Mike Green on Why Passive Investing Is Hurting Market Structure

Barry Ritholtz speaks to Mike Green, portfolio manager and chief strategist for Simplify Asset Management Inc. He previously served in the same roles for Logica Capital Advisers LLC. Prior to Logica, Michael managed macro strategies at Thiel Macro LLC; founded Ice Farm Advisors LP, a discretionary global macro hedge fund seeded by Soros Fund Management; and founded and managed the New York office of Canyon Capital Advisors, a $23 billion multi-strategy hedge fund. He is a CFA holder. 

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Episode Transcript

Speaker 1 (00:02):
Bloomberg Audio Studios, Podcasts, radio news. This is Master's in
Business with Barry rid Holts on Bloomberg Radio. Hey this
weekend 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,

(00:27):
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

(00:50):
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

(01:11):
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 structural problem leading

(01:34):
to the destabilization of the VICS. If you recall back
in twenty eighteen Val mcgeddon, 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

(01:57):
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.

Speaker 2 (02:16):
Verry, thank you for having me.

Speaker 1 (02:17):
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?

Speaker 2 (02:29):
Well, the initial career plan actually, so I grew up
on a farm in northern California. My initial career plan
was that I was going to 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 note, and so transition, like many
people did in my generation, into finance.

Speaker 1 (02:48):
Similar similar story. I'm always fascinating when to hear people
who were great in high school at mathematics or physics
and then go to university and say, oh, I'm only
pretty good at that. I'm in the same camp. Camp you.
You've had a fairly entrepreneurial background, not just in finance
over the past decade or two, but you founded or

(03:09):
co founded value add Software in the nineteen nineties. Tell
us a little bit about that experience.

Speaker 2 (03:14):
Sure, so that was actually an outgrowth from my experience
coming out of Wharton, And you mentioned 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 skill set around Excel et cetera.

Speaker 1 (03:30):
We did.

Speaker 2 (03:30):
Excel didn't even exist when I started. It was VisiCalc
and lotus, right, and so in the nineteen nineties I
developed the late nineteen eighties early nineteen nineties, I developed
a skill set around valuation in particularly discount of 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

(03:51):
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 mechanism to think
about the valuation of these. That's what value added Software
was originally. It also was the path for me into
the asset management space because coincidentally, Mitch Julis of Canyon
Partners was researching on the Internet in the early days

(04:14):
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 compustats 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 the value added license
to the Compustat database, and so that then led to
the sale of that business in the late nineteen nineties

(04:35):
to Credit Swiss, And.

Speaker 1 (04:36):
Then you end up actually at Kenyon Capital. Previously I
had Dominic Neil as a guest. But you stood up.
They're an LA outfit. You stood up the New York
office and ran about five billion dollars for them. Tell
us what it was like doing that a couple of
years before the financial crisis blew up.

Speaker 2 (04:56):
Well, it was very tight to the financial crisis, and
so I'll tell you candidly that I I thought there
was a very reasonable chance that I was going to
be out on my so the technical term in the
financial crisis. You mentioned dominicqu Miels is one of the
fantastically talented people at Canyon Partners. She was based out
in Los Angeles, and from kind of that nineteen ninety
six introduction to Mitch and Josh, they repeatedly tried to

(05:16):
get me to go to work for them in Los Angeles.
And finally, I think it was two thousand and three
or four, I ran into Mitch on the street on
actually on fifty seventh, just around the corner from where
we are right now, and he 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. I didn't want to be in
Los Angeles. My wife doesn't like to drive. I actually

(05:38):
came like within inches of accepting a Canyon Partner's offer
back in nineteen ninety eight. And then I'm going from
dinner at Mitch Julis's house to the airport. It's eleven
o'clock at night on a Friday, but bumper to bumper traffic,
and all I could think is, if I do this,
I'm done. My wife is going to leave me in
about two and a half minutes. And so we just
made a meeting of the minds. When they decided to

(06:01):
branch out 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.

Speaker 1 (06:18):
How do you more from small cap value into things
like derivatives and FX.

Speaker 2 (06:26):
So my actual background was originally in derivatives. My first
job on Wall Street, when I was still at the
Universit Pennsylvania, was trading crude oil futures to offset option
positions for spear leads in Kellogg. So I had a
background in derivatives. The opportunities to trade derivatives and be
involved in the hedge fund space was something that really

(06:46):
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
nineteen nineties, we had this huge disconnect where I'm a
value investor, I'm somebody who's focused on evaluation and small
caps and small cap value in particular, we're trading at
this incredible discount, and so I actually went into small

(07:06):
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 just got lucky, candidly that the dot com bubble
broke about six months after I made that transition. If
it had gone on for another two years, I might

(07:27):
not be sitting here to talk to you today.

Speaker 1 (07:28):
Right Hey, listen, smart as good luck is better, luck
is better, definitely absolutely true. So after a successful run
a 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 I was honest at his apartment
of Park Avenue for some event. But tell us what

(07:49):
it was like working with the people at Soros.

Speaker 2 (07:52):
Well, So again the Soros guys, in particular Scott Bessett
had actually rejoined Soros as the CIO. At that point,
he was the lead analyst for a stand Ruck and Miller,
and so he was returning to Soros. He basically tried
to build a stable of outside managers that he thought
were interesting and presented interesting ideas. Initially, same thing as
canyon partner is basically meaning.

Speaker 1 (08:12):
A 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.

