Speaker 1: Hello, and welcome to another episode of the Odd Thoughts Podcast.
Speaker 1: I'm Tracy Alloway and I'm Joe Wisenthal. So, Joe, I
Speaker 1: tweeted something recently and Uh, it provoked a large response
Speaker 1: on social media. It's weird how that happens, Right, you
Speaker 1: tweeted something that provoked a response. I find it very
Speaker 1: hard to believe. I know it's outrageous. Um, but I
Speaker 1: was talking about. Have you heard of the fire movement? Uh? Yes, vaguely,
Speaker 1: like I am familiar with it. It has to do
Speaker 1: with people retiring early, right, Yeah, So it's fire as
Speaker 1: an f I R E. And it stands for financial
Speaker 1: independence retire early. And the basic idea is you can
Speaker 1: save a lot of money, and if you invest it wisely,
Speaker 1: you can retire at an early age, like in your thirties.
Speaker 1: And supposedly it's it can work out for for even
Speaker 1: normal people or people on normal salaries. We're not talking
Speaker 1: about really wealthy people. And the thing that I always
Speaker 1: find really interesting about it is when you go and
Speaker 1: read about how people are actually investing that money so
Speaker 1: that they can retire early, they're almost all talking about
Speaker 1: doing it a themselves and be through passive investments like
Speaker 1: e t s right, exactly right. So people think, okay,
Speaker 1: they live frugally, they work for several years, they live frugally,
Speaker 1: but then they sort of have this confidence that historical
Speaker 1: returns that we've seen in stock and bond markets throughout
Speaker 1: the world will just always be there for them in
Speaker 1: the future, and so they just put a bunch of
Speaker 1: money in passive e t F or you know, passive
Speaker 1: ish e t f s, and then they count on
Speaker 1: that existing for the rest of their lives. And then
Speaker 1: they do something I don't know, they go read it
Speaker 1: or tweet for the next from thirty five until that's right.
Speaker 1: And the reason I find this, you know, it doesn't
Speaker 1: sound bad to me, to be honest, I would be fine.
Speaker 1: I would do that if I if I had confidence.
Speaker 1: You can see the allure for sure. But the reason
Speaker 1: I find it so interesting from a market perspective is
Speaker 1: to me, it hits upon like a number of very
Speaker 1: very important themes, But really it hits upon this question
Speaker 1: of whether or not the fire movement can exist without
Speaker 1: the bull market that we've seen for the last ten years. Right, Like,
Speaker 1: it's very easy to say dump all your money in
Speaker 1: something like um, you know a vanguard total stock market
Speaker 1: e t F and just watch it sore when that's
Speaker 1: the thing that's been happening for years and years and years. Well,
Speaker 1: I'll say two things. So one is it certainly raises
Speaker 1: the question about whether this subculture can continue to exist,
Speaker 1: But it also raises another question about people who aren't
Speaker 1: in that subculture but in a way of effect brought
Speaker 1: into it. Because this mantra that we've gotten from uh
Speaker 1: sort of the media and the fund management industry is okay,
Speaker 1: most people aren't saying you should try to retire at
Speaker 1: thirty five or forty, but this idea, never try at
Speaker 1: a time the market, never pick individual stocks, just have
Speaker 1: a broad, diversified basket of e t F that you
Speaker 1: may be rebalanced every once in a while has become
Speaker 1: so intense and extreme and everyone's being pushed to invest
Speaker 1: like that. So even if you are one of the
Speaker 1: fire people on Reddit, it still raises the question of
Speaker 1: how much is everyone else who is not planning on
Speaker 1: per se retiring early essentially blotted to a less extreme
Speaker 1: version of the same story. Absolutely, and you'll see a
Speaker 1: lot of the investment advice that the fire people talk
Speaker 1: about is actually very very similar to advice given to
Speaker 1: people generally when it comes to their for oh one
Speaker 1: case and stuff like that. Passive is supposed to be cheaper,
Speaker 1: it's supposed to be much better. But what if there's
Speaker 1: a downside to pass of investing. We've spoken about, you know,
Speaker 1: active versus passive on the podcast before, but we haven't
Speaker 1: done that much on how passive investing might actually be
Speaker 1: changing the way the market functions. No, absolutely, and it's
Speaker 1: such an important question given as we've been talking about,
Speaker 1: how many people have portfolios in which the only action
Speaker 1: they do is just add to the same basket of
Speaker 1: three or four ETFs every single month for their working lives.
Speaker 1: It's been fantastic since the crisis with the incredible rally
Speaker 1: in stocks and bonds simultaneously. But you know, as they say,
Speaker 1: past performance no guarantee of future returns, this is true.
Speaker 1: All right. Well, I'm happy to say that we have
Speaker 1: the perfect person to talk about this today. Our guest
Speaker 1: is Mike Green. He's the chief strategist and portfolio manager
Speaker 1: over at Logica Capital Investors. Mike, thanks for being on,
Speaker 1: Thank you for having me. So I guess my first
Speaker 1: question is how did you get interested in this particular
Speaker 1: area examining the impact of passive investing on the broader market.
Speaker 1: Is it something that you're observing in your sort of
Speaker 1: day job. Well, the way I think of my day
Speaker 1: job is to really try to understand the market structure.
Speaker 1: I'm not a trader in the traditional sense, wasn't trained
Speaker 1: on a prop desk or anything else. And so you know,
Speaker 1: I've always managed to make money by trying to figure
Speaker 1: out actually what people are being forced to do. What
Speaker 1: is the incentive structure that's causing people to do what
Speaker 1: I think is fundamentally irrational. Rather than just saying, hey,
Speaker 1: they're crazy and stupid and this will eventually stop, the
Speaker 1: opportunity to dig in and understand actually the incentive structures
Speaker 1: that have been created the restraint or the requirements for
Speaker 1: people to engage in certain transactions, whether it's from a
Speaker 1: regulatory framework, whether it's from a institutional framework basically built
Speaker 1: into their prospectuves. Ultimately, that can create the opportunity to
Speaker 1: identify trades that you think are irrational and have the
Speaker 1: potential to break as that behavior is brought to its
Speaker 1: logical extreme. So that's how I stumbled onto this stuff.
