WEBVTT - How Poker Explains the Battle of Passive and Active Investing 0:00:09.080 --> 0:00:12.400 Hello, and welcome to another edition of the Odd Thoughts Podcast. 0:00:12.480 --> 0:00:17.120 I'm Tracy Alloway and I'm Joe Wisenthal. So Joe, Um. 0:00:17.160 --> 0:00:19.599 Every once in a while, we like to talk about 0:00:19.840 --> 0:00:23.760 poker on this show, right, that's true. We've had a 0:00:23.840 --> 0:00:28.560 few Poker in Gambling episodes. I think it's one of 0:00:28.560 --> 0:00:32.560 our popular recurring themes. Yeah, and every time I usually 0:00:32.600 --> 0:00:37.760 managed to make my complete incomprehension of poker quite obvious. 0:00:37.880 --> 0:00:41.320 But one thing I do understand, and I think one 0:00:41.360 --> 0:00:43.879 reason we end up talking about poker so much, is 0:00:43.920 --> 0:00:47.239 because it's a game that's kind of all about a 0:00:47.280 --> 0:00:52.000 combination of luck and strategy. Right, Yeah, you know what. 0:00:52.040 --> 0:00:55.000 I like you always point out with these poker episodes 0:00:55.120 --> 0:00:57.040 that you don't really play poker, that you're not much 0:00:57.040 --> 0:01:01.040 of a gambler. It's my caveat, but you do seem 0:01:01.080 --> 0:01:04.880 to intuitively recognize that through the study of poker, there's 0:01:04.920 --> 0:01:07.119 a lot of interesting stuff there. So even though it's 0:01:07.120 --> 0:01:12.840 not your thing, you grasp it's power as a metaphor. Okay, 0:01:12.840 --> 0:01:17.640 all right, Well I would hope so I would hope 0:01:17.640 --> 0:01:19.679 that I'm able to talk about poker in the most 0:01:19.720 --> 0:01:23.520 basic sense. But please don't ask me about any hands 0:01:23.600 --> 0:01:26.479 and things like that. Okay, wait, Tracy, which is better 0:01:26.520 --> 0:01:32.720 a full house or a flush? Uh um, a full house? 0:01:33.400 --> 0:01:36.880 Yeah that's right. Okay, maybe I should play poker? Should 0:01:36.880 --> 0:01:40.520 we play? Okay? Okay. Look, the reason I'm bringing up 0:01:40.520 --> 0:01:45.000 poker yet again is because there's someone who's actually going 0:01:45.040 --> 0:01:48.200 to be able to connect poker with one of the 0:01:48.240 --> 0:01:51.920 biggest trends that's currently happening in financial markets, and that is, 0:01:51.960 --> 0:01:57.320 of course, the debate between active versus passive investment management. Right. 0:01:57.400 --> 0:02:00.280 I think we've also talked about this topic to or 0:02:00.320 --> 0:02:02.320 if we haven't, we really should have this idea that 0:02:02.720 --> 0:02:06.560 there's this huge wall of money every month, every day 0:02:06.680 --> 0:02:12.040 leaving traditional mutual funds, traditional investing strategies and opting for 0:02:12.120 --> 0:02:15.880 more passive strategies that are lower fees, not really intended 0:02:15.919 --> 0:02:20.080 to beat the market, but at low cost essentially replicate 0:02:20.120 --> 0:02:24.200 the market's performance. Yeah, that's right. And so the guy 0:02:24.280 --> 0:02:27.679 who we're going to speak with today has actually written, um, well, 0:02:27.760 --> 0:02:29.880 he's written a lot about poker, he's written a lot 0:02:29.919 --> 0:02:34.000 about luck and investment strategy, but he has also specifically 0:02:34.080 --> 0:02:38.120 written a really great paper about how passive investing the 0:02:38.240 --> 0:02:42.680 rise of passive investing provides both opportunities and challenges for 0:02:42.760 --> 0:02:45.720 active managers, and he kind of likens it to the 0:02:45.800 --> 0:02:49.480 idea of, you know, weak poker players either staying at 0:02:49.480 --> 0:02:53.880 the table or leaving. So it's a really interesting analogy. 