WEBVTT - Why The Rise of Passive Investing Might Be Distorting The Market 0:00:10.800 --> 0:00:14.080 Hello, and welcome to another episode of the Odd Thoughts Podcast. 0:00:14.160 --> 0:00:18.680 I'm Tracy Alloway and I'm Joe Wisenthal. So, Joe, I 0:00:18.720 --> 0:00:23.959 tweeted something recently and Uh, it provoked a large response 0:00:24.040 --> 0:00:27.360 on social media. It's weird how that happens, Right, you 0:00:27.480 --> 0:00:30.760 tweeted something that provoked a response. I find it very 0:00:30.760 --> 0:00:34.000 hard to believe. I know it's outrageous. Um, but I 0:00:34.040 --> 0:00:40.800 was talking about. Have you heard of the fire movement? Uh? Yes, vaguely, 0:00:40.920 --> 0:00:43.519 like I am familiar with it. It has to do 0:00:43.560 --> 0:00:49.120 with people retiring early, right, Yeah, So it's fire as 0:00:49.159 --> 0:00:52.360 an f I R E. And it stands for financial 0:00:52.400 --> 0:00:57.040 independence retire early. And the basic idea is you can 0:00:57.120 --> 0:01:00.720 save a lot of money, and if you invest it wisely, 0:01:01.200 --> 0:01:04.880 you can retire at an early age, like in your thirties. 0:01:05.240 --> 0:01:08.440 And supposedly it's it can work out for for even 0:01:08.480 --> 0:01:11.720 normal people or people on normal salaries. We're not talking 0:01:11.720 --> 0:01:14.360 about really wealthy people. And the thing that I always 0:01:14.400 --> 0:01:17.560 find really interesting about it is when you go and 0:01:17.600 --> 0:01:21.640 read about how people are actually investing that money so 0:01:21.720 --> 0:01:25.639 that they can retire early, they're almost all talking about 0:01:25.680 --> 0:01:30.399 doing it a themselves and be through passive investments like 0:01:30.520 --> 0:01:35.040 e t s right, exactly right. So people think, okay, 0:01:35.400 --> 0:01:39.520 they live frugally, they work for several years, they live frugally, 0:01:39.920 --> 0:01:43.000 but then they sort of have this confidence that historical 0:01:43.280 --> 0:01:46.240 returns that we've seen in stock and bond markets throughout 0:01:46.280 --> 0:01:48.640 the world will just always be there for them in 0:01:48.680 --> 0:01:50.640 the future, and so they just put a bunch of 0:01:50.640 --> 0:01:53.560 money in passive e t F or you know, passive 0:01:53.680 --> 0:01:56.000 ish e t f s, and then they count on 0:01:56.080 --> 0:01:58.280 that existing for the rest of their lives. And then 0:01:58.440 --> 0:02:00.400 they do something I don't know, they go read it 0:02:00.480 --> 0:02:04.080 or tweet for the next from thirty five until that's right. 0:02:04.600 --> 0:02:06.760 And the reason I find this, you know, it doesn't 0:02:06.760 --> 0:02:09.280 sound bad to me, to be honest, I would be fine. 0:02:09.320 --> 0:02:11.480 I would do that if I if I had confidence. 0:02:11.800 --> 0:02:15.160 You can see the allure for sure. But the reason 0:02:15.240 --> 0:02:17.760 I find it so interesting from a market perspective is 0:02:17.800 --> 0:02:20.760 to me, it hits upon like a number of very 0:02:20.880 --> 0:02:24.320 very important themes, But really it hits upon this question 0:02:24.440 --> 0:02:28.839 of whether or not the fire movement can exist without 0:02:28.880 --> 0:02:33.360 the bull market that we've seen for the last ten years. Right, Like, 0:02:33.400 --> 0:02:36.680 it's very easy to say dump all your money in 0:02:36.880 --> 0:02:41.360 something like um, you know a vanguard total stock market 0:02:41.360 --> 0:02:44.440 e t F and just watch it sore when that's 0:02:44.520 --> 0:02:48.480 the thing that's