Speaker 1: So what are in your view, the big structural trends
Speaker 1: or the big structural impositions on individual investors or pension
Speaker 1: funds or any other entity that has a lot of
Speaker 1: money that are all causing people to sort of invest
Speaker 1: in the same way. Right now, one of the big
Speaker 1: the key ideas here. So there's a couple of key things.
Speaker 1: The first is is that the growth of passive investing
Speaker 1: has has been well documented, right, and the narrative behind
Speaker 1: the out performance is fundamentally built around the work of
Speaker 1: Bill Sharp, who is the father of of the Sharp
Speaker 1: ratio um, the cap M formula, etcetera. Um his paper
Speaker 1: in called the Arithmetic of Active Management is this analysis
Speaker 1: that we've all heard that says fundamentally passive investors by
Speaker 1: definition are only matching the active investors in terms of
Speaker 1: their overall allocation, and so the difference is just going
Speaker 1: to be fees, which means that the active managers underperformed.
Speaker 1: Everyone accepts this today because we've seen the evidence of
Speaker 1: the outperformance of passive but very few will take the
Speaker 1: time to go back and actually look at the construction
Speaker 1: of the problem, the assumptions that existed under that the
Speaker 1: assumptions are just absurd, right, So in in the definition
Speaker 1: of what a passive investor is, according to Bill Sharp,
Speaker 1: is that passive investors hold all the securities in the market.
Speaker 1: How do they get in? That's magic. How do they
Speaker 1: get out? That's also magic. They never transact. Right the
Speaker 1: minute they transact, they cease to be passive investors. And
Speaker 1: as we know, passive vehicles are dealing with billions and
Speaker 1: billions of dollars of inflows on a daily and weekly basis.
Speaker 1: They're in the market transacting. They are the single largest
Speaker 1: transactors by far, and there's a result. They have to
Speaker 1: be influencing the market. They cannot be passive. So the
Speaker 1: fundamental premise on which this whole idea is built is flawed. Right.
Speaker 1: The second thing that has happened, though, is because passive
Speaker 1: investing has grown so large and so powerful, the resources
Speaker 1: to engage in lobbying efforts to institutionalize within the framework
Speaker 1: has expanded dramatically. Most people have a cursory familiarity with
Speaker 1: things like four oh one K plans and I RAS.
Speaker 1: Vast majority of Americans have some exposure through their employer
Speaker 1: to these plans. Those rules have changed over the years
Speaker 1: to the lobbying efforts of passive players like Van Garden
Speaker 1: Blackrock to inculcate passive strategies into these vehicles under the
Speaker 1: premise that this is the best possible vehicle for the
Speaker 1: vast majority of Americans to invest in. It's had the
Speaker 1: effect of creating this crowding that has further accelerated the
Speaker 1: performance of the benchmarks that these are ultimately tied to.
Speaker 1: Oh man, sorry, there's so much just in that first
Speaker 1: couple of minutes, um, that I find really really fascinating.
Speaker 1: Oh why don't we go back to the first point,
Speaker 1: which is this idea that when we're evaluating the performance
Speaker 1: of passive versus active, we're not actually taking into account
Speaker 1: the way that passive can influence the market. So how
Speaker 1: are you seeing passive investing actually impact the market? Now?
Speaker 1: We're seeing it in a couple of different ways, right, Um.
Speaker 1: One is is that we're seeing a distinct performance advantage
Speaker 1: that is being created for those securities that are in
Speaker 1: indices that are being invested into by passive investors. This
Speaker 1: is a fairly well studied phenomenon in terms of the
Speaker 1: dynamic of what's called index inclusion. So we have one
Speaker 1: off events in which we can look at securities that
Speaker 1: have been put into an index or have been ejected
Speaker 1: from a widely traded index, and we see that there
Speaker 1: is a distinct and permanent shift in the valuation the
Speaker 1: price levels associated with those securities. This is a well
Speaker 1: documented academic literature. But the literature has not studied is
Speaker 1: the dynamic of the continued inclusion the continued flow of capital.
Speaker 1: And that becomes a harder problem because suddenly they're on
Speaker 1: par with all of the other constituents in the index,
Speaker 1: and they're all experiencing it. Right. So I gave a
Speaker 1: speech several years ago in which I compared it to
Speaker 1: the David Foster Wallace, this is water right. The media
Speaker 1: him in which we're actually participating is being skewed by
Speaker 1: the behavior of these passive flows. The best analogy to
Speaker 1: think about this, most people have had exposure to the
Speaker 1: carnival game where you're shooting water at horses that are
Speaker 1: racing across. Right. The best strategy to play that game
Speaker 1: is to wait until the table is relatively full so
Speaker 1: it gets a large prize, and then you and a
Speaker 1: friend simultaneously go to the table and you both shoot
Speaker 1: at the same horse, abandoning one of your horses, but
Speaker 1: the objective is to win, right, and by simultaneously exerting
Speaker 1: pressure on the water sensor, you're giving the perception that
Speaker 1: you are more accurate, causing that horse to outperform. All right,
Speaker 1: That's what we're seeing with the benchmarks, as more and
Speaker 1: more people are shooting water at the stocks that are
Speaker 1: explicitly in these benchmarks, and in particular the larger stocks.
Speaker 1: Right because of the momentum bias associated with this and
Speaker 1: some of the techniques under which many industries are constructive
Speaker 1: it's called sampling techniques, where they're trying to with a
Speaker 1: minimum number of transactions, replicate the behavior of the index.
Speaker 1: These securities are in turn those horses that are receiving
Speaker 1: additional uh participants or water flow at the at them,
Speaker 1: leading to the perception that their performance is better because
Speaker 1: those are the benchmarks. That then leads you to conclude
Speaker 1: that all of the active managers are actually underperforming, when
Speaker 1: the problem is just how we're measuring it. So there's
Speaker 1: this uh yeah, I guess some people will call it
Speaker 1: a virtuous cycle. Some people might call it a vicious cycle.