0:02:54.200 --> 0:03:06.919 So should we should we get started? Let's introduce him? Okay, 0:03:07.000 --> 0:03:10.600 so we have Michael Mobison. He is, of course, the 0:03:10.720 --> 0:03:15.040 head of Global Financial Strategies at Credit Suez. Uh, Michael, 0:03:15.080 --> 0:03:17.720 thank you so much for joining us today. Tracy Joe. 0:03:17.760 --> 0:03:20.280 Great to be with you, guys. I mean, shall we 0:03:20.360 --> 0:03:23.240 start with that poker analogy? Why did you reach for 0:03:23.400 --> 0:03:28.160 poker when it came to describing the dynamic between active 0:03:28.360 --> 0:03:32.120 versus passive management? Right now? You know, Tracy, I actually 0:03:32.120 --> 0:03:34.440 think it's a very very powerful way to think about 0:03:34.440 --> 0:03:37.320 this problem. So let's imagine I say, Tracy, Joe, do 0:03:37.320 --> 0:03:38.840 you want to come to my house Friday night to 0:03:38.880 --> 0:03:42.360 play poker? Your first question, I suppose, assuming you like 0:03:42.400 --> 0:03:44.800 to make money, is who else will be there? First 0:03:44.800 --> 0:03:47.400 of all, I would just I'm just gonna say, yes, 0:03:48.040 --> 0:03:50.840 I'm junking, but yes. If I were smarter and more rational, 0:03:50.880 --> 0:03:53.040 I would ask that. But I would Okay, Joe, you 0:03:53.080 --> 0:03:54.800 ask you say who else will be there, And I say, hey, 0:03:54.880 --> 0:03:57.920 couple really rich players who are very bad at poker, 0:03:58.120 --> 0:04:00.040 You'd be like, I'll be right over right, because you 0:04:00.080 --> 0:04:02.440 could see where your money is going to come from. 0:04:02.480 --> 0:04:04.720 But by by by contrast, if I say, hey, the 0:04:04.720 --> 0:04:07.400 players that come are really great players, they're really sharp, 0:04:08.040 --> 0:04:09.960 you probably know they're better than you. You probably say 0:04:10.000 --> 0:04:12.520 I got I got better things to do, right, So 0:04:12.600 --> 0:04:14.840 to me, there there are a couple really big lessons 0:04:14.880 --> 0:04:18.440 from poker and thinking about this active indexing discussion. One 0:04:18.560 --> 0:04:21.560 is it's very important for active managed to recognize for 0:04:21.600 --> 0:04:24.240 every winner, there has to be a loser. Right, A 0:04:24.320 --> 0:04:27.039 thousand dollars walks into my house to play poker on 0:04:27.080 --> 0:04:30.000 Friday night, A thousand dollar walks out, right, So it's 0:04:30.000 --> 0:04:32.560 gonna get shuffled around. But that's the main thing is 0:04:32.600 --> 0:04:34.440 there's got to be a winner for a loser for 0:04:34.440 --> 0:04:37.960 every winner. And second is, if you pay to play, 0:04:38.320 --> 0:04:40.320 the amount of money walking out will be slightly less 0:04:40.360 --> 0:04:42.680 than the money walking in the house takes a cut. 0:04:42.680 --> 0:04:45.760 The house takes a cut, and we call that fees. Right, 0:04:45.800 --> 0:04:49.440 So here's the here's the interesting provocation is it might 0:04:49.480 --> 0:04:52.280 be might it be the case that as we've seen 0:04:52.279 --> 0:04:55.760 the shift from active to indexing, that the people who 0:04:55.800 --> 0:04:59.320 are leaving the table or taking their money away from 0:04:59.360 --> 0:05:02.440 active managers are going to be our indexers. And so 0:05:02.720 --> 0:05:06.200 the weaker players, in effect are leaving the table. And 0:05:06.240 --> 0:05:09.480 so while it may may superficially make seem to make 0:05:09.520 --> 0:05:11.320 sense that if these people are leaving, it's gonna make 0:05:11.320 --> 0:05:13.680 it easier for us, in a sense, it actually makes 0:05:13.680 --> 0:05:15.880 it more difficult because the people who are remaining at 0:05:15.880 --> 0:05:19.760 the table are the smart players, the more motivated players, 0:05:19.839 --> 0:05:22.560 the players are more resources. So in a sense, it 0:05:22.560 --> 0:05:24.640 doesn't make it easier to beat beat the market. It 0:05:24.680 --> 0:05:27.440 actually makes it as difficult or maybe even more difficult 0:05:27.440 --> 0:05:29.080 than it did before. And that's somewhat counter into it. 0:05:29.080 --> 0:05:30.440 If you just say, if these people are sort of 0:05:30.440 --> 0:05:33.280 not in participating, right you, you often hear the other 0:05:33.320 --> 0:05:36.280 are the opposite. It's like, oh, there's all this dumb money. 