markets, US or global, there are some higher fee products, 10, 20, 30 basis points, but it’s the scale trillions and trillions of dollars that have allowed them to take a fund like that down to three basis points or four basis points. So

00:47:23 (Speaker Changed) That’s actually exactly the point that I would emphasize, which is, is that we have allowed the industry to change so dramatically from that thought experiment of Grossman STIGs in which everybody was roughly the same size, Merrill was bigger, but it was a whole bunch of individual brokers who were able to do whatever they individually wanted to. Right? Now what you’ve effectively done is you’ve created an industry that like so many other industries has become remarkably concentrated. And so one of the ironies is when Eric is talking about passive share, the way that that calculation is done is simply by adding up Vanguard, BlackRock, et cetera. Right? Right. Now that actually was the focus of a research piece that I actually inspired, I challenged two Harvard professors, actually a Harvard professor and a PhD candidate. Alex Chenko was the PhD candidate. Marco Salmon was the Harvard professor. I was the adjudicate on a paper that they’d written where they did an analysis on the impact of passive. I very much agreed with the work that they had done, public record, but they had done their scaling of the impact by looking at it and saying the share of passive is 15%, roughly what Eric was working off of, right?

00:48:29 (Speaker Changed) In other words, when you look at ETFs and mutual funds, passive is about 50% of mutual funds. Now it’s over 50%. But the non funds, the direct ownership is primarily active. You’re, you’re saying that is somewhat overstated. It

00:48:45 (Speaker Changed) Is very much overstated. So it actually turns out, so the, the statistics that people are using for that is very quickly the mutual fund or 40 act industry is about 35% of the equity market in total. A little bit more than half of that, as you’re pointing out, is passive in its structure. And so we can multiply points,

00:49:01 (Speaker Changed) Let’s round that up to 2020

00:49:02 (Speaker Changed) Call 20%, right? That’s the quick answer in terms of how much is passive. But remember passive actually got started even before Bogle. It got started in the institutional space. It was Wells Fargo that was the first, that’s right in the passive space. And so it actually turns out that away from the retail space, passive is even larger in the institutional space. And that’s the area under the iceberg that you’re missing, right? So Marco Salmon and Alex Chico’s work focused on exactly that. They went and they did a, they did an actual experiment where they tracked what fraction of shares had to trade in response to an index rebalancing. And the answer is around 40%

00:49:40 (Speaker Changed) Right? Now, I’ve seen some pushback to that. That says there’s a lot of end of day trading. There’s a lot of people who are either front running or piggybacking those trades and you can’t credit all of that 40% rebalance number to to passive. And so that’s how they end up with Fidelity had a study, I wanna say it was 27 or 28%. Somebody else had another study that 23%. But let’s give you 30%. So if it’s 30% going to 40%, going to 50%, when 50% of the market is purely passive, doesn’t that mean that folks like David Einhorn are just gonna clean up? So doesn’t it create, isn’t it homeostatic and going back and forth?

00:50:24 (Speaker Changed) So if it were a stable situation, absolutely. The case, the problem is, is that when you talk about going from 30% to 35% to 40%, what you actually have is the scenario that we have in markets today where more than a hundred percent of the flows, which is actually what determines the majority of transaction activity, is passive in its construction, right? Again, the active space is losing assets, it’s seeing net redemptions. The passive space is actually receiving more than a hundred percent of the inflows. And if you go back and you think about the dynamics of Andrew Lowe stating 90%, or John Bogle himself highlighting that between 80 and 90% markets begin to break down, it’s important to recognize that 90% of the trading activity no longer has a fundamental component to it. That’s actually research that was done by JP Morgan as of 2017. And all the components that you’re talking about, the arbitrage, the normalization, et cetera, all of those are done in the facilitation of that end of day market. On closing balance is tied to the mutual fund, ETF orders, et cetera.