Speaker 1: But what you're describing essentially is, Okay, we look at
Speaker 1: all these fund managers, maybe they're underperforming the SMP five
Speaker 1: hundred over some period of time, but it's essentially because
Speaker 1: all the money is going into the SPI as a whole,
Speaker 1: and then that accelerates because the fund managers appear to
Speaker 1: be unperforming. That appears to vindicate the idea that oh, yeah,
Speaker 1: of course, just go passive active doesn't work, and the
Speaker 1: problem or the disparity grows larger. So if this is true,
Speaker 1: it means that something like quite big and fundamental has
Speaker 1: actually happened or changed in the market, which is that
Speaker 1: there used to be a point where things would get
Speaker 1: too expensive, and that's when investors would stop buying them
Speaker 1: and eventually the price would sort of self regulate itself
Speaker 1: and drop back a little bit. But now what you're
Speaker 1: saying is basically, because we have so much money hitting
Speaker 1: the same target over and over and we basically have
Speaker 1: flows chasing flows, that markets are no longer self limiting,
Speaker 1: so to speak. Unfortunately, I think that's correct. I mean,
Speaker 1: there will ultimately be limits, but they're far beyond anything
Speaker 1: that we have currently experienced. So any reference to historical
Speaker 1: dynamics becomes an inherently flawed because we did not have
Speaker 1: these participants in the past. So it's a good thesis
Speaker 1: or it's a provocative thesis. And obviously you can point
Speaker 1: to the data that shows lots of fund managers under
Speaker 1: performing the benchmarks that have been set by them, and
Speaker 1: maybe that's uh, maybe those benchmarks are arbitrary. But how
Speaker 1: do we know that's true? What are some other indicators, like,
Speaker 1: how do we know it's not just fees that are
Speaker 1: causing them to underperform, or how do we know it's
Speaker 1: not just that they're bad at their jobs and they're
Speaker 1: bad at picking stocks that are causing them to underperform.
Speaker 1: What other evidence is there that people that they're actually
Speaker 1: still I guess doing a good job in spite of
Speaker 1: their underperformance. So the easiest way to actually tease something
Speaker 1: like this out is to look at the performance of
Speaker 1: benchmarks that UM are designed to model many of the
Speaker 1: strategies of active managers the generation of alpha and have
Speaker 1: historically worked quite well and doing so UM but charge
Speaker 1: no fees. So a simple example of that would be
Speaker 1: the by right index from the cbo E, which is
Speaker 1: you own the S ANDP, so you are actually tied
Speaker 1: explicitly to the benchmark and you sell an out of
Speaker 1: the money option on a continuous basis, capturing the premium
Speaker 1: associated with that option. Right, that has always historically delivered
Speaker 1: quote unquote alpha. Right. What you're actually doing is you're
Speaker 1: selling some of your top side exposure. You have full
Speaker 1: down side exposure in exchange for that sale of the
Speaker 1: top side, you are actually receiving a premium. Right. That
Speaker 1: premium delivers return regardless of the underlying return of the
Speaker 1: s and P five hundred the underlying and so that
Speaker 1: shows up as a alpha producing strategy. Right. We have
Speaker 1: seen this alpha decline in a nearly linear form over
Speaker 1: the past twenty five years. Right, it's not tied to
Speaker 1: interest rates, it's not tied to the implied versus realized
Speaker 1: which is the traditional component that people have focused on.
Speaker 1: We've seen these strategies that should offer a consistent return
Speaker 1: deliver now negative alpha, which is highlighting part of the problem.
Speaker 1: We're using tools that presume the efficient market hypothesis is
Speaker 1: true right to measure performance. So the calculation of alpha
Speaker 1: is literally just the intercept in a y equals m
Speaker 1: x plus b equation, a linear equation. If you try
Speaker 1: to solve a linear equation, if you try to use
Speaker 1: a linear equation to solve what has become a curved
Speaker 1: or distorted surface. Right mechanically, that alpha shifts increasingly negative
Speaker 1: in the same fashion that we're seeing this happen across
Speaker 1: these types of strategies. So one of the guests that
Speaker 1: we had on the podcast, I think it was maybe
Speaker 1: like three or four years ago now, we talked to
Speaker 1: Michael Morison, and he has a sort of separate model
Speaker 1: or theory about how this is all going on, and
Speaker 1: he basically kind of likened it to the online poker
Speaker 1: boom in the early two thousands, in which a bunch
Speaker 1: of bad players started playing poker and that was a
Speaker 1: really good time for professional pokers. A shark poker players
Speaker 1: the sharks could eat the fish, and then when the
Speaker 1: fish realized that they suck at it, they stopped playing.
Speaker 1: And then it's just sharks versus sharks, and the only
Speaker 1: thing is they are all good, but there the house
Speaker 1: gets a rank and they all start to underperform, and
Speaker 1: that the only real phenomenon with the passive emergence is
Speaker 1: just that people who never should have been trying to
Speaker 1: invest in the stocks in the first place aren't anymore,
Speaker 1: and that the alpha that the fun the professionals generated
Speaker 1: was just a result of there being a lot of
Speaker 1: bad players in the market, and now they're gone because
Speaker 1: they all they're all buying spy or whatever, and it's
Speaker 1: not their fault, but they just there's no bad there
Speaker 1: are fewer and fewer bad players. That sounds like a
Speaker 1: plausible way, a plausible story that is a little more
Speaker 1: benign than your vision. Yeah. So I know Michael personally,
Speaker 1: I kind of as a friend. Um, he's wrong. Um,
Speaker 1: in really simple terms, he's framing the problem incorrectly. So
Speaker 1: we all like to think of Wall Street is gambling,
Speaker 1: and so it's easy to draw an analogy to something
Speaker 1: like poker. The difference is poker is what's called innergotic system.