been happening for years and years and years. Well, 0:02:48.600 --> 0:02:51.120 I'll say two things. So one is it certainly raises 0:02:51.120 --> 0:02:54.560 the question about whether this subculture can continue to exist, 0:02:54.960 --> 0:02:57.720 But it also raises another question about people who aren't 0:02:57.720 --> 0:03:01.000 in that subculture but in a way of effect brought 0:03:01.040 --> 0:03:05.359 into it. Because this mantra that we've gotten from uh 0:03:05.520 --> 0:03:09.280 sort of the media and the fund management industry is okay, 0:03:09.480 --> 0:03:11.560 most people aren't saying you should try to retire at 0:03:11.600 --> 0:03:15.400 thirty five or forty, but this idea, never try at 0:03:15.320 --> 0:03:18.840 a time the market, never pick individual stocks, just have 0:03:19.080 --> 0:03:22.360 a broad, diversified basket of e t F that you 0:03:22.400 --> 0:03:25.080 may be rebalanced every once in a while has become 0:03:25.200 --> 0:03:28.280 so intense and extreme and everyone's being pushed to invest 0:03:28.360 --> 0:03:30.280 like that. So even if you are one of the 0:03:30.280 --> 0:03:34.000 fire people on Reddit, it still raises the question of 0:03:34.160 --> 0:03:36.440 how much is everyone else who is not planning on 0:03:36.520 --> 0:03:40.760 per se retiring early essentially blotted to a less extreme 0:03:40.880 --> 0:03:43.600 version of the same story. Absolutely, and you'll see a 0:03:43.640 --> 0:03:46.280 lot of the investment advice that the fire people talk 0:03:46.320 --> 0:03:49.320 about is actually very very similar to advice given to 0:03:49.600 --> 0:03:51.600 people generally when it comes to their for oh one 0:03:51.600 --> 0:03:54.760 case and stuff like that. Passive is supposed to be cheaper, 0:03:54.800 --> 0:03:58.240 it's supposed to be much better. But what if there's 0:03:58.240 --> 0:04:02.120 a downside to pass of investing. We've spoken about, you know, 0:04:02.360 --> 0:04:06.240 active versus passive on the podcast before, but we haven't 0:04:06.280 --> 0:04:09.200 done that much on how passive investing might actually be 0:04:09.280 --> 0:04:13.840 changing the way the market functions. No, absolutely, and it's 0:04:13.880 --> 0:04:17.480 such an important question given as we've been talking about, 0:04:17.520 --> 0:04:20.640 how many people have portfolios in which the only action 0:04:20.680 --> 0:04:23.760 they do is just add to the same basket of 0:04:23.839 --> 0:04:27.680 three or four ETFs every single month for their working lives. 0:04:27.880 --> 0:04:31.479 It's been fantastic since the crisis with the incredible rally 0:04:31.520 --> 0:04:35.600 in stocks and bonds simultaneously. But you know, as they say, 0:04:35.880 --> 0:04:39.400 past performance no guarantee of future returns, this is true. 0:04:39.880 --> 0:04:41.839 All right. Well, I'm happy to say that we have 0:04:41.920 --> 0:04:45.200 the perfect person to talk about this today. Our guest 0:04:45.360 --> 0:04:49.000 is Mike Green. He's the chief strategist and portfolio manager 0:04:49.160 --> 0:04:53.280 over at Logica Capital Investors. Mike, thanks for being on, 0:04:53.760 --> 0:04:56.960 Thank you for having me. So I guess my first 0:04:57.040 --> 0:05:01.440 question is how did you get interested in this particular 0:05:01.600 --> 0:05:06.880 area examining the impact of passive investing on the broader market. 0:05:06.920 --> 0:05:09.240 Is it something that you're observing in your sort of 0:05:09.440 --> 0:05:11.520 day job. Well, the way I think of my day 0:05:11.600 --> 0:05:14.920 job is to really try to understand the market structure. 