00:51:30 (Speaker Changed) So what do you, what do you think about, not traditional passive, but some of the concentrated portfolios. I, I had Andrew Slimmons of Morgan Stallion not too long ago. He runs a 20 or a 30 name portfolio that has done pretty well. We continue to see people like Bill Miller Slag, the active side of the industry, calling them mostly closet indexers and said, if you, if you want to beat the market, you have to look different from the market. You have all sorts of things like smart beta and thematic investing. And I know Simplify has an India based ETF. There’s a lot of choices for people who want to run, let’s call it a core and satellite type of portfolio where, hey, our core is gonna be look very similar to the market, but we are gonna put our own stink on it. ’cause we want to have exposure to Japan, exposure to India, exposure to momentum, blah, blah, blah. Isn’t that the sort of, the direction things seem to be heading

00:52:30 (Speaker Changed) In? Not at all. So yeah, so there’s a lot of highlight around the growth of active ETFs, for example. They’re about 25% of the

00:52:37 (Speaker Changed) Flow. They become huge, right? They have not been, no. And they’re capturing some flow.

00:52:40 (Speaker Changed) They are capturing some flow, but they haven’t become huge. Let’s actually be

00:52:43 (Speaker Changed) Really clear on that. They’ve become bigger, so I’m, I’m overstating it. They’re much bigger today than they were five years ago

00:52:49 (Speaker Changed) With the offset being that the mutual fund and hedge fund spaces are much smaller.

00:52:53 (Speaker Changed) Fair,

00:52:54 (Speaker Changed) Right? Fair. So what you’ve actually had is a net decrease in the quantity of active, but it’s instructive that everybody points out like, oh, look how robust the space is and how wonderful it is, right? The simple reality is, is that nobody can actually afford to acknowledgement of the concerns that I’m highlighting. It’s really very straightforward. There is no such thing as passive investing. Everybody is an active investor. Well,

00:53:16 (Speaker Changed) They’re an active trader when they’re deploying the capital. They’re also an active trader, but they’re not actively selecting stocks. They’re relying on a on index,

00:53:23 (Speaker Changed) Which actually is a decision process. It’s an algorithm. Sure, of course.

00:53:27 (Speaker Changed) Right, right. I did a column a couple years ago, how passive, how active is your passive? Where, hey, even the s and p 500, someone decided it’s gonna be market cap weighted. Someone decided what the rules are and there’s regularly additions and deletions that seem to be, you remember when Tesla was added? That seemed to be an editorial decision, not a, a systematic algorithm deciding.

00:53:50 (Speaker Changed) Well, it actually technically was a very systematic decision. Right. And so we actually, Tesla was a fascinating example on this because we actually had received a lot of speculation around it. The rules for inclusion in the s and p 500 are pretty straightforward. You need to be of sufficient size and you need to have at least five consecutive quarters of profitability. Right. So once Tesla began actually reporting profits and then moving towards that fifth quarter, it became very clear that on a pure size basis, they were gonna be the next player to be included. And the size that they were going to be included in was gonna require an insane amount of passive buying.

00:54:25 (Speaker Changed) There was a ton of front running also. Yeah. Ton of active running.

00:54:28 (Speaker Changed) Exact same thing just happened with SMCI, for example. Right.

00:54:30 (Speaker Changed) Well, they’re they’re a lot smaller.

00:54:32 (Speaker Changed) It doesn’t really matter though,

00:54:33 (Speaker Changed) Actually. So, so I’m glad you brought up Tesla. We’re recording this on the first day in May two months ago. Tesla originally part of the magnificent seven down 65% from its recent highs doesn’t seem like active flows or passive flows. Were helping Tesla. And then over the last month, you know, they cut a deal in China, they, they kind of explained away some issues with the self-driving problems. They cut prices and suddenly they’re back to only down 50%, which is a big move when you’re down 65%. Doesn’t that belie the whole argument that passive is destroying price discovery. Obviously a bunch of active managers figured out Tesla was way too richly priced back in 21 and after it got whacked by two thirds, someone else turned around and said, alright, this has gone too far. There’s, this is not a worthless company heading to bankruptcy. We wanna own it. Isn’t there plenty of of price discovery going on?