Speaker 1: The distribution of cards, the frequency in which you can
Speaker 1: pull the cards out at this particular suits. Uh. The
Speaker 1: hands that can be constructed are the finite in their
Speaker 1: underlying construction. Statistically, that's not going to change over any
Speaker 1: period of time. Any sample that I draw, as long
Speaker 1: as I'm drawing from a deck, is going to have
Speaker 1: the same distribution and probability. All right. That's what in
Speaker 1: our godic system is. It's what the tools that we
Speaker 1: use when you talk about Monte Carlo type simulations. They
Speaker 1: presume the exact opposite of what you said. Past performance
Speaker 1: is not a guarantee of future success, because we know
Speaker 1: that a blackjack table, or a poker table, or a
Speaker 1: um game of craps roulette is going to have the
Speaker 1: exact same probability distribution at any point in time. Alright,
Speaker 1: That's not how markets work. Markets have an infinite and
Speaker 1: infinite number of combinations, and they also have a singular
Speaker 1: direction in terms of the era of time. We have
Speaker 1: no certainty as to what the forward distribution is. The
Speaker 1: Michael's premise is fundamentally wrong. I want to ask you
Speaker 1: about another potential impact that you're if you're correct your
Speaker 1: thesis around the impact of passive investing on the market,
Speaker 1: another potential impact that could be playing out, and that's
Speaker 1: in the arena of volatility. So presumably if you have
Speaker 1: close chasing clothes, then the market becomes much quieter, I suppose.
Speaker 1: I don't think that's true, actually, so I just want
Speaker 1: to be very clear on that, right, certain types of
Speaker 1: behaviors of volatility become very different. Right, So when you
Speaker 1: have a market that is I would describe it as
Speaker 1: more accurately continually providing liquidity because you've removed the restrictions
Speaker 1: you you mentioned earlier. The idea that valuation or a
Speaker 1: focus on valuation creates self regulatory or self limiting behavior.
Speaker 1: People eventually will stop buying and hold cash as an
Speaker 1: alternative to holding securities because they find them unattractively valued
Speaker 1: and guaranteeing or virtually guaranteeing a negative return in forward
Speaker 1: expected space. Right, when you remove that restriction and instead
Speaker 1: you place the investments with the world's simplest algorithm, right,
Speaker 1: which passive is right. Passive is literally an algorithm that says,
Speaker 1: if you give me cash, then buy, if you ask
Speaker 1: for cash, then sell. Right. You remove those limits right
Speaker 1: and simultaneously, as long as the money coming in is positive, right,
Speaker 1: the flows are positive, you're providing liquidity to the market,
Speaker 1: which dampens volatility to a certain extent. Now, there's a
Speaker 1: host of extenuating factors that have been created through what
Speaker 1: are called yield enhancement strategies, basically strategies that are built
Speaker 1: around selling volatility that further influenced this dynamic. What we're
Speaker 1: actually seeing is daily volatility in terms of the point
Speaker 1: change is significantly less than weakly volatility, which is significantly
Speaker 1: less than monthly volatility, which is significantly less than annualized volatility.
Speaker 1: And that's the sort of behavior that you would expect
Speaker 1: to see if you're seeing this dampening on a localized basis,
Speaker 1: but the ability to inflate valuations over time. So I
Speaker 1: want to get to soon how this could all go
Speaker 1: bad and belly up and all the grim stuff that
Speaker 1: I'm I'm sure people are waiting for. But before we
Speaker 1: do that, I want to talk a little bit about
Speaker 1: what you identified up front is the sort of second
Speaker 1: key dynamic, which are these sort of other factors just
Speaker 1: sort of driving this trend overall, And you mentioned, uh,
Speaker 1: lobbying efforts and regulation. It also feels like, I don't
Speaker 1: want to say propaganda, but there's also been just a
Speaker 1: lot of media coverage about how nobody should ever time
Speaker 1: the market, nobody should ever pick stocks, nobody should ever
Speaker 1: just just keep investing, writing it out kind of the
Speaker 1: fire belief. Talk a little bit more about how this emerge,
Speaker 1: This sort of consensus around just if you have cash,
Speaker 1: put it in stocks, if you need cash, cell stocks, Well,
Speaker 1: I mean, we've heard this repeatedly before, and it's part
Speaker 1: of what I think gives rise to a little bit
Speaker 1: of sanctimony from the active manager space of this is
Speaker 1: all craziness, this is a cycle, it will end. I
Speaker 1: think it's a deep under appreciation for how we've structurally
Speaker 1: changed the system in terms of those dynamics, and the
Speaker 1: regulatory framework is a great one. You know. We tend
Speaker 1: to take for granted the underlying structure of a market,
Speaker 1: the underlying dynamic, but vehicles like four oh one case
Speaker 1: and iras, which represent the vast majority of individual American
Speaker 1: savings and actually are can be thought of colloquially as
Speaker 1: the world's largest sovereign wealth fund. Roughly sixteen trillion dollars
Speaker 1: in assets across the American public in four oh one
Speaker 1: case and I ras, people tend to think of stock
Speaker 1: ownership is heavily concentrated amongst the extremely wealthy. The reality
Speaker 1: is that four one case and iras are actually mechanisms
Speaker 1: by which the vast majority of Americans are capable of
Speaker 1: saving relatively small sums. The median investor, once they hit retirement,
Speaker 1: has somewhere in the neighborhood of two or fifty thousand
Speaker 1: dollars in their four oh one K and those funds
Speaker 1: need to be spent right so to fund retirement. So
Speaker 1: this is not a story of concentration of wealth. What
Speaker 1: it is the story is the mechanisms that are available
Speaker 1: for people to invest in their four oh one case
Speaker 1: have increasingly been directed to passive assets. There's a passing
Speaker 1: familiarity with something that's called the Department of Labor fiduciary
Speaker 1: role right, which came into being in April of two
Speaker 1: thousand sixteen. This actually changed the structure of for a
Speaker 1: one case quite significantly. Any corporation that offered a four
Speaker 1: oh one K had to offer passive strategies, had to
Speaker 1: offer low cost passive index alternatives to their employees, or
Speaker 1: they became liable to their employees for the excess fees
Speaker 1: that they were charged they were being charged to them
Speaker 1: and therefore oh one K and even more crazily potentially
Speaker 1: becoming liable for the under performance of the investments that
Speaker 1: they were offering right now. So corporations aren't in the
Speaker 1: business of guaranteeing a return relative to the SMP five
Speaker 1: or the Vanguard Total Market Index. They are in the
Speaker 1: business of trying to quickly and easily to spend benefits
Speaker 1: to their employees to keep them happy, right, And so
Speaker 1: this created a very accelerated shift into passive vehicles that
Speaker 1: began in two thousand and sixteen became formalized in early seventeen.