0:05:14.920 --> 0:05:17.360 I'm not a trader in the traditional sense, wasn't trained 0:05:17.400 --> 0:05:20.280 on a prop desk or anything else. And so you know, 0:05:20.320 --> 0:05:22.479 I've always managed to make money by trying to figure 0:05:22.480 --> 0:05:24.560 out actually what people are being forced to do. What 0:05:24.680 --> 0:05:26.719 is the incentive structure that's causing people to do what 0:05:26.839 --> 0:05:29.720 I think is fundamentally irrational. Rather than just saying, hey, 0:05:29.720 --> 0:05:33.200 they're crazy and stupid and this will eventually stop, the 0:05:33.279 --> 0:05:37.719 opportunity to dig in and understand actually the incentive structures 0:05:37.720 --> 0:05:40.719 that have been created the restraint or the requirements for 0:05:40.760 --> 0:05:43.000 people to engage in certain transactions, whether it's from a 0:05:43.000 --> 0:05:48.080 regulatory framework, whether it's from a institutional framework basically built 0:05:48.120 --> 0:05:53.800 into their prospectuves. Ultimately, that can create the opportunity to 0:05:53.839 --> 0:05:56.840 identify trades that you think are irrational and have the 0:05:56.839 --> 0:05:59.160 potential to break as that behavior is brought to its 0:05:59.160 --> 0:06:01.960 logical extreme. So that's how I stumbled onto this stuff. 0:06:02.200 --> 0:06:06.120 So what are in your view, the big structural trends 0:06:06.240 --> 0:06:10.080 or the big structural impositions on individual investors or pension 0:06:10.080 --> 0:06:12.720 funds or any other entity that has a lot of 0:06:12.760 --> 0:06:16.279 money that are all causing people to sort of invest 0:06:16.320 --> 0:06:18.040 in the same way. Right now, one of the big 0:06:18.160 --> 0:06:20.560 the key ideas here. So there's a couple of key things. 0:06:20.640 --> 0:06:22.960 The first is is that the growth of passive investing 0:06:22.960 --> 0:06:25.880 has has been well documented, right, and the narrative behind 0:06:26.000 --> 0:06:30.040 the out performance is fundamentally built around the work of 0:06:30.080 --> 0:06:32.559 Bill Sharp, who is the father of of the Sharp 0:06:32.680 --> 0:06:37.599 ratio um, the cap M formula, etcetera. Um his paper 0:06:37.640 --> 0:06:41.440 in called the Arithmetic of Active Management is this analysis 0:06:41.480 --> 0:06:44.880 that we've all heard that says fundamentally passive investors by 0:06:44.920 --> 0:06:47.680 definition are only matching the active investors in terms of 0:06:47.680 --> 0:06:49.960 their overall allocation, and so the difference is just going 0:06:50.040 --> 0:06:52.640 to be fees, which means that the active managers underperformed. 0:06:54.080 --> 0:06:57.719 Everyone accepts this today because we've seen the evidence of 0:06:57.720 --> 0:07:00.440 the outperformance of passive but very few will take the 0:07:00.440 --> 0:07:02.600 time to go back and actually look at the construction 0:07:02.640 --> 0:07:05.839 of the problem, the assumptions that existed under that the 0:07:05.880 --> 0:07:10.840 assumptions are just absurd, right, So in in the definition 0:07:10.920 --> 0:07:13.760 of what a passive investor is, according to Bill Sharp, 0:07:14.360 --> 0:07:18.160 is that passive investors hold all the securities in the market. 0:07:18.760 --> 0:07:21.800 How do they get in? That's magic. How do they 0:07:21.840 --> 0:07:26.280 get out? That's also magic. They never transact. Right the 0:07:26.320 --> 0:07:30.000 minute they transact, they cease to be passive investors. And 0:07:30.040 --> 0:07:33.400 as we know, passive vehicles are dealing with billions and 0:07:33.400 --> 0:07:36.320 billions of dollars of inflows on a daily and weekly basis. 