Speaker 2 (08:21):
One 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

(08:42):
interested in running your own firm, We'll see you. That's
what led to Ice Farm Capital. The name, actually, I
funnily enough, comes from a vacation property that I used
to own. We sold it when we moved to California
to follow in the rest of the career. But I
owned a nineteenth century ice harvesting operation, which sound insane
until you actually stop and think about all the characteristics

(09:04):
of what the world would have looked like in nineteen hundred.
Ice was very much a business like cable television. Back then,
you actually didn't own your ice box. You leased your
ice box from the ice company. The iceman cometh right.
The iceman 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

(09:24):
in the United States in nineteen hundred and by nineteen
thirty five, 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 exciting vacation
destination just outside of Scranton, Pennsylvania, that was in the

(09:45):
Pocono Foothills. It was effectively a property that is between
two three thousand foot mountains and so in the northeast
it constantly stays cool. It was fed by five artesian springs,
and so this is the fantastic, most perfect place to
grow ice and see ice farm. And we had like
railroad tracks that went to New York and Philadelphia, et
they're all abandon long since abandoned, but that was the

(10:07):
genesis of the name. We're always looking for a name.
Toron the te launcha farm.

Speaker 1 (10:11):
No, that's great, and there's if you look at every
Greek mythological creature or god, like, all the names have
been taken. 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 Teal, which I found fascinating

(10:33):
because people have a tendency to read into the politics
of the investors. The New York Post famously does this
all the time. But you know, the politics is capital
is capital, whether it's coming from source management or Teal
tell Us a little bit about what it was like
working with Peter Teel Well.

Speaker 2 (10:53):
So those are pretty much the two extremes, right, one
certainly perceived as you know, right wing in one way,
and the others perceived is very much left wing. I
don't care about the politics component. 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,

(11:15):
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 Gerrard and the dynamic of mimicry and
people's desire to imitate what other people have or to

(11:37):
try to obtain what other people value. I think it's
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 built a phenomenal pool of
capital that it was a real privilege to have the
opportunity to work with him on.

Speaker 1 (11:53):
And he was an early investor. People sometimes forget he
was early in Facebook, he was early in I think
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 as a coincidence, but at a
certain point there's a certain set of insights and skills there.

Speaker 2 (12:12):
Yeah, I don't think Luck plays nearly as much of
a role as people would like to think because it
relates to Peter. I do think that a lot of
the dynamics that we saw coming out of 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

(12:34):
nineteen nineties time period. Then I think started to think
about it less on the pure technology front and more
on exactly as I was referring to with rhine Asia,
are 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 want
to be able to get their email, they want to
be able to do their work away from the office,

(12:55):
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.

Speaker 1 (13:10):
There's a whole long conversation about the evils of how
we use tech. But before I leave the teal macro,
I got to ask you about the famous vommageddon trade
in twenty eighteen. You had identified in advance that there
were some structural problems with XIV, and on behalf of

(13:31):
that funds you made a bet that, hey, this thing
is going to blow up. Tell us a little bit
about that trade.

Speaker 2 (13:37):
Sure, so, XIV, which has been reintroduced in various forums,
was just an inverse of the VIX index.

Speaker 1 (13:44):
Meaning when market volatility went down, that should go up.

Speaker 2 (13:48):
It should go up. The irony, of course, 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 vul's surface.

Speaker 1 (14:02):
Right, just describe define what you mean by that.

Speaker 2 (14:05):
So the structure of the vall's surface is generally upward sloping,
meaning that people are more uncertain and priced greater uncertainty
about events far off into the future as compared to
events that are relatively nearby right now. When that inverts,
when the VIC spikes on a risk off event, that
actually means that you're suddenly if you're inverse, right, so

(14:25):
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 fifteen and buying it back around twelve.

(14:48):
That's a crazy return when you think about it that
that's happening every single month. You're basically generating twenty close
to twenty five percent 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 six
hundred percent in twenty seventeen. Right now, my observation was

(15:09):
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 vic's futures.
On normal trading days it was about seventy percent of
the daily volume. Was simply the rebalancing of these things.

Speaker 1 (15:25):
Wow, that's huge.

Speaker 2 (15:26):
So the passive component of that, which will feed into
a discussion we'll have later on, had just become so
large that it relied on liquidity that was not necessarily
going to be there.

Speaker 1 (15:36):
Right, very similar to the financial crisis, where people had
long term debts but it was so much cheaper to
finance that with short term paper. Hey, we'll just roll
it over.

Speaker 2 (15:46):
Every thirty days one 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 nineteen
eighty seven folio insurance components. Right, it was the exact
same trade. So like down to the point the portfolio
insurance was consuming somewhere around thirty to forty percent of

(16:08):
the volume on the S and P five hundred on
a normal basis. Paul's observation, Paul Tuder 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, like, look, there's

(16:29):
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 that's the exact opposite.
And so what you were actually building was a bimodal distribution,
meaning two homps 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

(16:51):
is all hell was about to break loose.

Speaker 1 (16:53):
Right.

Speaker 2 (16:53):
We basically came to the conclusion there was roughly a
ninety five percent chance it was going to 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.

Speaker 1 (17:08):
An amazing leverage. So how much how much were you
putting at risk at that moment that Hey, this this
analysis is correct and the timing this should happen within
two years.

Speaker 2 (17:20):
So we were actually ultimately limited by the liquidity in
the space, but it was large enough that we were
able to put a sizeable amount of amount and make
a meaningful.

Speaker 1 (17:28):
Long So you made this trade on behalf of Teal
macro put any of your own capital into it also.

Speaker 2 (17:34):
Well, that's one of the funny things that everybody discovers
is you go through this industry, 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 underinvested in things like equities,
et cetera.