0:05:36.560 --> 0:05:40.640 People are just indexing. People are not discriminating between one 0:05:40.640 --> 0:05:42.839 stock or the other. Active has got to be really 0:05:42.880 --> 0:05:47.039 easy now. But as you explain it pretty nicely there, 0:05:47.720 --> 0:05:50.559 the remaining tables, of the remaining players at the table 0:05:50.680 --> 0:05:53.400 are all really good or are getting better and better 0:05:53.440 --> 0:05:56.520 and I'll just say Joe and talking to managers. UM, 0:05:56.560 --> 0:05:59.919 there's a really interesting distinction that behavioral economists make between 0:06:00.960 --> 0:06:04.880 the price is right, which means markets are informational, e efficient, 0:06:04.960 --> 0:06:07.640 sort of fancy, and what they call no free lunch, 0:06:07.680 --> 0:06:10.720 which means there is no strategy that consistently beats the market. 0:06:10.960 --> 0:06:13.200 And here's the thing I think active managers struggle with. 0:06:13.680 --> 0:06:15.680 If there's no if the prices are right, there is 0:06:15.680 --> 0:06:17.280 no free lunch. I think we'd all agree on that. 0:06:17.279 --> 0:06:19.880 That's easy, but it could be the case there's no 0:06:19.920 --> 0:06:22.360 free lunch and prices are not right. So I think 0:06:22.400 --> 0:06:24.719 a lot of actor active managers see these sort of 0:06:24.720 --> 0:06:28.000 inefficiencies out there, but it's very difficult to exploit them. 0:06:28.040 --> 0:06:30.039 Let me give you a really sort of trivial example. 0:06:30.279 --> 0:06:32.719 Let's say you're a hedge fund manager and you know 0:06:32.760 --> 0:06:35.359 you're investing in the restaurant sector, and you buy the 0:06:35.440 --> 0:06:38.920 inexpensive one attractive one, and you short the expensive one 0:06:39.080 --> 0:06:42.479 and not so good quality one. Well, so you like 0:06:42.520 --> 0:06:46.320 your trade. Right. If investors decide we like restaurants, what 0:06:46.320 --> 0:06:48.800 do they do? The answer is, today they typically go 0:06:49.000 --> 0:06:51.080 right to the e t F. They buy the restaurant 0:06:51.080 --> 0:06:54.800 et F and they all rise together, so there's no discrimination. 0:06:55.360 --> 0:06:57.880 Likewise that they say we don't like restaurants, they sell 0:06:57.960 --> 0:07:00.280 the E T F and they all go down. So 0:07:00.760 --> 0:07:03.640 we're getting more of these sort of intersector correlations and 0:07:03.680 --> 0:07:06.840 there's less a discrimination between good and bad, which makes 0:07:06.880 --> 0:07:11.680 it very difficult to express your skill as an active manager. Michael, 0:07:11.720 --> 0:07:14.880 can we take a step back, because I'm trying to 0:07:14.960 --> 0:07:18.360 grapple with this concept of life getting harder for active 0:07:18.360 --> 0:07:21.360 managers thanks to the rise of passive But could you 0:07:21.440 --> 0:07:25.280 maybe give us your perspective on why passive has proved 0:07:25.320 --> 0:07:31.200 so popular over the past few years. So, um, it's 0:07:31.240 --> 0:07:33.200 really been eight, right, eight or nine years. I think 0:07:33.240 --> 0:07:36.480 something like our data show the last decade there's been 0:07:36.520 --> 0:07:40.040 one point to trillion dollars taken out of active funds 0:07:40.080 --> 0:07:44.000 and one point for trillion gone into indexing or passive funds, 0:07:44.000 --> 0:07:47.560 so at two point six trillion dollar net swing. So 0:07:47.600 --> 0:07:49.120 I think here's the way to think about this and 0:07:49.160 --> 0:07:52.120 sort of the centerpiece of this report was worked by 0:07:52.480 --> 0:07:56.680 a very famous paper from by Sandy Grossman and Joe 0:07:56.720 --> 0:08:01.600 Stiglets called on the Impossibility of Information Efficient Markets. On 0:08:01.680 --> 0:08:05.000 the Impossibility of Informational efficient markets, So in nineteen eighties, 0:08:05.040 --> 0:08:07.520 and interesting just as a side known interesting date because 0:08:07.560 --> 0:08:10.680 the nineteen seventies was probably the peak of enthusiasm for 0:08:10.720 --> 0:08:13.760 the efficient market hypothesis. So having written this in nineteen 0:08:13.800 --> 0:08:15.400 eight you can see they're writing it sort of a 0:08:15.400 --> 0:08:18.760 counter to the prevailing academic wisdom at the time. And 0:08:18.760 --> 0:08:21.000 here's the basic argument they made. They said, hey, folks, 0:08:21.080 --> 0:08:25.880 markets can't be perfectly informational efficient because there's a cost 0:08:26.080 --> 0:08:29.480 to gathering information and reflecting in prices, and as a 0:08:29.560 --> 0:08:32.400 payoff for that cost, you should get a requisite benefit 0:08:32.720 --> 0:08:35.000 in the form of excess returns in the market. Now, 0:08:35.000 --> 0:08:38.199 you can argue that these things should be roughly inequal portions, 0:08:39.040 --> 0:08:41.880 but there's got to be some inefficient so so some 0:08:41.920 --> 0:08:46.760 academics today have taken to this phrase markets are efficiently inefficient. 