0:07:36.800 --> 0:07:39.640 They're in the market transacting. They are the single largest 0:07:39.640 --> 0:07:42.280 transactors by far, and there's a result. They have to 0:07:42.320 --> 0:07:45.200 be influencing the market. They cannot be passive. So the 0:07:45.200 --> 0:07:49.600 fundamental premise on which this whole idea is built is flawed. Right. 0:07:50.160 --> 0:07:53.160 The second thing that has happened, though, is because passive 0:07:53.160 --> 0:07:56.440 investing has grown so large and so powerful, the resources 0:07:56.480 --> 0:08:01.040 to engage in lobbying efforts to institutionalize within the framework 0:08:01.080 --> 0:08:05.640 has expanded dramatically. Most people have a cursory familiarity with 0:08:05.720 --> 0:08:07.880 things like four oh one K plans and I RAS. 0:08:08.280 --> 0:08:11.160 Vast majority of Americans have some exposure through their employer 0:08:11.200 --> 0:08:15.040 to these plans. Those rules have changed over the years 0:08:15.040 --> 0:08:17.760 to the lobbying efforts of passive players like Van Garden 0:08:17.800 --> 0:08:22.120 Blackrock to inculcate passive strategies into these vehicles under the 0:08:22.120 --> 0:08:25.800 premise that this is the best possible vehicle for the 0:08:25.880 --> 0:08:28.920 vast majority of Americans to invest in. It's had the 0:08:28.920 --> 0:08:32.120 effect of creating this crowding that has further accelerated the 0:08:32.120 --> 0:08:34.840 performance of the benchmarks that these are ultimately tied to. 0:08:36.080 --> 0:08:39.880 Oh man, sorry, there's so much just in that first 0:08:40.000 --> 0:08:43.640 couple of minutes, um, that I find really really fascinating. 0:08:43.640 --> 0:08:46.480 Oh why don't we go back to the first point, 0:08:46.679 --> 0:08:50.239 which is this idea that when we're evaluating the performance 0:08:50.400 --> 0:08:54.560 of passive versus active, we're not actually taking into account 0:08:54.600 --> 0:08:57.959 the way that passive can influence the market. So how 0:08:58.000 --> 0:09:02.839 are you seeing passive investing actually impact the market? Now? 0:09:03.880 --> 0:09:06.280 We're seeing it in a couple of different ways, right, Um. 0:09:06.400 --> 0:09:09.720 One is is that we're seeing a distinct performance advantage 0:09:09.760 --> 0:09:12.480 that is being created for those securities that are in 0:09:12.480 --> 0:09:16.920 indices that are being invested into by passive investors. This 0:09:17.000 --> 0:09:19.520 is a fairly well studied phenomenon in terms of the 0:09:19.600 --> 0:09:22.440 dynamic of what's called index inclusion. So we have one 0:09:22.480 --> 0:09:24.800 off events in which we can look at securities that 0:09:24.800 --> 0:09:27.240 have been put into an index or have been ejected 0:09:27.280 --> 0:09:30.439 from a widely traded index, and we see that there 0:09:30.520 --> 0:09:34.280 is a distinct and permanent shift in the valuation the 0:09:34.320 --> 0:09:37.360 price levels associated with those securities. This is a well 0:09:37.440 --> 0:09:42.040 documented academic literature. But the literature has not studied is 0:09:42.040 --> 0:09:45.760 the dynamic of the continued inclusion the continued flow of capital. 