Speaker 1 (17:48):
Because so much of your income is that you know,
I've had that exact conversation, Hey, why don't you own
more common stocks? You talk about passive investing this and that,
I don't know, how about ninety five percent of my
net worth is up in market related investments.

Speaker 2 (18:02):
You're in the same leg one hundred percent, and it's
hard for people to understand that. So it's great to
have the opportunity to actually share that. 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.

Speaker 1 (18:19):
Right, it's double concent trade risk. There were lots of
rumors about that trade at the time. Some people said
it was fifty million, one hundred million, two hundred 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 trend profit, right, this was a giant win.

Speaker 2 (18:38):
Yeah, the notional amount of the trade was about a
quarter billion dollars and we did well.

Speaker 1 (18:44):
I'm going to guess you don't have to sit. You
don't have to admit or deny the following. But if
the if that was your notational one hundred isn't a
ridiculous profit margin. That's Barry saying it. That's not Mike.
So any compliance people listening, I'm just spit bowling here.
A couple of months ago, I had David Einhorn on
and he made some news basically saying passive has broken

(19:08):
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, and his performance has since rebounded. So,

(19:32):
given that Einhorn has credited you with this insight, tell
us how you came about to this belief.

Speaker 2 (19:38):
Sure, so the XIV trade was actually part of a
broader research into the dynamics of passive And if I'm
going to run through that language and help explain it,
the single biggest contributor to that research was actually a
twenty sixteen paper by Los A. Peterson at AQR Brilliant individual.
He wrote a paper called sharpening the Arithmetic of Active Management. Right.

(20:01):
That paper refers back to the foundational literature of Bill Sharp,
who wrote the famous paper in nineteen ninety one 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.

(20:23):
There's an assumption of completeness and markets. What Lasse pointed
out in his paper was that passive had to transact
during periods in which there was index rebalancing, 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

(20:45):
recognized one additional feature that Lasse had not highlighted, which
is that passive investors are always transacting because of the
dynamics of flow. So you get your paycheck, you put
six percent aside that flows into various Vanguard funds. There
transacting on a daily basis, And just to put it
in perspective, over the past couple of years, Vanguard has

(21:05):
averaged somewhere in the neighborhood of three hundred billion dollars
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

(21:28):
the S and P five hundred, 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.

Speaker 1 (21:37):
So let me push back on that definition a little bit,
because I don't want us because you and I are
going to disagree about some things, but I want us
to have some fundamental agreement. My definition of passive is
rather than trying to time the market or pick specific stocks,
or have a concentrated portfolio, meaning a high active share

(21:57):
so you don't look like the index, you're just going
to default to a broad index, whether it's the S
and P five hundred or the Vanguard Total Market, which
I think is eight hundred, and then there's an even
larger one that's a few thousand, and I'm going to
own the whole market. And what that will allow me
to do is have minimal trading costs, minimal tax costs,

(22:19):
and avoid all the behavioral problems that comes with active management.
And so I'm going to own this in a four
oh one k. It'll be a mutual funds in a
taxable account, it'll be an ETF and I'll let that run.
So I don't think you're that disagreeing with that definition
or how far off is my definition from yours.

Speaker 2 (22:39):
Well, the only difference in our definitions is actually the
process of how you get to hold it. Right, So
the natural conclusion that you're making is actually consistent with
Sharp's paper, which is the idea that passive investors hold
every security. The problem is how do you get in
to hold those securities and how do you get out
when the time comes to sell them.

Speaker 1 (23:00):
No, you're not disagreeing at all. You set up your
four o one K, or you set up your investment plan,
and whether you're making a purchase and putting it away
or dollar cost averaging in your four oh one K
or in any other My partner Josh calls this the
relentless bid. The constant flow of money into four oh
one k or iras have operated as a little bit

(23:24):
of a floor on the market. You know, the dot
com financial crisis and pandemic crash is notwithstanding. Most of
the time there you can count on positive inflows to equities.

Speaker 2 (23:37):
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.

Speaker 1 (23:43):
Yeah.

Speaker 2 (23:44):
Absolutely, 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.

Speaker 1 (24:02):
It goes I mean other than I mean, obviously, it's
not like, Okay, everybody in nineteen ninety nine buy stocks
and then no one buys stocks for the next thirty 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

(24:23):
investor throws money into the market on a regular basis
and takes money out of the market when it's needed
for other purposes.

Speaker 2 (24:32):
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

(24:53):
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. And

(25:16):
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? If so,
then buy? Did you ask for cash? If so, then sell?

Speaker 1 (25:32):
That starts to.

Speaker 2 (25:32):
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 had my last purchase,
I buy more of as a proportion of my assets,
I buy less of things that went down. The second

(25:56):
thing that it ultimately does is it creates conditions under
which 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 going to hold it in my portfolio.
I'm going to use this as an opportunity for me

(26:18):
to reduce my exposure to the market. Or I could
choose to use it to buy something without having to
sell something.

Speaker 1 (26:24):
Given that, what are the risks to the US economy
and to the markets from too much passive investments flowing
in to equities?

Speaker 2 (26:35):
So the key risk ultimately lies in that very simple language, Right,
did you give me cash? Ift? So then buy? Did
you ask for cash? Iifts? So then sell? And I
just want to pause for a second and go through
a little bit of financial history here, because I think
it's really important for people to understand this. Things that
we think of as having always been there, things like
four to oh one ks and iras are actually very

(26:56):
recent inventions, and there have been dramatic changes around on
their implementation within your investment career and my investment career,
which are roughly similar in duration.