0:08:47.520 --> 0:08:50.240 So I think what's happened as a confluence of factors, 0:08:50.240 --> 0:08:55.920 including technology, including things like Bloomberg, this amazing access to information, 0:08:56.440 --> 0:09:02.920 dissemination of information, regulatory shifts, overall cost of computing, and 0:09:02.960 --> 0:09:05.360 so forth. I think markets have simply gotten more efficient. 0:09:05.600 --> 0:09:09.319 So as a consequence, paying a lot for for this 0:09:09.360 --> 0:09:12.920 price discovery function doesn't make as much sense. I think 0:09:12.920 --> 0:09:16.360 there's there's been that natural pressure that's happened. But just 0:09:16.440 --> 0:09:19.199 to be super clear about this, um, the markets can't 0:09:19.240 --> 0:09:24.680 go d indexing, right Obviously, active managers provide two vital 0:09:25.440 --> 0:09:29.240 um contributions to society. The first is what I mean 0:09:29.240 --> 0:09:31.520 the academs call this price discovery. It's a fancy way 0:09:31.520 --> 0:09:34.320 of saying they make markets efficient, and that's a huge 0:09:34.320 --> 0:09:38.439 societal good actually. And the second is they provide liquidity. Right, 0:09:38.480 --> 0:09:41.400 So if you need to buy or sell yourself, if 0:09:41.440 --> 0:09:44.120 everyone's index, no one's moving around, right, so you need liquidity. 0:09:44.160 --> 0:09:47.200 So those are two really vital things. And the index 0:09:47.280 --> 0:09:50.839 and community, I think, by their own admission uh takes 0:09:50.840 --> 0:09:54.040 advantage of that positive externality that comes as a consequence 0:09:54.040 --> 0:09:56.840 of active manager So so they can't go away altogether. 0:09:57.320 --> 0:09:59.719 And I think the operative sort of concept here is 0:09:59.760 --> 0:10:05.280 this efficiently inefficient and and and many factors, not only sophistication, 0:10:05.440 --> 0:10:10.040 but many other factors have contributed to greater broader market efficiency. 0:10:10.559 --> 0:10:14.800 So we can't have a market that's entirely passive, and 0:10:14.960 --> 0:10:18.280 we're still a long way away from that, which raises 0:10:18.320 --> 0:10:22.359 the question, and this really gets to trying to distinguish 0:10:22.400 --> 0:10:25.040 between skill and luck and why poker is a good 0:10:25.040 --> 0:10:27.760 game Because it's a mix of a pure gambling game 0:10:27.800 --> 0:10:31.360 and also a skill game. It's really hard to tell 0:10:31.400 --> 0:10:34.880 who's good. You could have someone who has a mutual 0:10:34.920 --> 0:10:37.800 fund it beats the market for several years in a row, 0:10:37.880 --> 0:10:40.200 but then they blow up. Maybe they were just lucky. 0:10:41.240 --> 0:10:43.920 How do you approach this question? And you've written a 0:10:43.960 --> 0:10:46.000 lot about this, but it seems like it's the crucial 0:10:46.120 --> 0:10:50.400 question for identifying who's good at active management. How do 0:10:50.440 --> 0:10:53.760 you know? How do you start thinking about this question 0:10:53.760 --> 0:10:57.480 of identifying who's actually a good manager. So it's a 0:10:57.520 --> 0:10:59.760 great question, Joe, it's a tricky question. Let's take it 0:10:59.760 --> 0:11:02.280 into resteps. The first step would be something like this 0:11:02.360 --> 0:11:04.160 if if you and I can't really do that or 0:11:04.280 --> 0:11:07.200 not convinced that we should do that, we should be indexed, right, 0:11:07.240 --> 0:11:09.840 So let's just be clear that for most people that's 0:11:09.880 --> 0:11:12.160 the proper prescription, and I think most people who are 0:11:12.160 --> 0:11:14.320 thoughtful about markets would would be on the same page 0:11:14.360 --> 0:11:17.559 with that. Second thing is to think about asset classes. 