Speaker 1: And if we had not stopped the Phase two implementation
Speaker 1: of the d O L fiduciary role in t eighteen,
Speaker 1: this would have actually gotten far crazier. The second thing
Speaker 1: that's changed is the mechanism that people invest. All right,
Speaker 1: So four oh one case, again, we're a product of
Speaker 1: the nineteen seventies. They're created in nineteen seventy eight started
Speaker 1: the bull market. In nineteen eight one, there was only
Speaker 1: about seventy five hundred billion dollars invested in four oh
Speaker 1: one case. Today that numbers around seven trillion UM. In
Speaker 1: two thousand three, we introduced products called target date funds.
Speaker 1: I believe it was somewhere around two thousand five that
Speaker 1: we began to change what's called the quality the qualified
Speaker 1: default investment alternative for people who go into four oh
Speaker 1: one case. One of the traditional problems that people had
Speaker 1: in going into four oh one case is that their
Speaker 1: employees felt uncomfortable making an allocation choice, and so they
Speaker 1: would default to the cash that was being put in
Speaker 1: there and there was no actual investment of these proceeds.
Speaker 1: In two thousand five, that changed with the designation of
Speaker 1: a q d I A that was not cash. Effectively,
Speaker 1: the HR Department decided on any base allocation, so if
Speaker 1: you went in, you didn't change anything. Typically you would
Speaker 1: go into something like an SMP five underd or a
Speaker 1: total market index, or potentially into an actively managed product.
Speaker 1: There's active lobbying for designation is appropriate for q d A,
Speaker 1: and the recent passage of the Secure Act further enforces this.
Speaker 1: Starting around two thousand twelve, a default a qdi A
Speaker 1: default became a target date fund right, which means that
Speaker 1: your money is being put into a set proportion of
Speaker 1: equities and bonds based on your age um. That is,
Speaker 1: in turn investing almost exclusively through passive vehicles. There are
Speaker 1: a few exceptions to that, but the vast majority of
Speaker 1: of target date funds are investing through passive vehicles and
Speaker 1: so directing incremental flows into the market into those assets
Speaker 1: um and this has now become the dominant investment vehicle
Speaker 1: in the United States for money flowing into four own
Speaker 1: k the the number is close to Incremental dollars are
Speaker 1: now going into target date funds. I know Joe wants
Speaker 1: to get to the bad stuff happening, but just before
Speaker 1: we do. I mean, you mentioned active managers there, and
Speaker 1: often one of the complaints we see from active managers
Speaker 1: is the reason they're under performing is because the market
Speaker 1: is so distorted by the Federal Reserve or other central
Speaker 1: banks and massive amounts of liquidity that they can't possibly
Speaker 1: compete with, you know, the irrationality of everything. Is there
Speaker 1: any space in your particular view of the markets for
Speaker 1: central bank liquidity uh distorting some of the flows? So
Speaker 1: there is, but not in the manner that many active
Speaker 1: managers complain about, right, and um, it takes two forms.
Speaker 1: One is the low level of interest rates that we've
Speaker 1: arrived at through central bank actions. And those interest rates
Speaker 1: are certainly in terms of risk free rates, those are
Speaker 1: a policy choice. The central bank chooses the level to
Speaker 1: set the front of the curve, and everything else in
Speaker 1: the risk free space has to be set as some
Speaker 1: function of that number, right, so it will always be
Speaker 1: the anchor point. And there there's there's true complaints about
Speaker 1: that those low levels of interest rates relative to what
Speaker 1: they were even fifteen twenty years ago, has created a
Speaker 1: condition in which there is a desperate search for yield
Speaker 1: because people have a shortage of financial assets that would
Speaker 1: allow them to meet their retirement or return objectives. UM.
Speaker 1: That has given rise to a cottage industry that we
Speaker 1: call yield enhancement strategies and Asia. These are often referred
Speaker 1: to as what are called autocollables in the United States
Speaker 1: that could take the form of things like put writing
Speaker 1: or call writing strategies, overlay strategies UM. Very publicly a
Speaker 1: firm called Harvest was a very active seller of yield
Speaker 1: enhancement strategies. UBS was sued about the under performance of
Speaker 1: these strategies and going to twenty nineteen UM and so
Speaker 1: I would argue that central banks are primarily responsible for
Speaker 1: the rise of those yield enhancement strategies, and those in
Speaker 1: particular are creating a lot of the vol dampening that
Speaker 1: you're referring to, Joe right and UH listeners, remember a
Speaker 1: couple of weeks ago we talked to Ben Effort about
Speaker 1: exactly that factor, the Asian retail buyers going back and
Speaker 1: UH buying all these sort of selling volatility to generate
Speaker 1: yield in this environment that you're describing, in which UH
Speaker 1: there's this wall of money that comes in every paycheck
Speaker 1: or every month or whatever it is. Is there a
Speaker 1: reason for anyone two to sort of like you know,
Speaker 1: security selection, stock selection? What people the old star mutual
Speaker 1: fund managers or is trying that or trying to find
Speaker 1: a good uh stock selector just kind of a loser
Speaker 1: way to play it at this point, Well, it depends
Speaker 1: on what your objective is. Right. If your objective is
Speaker 1: to allocate capital, right, that's a very important role. Right.
Speaker 1: The role of financial markets is actually to set the
Speaker 1: marginal price of capital so that companies and access that
Speaker 1: either in the form of debt markets or in the
Speaker 1: form of equity markets. We focused on the equity markets.