Speaker 1 (27:05):
It actually predates US, but had not become popular like
it had existed for about twenty years before people start
to figure out, wait, I could put this money away
and have a grow tax free. It really took a
few decades before the market kind of came to grips
with that.

Speaker 2 (27:21):
Yeah, I mean so just very quickly. Iras were actually
created in nineteen seventy two to facilitate a key risk
that nobody had ever imagined before, which is, if you
were a union employee who was fired in the nineteen
seventy one 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 seventy

(27:43):
five percent marginal attacks ray. 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 you could maintain those assets even if you lost
your job. Right. The second tool that was introduced was
the four one K, which refers to a specific provision
of the tax code that created the defined contribution. Right,

(28:06):
if you launch yourself all the way back to nineteen
eighty one and the start of the Bowl market in
nineteen eighty two, the start of the Bowl market in
US equities following the election of Reagan. The total assets
in those two were about one hundred billion dollars in each. Right, today,
iras I believe are around seventeen trillion and four oh
one k's are somewhere in the neighborhood of eight to

(28:28):
nine trillion. Right, these are the single largest pools of
assets on the planet. Is the American retirement system. There
is a subsequent change in two thousand and six called
the Pension Protection Act that one tried to push more
and more people into four oh one k's, right by
making it what's called an opt out framework as compared

(28:50):
to an opt in right.

Speaker 1 (28:51):
You can blame Dick Taylor and Nudge for that.

Speaker 2 (28:54):
One 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.

Speaker 1 (29:05):
Cause to the QFIDS right.

Speaker 2 (29:08):
So QDIA is is what QDI is 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

(29:31):
for HR managers or CFOs to declare, this is where
we're going to default people into. Initially those were balanced funds,
so this is part of the key growth of PIMCO,
which had skill set in both in both equities and
fixed income. So the growth of balanced funds was a
really really key characteristic of that two thousand and six
to twenty twelve market. And then in twenty twelve they

(29:52):
changed the QDIA to what's called a target date fund,
which is what about eighty five percent of Americans now
default into in their retirement assets.

Speaker 1 (30:00):
Right. What the way it used to be is you
would start out a company, even if they had 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
four oh one K. Cash would just pile up in
there if you didn't give some form of diffraction. So

(30:24):
essentially what was designed to say, Hey, you got to
get off your button, 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 in some ways
just reminding us of the strength of behavioral finance that

(30:44):
people are so lazy, just like would you put me
in okay, great, and they don't even think twice about
it one.

Speaker 2 (30:49):
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 four oh one
K plans and made the choice to go into those
one K plans, they typically would choose from a universe
of active managers. Right. That's the world that largely existed
prior to two thousand and six. The passive share at

(31:10):
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 one percent market share in nineteen ninety two.

Speaker 1 (31:20):
Vanguard formed in nineteen seventy four. 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 are just a raft of scandals,
the accounting scandal, the Anaal scandal, the IPO spinning scandal,
the just go down the whole list, and then burning
made off and then the financial crisis. My general sense

(31:43):
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 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're having a discussion with a

(32:04):
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?

Speaker 2 (32:23):
Quick answer is you shouldn't. And that's actually a part
of the problem is that the individual choice should be
to bypassive right the problem is is when all of
the individuals bypassive, we actually change the structure of the
market and so it no longer represents what it historically did.

Speaker 1 (32:39):
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 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 going to try a fee and just

(33:00):
load up on the S and P five hundred. It's
obviously a lot more significant than that. But given what
you're saying that fiduciary should be looking for low cost
at least in a COREN satellite setup, how do you
go about reducing the risks to what you see as
market structure problems caused by a simple default to passive.

Speaker 2 (33:24):
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
black rocks who are spending far more on lobbying than
the rest of the industry combined. So part of what's

(33:45):
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 understandable. We all want that desire. Certainly,
that's your desire as well.

Speaker 1 (34:04):
I mean, is it an overwhelming amount of academic literature
that says, you know, some active managers managed to outperform,
but by the time you get to ten years and
take in taxes and costs and fees, you would have
been better off impassive. The more people who find their
way into passive vehicles, doesn't that create more opportunities for

(34:26):
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 the past. But aren't there more and
more opportunities for people who have a skill set to
identify inefficiencies Wherever they pop up.

Speaker 2 (34:50):
So I'm really glad you asked me that question, because
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

(35:11):
that articulation. So what you're referring to is broadly called
the Grossman Stiglitz paradox, the dynamic that the more people
choose not to put an 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

(35:31):
efficient markets. The problem again goes into the details of
the assumption of the model. So really what Grossman Stiglitz
is all about is the wisdom of crowds. You're familiar
with the micromobison examples of these, or the articulation that
we're all familiar with. You go to the county fair,
the giant jar of jellybeans, and you're supposed to guess

(35:51):
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
as a jelly bean and all that sort of stuff, right,
and people who are making just total wild guesses. Right.

(36:13):
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 Grossmuns Stiglitz
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

(36:35):
prices get pushed off. If I'm 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.

Speaker 1 (36:45):
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.

Speaker 2 (36:55):
So that's actually exactly what isn't the case. So what's
actually happening is we're giving more, We're in 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

(37:19):
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 ten thousand times whose vote's going
to count.

Speaker 1 (37:32):
So I did a lot of prep work for this.
You and I have had disagreements on Twitter about passive
versus active. I think our disagreements are less than I
previously realized. I think we both understand the advantages of
low cost indexing. But let's talk about some of the

(37:52):
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 Balchunis, who is the etf. Wizard at Bloomberg Intelligence
put out a report Passive investing worries appear overblown as
active as in control, and his key takeaway was when
you looked at the S and P five hundred stocks

(38:15):
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 the active managers are
still doing okay and the struck market structure is behaving

(38:36):
as it should.