0:11:17.760 --> 0:11:20.680 So we tenderally talked about mark equities, but of course 0:11:20.679 --> 0:11:23.880 there are lots of different markets, including fixed income markets, 0:11:23.960 --> 0:11:26.840 emerging markets, and so forth. And one of the areas 0:11:26.840 --> 0:11:29.840 where skill can be expressed more readily is when there's 0:11:29.880 --> 0:11:33.200 a large dispersion of results. Right, so the difference between 0:11:33.240 --> 0:11:35.360 the very best players and the average players and the 0:11:35.360 --> 0:11:38.679 poor players is wide versus narrow. And in fact, David 0:11:38.679 --> 0:11:41.920 Swinson at Yale has this nice passage in his book 0:11:41.920 --> 0:11:44.040 where he says, what we do at Yales we look 0:11:44.080 --> 0:11:46.400 for this dispersion of returns for the asset class. And 0:11:46.440 --> 0:11:49.320 if there's lots of dispersion, we Yale, we'll try to 0:11:49.360 --> 0:11:52.000 find the skillful person. We're going to pay them fairly 0:11:52.080 --> 0:11:54.760 handsome fees and we go at So so the second 0:11:54.840 --> 0:11:56.960 question would be that of asset class. And then the 0:11:57.000 --> 0:11:59.880 third now would be can we be more sophisticated in 0:12:00.120 --> 0:12:03.120 assessing uh the skill of the managers? And you know, 0:12:03.160 --> 0:12:06.439 there's a very nice paper by Rust Warmers and it's 0:12:06.480 --> 0:12:09.840 Warmers and Jones about some techniques to do this, and 0:12:09.920 --> 0:12:12.120 some things you might want to think about would be uh, 0:12:12.400 --> 0:12:15.280 looking at past performance but adjusting it very carefully for 0:12:15.320 --> 0:12:18.320 exposure to factors and things like skewness. It will be 0:12:18.320 --> 0:12:22.640 looking at the characteristic characteristics of the manager him or herself, 0:12:23.160 --> 0:12:27.719 so their age, their education. Uh, A factor would be 0:12:27.720 --> 0:12:31.640 the size of the fund, this fund strategy, so there 0:12:31.679 --> 0:12:33.640 there there are some ways that you can sort of 0:12:33.840 --> 0:12:36.000 shade the odds in your face once it is also 0:12:36.040 --> 0:12:38.440 a fan of skin in the game right. Measure whether 0:12:38.480 --> 0:12:41.880 a fund manager the degree to which they're putting their 0:12:41.880 --> 0:12:43.400 own money at risk and the skin of the game 0:12:43.440 --> 0:12:46.240 things an interesting one because uh and I agree with that, 0:12:46.320 --> 0:12:48.160 but I also think you can't take it too far. 0:12:48.280 --> 0:12:50.560 So skin of the game is important in the sense 0:12:50.559 --> 0:12:53.640 that people care about it and it dampens down principal 0:12:53.640 --> 0:12:56.480 agent concerns. But by the same token, if someone has 0:12:57.320 --> 0:12:58.880 their net worth and a fund and let's say it's 0:12:58.880 --> 0:13:01.200 two thousand and eight thousand nine, it's going down a lot. 0:13:02.000 --> 0:13:05.200 They start to worry about their own livelihood versus the 0:13:05.320 --> 0:13:07.160 long term interests of their fund. So so I think 0:13:07.200 --> 0:13:09.880 they have to have enough in there so they they 0:13:09.920 --> 0:13:12.480 deal with this principalazon issue, but not so much that 0:13:12.559 --> 0:13:17.440 at some point their objectivity or their responsibilities get distored 0:13:17.480 --> 0:13:20.239 it based on their own worries about paying for the groceries. 0:13:20.920 --> 0:13:22.720 So that's that's the whole skill luck and I would 0:13:22.720 --> 0:13:24.480 just say that, you know, having written a book about 0:13:24.480 --> 0:13:26.800 skill and luck. It's interesting that last thing I'll say 0:13:26.800 --> 0:13:29.360 is that that investing appears to be an activity that's 0:13:29.640 --> 0:13:33.280 luck laden. And I think there's a sort of counterintuitive 0:13:33.320 --> 0:13:35.440 reason that's the case, and we call it the paradox 0:13:35.480 --> 0:13:38.160 of skill, and the paradox of skill says and activities 0:13:38.160 --> 0:13:40.480 were both skill and luck contribute to outcomes, and that's 0:13:40.480 --> 0:13:43.080 certainly true for investing. It can be the case that 0:13:43.240 --> 0:13:48.080 as skill increases, luck becomes more important, which seems not sensical, right. 