0:09:45.760 --> 0:09:48.440 And that becomes a harder problem because suddenly they're on 0:09:48.559 --> 0:09:51.000 par with all of the other constituents in the index, 0:09:51.480 --> 0:09:54.440 and they're all experiencing it. Right. So I gave a 0:09:54.440 --> 0:09:56.439 speech several years ago in which I compared it to 0:09:56.520 --> 0:09:59.920 the David Foster Wallace, this is water right. The media 0:10:00.080 --> 0:10:03.600 him in which we're actually participating is being skewed by 0:10:03.640 --> 0:10:07.320 the behavior of these passive flows. The best analogy to 0:10:07.320 --> 0:10:09.559 think about this, most people have had exposure to the 0:10:09.600 --> 0:10:13.280 carnival game where you're shooting water at horses that are 0:10:13.360 --> 0:10:17.280 racing across. Right. The best strategy to play that game 0:10:17.320 --> 0:10:19.520 is to wait until the table is relatively full so 0:10:19.559 --> 0:10:21.400 it gets a large prize, and then you and a 0:10:21.440 --> 0:10:24.800 friend simultaneously go to the table and you both shoot 0:10:24.800 --> 0:10:27.160 at the same horse, abandoning one of your horses, but 0:10:27.200 --> 0:10:31.360 the objective is to win, right, and by simultaneously exerting 0:10:31.559 --> 0:10:35.800 pressure on the water sensor, you're giving the perception that 0:10:35.880 --> 0:10:39.640 you are more accurate, causing that horse to outperform. All right, 0:10:40.160 --> 0:10:42.160 That's what we're seeing with the benchmarks, as more and 0:10:42.200 --> 0:10:44.600 more people are shooting water at the stocks that are 0:10:44.640 --> 0:10:48.880 explicitly in these benchmarks, and in particular the larger stocks. 0:10:49.080 --> 0:10:52.000 Right because of the momentum bias associated with this and 0:10:52.320 --> 0:10:54.680 some of the techniques under which many industries are constructive 0:10:54.679 --> 0:10:57.240 it's called sampling techniques, where they're trying to with a 0:10:57.320 --> 0:11:00.760 minimum number of transactions, replicate the behavior of the index. 0:11:01.400 --> 0:11:04.360 These securities are in turn those horses that are receiving 0:11:04.360 --> 0:11:08.800 additional uh participants or water flow at the at them, 0:11:08.880 --> 0:11:12.520 leading to the perception that their performance is better because 0:11:12.559 --> 0:11:15.440 those are the benchmarks. That then leads you to conclude 0:11:15.440 --> 0:11:18.319 that all of the active managers are actually underperforming, when 0:11:18.320 --> 0:11:22.439 the problem is just how we're measuring it. So there's 0:11:22.480 --> 0:11:25.079 this uh yeah, I guess some people will call it 0:11:25.080 --> 0:11:27.720 a virtuous cycle. Some people might call it a vicious cycle. 0:11:28.240 --> 0:11:31.320 But what you're describing essentially is, Okay, we look at 0:11:31.320 --> 0:11:35.680 all these fund managers, maybe they're underperforming the SMP five 0:11:35.760 --> 0:11:40.960 hundred over some period of time, but it's essentially because 0:11:41.720 --> 0:11:45.199 all the money is going into the SPI as a whole, 0:11:45.559 --> 0:11:48.959 and then that accelerates because the fund managers appear to 0:11:48.960 --> 0:11:53.120 be unperforming. That appears to vindicate the idea that oh, yeah, 0:11:53.160 --> 0:11:57.120 of course, just go passive active doesn't work, and the 0:11:57.200 --> 0:12:02.640 problem or the disparity grows larger. So if this is true, 0:12:02.960 --> 0:12:07.559 it means that something like quite big and fundamental has 0:12:07.600 --> 0:12:10.360 actually happened or changed in the market, which is that 0:12:11.240 --> 0:12:14.880 there used to be a point where things would get 0:12:14.920 --> 0:12:19.760 too expensive, and that's when investors would stop buying them 0:12:19.800 --> 0:12:23.319 and eventually the price would