Speaker 2 (38:37):
So it'd be nice if that was the case. Unfortunately,
the analysis was deeply flawed. I pointed this out in
responses to Eric. Would you discover if you actually dig
into that analysis? This is that the least passively owned
stocks are the Apples, Microsoft, in videos, et cetera, the
world the largest company, meaning the.

Speaker 1 (38:54):
Active managers are buying those big magnificent seven socks.

Speaker 2 (38:59):
Except that or not. And so the reason why that
disconnect comes.

Speaker 1 (39:03):
Is because you hold on, 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 ten.

(39:24):
They all seem to own United Health. Now, if they're
not closet indexers, if they don't own three hundred stocks,
maybe they stop after ten or twenty. But those big
big cap dare I call them nifty to fifty stocks,
they seem to be the favorites of the active managers.
Make the other case.

Speaker 2 (39:42):
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 two thousand has two
thousand out of the roughly thirty five hundred stocks available
publicly traded, it's about four percent of the toll market cap.
So somebody has to actually go out and own that.

(40:02):
We know it's not Vanguard, we know it's not Black Rock.
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

(40:23):
if you are going to compete with the S and
P five hundred. 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 etstead of their world. But almost no active manager
can carry them in the size that a passive vehicle
can because of concentration limits.

Speaker 1 (40:43):
Why how much is Tesla in the S and P
five hundred, or Netflix or Nvidia? None of them are
more than ten percent. Didn't the SMP and the Nasdaq
one hundred change those rules like ten fifteen years ago?

Speaker 2 (40:57):
So ten to fifteen years ago they changed to you
market from market cap weighted to float adjusted weights. I
think that's what you're referring to. But actually, interestingly enough,
this is part of the dynamic and where regulation plays
a role. Entities like the S and P five hundred
Growth Fund are far more concentrated than is legally allowed
by the forty Act by which they're governed. They are

(41:19):
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 that you're picking
up a sector fund for example. This is very notorious

(41:39):
in rets. It's also very clear in things like a
technology index, the XLK for example, or the xl in
the energy space XLE is I believe forty percent Exonomobile,
forty percent Chevron, right, nobody can actually run an active
portfolio that looks anything remotely are that's pretty crazy?

Speaker 1 (41:58):
Yeah? That that that that's absolutely ridiculous.

Speaker 2 (42:02):
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
going to overweight energy, I'm going to allocate to an
individual indust industry and sort of turn around and then
say that those stocks that are most passively owned don't

(42:25):
exhibit this type of behavior. Is to confuse those two dynamics.

Speaker 1 (42:29):
So also with an Eric's research piece was something that said, hey,
we went back and looked at draw downs of ten
percent or more of the components in the S and
P five hundred. The stocks with the highest passive ownership
didn't weren't subject to greater volatility or larger draw downs
than any of the rest of the ownership, which is

(42:50):
a big part of the argument that hey, the structure
is damaged and when it finally breaks, these passively owned
vehicles are going to be a disaster.

Speaker 2 (42:58):
So there's two separate components. So 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, etc. The world, I'm
going to come to that conclusion. But the unfortunate answer.

Speaker 1 (43:16):
Well, what about the most passively held?

Speaker 2 (43:18):
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 one hundred names in my portfolio.
One hundred names in my portfolio to be equal weight

(43:40):
to Apple, for example, in the index, it 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 going to look
for managers that are trying to add value. Otherwise, why

(44:01):
not just bypassive? Why not go with a low cost solution.

Speaker 1 (44:04):
So that kind of raises the question about what is
the solution to this. I brought up Balchunis, but I recall, oh,
maybe it's ten years ago. 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

(44:25):
previous twenty thirty 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 one 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 are trillion dollars.

(44:49):
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

(45:09):
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?

Speaker 2 (45:27):
Yeah? I know. So there's 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

(45:49):
the time that Vanguard was actually running, fifty basis points
would have been considered really cheap fees, right, that's right, right,
And initially introduced, I believe the fees on the Vanguard
funds were about seventy five basis points zero point seventy
five percent as compared to most active managers who are
between one and a half and two percent, right, So
that pulling down was absolutely critical. Today you're at a

(46:10):
point where the three basis point candidately, it just doesn't
mean it's free, it's factally free. It's effectively free. And
one of the reasons that it's able to be effectively
free is because they 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, meaning.

Speaker 1 (46:29):
People want to short stocks, they borrow it, they borrow
paying a feele. You go to black Rock and Vanguard, Absolutely,
those are the two that you go to. 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 thirty percent

(46:49):
active funds. Black Rock is a little more forty something
percent active funds. So they have an abandon that space.
And when you look outside of their core or you know,
S and P five hundred or for Vanguard, it's VTI
or Voo, or you have a run of total markets
or total global markets. US are global. There are some

(47:10):
higher fee products ten twenty thirty 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.

Speaker 2 (47:22):
So that's actually exactly the point that I would emphasize,
which is that we have allowed the industry to change
so dramatically from that thought experiment of Grossmann Stiglus, in
which everybody was roughly the same size. Marril 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,

(47:45):
like so many other industries, has become remarkably concentrated. And
so one of the iron news is when Eric is
talking about passive share, the way that that calculation is
done is simply by adding up Vanguard, Black Rock, et cetera.
Right now, that actually was the focus of a research
piece that I actually inspired. I challenged to Harvard professors,

(48:05):
actually a Harvard professor and a PhD candidate. Alex Chinko
was the PhD candidate. Marco Salmon was the Harvard professor.
I was the adjudicant 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 this public record, but they had done their scaling
of the impact by looking at it and saying the

(48:26):
share of passive is fifteen percent roughly what Eric was
working off of.