Speaker 1: I would actually argue the impact of passive on the
Speaker 1: debt and the rate and credit markets is increasingly pernicious
Speaker 1: um because the models that are totally flawed. That is
Speaker 1: actually a very important role. Taking money from bad companies
Speaker 1: and giving it to good companies is a critical role
Speaker 1: in a capitalist system, effectively allowing those who are efficient
Speaker 1: and intelligent allocators of capital to give money to management
Speaker 1: teams that have good prospects in terms of generating future wealth.
Speaker 1: What we've created now is a distortion. That's a fun
Speaker 1: house mirror effect right where we've presumed that everybody else
Speaker 1: is doing this for us. Therefore it is a fool's
Speaker 1: game to do it ourselves, right, and the rewards very
Speaker 1: clearly are accruing to those who are engaged in various
Speaker 1: ways of leveraging this phenomenon. You asked, you know, how
Speaker 1: can people beat the market? While we saw in two
Speaker 1: thousand seventeen a product x I v UM that was
Speaker 1: basically a hyper leveraged and leveraged, increasingly levered exposure of
Speaker 1: the SMP become the stock market Darling, Right. And the
Speaker 1: downside to leverage is what we saw in February fifen,
Speaker 1: which is in a single event that stock basically went
Speaker 1: to zero, right, um. And so this is the conundrum, right.
Speaker 1: You can approach this from the standpoint of I want
Speaker 1: increasingly levered exposure to this and that will allow me
Speaker 1: to outperform over a short period of time. And I
Speaker 1: presume that I have the skill to break away from
Speaker 1: the market when the greater fuel theory is about to
Speaker 1: be exhausted. But if you're holding that recourse leverage, you
Speaker 1: could lose everything in the process. Let's talk about those
Speaker 1: yield enhancers or the overlay strategies, because I suspect this
Speaker 1: is probably where things start to wobble a little bit.
Speaker 1: But how pervasive is the use of this kind of
Speaker 1: strategy to enhance yields and who is most actively deploying it,
Speaker 1: So it's very hard to track. Um. There are lots
Speaker 1: and lots of institutional strategies that are not disclosed to
Speaker 1: the market that involve various forms of yield enhancement. I
Speaker 1: know that most forms of private wealth management offer products
Speaker 1: that they call yield enhancement, which are various forms of
Speaker 1: you know, selling puts on an investment grade bond index
Speaker 1: to modestly enhance the yield, effectively saying I will take
Speaker 1: double downside exposure and exchange for slightly less or slightly
Speaker 1: higher coupon in in current form um, these are not
Speaker 1: well tracked. Chris Cole and Ben Effort, among others, have
Speaker 1: made estimates. Um it is very clearly in the trillions
Speaker 1: of dollars that is involved in this type of behavior.
Speaker 1: But again it's a natural byproduct of an environment in
Speaker 1: which yields have fallen dramatically UH in response to fears
Speaker 1: about securities, prices and that is the second area, and
Speaker 1: I didn't talk about this, where the central bank influence
Speaker 1: is quite significant. You know, you effectively have expanded the
Speaker 1: demand for financial assets dramatically because central banks target asset
Speaker 1: price stability in their behavior. Right. So the way that
Speaker 1: they can do that is by cutting interest rates, which
Speaker 1: raises the price of a bond. Right, When I cut
Speaker 1: interest rates, it raises the price of the bond. The
Speaker 1: benefit is not actually that this stimulates borrowing, an investment
Speaker 1: in the economy, which is what the FED is presuming.
Speaker 1: Is the channel that is occurring, right, The idea of
Speaker 1: being by cutting interest rates, I make more economic that
Speaker 1: marginal factory that could be built, or that marginal home
Speaker 1: that could be built. Instead, what you're actually doing is
Speaker 1: in levered portfolios, you're expanding collateral. You're increasing the borrowing
Speaker 1: capacity to buy other financial assets. Right, and so again
Speaker 1: it's a liquidity enhancement that is driving prices higher, driving
Speaker 1: interest rates lower, and increasing the need for these types
Speaker 1: of yield enhancement strategies, which in turn are fundamentally providing
Speaker 1: insurance to the market from individuals who don't know that
Speaker 1: they're providing insurance. So obviously, uh, we've seen this passive trend.
Speaker 1: It's exploded as you laid out, starting in the early nineties,
Speaker 1: there's been a series of regulatory changes that also just
Speaker 1: sort of encouraged individuals and institutions to invest this way.
Speaker 1: What are the limits, like, where does it and and
Speaker 1: in your view of the distortions that are being caused
Speaker 1: by it, how how far? How far could it go?
Speaker 1: So I think it's very hard to define that, right, Um,
Speaker 1: there are limits in terms of of the underlying behavior
Speaker 1: of what gets contributed. Um. And so if you think
Speaker 1: about the dynamics of buying behavior, ultimately that faces limits
Speaker 1: in terms of the nominal quantity of dollars that are
Speaker 1: available to be incrementally deployed. Right So Americans savings into
Speaker 1: therefore one case will only change in proportion the quantity
Speaker 1: that can be invested by every individual, the amount that
Speaker 1: goes up every year, and the number of Americans that
Speaker 1: participate in four O one case and are employed with
Speaker 1: super low levels of unemployment and you know, very low
Speaker 1: levels of labor force growth and relatively high levels of participation,
Speaker 1: although things like the Secure Act have tried to expand
Speaker 1: participation even further. UM, I would argue we're beginning to
Speaker 1: approach the limits in terms of the quantity that can
Speaker 1: be contributed. Um. There are similar limitations in terms of
Speaker 1: corporate share buybacks, which are ultimately bound by the earnings
Speaker 1: capability of corporations. They've taken an increasing fraction of their
Speaker 1: earnings in cash flow more than because of the ability
Speaker 1: to borrow money, which ultimately still has to be serviced
Speaker 1: and so faces its own limits. UM. But there are
Speaker 1: limits in terms of how much can be deployed in
Speaker 1: these types of strategies. Right on the other side of
Speaker 1: the equation, most endowments, most Americans, through their four oh
Speaker 1: one case, need to take actually a percentage of their
Speaker 1: underlying portfolio, and so that is actually bound only by
Speaker 1: the price level of the financial assets themselves, right, And
Speaker 1: so there is a point at which the outflows begin
Speaker 1: to outweigh the inflows, and this should reverse. Where that
Speaker 1: happens is anyone's guess what does that reversal actually look like.