00:55:38 (Speaker Changed) So unfortunately, I think the answer to that is no. Right? There’s always gonna be a subjective component to that. I would highlight, when you look at something like Tesla, there’s a couple of things that are really interesting. One is, who was the largest seller of Tesla

00:55:49 (Speaker Changed) Besides Elon?

00:55:50 (Speaker Changed) No, that’s exactly the point. Oh,

00:55:52 (Speaker Changed) Okay.

00:55:52 (Speaker Changed) So let’s, so why did Tesla go down over that time period in which he was acquiring Twitter? ’cause he had to sell a ton of Tesla shares.

00:56:00 (Speaker Changed) There are a lot of other reasons, like I I will make a fundamental case for you. The, yeah, Elon sold some, he didn’t sell enough to whack it. Two thirds. Their cars are kind of long in the tooth. They, they haven’t really introduced an upgraded E. Even the X and Y look very much like the model S and, and I’m sorry, the model three and the model Y looked like the S and the X. There’s, China has become a ongoing problem. Five years ago, they were a decade ahead of everybody in the software. Now they’re, I don’t know, 3, 4, 5 years ahead of everybody. And there’s a boat ton of competition. It’s not just four gm, BMW, Mercedes, Audi, Volkswagen, Volvo, ul go down the list. You could buy an ev, rolls Royce, a Maserati if you want. Everybody is piled into the space. So fundamentally you can make a case. Yeah, Elon sold a bunch of stock, but suddenly it’s a more challenging environment and the stock had become overpriced. That’s the argument I would make. That, that, that Tesla had become overvalued. And it seems like the market picked up all on a lot of it, especially, what did it peak at, at 1.2, 1.3 trillion that kind of suggested we are gonna own the EV space for the next decade.

00:57:28 (Speaker Changed) It wasn’t even just own the EV space. So first of all, I actually agree with you, and I think most fundamental managers would agree with you that Tesla was overvalued. But the simple reality is overvaluation doesn’t actually affect anything. Right? What affects things is people actually executing trades. Right? The only thing that

00:57:44 (Speaker Changed) Can cost. So, so how much did Elon sell? I mean, it, he it didn’t seem like he sold What did, what did he overpay for Twitter? Yeah,

00:57:52 (Speaker Changed) $40 billion. Right.

00:57:53 (Speaker Changed) And he didn’t pay for, that wasn’t all Tesla stock. It was, I think he had to pay 10 or 20% of it. Let’s call 10 billion out of 1.2 trillion. Shouldn’t have crushed the stock. So

00:58:04 (Speaker Changed) Let’s use Bitcoin as an example for a second, right? How much money has flowed into the Bitcoin ETFs?

00:58:10 (Speaker Changed) I don’t know, $60 billion over the past decade?

00:58:14 (Speaker Changed) Well, not over the, over the past decade, but in particular since the introduction in January. Oh

00:58:18 (Speaker Changed) God, you look at the BlackRock ETF, it was at $5 billion in a month and it’s probably close to $10 billion now, right?

00:58:27 (Speaker Changed) So there’s been about $40 billion worth of inflows against a Bitcoin valuation or a market cap of Bitcoin going into it of about $400 billion. And it costs a 65% appreciation. So $40 billion in it’s

00:58:42 (Speaker Changed) Non-linear. Yeah, it’s totally non That’s

00:58:43 (Speaker Changed) Fair. Same thing’s true on Tesla, right? Everything happens at the margin. By the way, why did, why did Amazon sell off so, so firmly over the past couple of years as well?

00:58:52 (Speaker Changed) Because Bezos departed and the company is a shell of the delightful retailer. It once was.

00:58:58 (Speaker Changed) Wouldn’t that be awesome if it was true? Except it really boils down to Mackenzie Scott selling her shares.