Speaker 1 (48:29):
Right. In other words, when you look at ETFs mutual funds,
passive is about fifty percent of mutual funds. Now it's
over fifty percent, but the non funds, the direct ownership
is primarily active. You're saying that is somewhat overstated.

Speaker 2 (48:45):
It is very much overstated. So it actually turns out
the statistics that people are using for that is very quickly.
The mutual fund or forty act industry is about thirty
five percent 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 multip
plates round up to right. That's the quick answer in

(49:05):
terms of how much is passive. But remember passive actually
got started even before Bogel, it got started in the
institutional space as well as Fargo that was first 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 Chinko's

(49:27):
work focused on exactly that they went and they did.
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 forty percent.

Speaker 1 (49:40):
Right now, I've seen some pushback to that that says
there's a lot of end to day trading, there's a
lot of people who are either front running or piggybacking
those trades, and you can credit all of that forty
percent rebalance number to passive and so that's how they
end up with. Fidelity had to study. I want to
say it was twenty twenty seven or twenty eight percent.

(50:02):
Somebody else had another study that twenty three percent. But
let's give you thirty percent. So if it's thirty percent
going to forty percent, going to fifty percent, when fifty
percent of the market is purely passive. Doesn't that mean
that folks like David Einhorn are just going to clean up?
Doesn't it create? Isn't it homeostatic and going back and forth?

Speaker 2 (50:24):
So if it were a stable situation, absolutely the case.
The problem is is that when you talk about going
from thirty percent to thirty five percent to forty percent,
what you actually have is the scenario that we have
in markets today. We're more than one hundred percent of
the flows, which is actually what determines the majority of
transaction activity is passive in its construction. Right Again, the

(50:46):
active space is losing assets, it's seeing net redemptions. The
passive space is actually receiving more than one hundred percent
of the inflows. And if you go back and you
think about the dynamics of Andrew Lowe stating ninety percent
or John Bogel himself highlighting the between eighty and ninety percent,
markets begin to break down, it's important to recognize that
ninety percent of the trading activity no longer has a

(51:10):
fundamental component to it. That's actually research that was done
by JP Morgan as of twenty seventeen, 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.

Speaker 1 (51:30):
So what do you think about not traditional passive, but
some of the concentrated portfolios. I had andrews Lemons of
Morgan Stanley on not too long ago. He runs a
twenty or a thirty 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,

(51:55):
and said, 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 as 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,

(52:15):
our core is going to be look very similar to
the market, but we're going to put our own stink
on it because 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.

Speaker 2 (52:30):
In, not at all. So yeah, so there's a lot
of highlight around the growth of active ets. For example,
they're about twenty five percent.

Speaker 1 (52:37):
Become used right now, and they are capturing some flow.

Speaker 2 (52:40):
They are capturing some flow, but they haven't become huge.

Speaker 1 (52:42):
Let's actually be really become bigger. So I'm overstating it.
They're much bigger today than they were five years.

Speaker 2 (52:49):
Ago, with the offset being that the mutual fund and
hedge fund spaces are much smaller. Fair, right, So what
you've actually had is a net decrease in the quantity
of active but it's instructive. 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 acknowledge many of the concerns that I'm highlighting. It's

(53:10):
really very straightforward. There is no such thing as passive investing.
Everybody is an active investor.

Speaker 1 (53:16):
Well, they're an active trader when they're deploying the capital,
but they're not actively selecting stocks. They're relying on an index.

Speaker 2 (53:24):
Which actually is a decision process as an of course.

Speaker 1 (53:27):
Right, right, I did a column a couple of years ago,
how passive? How active is you're passive? Where Hey, even
the S and P five hundred, someone decided it's going
to 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 systematic algorithm deciding.

Speaker 2 (53:50):
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
and around it. The rules for inclusion in the S
and P. Five hundred are pretty straightforward. You need to
be all of sufficient size and you need to have
at least five consecutive quarters of profitability. So once Tesla
began actually reporting profits and then moving towards that fifth quarter,

(54:15):
it became very clear that on a pure size basis,
they were going to be the next player to be included,
and the size that they were going to be included
in was going to require an insane amount of passive buying.

Speaker 1 (54:25):
There was a ton of front running, also a ton
of active running.

Speaker 2 (54:28):
The exact same thing just happened with SMCI, for example.

Speaker 1 (54:30):
Well, they're a lot smaller.

Speaker 2 (54:32):
It doesn't really matter, though, So I'm glad.

Speaker 1 (54:34):
You brought up Tesla. We're recording this on the first
day of May of two months ago. Tesla, originally part
of the Magnificent seven, down sixty five percent from its
recent highs. Doesn't seem like active flows or passive flows
were helping Tesla. And then over the last month, you know,

(54:55):
they cut a deal in China, they kind of explained
away some issues with the self driving problems. They cut prices,
and suddenly they're back to only down fifty percent, which
is a big move when you're down sixty five percent.
Doesn't that belie the whole argument that passive is destroying

(55:16):
price discovery. Obviously, a bunch of active managers figured out
Tesla was way too richly priced back in twenty one,
and after it got whacked by two thirds, someone else
turned around and said, all right, this has gone too far.
This is not a worthless company heading to bankruptcy. We
want to own it. Isn't there plenty of price discovery

(55:37):
going on?