Speaker 1: I mean, you mentioned the VIX exchange traded notes earlier,
Speaker 1: and uh, some of our listeners will remember the v
Speaker 1: apocalypse of I guess it was early now and the
Speaker 1: products ended up sort of impacting the volatility market itself.
Speaker 1: Is that something that you would expect to happen as
Speaker 1: these clothes start to reverse? Unfortunately? Yes, right, because the
Speaker 1: way that markets work is the prices are set by transactions. Right.
Speaker 1: They're a little bit like Schrodinger's cat. They're neither alive
Speaker 1: nor dead until an actual transaction occurs. The presumption of
Speaker 1: continuity of those prices that you know Apple will trade
Speaker 1: at and then to nine is simply an assumption. In
Speaker 1: the presence of massive flows in either direction, these prices
Speaker 1: can become discontinuous. We've seen it to the top side
Speaker 1: of the past four months. Basically, the downside could be
Speaker 1: created when you have outflows similar to what we saw
Speaker 1: in December of eighteen, which had the largest equity outflows
Speaker 1: in the history of the market. So what do you
Speaker 1: do in the meantime? If if one is an investor,
Speaker 1: you look at this situation, it seems unto sustainable. The
Speaker 1: assumptions seem ridiculous. If you don't want to play along
Speaker 1: with this idea of just writing the market or sort
Speaker 1: of thinking you'll be smart enough to get out a
Speaker 1: day before everyone else. Uh, what are other ways to
Speaker 1: make money in the meantime that are satisfactory too. For
Speaker 1: if you're fund you have investors that want to see
Speaker 1: their quarterly returns. What makes sense here? Ultimately, everyone's bound
Speaker 1: by their own capability, UM and their own interest in
Speaker 1: doing that. Right. UM, you may not want to participate this,
Speaker 1: but you need you need to be aware that your
Speaker 1: neighbor maybe getting rich while you're not. UM. Certainly, my
Speaker 1: wife would highlight, uh, you know that that underlying dynamic.
Speaker 1: When I see these types of structures, it can be
Speaker 1: very different. Right, when you have an exposure like the
Speaker 1: x I V there were unique opportunities to purchase vehicles
Speaker 1: that allowed you to profit from that without significant uh,
Speaker 1: day to day involvement. I don't think that's I don't
Speaker 1: think that exists in this framework. Right. What we're doing
Speaker 1: at Logica as we are seeking ways to capitalize from
Speaker 1: obtaining non recourse leverage in both directions, right, using the
Speaker 1: tools of finance to purchase products that need to be
Speaker 1: managed on a continuous basis, but give us exposure to
Speaker 1: that top side leverage as well as the exposure to
Speaker 1: the downside leverage in a February eighteen type event. So
Speaker 1: it's you know, this is a UM, it's a buyer,
Speaker 1: beware market. Um, if everybody decided to take you know,
Speaker 1: my concerns to heart, then that would result in the
Speaker 1: flows turning very negative and the markets would crash. Um.
Speaker 1: Hopefully nobody's paying attention and they continue to go up.
Speaker 1: Is it plausible that it deflates quietly, that the rather
Speaker 1: than there being some sort of you know, Tracy used
Speaker 1: the word of apocalypse earlier in the end, like the
Speaker 1: x I V blow up, it was kind of minor
Speaker 1: and it didn't really have any sort of big spillover ramifications.
Speaker 1: Is it possible that, rather than and a volatility blow up,
Speaker 1: that it ends up being more just like you know,
Speaker 1: a helium balloon ten days after a birthday party that
Speaker 1: sort of starts sagging down And isn't it doesn't pop?
Speaker 1: Or do you think it will pop? Well? What I
Speaker 1: think has no bearing on what actually occurs, right, But
Speaker 1: you're here, so what I'm here? So I get to pontificate.
Speaker 1: You know, my belief is that it will pop. When
Speaker 1: that happens, I don't know. Um. And as a result,
Speaker 1: you know, you're forced to engage strategies that allow you
Speaker 1: to both participate and protect yourself. I think those tools
Speaker 1: that are available. Ironically, Um, people misunderstand many of the
Speaker 1: tools that they are using, and so those are being
Speaker 1: provided to me at the lowest cost they have ever
Speaker 1: been provided in history. So I'm actually quite excited about
Speaker 1: that and speaking against my own interest here. Now, what
Speaker 1: do you say, uh, I mean going back to connecting
Speaker 1: some of the dots here, are you talking when you
Speaker 1: say tools that are available to you to protect yourself
Speaker 1: at the lowest price in history? Are these more or
Speaker 1: less the sort of deep out of the money put
Speaker 1: that Korean retail investors are selling to generate yield, depressing
Speaker 1: the cost of a you know, a black tail risk insurance.
Speaker 1: Is that sort of conceptually what you're saying there? Uh? No, okay, okay.
Speaker 1: I have a really simple question which sort of goes
Speaker 1: back to the intro uh, the introductory discussion that Joe
Speaker 1: and I were having. Should someone looking to retire relatively
Speaker 1: early invest their money in something like the Banguard Total
Speaker 1: Stock Fund. So it's funny when you mentioned the fire concept,
Speaker 1: right because you both are relatively young, um and far
Speaker 1: better looking than I am. But the um, you know,
Speaker 1: fire pre global financial crisis actually stood for finance, insurance
Speaker 1: and real estate and was, it was an indicator. It
Speaker 1: was indicative of a bubble that was happening within a
Speaker 1: sector of the economy. Right, I would argue the idea
Speaker 1: of a fire movement in which people seek to remove
Speaker 1: their human capital from the labor force at an early age,
Speaker 1: is indicative of a is a clear indication of a bubble. Right,
Speaker 1: that's a that's an absurd use of a human being
Speaker 1: to retire at thirty five to pursue their own objectives.
Speaker 1: You happen to have struck it phenomenally rich and and
Speaker 1: or you happen to be born into dilettant wealth, more
Speaker 1: power to you. It's a fantastic mechanism for redistributing that wealth.