sort of self regulate itself 0:12:23.360 --> 0:12:26.760 and drop back a little bit. But now what you're 0:12:26.760 --> 0:12:29.360 saying is basically, because we have so much money hitting 0:12:29.400 --> 0:12:32.040 the same target over and over and we basically have 0:12:32.160 --> 0:12:37.120 flows chasing flows, that markets are no longer self limiting, 0:12:37.240 --> 0:12:40.679 so to speak. Unfortunately, I think that's correct. I mean, 0:12:40.679 --> 0:12:43.440 there will ultimately be limits, but they're far beyond anything 0:12:43.480 --> 0:12:46.640 that we have currently experienced. So any reference to historical 0:12:47.120 --> 0:12:51.280 dynamics becomes an inherently flawed because we did not have 0:12:51.360 --> 0:12:54.800 these participants in the past. So it's a good thesis 0:12:54.880 --> 0:12:58.480 or it's a provocative thesis. And obviously you can point 0:12:58.559 --> 0:13:01.800 to the data that shows lots of fund managers under 0:13:01.800 --> 0:13:05.559 performing the benchmarks that have been set by them, and 0:13:05.720 --> 0:13:09.000 maybe that's uh, maybe those benchmarks are arbitrary. But how 0:13:09.000 --> 0:13:12.839 do we know that's true? What are some other indicators, like, 0:13:12.880 --> 0:13:15.160 how do we know it's not just fees that are 0:13:15.160 --> 0:13:17.199 causing them to underperform, or how do we know it's 0:13:17.280 --> 0:13:19.800 not just that they're bad at their jobs and they're 0:13:19.800 --> 0:13:22.559 bad at picking stocks that are causing them to underperform. 0:13:22.920 --> 0:13:27.080 What other evidence is there that people that they're actually 0:13:27.120 --> 0:13:29.760 still I guess doing a good job in spite of 0:13:29.760 --> 0:13:32.600 their underperformance. So the easiest way to actually tease something 0:13:32.640 --> 0:13:34.440 like this out is to look at the performance of 0:13:34.960 --> 0:13:37.839 benchmarks that UM are designed to model many of the 0:13:37.880 --> 0:13:41.400 strategies of active managers the generation of alpha and have 0:13:41.559 --> 0:13:44.880 historically worked quite well and doing so UM but charge 0:13:44.920 --> 0:13:47.000 no fees. So a simple example of that would be 0:13:47.000 --> 0:13:49.080 the by right index from the cbo E, which is 0:13:49.520 --> 0:13:52.080 you own the S ANDP, so you are actually tied 0:13:52.120 --> 0:13:54.960 explicitly to the benchmark and you sell an out of 0:13:54.960 --> 0:13:57.840 the money option on a continuous basis, capturing the premium 0:13:57.880 --> 0:14:03.240 associated with that option. Right, that has always historically delivered 0:14:03.320 --> 0:14:06.240 quote unquote alpha. Right. What you're actually doing is you're 0:14:06.240 --> 0:14:08.720 selling some of your top side exposure. You have full 0:14:08.840 --> 0:14:12.640 down side exposure in exchange for that sale of the 0:14:12.679 --> 0:14:15.960 top side, you are actually receiving a premium. Right. That 0:14:16.040 --> 0:14:19.920 premium delivers return regardless of the underlying return of the 0:14:20.040 --> 0:14:22.600 s and P five hundred the underlying and so that 0:14:22.640 --> 0:14:26.480 shows up as a alpha producing strategy. Right. We have 0:14:26.600 --> 0:14:29.840 seen this alpha decline in a nearly linear form over 0:14:29.840 --> 0:14:32.840 the past twenty five years. Right, it's not tied to 0:14:32.840 --> 0:14:35.560 interest rates, it's not tied to the implied versus realized 0:14:35.600 --> 0:14:37.840 which is the traditional component that people have focused on. 0:14:38.360 --> 0:14:43.000 We've seen these strategies that should offer a consistent return 0:14:43.680 --> 0:14:47.120 deliver now negative alpha, which is highlighting part of the problem. 