Speaker 2 (55:38):
So, unfortunately, I think the answer to that is no, Right,
there's always going to 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 is the largest seller of Tesla besides Elon? No,
that's exactly the right. Oh okay, so well, I did
Tesla go down over that time period in which he
was acquiring Twitter because he had to sell a ton
of Tesla shares.

Speaker 1 (56:00):
There are a lot of other reasons, Like 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 along in the tooth that they
haven't really introduced an upgraded Even the X and Y
look very much like the models, and I'm sorry, the

(56:21):
Model three and the Model Y look like the S
and the X. China has become an ongoing problem. Five
years ago, they were a decade ahead of everybody in
the software. Now they're I don't know, three, four or
five years ahead of everybody. And there's a boat ton
of competition. It's not just for GM, BMW, Mercedes, Audi, Volkswagon, Volvo,

(56:47):
Renault go down the list. You could buy an Evy, Rolls,
Royce and Maserati if you want. Everybody is piled into
the space. So fundamentally, you can make a case Elon
sold a bunch of stock, but suddenly it's a more
challenging environment and the stock had become overpriced. That's the

(57:09):
argument I would make that that that Tesla had become overvalued,
and it seems like the market picked up on a
lot of it, especially what did a peak at at
one point two one point three trillion. That kind of
suggested we're going to own the EV space for the
next decade.

Speaker 2 (57:28):
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.
What affects things is people actually executing trades. Right.

Speaker 1 (57:44):
The only so how much did Elon sell? I mean it,
it didn't seem like he sold what did he overpaid
for Twitter?

Speaker 2 (57:53):
Right?

Speaker 1 (57:53):
And he didn't pay for that wasn't all Tesla stock
it was I think he had to pay ten or
twenty percent of it. It's called ten billion out of
one point two trillion. Shouldn't have crushed the stock.

Speaker 2 (58:04):
So let's use Bitcoin as an example for a second,
how much money has flowed into the Bitcoin ETFs.

Speaker 1 (58:10):
I don't know, sixty billion dollars over the past decade.

Speaker 2 (58:14):
Well, not over over the past decade, but in particular
since the introduction in January.

Speaker 1 (58:18):
Oh god, you look at the blackrock ETF It was
at five billion dollars in a month, and it's probably
close to ten billion dollars now.

Speaker 2 (58:27):
Right, So this's been about forty billion dollars worth of
inflows against a bitcoin valuation or a market cap of
bitcoin going into it of about four hundred billion dollars
and it costs US sixty five percent appreciation, So forty
billion dollars non linear? Yeah, that's fair. Same thing's true
on Tesla, right, Everything happens at the margin. By the way,

(58:49):
why did Amazon sell off so firmly over the past
couple of years.

Speaker 1 (58:52):
Sous Bezos departed and the company is a shell of
the delightful retailer it once was.

Speaker 2 (58:58):
Wouldn't that be awesome if it was true? Accept It
really boils down to Mackenzie Scott selling her shares.

Speaker 1 (59:04):
There's a lot of that. So let me shift gears
on you. Since we're talking about structure, I want to
change things up and for a one more thing at
you about structure, because I'm enjoying this conversation. So a
couple of years ago we started working with the folks
at O'Shaughnessey Asset Management, who rolled out a product called Canvas,
which was a direct indexing product. Directly indexing has been

(59:28):
around for decades. It to me, it's never been particularly impressive.
And O'Shaughnessy had a couple of things going for them
that nobody else did. They over their course of twenty
thirty 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 compustat in the

(59:51):
old days is and the only thing that's close. But
it was really very specific to them. And second, you
know the team at O'shaughnessee and I've had all these
folks on between Patrick O'Shaughnessy and Jim who famously wrote
the book What Works on Wall Street are really a
first quant book for the public. They created a form

(01:00:12):
of direct indexing that as someone who's been a skeptic,
Dave Nottig and I have disagreed about this for years
when we first saw this, and I want to say
twenty nineteen, it's like, oh, I get it. You can
do so much more now. And of the four point
whatever billion dollars we run, over a billion is on
the Canvas platform now owned by Franklin Templeton. And what

(01:00:35):
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 to business, you have a
bunch of founder's stock, you have a bunch of IPO stock,
and you want to diversify out of that core portfolio.

(01:00:59):
But the capital game are going to be fairly weighty.
You could use direct indexing to tax loss, harvest and
order of magnitude better results than if you own half
a dozen ETFs or mutual funds. Just and first quarter
of twenty twenty, anytime you have a thirty plus percent

(01:01:22):
decrease that fits nicely in the range of the calendar quarter.
You know, instead of being seventy five eighty basis points,
it's three hundred O'Shaughnessy has case studies four hundred, five
hundred based points. Giant game changer. Long ask question, short
conclusion is do things like direct indexing, which have always

(01:01:46):
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?

Speaker 2 (01:02:03):
So it is a very long question with a lot
of different components to it. First, direct and next thing
is almost by definition always going to 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.

Speaker 1 (01:02:23):
That's right, understand. Let me let me clarify. I'm referring
to the tax al for 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 to call it passive because
it's not, but it apes passive investments or whatever funds
you want to put.

Speaker 2 (01:02:42):
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.
Expos's exactly right. The ability to arbitrage your individual tax
positions falls way outside the dynamics of market efficiency. Right,
every individual is going to have their own components. We
could get into tons of conversations around exactly that issue,

(01:03:05):
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
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?

(01:03:26):
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 twenty five percent market share. It actually turns out
perversely that passive is beneficial to the market. It's once
you go past that point that it starts contributing to

(01:03:46):
higher volatility, much higher correlations, and the risk of severe
left tail events, which brings us full circle back to
the XIV type dynamic.