Speaker 1: Let's take the most valuable thing that any human being has,
Speaker 1: which is their capacity to contribute to an economy, and
Speaker 1: turn into a life of leisure at that young age. Like,
Speaker 1: it's just it's it's stupid idea. Yeah, I whenever I
Speaker 1: read those message boards, that is seemed to be a
Speaker 1: huge issue is boredom, and so people retire and then
Speaker 1: they just like then they're all asking each other what
Speaker 1: they should do with their lives. I was sometimes I
Speaker 1: fantasize about retirement. My wife says I would get bored
Speaker 1: just tweeting all the time, and I think I would
Speaker 1: enjoy it. But maybe she's right. Having taken a couple
Speaker 1: of sabbaticles over the course of my career, that can
Speaker 1: be periods of intense creativity. But you absolutely need to
Speaker 1: use that in the prospect of, you know, leveraging that
Speaker 1: human capital and those insights that you've developed a return
Speaker 1: to an economy. I just think the entire premise is wrong. Well,
Speaker 1: Mike Green from Logical Capital Advisors, that was an absolutely
Speaker 1: fantastic conversation. Thank you so much for coming on all
Speaker 1: thoughts my pleasure. Thanks Mike, that was awesome. Thank you. Joe.
Speaker 1: Can I just say the notion of you retiring early
Speaker 1: so that you could tweet even more is very, very
Speaker 1: worrying to me for for many reasons. Obviously I would
Speaker 1: miss you on all thoughts, but also it would be
Speaker 1: so painful. Don't worry, Trazy I have. I have no
Speaker 1: prospect of doing that any attempt soon. I have two
Speaker 1: kids under four, so there's no there's no path towards
Speaker 1: me retiring early to a life just tweeting more. So well,
Speaker 1: we'll continue the podcast for a while. All right, the world,
Speaker 1: thanks you. But I have to say I found that
Speaker 1: conversation so so interesting because, as we alluded to in
Speaker 1: the intro, it sort of touches on a couple of
Speaker 1: big thing themes. So one is the bowl market and
Speaker 1: how high can valuations actually go, And the other one,
Speaker 1: of course, is the debate between active and passive management.
Speaker 1: And of course we've had all these other episodes with
Speaker 1: people like Chris Cole, with people like Ben I for
Speaker 1: Sultan Posar, who's done some work on volatility overlay strategies,
Speaker 1: and to see all of that come together in one
Speaker 1: conversation is really unexpected and very pleasing. Yeah. Absolutely, and
Speaker 1: I really do think that, and I'm struck by I
Speaker 1: hadn't well, I would say two things I had not
Speaker 1: realized prior to this conversation with Mike. The full degree
Speaker 1: of sort of regulatory changes that we've seen since arguably
Speaker 1: the start of this bowl market in the early nineteen eighties,
Speaker 1: essentially designed to just make sure de facto that there
Speaker 1: is this fresh cash being put to work every single
Speaker 1: month or every single pay period. And also, you know,
Speaker 1: I have to admit, like, as a member of the
Speaker 1: financial media, this idea that uh, passive is better, that
Speaker 1: you're sort of a fool if you ever try to
Speaker 1: time the market, that you're a fool if you try
Speaker 1: to engage in your own security. Uh selection. Like that message,
Speaker 1: that sort of ideological message. I mean, I largely have
Speaker 1: bought it, and I'm not saying I agree or disagree
Speaker 1: with it, but it's certainly one that I think many
Speaker 1: people in the financial media practice of really internalized, especially
Speaker 1: like if you remember the sort of irresponsibility of the
Speaker 1: late nineties and the way like media is just so
Speaker 1: like hyped up on individual text docs that people got
Speaker 1: burned on. There's been this major course correction since then.
Speaker 1: It feels like to not move away from that style
Speaker 1: of talking about the market. Yeah, but you mentioned the
Speaker 1: regulation that is shaping some of this and the lobbying,
Speaker 1: and I find that really interesting. I find Mike's emphasis
Speaker 1: on incentives very very interesting, And again it goes back
Speaker 1: to some of the discussions we've had about economic models
Speaker 1: that don't actually take into account the way the real
Speaker 1: world works. So you know, if you're buying that e
Speaker 1: t F, as soon as you put money in, the
Speaker 1: e t F is deploying that money that's just like
Speaker 1: what it does, that's what it's created and incentivized to do.
Speaker 1: And the idea that that wouldn't that behavior wouldn't have
Speaker 1: an impact on the market like it seems quaint. After
Speaker 1: that discussion, two things I think we should schedule for
Speaker 1: future episodes is one we should do really examine the
Speaker 1: fiduciary role rule, because that is one of these things that,
Speaker 1: again I think a lot of people in the media
Speaker 1: had just sort of taken as yeah, that makes sense
Speaker 1: that UH advisors should have a fiduciary responsibility to investors
Speaker 1: to look out for their best interest. But really sort
Speaker 1: of examine UH that story more fully. And we should
Speaker 1: also have Michael Mobison back on and sort of repress him.
Speaker 1: It's been a while since we've talked to him on
Speaker 1: some of these questions about passive versus active, So new
Speaker 1: territories to explore for us. Excellent. I agree with both
Speaker 1: those ideas. Alright. This has been another episode of the
Speaker 1: All Thoughts podcast. I'm Tracy Allaway. You can follow me
Speaker 1: on Twitter at Tracy Alloway and I'm Joe wisn't Thal.
Speaker 1: You can follow me on Twitter at the Stalwart And
Speaker 1: you should definitely Follow our guest Today on Twitter, Michael Green.
Speaker 1: He's at prof plum Very high value follow, and be
Speaker 1: sure to follow our producer on Twitter, Laura Carlson. She's
Speaker 1: at Laura M. Carlson. Follow the Bloomberg head of podcast,
Speaker 1: Francesca Levy at Francesca Today, and check out the whole
Speaker 1: family of Bloomberg podcasts under the handle at podcasts. Thanks
Speaker 1: for listening.