00:59:03 (Speaker Changed) There’s, there’s a lot of that. So let me, let me shift gears on you since we’re talking about structure. I, I wanna change things up and throw one more thing at you about structure. ’cause I, I, I’m enjoying this conversation. So a couple of years ago we started working with the folks at osuna, the asset management who rolled out a product called Canvas, which was a direct indexing product. Direct indexing has been around for decades. It, to me it’s never been particularly impressive. And Nessy had a couple of things going for them that nobody else did. They, they, over their course of 20, 30 years created their own incredibly clean database that they had built out that was, you know, you have to look at crisp, maybe as the, or CompUSA in the old days is, and the only thing that’s close, but it was really very specific to them.

00:59:56 And second, you know, the team at, at O’Shaughnessy, and I’ve had all these folks on between Patrick O’Shaughnessy and Jim who famously wrote the book, what Works on Wall Street, a really a first quant book for the public. They created a a form of direct indexing that as someone who’s been a skeptic, Dave Tigan and I have disagreed about this for years. When we first saw this in, I wanna say 2019, it’s like, oh, I get it. You can do so much more now. And of the, you know, four point whatever billion dollars we run over a billion is on the canvas platform now owned by Franklin Templeton. And what we have discovered is, if you have any sort of, this is a long way to go, but I’ll get there. If you have any sort of potential capital gains, you’ve inherited a portfolio, you’ve sold a business, you have a bunch of founder stock, you have a bunch of IPO stock and you want to diversify out of that core portfolio, but the capital gains are gonna be fairly weighty.

01:01:03 You could use direct indexing to tax loss, harvest and order of magnitude better results than if you own a half a dozen ETFs or mutual funds just and, and first quarter of 2020, anytime you have a 30 plus percent decrease, that fits nicely in, in the range of the calendar quarter. You know, instead of being 75, 80 basis points, it’s 300 shawnessy has case studies, 400, 500 basis points, giant game changer, long asked question. Short conclusion is do things like direct indexing, which have always been a small part of the market, but seem to be catching a bid. Now, might this interfere with that relentless bid of passive? Can something like this change the game for what you see as a structural problem in passive?

01:02:02 (Speaker Changed) So it is a very long question. A lot of different components to it. First, direct and indexing is almost by definition always gonna be relatively small. It’s a tax arbitrage strategy. It requires people to start with a lot and then try to maintain most of it. Right? And so the return differentials that you’re quoting there are obviously a tax advantaged return differential. It’s not the absolute levels of performance.

01:02:23 (Speaker Changed) That’s right. Understand, let me, let me clarify. I’m referring to the tax alpha returns. Yep. Over and above what you get from the market. And it’s not aimed at market performance in its own way. It is a form of, I don’t want us call it passive because it’s not, but it apes passive investments or whatever funds you want to put in

01:02:42 (Speaker Changed) There. Well, what it’s doing is it’s seeking diversification, right? So it really doesn’t, what you’re doing is you’re taking heavily appreciated individual positions and you’re then diversifying it into a market market exposure. Exactly. That’s exactly right. Right. The ability to, to arbitrize your individual tax positions falls way outside the dynamics of market efficiency, right? Every individual is gonna have their own components. We could get into tons of conversations around exactly that issue. And that actually almost perfectly fits with what the critical point that I would make is. It’s not so much that passive itself is a terrible thing. It’s actually the, the idea of a systematically algorithmic investment in which the simple determining algorithm is, did you give me cash? If so, then buy, did you ask for cash? If so, then sell. That actually can diversify a market. It creates a different mechanism and it can actually lower volatility. And candidly, I think we saw that up to a certain point of market share around 25% market share. It actually turns out perversely the passive is beneficial to the market. It’s once you go past that point that it starts contributing to higher volatility, much higher correlations, and the risk of severe left tail events. Which brings us full circle back to the XIV type dynamic. So,

01:03:56 (Speaker Changed) So then let me ask you one final question before we jump to our favorite questions. Whoosh. Has the burden for dealing with the, the challenges of passive attracting so much in assets, shouldn’t it be on the active managers to reduce their costs, put up better performance numbers over longer periods of time and take advantage of all of these inefficiencies? Passive creates? Isn’t this a system that should heal itself if active managers start to perform lower their fees and attract more capital?