Speaker 1 (01:03:56):
So then let me ask you one final question before
we jump to our favorite questions. Who has the burden
for dealing with 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

(01:04:20):
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.

Speaker 2 (01:04:36):
So 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.

(01:04:59):
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 intercept on a Y equals mx plus p
and linear equation. Right, So I know this is hard
for people, just like mentally, imagine your back in high school.

(01:05:23):
It's your freshman year and you're doing a Y equals
mx plus bograph and algebra. Right, what happens? That's the
same thing as saying the portfolio return equals the market
return x times of 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,

(01:05:46):
it actually mechanically pushes the alpha's negative. The intercepts get
pushed negative.

Speaker 1 (01:05:51):
Right.

Speaker 2 (01:05:51):
You can run this experiment with yourself. Just draw a
positively curved line and then draw a series of straight
lines that bisect it or intersect it. Understand how hard
this is?

Speaker 1 (01:06:02):
Over No, by the way I see the curve, I
see the intersect. Okay, where I would just push back
on the algebras simply and he seated one of your
early accounts. Soros's concept of reflexivity should say that the
bigger passive gets it creates the more opportunities for active
and therefore.

Speaker 2 (01:06:22):
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.

Speaker 1 (01:06:34):
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.

Speaker 2 (01:06:45):
So the quick answer is, unfortunately, if I'm right, you'll
have an XIV type event for the S and P
five hundred. I realize, how ridiculous. So you want to.

Speaker 1 (01:06:55):
Buy out of the money puts on the SPX going
out as far as the leaps.

Speaker 2 (01:07:00):
Somebody will eventually win on that. But it is very
stochastic in its framework.

Speaker 1 (01:07:04):
Meaning you don't know if this is next year, five
years from now. You look at it as an eventuality.
I look at it as a tail risk that the
market itself hopefully corrects.

Speaker 2 (01:07:15):
And I would absolutely agree with you if that, if
it could correct it, the problem is, and I'll share
this with your audience, right. I presented this type of
work to the FED. I've presented it to the IMF
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. They actually acknowledge that. My reaction

(01:07:37):
to that was fantastic. How can I help? What can
we do? And their answer is there's nothing we can do.
That's both the Vanguard and Blackrock control the regulatory apparatus.
If we raise an alarm prior to the event happening,
all that happens is we get fired.

Speaker 1 (01:07:52):
Huh. So let me ask you one or two other
questions then related to those entities. 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

(01:08:14):
recession in first quarter twenty twenty three. I'm kind of
paraphrasing something you said. Tell us why you think last
year should have been declared a recession or NBR might
declare to recession.

Speaker 2 (01:08:26):
I think in hindsight we might ultimately declare because we
did see a combination of an increase in unemployment, we
saw a decrease in industrial production, and we saw broad
deterioration in terms of the economy. Things like leading economic indicators, etc.
Are all consistent with historical recessions. Now, whether we choose
to acknowledge that really boils down to the depth at

(01:08:47):
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 draw down is,
And so the debate can be around how deep the
draw down 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

(01:09:10):
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 now.

Speaker 1 (01:09:28):
I remember the two thousands BLS was showing some quarters
where one hundred percent 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,

(01:09:49):
in certain commentary, Hey, you look at the past twelve 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 slipped and there's
a lot of new part time jobs. But the new
work from home remote hybrid model lets a lot of

(01:10:10):
people work part time and still do childcare. Whatever. Tell
me what's wrong with the BLS model.

Speaker 2 (01:10:17):
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 for your job as a door dash driver. Right. Ironically,

(01:10:40):
that falls into a category food service that's treated as
high propensity to create additional jobs. And so this'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 going to create new jobs? Because of its
sac code, it's actually treated as a high perpen city
job formation, and it's assigned additional jobs in the establishment payroll.

Speaker 1 (01:11:05):
What about all the Uber drivers and Lyft drivers out there.

Speaker 2 (01:11:07):
So I actually think this is actually a fascinating dynamic.

Speaker 1 (01:11:10):
Because what you said we used to call those people unemployed.

Speaker 2 (01:11:13):
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 discussion that we're having, where it's in the details
that ultimately matter. In two thousand and eight, 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

(01:11:35):
in twenty ten. What you really had was the Uber
X introduced in competition. Would Lyft in twenty twelve. This
or 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. You'd be like, Hey,
I'm an LPIOD. I'll pay you under the table, right, Okay,

(01:11:55):
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 twenty twelve, we introduced what's called the
ten ninety nine I think it's kay that changed the
reporting crew requirements around that type of business. It made
it much easier and much more electronic. And then in

(01:12:17):
twenty twenty one we actually substantively changed the rules. We
went from being able to treat up to twenty thousand
dollars in income as independent and not requiring filing taxes
to six hundred dollars. Well, when you go from twenty
thousand to six hundred, you catch a whole bunch of
new businesses and that's really what's showing up in the
employment numbers.

Speaker 1 (01:12:36):
Huh, 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 twenty eight funds with over four billion dollars
in assets. If you enjoy this conversation, check out any
of the five hundred we've had over the past ten years.

(01:13:00):
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

(01:13:22):
or here in the Masters and Business feed, I would
be remiss if I did not thank the crackstaff that
helps put these conversations together each week. Sarah Livesey is
my audio engineer. Attico Vaalbroun 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.

(01:13:46):
I'm Barry Rittons. You've been listening to Masters in Business
on Bloomberg Radio.