0:13:48.400 --> 0:13:50.440 But the key here is to think about skill on 0:13:50.640 --> 0:13:55.320 with across two dimensions. The first is absolute skill, and 0:13:55.360 --> 0:13:56.880 I think if you look around the world, look at 0:13:56.880 --> 0:13:59.360 the world of investing, or sports or business, I think 0:13:59.400 --> 0:14:03.319 we can say fairly unqualified that that absolute skills never 0:14:03.360 --> 0:14:05.839 been better. The second dimension of skill, that is the 0:14:05.880 --> 0:14:09.200 important one, and that's relative skill. The difference between the 0:14:09.280 --> 0:14:11.880 very best players and the average players, and that we've 0:14:11.920 --> 0:14:15.440 also seen in almost every domain has shrunk. So we 0:14:15.480 --> 0:14:18.400 see that for example in batting averages for baseball players. 0:14:18.520 --> 0:14:20.840 If you look at you know, running races, you see 0:14:20.840 --> 0:14:23.240 the difference between the gold medal winner and the bronze 0:14:23.240 --> 0:14:25.440 medal winner is much less today than it was a 0:14:25.520 --> 0:14:29.360 generation or two before and in markets that's basically expresses 0:14:29.360 --> 0:14:33.200 mostly efficient markets. So it's a consequence markets appear to 0:14:33.240 --> 0:14:36.280 be mostly luck, but it's actually not because of a 0:14:36.360 --> 0:14:39.000 lack of skill. It's actually because of a surfeit of skill, right, 0:14:39.040 --> 0:14:42.640 too much skill canceling out right, Even in professional athletics, 0:14:42.640 --> 0:14:44.600 we can see this that there's more and more parity 0:14:44.600 --> 0:14:47.720 in many professional sports. And again, the athletes themselves are 0:14:47.760 --> 0:14:50.920 absolutely amazing, and you put them back in the sixties 0:14:50.920 --> 0:14:54.160 and they would clean up. But they're so equal now 0:14:54.160 --> 0:14:57.440 and their skills because of selection of players and training 0:14:57.480 --> 0:15:00.720 and and and so forth, that it appears to be 0:15:00.760 --> 0:15:02.560 more random. So it's this interesting thing in our world. 0:15:02.600 --> 0:15:06.280 Our world is grinding towards greater skill, and yet luck 0:15:06.360 --> 0:15:10.960 is becoming more important in many of our outcomes. Well, Michael, 0:15:11.080 --> 0:15:14.240 on that note, I mean you're talking about relative skills 0:15:15.000 --> 0:15:18.080 becoming ever more sort of compressed, or the gap between 0:15:18.120 --> 0:15:21.280 different UM managers I guess in this case becoming ever 0:15:21.360 --> 0:15:25.640 more compressed. You also mentioned dispersion UM. One of the 0:15:25.680 --> 0:15:28.560 big themes that we've had in financial markets, at least 0:15:28.560 --> 0:15:32.440 since the Financial crisis, has been the idea of asset 0:15:32.480 --> 0:15:38.480 classes moving altogether correlation increasing and it basically making life 0:15:38.520 --> 0:15:42.360 a nightmare for active managers. So how much does that 0:15:42.480 --> 0:15:49.920 play into UM the current debate about active versus passive? No, Tracy, 0:15:49.960 --> 0:15:52.320 I think that's a huge issue right now. I do 0:15:52.440 --> 0:15:54.720 think that UM and I think that's one of the 0:15:54.760 --> 0:15:59.520 one of the effects of indexing and e t f 0:15:59.600 --> 0:16:02.360 s is that, as I mentioned before my little restaurant example, 0:16:02.400 --> 0:16:05.160 things do tend to get more correlated and you need 0:16:05.320 --> 0:16:08.480 you need dispersion to express skill. Right, that's really the 0:16:08.560 --> 0:16:11.280 key idea UM the other thing. So so you're I 0:16:11.280 --> 0:16:13.000 think that's exactly right, and you want to look for that, 0:16:13.040 --> 0:16:15.680 and it's it is the dispersions different by asset classes 0:16:15.720 --> 0:16:17.760 and even within industries and sectors. So you have to 0:16:17.840 --> 0:16:20.000 keep a track on that step. But that but that's uh, no, 0:16:20.080 --> 0:16:22.240 I think that's exactly right. Nothing I'll mentioned to you. 0:16:22.280 --> 0:16:25.360 That's that's interesting. It's also uh one of our One 0:16:25.360 --> 0:16:27.920 of my favorite pictures in the report is we show 0:16:27.920 --> 0:16:31.120 a picture of the standard deviation of excess returns of 0:16:31.200 --> 0:16:33.760 mutual funds. Right, so here's what I want you just 0:16:33.960 --> 0:16:36.520 envision that we plot the excess returns for all mutual 0:16:36.560 --> 0:16:39.320 funds in a particular year. It looks like a you know, 0:16:39.400 --> 0:16:41.720 roughly not exactly a bell shape, but pretend it's a 0:16:41.760 --> 0:16:45.240 bell shaped distribution, and uh, we look at how fat 0:16:45.320 --> 0:16:48.040 the bell shape is. Right, So if you're a skillful manager, 0:16:48.080 --> 0:16:50.600 it's like my poker analogy, you want a fat bell, right, 0:16:50.640 --> 0:16:53.040 so you have lots of positive excess returns and lots 0:16:53.040 --> 0:16:55.160 of negative access returns, and if you're a smart player, 0:16:55.440 --> 0:16:57.920 you can see where your profits are coming from. Well, 0:16:57.960 --> 0:16:59.440 what we see if we have and we have these 0:16:59.520 --> 0:17:02.840 data back in nineteen sixties, is that that fat bell 0:17:02.960 --> 0:17:06.600 shaped curve has gotten skinnier and skinnier and skinnier over 0:17:06.640 --> 0:17:11.000 the decades. There was actually a very brief reversal in 0:17:11.000 --> 0:17:14.119 the late nineties early two thousands around the dot com phenomenon, 0:17:14.160 --> 0:17:17.840 which is really interesting because that core coincides with mom 0:17:17.840 --> 0:17:20.640 and pop coming rushing back into the market. So essentially 0:17:20.640 --> 0:17:22.359 they are the ones that were the weak players at 0:17:22.400 --> 0:17:24.600 the table. But as soon as they got showed back 0:17:24.600 --> 0:17:27.560 out after the early two thousand's, we went right back 0:17:27.600 --> 0:17:31.480 to trend. So today as it stands, uh, there's very 0:17:32.080 --> 0:17:35.840 historically speaking, very little positive access return but there's also 0:17:35.960 --> 0:17:39.159 very little negative excess return. So that's another way. It's 0:17:39.359 --> 0:17:42.520 another speaks the same issue of correlations. Just very difficult 0:17:43.000 --> 0:17:45.840 to distinguish yourself. Now, there are ways Joe's questions spoke 0:17:45.840 --> 0:17:47.840 to before, there are ways to do this shade the 0:17:47.880 --> 0:17:50.640 odds in your favor of finding skillful managers. But it's 0:17:50.640 --> 0:17:52.800 just important to bear all these things in mind. It's 0:17:52.840 --> 0:17:56.120 just like other things in life, just very competitive. It's 0:17:56.200 --> 0:17:59.960 interesting the idea that for a brief time the dispersion 0:18:00.040 --> 0:18:04.320 and really widened this sort of you know, after the fact, 0:18:04.359 --> 0:18:07.159 pretty clear evidence that that was a mania or a bubble. 0:18:07.200 --> 0:18:09.399 Can do you ever, can that be used sort of 0:18:09.440 --> 0:18:12.640 as a market timing technique or is it just not 0:18:12.960 --> 0:18:15.439 strong enough of a signal? And really, Joe, it's a 0:18:15.440 --> 0:18:18.439 super interesting question. And we have another picture that's related 0:18:18.480 --> 0:18:20.960 to that, which we're you know, we show on one 0:18:21.000 --> 0:18:25.400 access Mom and Pops participations individual direct participation or markets. 0:18:25.880 --> 0:18:29.080 At the beginning of the series, it's about fift about fifty, 0:18:29.560 --> 0:18:32.840 and it's now about so it's drifted lower. So some 0:18:32.920 --> 0:18:35.520 mom and propagetting the memo basically right that they shouldn't 0:18:35.560 --> 0:18:39.240 be doing it directly. But but even though there's that 0:18:39.280 --> 0:18:41.480 long term trend is down again. That was that lift 0:18:41.520 --> 0:18:44.679 in the late nine so so there was a temptation 0:18:44.720 --> 0:18:47.840 to come into markets and that was really good for 0:18:47.880 --> 0:18:51.120 active managers they could take advantage of that. Okay, so uh. 0:18:51.200 --> 0:18:53.320 The two other questions would be something like this, one 0:18:53.440 --> 0:18:57.480 is UM, are there other signatures of what individuals are doing? 