01:04:35 (Speaker Changed) So the the answer is very quickly, no. And unfortunately, this brings us back to the question you had asked of, doesn’t it get easier? And ironically, what ends up happening mathematically, what occurs, that constant bid that you’re describing perversely changes the return profile of the market and it actually turns it into a, this is difficult for people to see over radio, but I’m drawing a convex upward sloping curve, right? It pushes valuations higher over time. Now, perversely what we call alpha in the industry, which is typically how we evaluate individual managers, it turns out, is actually over time just the, so the intercept on a y equals MX plus B and linear equation, right? So I know this is hard for people just like mentally imagine you’re back in, in high school, it’s your freshman year and you’re doing a y equals MX plus B graph in algebra, right? What happens? That’s the same thing as saying the portfolio return equals the market return X times a beta plus alpha. The residual in that, the intercept in that, if I curve that surface and I try to use a linear equation to solve it, it actually mechanically pushes the alphas negative, the intercepts get pushed negative, right? You can run this experiment with yourself, just draw a positively curved line and then draw a series of straight lines that bisected or intersected, right? Understand how hard this is over,

01:06:02 (Speaker Changed) Over. No, I by the way, I I see the curve. I see the intersect. Okay. Where, where I would just push back on the algebra is simply and, and he seeded one of your early accounts, Soros concept of reflexivity should say that the bigger passive gets, it creates more opportunities for active and therefore, so

01:06:22 (Speaker Changed) It does in exactly the way that the XIV did. And that’s why I chose the XIV for that trade because it had already gotten to the levels of passive that I could very clearly see it happening almost immediately.

01:06:34 (Speaker Changed) So last question before I, we do a speed round of my favorite five questions. What’s the trade that will capitalize on the damage that passive is doing to market structure?

01:06:45 (Speaker Changed) So the quick answer is, unfortunately, if I’m right, you’ll have an XIV type event for the s and p 500. I realize how ridiculous and terrify.

01:06:54 (Speaker Changed) So you wanna buy outta the money puts on the SPX going out as far as the LEAPS will

01:07:00 (Speaker Changed) Let you go. Somebody will eventually win on that. But it is very stochastic in its framework, meaning

01:07:04 (Speaker Changed) You don’t know if this is next year, five years from now, it, you look at it as an eventuality. I look at it as a, a tail risk that the market itself hopefully corrects.

01:07:15 (Speaker Changed) And I would absolutely agree with you if that, if it could correct it. The problem is, and I, I’ll I’ll share this with your audience, right? I presented this type of work to the Fed. I’ve presented it to the IMFs financial stability group every single time going in and saying, please tell me why I’m wrong. And unfortunately the answer is, you’re right. Right? Really, they actually acknowledge that really. And my reaction to that was fantastic. How can I help? What can we do? And their answer is, there’s nothing we can do. That’s not their

01:07:43 (Speaker Changed) Jobs.

01:07:44 (Speaker Changed) Vanguard and BlackRock control the regulatory apparatus. If we raise an alarm prior to the event happening, all that happens is we get fired.

01:07:52 (Speaker Changed) Huh. So, so let me ask you one or two other questions then related to those entities. So, so you said some of the models that BLS and NBR use are flawed. I’m a big fan of George Box’s statement. All models are wrong, but some are useful. NBER should declare a recession in first quarter 2023. I’m kind of paraphrasing something you said. Tell us why you think last year should have been declared a recession or, or NBR might declare a recession.

01:08:26 (Speaker Changed) I think in hindsight we might ultimately declare, ’cause we did see a combination of an increase in unemployment. We saw a decrease in industrial production and we saw a broad deterioration in terms of the economy. Things like leading economic indicators, et cetera, are all consistent with historical recessions. Now, whether we choose to acknowledge that really boils down to the depth at which it occurred. And so the NBR looks at three separate components. They talk about how broad it is, how long it’s occurring, and how deep the drawdown is. And so the debate can be around how deep the drawdown was at that point. I think the bigger issue that most people are struggling with is actually around things like the employment numbers, where there’s been a very substantive change in how we calculate that data, what’s called the birth death adjustment model, which was designed to reduce the need for periodic reassessments of what the levels of employment were in the economy tied to new business formation. There was an attempt to do that in a statistical framework. And unfortunately that statistical framework is now broken down in the now.