0:18:58.200 --> 0:19:00.600 And to me, the best lead on that. So if 0:19:00.600 --> 0:19:04.240 you said which would be funds flows? Because it's almost 0:19:04.280 --> 0:19:08.200 always the case, it's true to a lesser degree for institutions, 0:19:08.240 --> 0:19:10.919 but for sure for individuals. They tend to want to 0:19:10.920 --> 0:19:14.919 do today what they should have done two years ago. Right, 0:19:14.960 --> 0:19:17.879 so they tend to inflate certain you know, not as 0:19:17.960 --> 0:19:20.480 dramatic as the dot coms, but you get a little 0:19:20.480 --> 0:19:23.520 bit of excesses. So that the funds flow thing, I 0:19:23.520 --> 0:19:26.120 think it's probably the place I would be looking at 0:19:26.160 --> 0:19:31.840 to see if they're signatures of UM individual performance. The 0:19:32.200 --> 0:19:34.200 one area, by the way, where it's interesting to take 0:19:34.200 --> 0:19:38.800 a look at is UM so called smart beta UH strategies. Right, 0:19:38.840 --> 0:19:42.960 so these are factors that academics typically have unearthed to 0:19:43.119 --> 0:19:46.439 show so called excess returns. And there's a there's a 0:19:46.560 --> 0:19:49.399 very interesting discussion that everyone should think about. One is 0:19:49.440 --> 0:19:52.639 you know. Are these truly just factors? For example, small 0:19:52.720 --> 0:19:55.119 caps do better in large caps, or cheap stocks do 0:19:55.160 --> 0:19:58.040 better than expensive stocks. Are these just measures of risk, 0:19:58.359 --> 0:20:00.359 which case they're not that interesting because you're is getting 0:20:00.359 --> 0:20:04.119 compensated for risk you're assuming. Are they behavioral because they 0:20:04.160 --> 0:20:07.040 arise because people are sub optimal in their behaviors. And 0:20:07.080 --> 0:20:09.200 the third thing, which is really interesting is do they 0:20:09.240 --> 0:20:11.840 work at least in the short run because people believe 0:20:11.920 --> 0:20:13.400 they were right? And if I come to you side, 0:20:13.440 --> 0:20:16.920 Joe Tracy, low ball is awesome and you got, oh great, 0:20:17.000 --> 0:20:19.080 you buy low Ball, what what's your initial reaction? The 0:20:19.080 --> 0:20:21.240 answer is it does well because you bought it and 0:20:21.280 --> 0:20:23.720 a lot of other people did as well. So it's 0:20:23.760 --> 0:20:26.000 neither of those. It's not behavioral or risk. It's just 0:20:26.040 --> 0:20:28.640 this sort of funds flow. So so there's some very 0:20:28.640 --> 0:20:32.119 interesting cross currents and thinking about where people are putting 0:20:32.119 --> 0:20:34.320 their money that to me would be maybe the next 0:20:34.320 --> 0:20:39.760 derivative signature of sort of that question. So, Michael, in 0:20:39.880 --> 0:20:44.520 the battle between active versus passive and indexing, where do 0:20:44.560 --> 0:20:47.760 you see us actually going from here? Because the the 0:20:47.920 --> 0:20:51.600 standard accepted argument seems to be that eventually will have 0:20:51.680 --> 0:20:54.240 so much money wrapped into passive, that that'll just make 0:20:54.280 --> 0:20:58.120 life so easy for the active managers that their returns 0:20:58.160 --> 0:21:01.320 are going to be absolutely color and everyone is going 0:21:01.359 --> 0:21:04.000 to shift back to active managers. But your argument is 0:21:04.040 --> 0:21:08.919 actually much more subtle than that, Tracy. And there is 0:21:08.920 --> 0:21:13.119 a very important paper, it's well known, written by Bill Sharp, 0:21:13.160 --> 0:21:16.240 obviously won the Nobel Prize um called the Arithmetic of 0:21:16.280 --> 0:21:18.199 Active Management. And this is something that needs to be 0:21:18.359 --> 0:21:21.480 people have to bear in mind. And the arithmetic arithmetic 0:21:21.520 --> 0:21:24.720 of active management basically says that the returns for active 0:21:24.760 --> 0:21:27.880 and passive in the aggregate will be equal to one another. Right, 0:21:28.680 --> 0:21:30.600 pre feast. Now just think about this for a second. 0:21:30.640 --> 0:21:33.119 Let's just pretend for simplicity that the market is the 0:21:33.200 --> 0:21:36.560