01:09:28 (Speaker Changed) Now I remember the two thousands BLS was showing some quarters where 100% of the job creation for the month was due to birth death adjustments. And a lot of people called them out on it and they subsequently made adjustments to their model. I’ve seen in certain reports and certain commentary, Hey, you look at the past 12 months, it’s all been adjustments. I’m not seeing that in the data. I’m seeing a lot of new job creation. Yeah. If you look at the household survey, it’s, it’s slipped and there’s a lot of new part-time jobs, but the new work from home remote hybrid model lets a lot of people work part-time and still do childcare, whatever. Tell ’em, tell me what’s wrong with the BLS model.

01:10:17 (Speaker Changed) Well, so the biggest issue with the BLS model is actually the conversion of those new businesses to jobs, right? So in particular, if you take a job in, let’s just say food service, right? Or you create a job for yourself in food service by forming an independent company so that you can deduct some of your expenses for tax purposes Sure. For your job as a DoorDash driver, right? Ironically, that falls into a category food service that’s treated as high propensity to create additional jobs. And so there’s a statistical model that then turns around and says, well, you started this DoorDash business called Mike, LLC, what’s the prospect that that’s gonna create new jobs because of its SAC code, it’s actually treated as a high propensity job formation and it’s assigned additional jobs in the, the establishment payroll. What?

01:11:05 (Speaker Changed) What about all the Uber drivers and Lyft drivers out there?

01:11:07 (Speaker Changed) So I actually think this is actually a fascinating dynamic ’cause what this, because

01:11:10 (Speaker Changed) We used to, you said, we used to call those people unemployed.

01:11:13 (Speaker Changed) We did actually used to call those people unemployed. And so again, these are revisions that have happened within the data sets. And it’s all very similar to this type of of discussion that we’re having where it’s in the details that ultimately matter. In 2008, we didn’t have Uber, right? It’s important to recognize that. So if you wanted to go drive New York City taxi, that was an entirely different job. You didn’t even have Uber in 2010. What you really had was the UberX introduced in competition with Lyft in 2012. Right? This we’re way out of the recession at this point. That changes the dynamics. But you used to be able to be unemployed and go get a cash paying job. I could go bartend at your bar, for example, right? And be like, Hey, I’m gonna help you out. I’ll, I’ll pay you under the table.

01:11:54 Right? Okay, you, you pocket some of your receipts, you sell some beer for cash, you pay me with it. Nobody knows anything. From the government standpoint, those rules actually began to change quite significantly. In 2012, we introduced what’s called the 10 99. I think it’s K that changed the reporting requirements around that type of business. It made it much easier and much more electronic. And then in 2021, we actually substantively changed the rules. We went from being able to treat up to $20,000 in income as independent and not requiring filing taxes to $600. Well, when you go from 20,000 to 600, you catch a whole bunch of new businesses. And that’s really what’s showing up in the employment numbers, huh.

01:12:37 (Speaker Changed) Re really fascinating stuff. Thank you, Mike, for being so generous with your time. We have been speaking with Mike Green. He is the chief strategist at Simplify Asset Management, helping to oversee 28 funds with over $4 billion in assets. If you enjoy this conversation, check out any of the 500 we’ve had over the past 10 years. You can find those at iTunes, Spotify, YouTube, wherever you find your favorite podcast. Speaking of podcasts, check out my new podcast at the money short conversations with experts about your money, earning it, spending it, and most of all investing it. Find that wherever you find your favorite podcasts or here in the Masters in Business Feed. I would be remiss if I did not thank the crack staff that helps put these conversations together each week. Sarah Livesey is my audio engineer. Atika BR is my project manager. Anna Luke is my producer. Sage Bauman is the head of podcasts here at Bloomberg. Sean Russo is my head of research. I’m Barry Ritholtz. You’ve been listening to Masters in Business on Bloomberg Radio.

 

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