0:14:47.600 --> 0:14:51.720 We're using tools that presume the efficient market hypothesis is 0:14:51.720 --> 0:14:57.600 true right to measure performance. So the calculation of alpha 0:14:57.800 --> 0:15:00.120 is literally just the intercept in a y equals m 0:15:00.160 --> 0:15:03.040 x plus b equation, a linear equation. If you try 0:15:03.040 --> 0:15:04.640 to solve a linear equation, if you try to use 0:15:04.640 --> 0:15:06.960 a linear equation to solve what has become a curved 0:15:07.080 --> 0:15:12.560 or distorted surface. Right mechanically, that alpha shifts increasingly negative 0:15:12.600 --> 0:15:15.040 in the same fashion that we're seeing this happen across 0:15:15.120 --> 0:15:17.880 these types of strategies. So one of the guests that 0:15:17.920 --> 0:15:20.960 we had on the podcast, I think it was maybe 0:15:20.960 --> 0:15:23.480 like three or four years ago now, we talked to 0:15:23.640 --> 0:15:27.560 Michael Morison, and he has a sort of separate model 0:15:27.760 --> 0:15:29.760 or theory about how this is all going on, and 0:15:29.800 --> 0:15:33.720 he basically kind of likened it to the online poker 0:15:33.760 --> 0:15:36.720 boom in the early two thousands, in which a bunch 0:15:36.760 --> 0:15:39.200 of bad players started playing poker and that was a 0:15:39.200 --> 0:15:43.440 really good time for professional pokers. A shark poker players 0:15:43.520 --> 0:15:45.720 the sharks could eat the fish, and then when the 0:15:45.760 --> 0:15:48.520 fish realized that they suck at it, they stopped playing. 0:15:48.840 --> 0:15:51.000 And then it's just sharks versus sharks, and the only 0:15:51.040 --> 0:15:53.920 thing is they are all good, but there the house 0:15:53.960 --> 0:15:56.640 gets a rank and they all start to underperform, and 0:15:56.680 --> 0:15:59.600 that the only real phenomenon with the passive emergence is 0:15:59.640 --> 0:16:02.120 just that people who never should have been trying to 0:16:02.160 --> 0:16:04.760 invest in the stocks in the first place aren't anymore, 0:16:05.120 --> 0:16:08.359 and that the alpha that the fun the professionals generated 0:16:08.640 --> 0:16:10.480 was just a result of there being a lot of 0:16:10.480 --> 0:16:13.720 bad players in the market, and now they're gone because 0:16:13.720 --> 0:16:17.040 they all they're all buying spy or whatever, and it's 0:16:17.040 --> 0:16:19.320 not their fault, but they just there's no bad there 0:16:19.360 --> 0:16:23.040 are fewer and fewer bad players. That sounds like a 0:16:23.160 --> 0:16:26.880 plausible way, a plausible story that is a little more 0:16:26.920 --> 0:16:30.280 benign than your vision. Yeah. So I know Michael personally, 0:16:30.320 --> 0:16:33.400 I kind of as a friend. Um, he's wrong. Um, 0:16:33.480 --> 0:16:35.920 in really simple terms, he's framing the problem incorrectly. So 0:16:35.960 --> 0:16:37.560 we all like to think of Wall Street is gambling, 0:16:37.560 --> 0:16:39.400 and so it's easy to draw an analogy to something 0:16:39.400 --> 0:16:42.680 like poker. The difference is poker is what's called innergotic system. 0:16:42.840 --> 0:16:45.320 The distribution of cards, the frequency in which you can 0:16:45.320 --> 0:16:48.480 pull the cards out at this particular suits. Uh. The 0:16:48.520 --> 0:16:50.560 hands that can be constructed are the finite in their 0:16:50.600 --> 0:16:53.800 underlying construction. Statistically, that's not going to change over any 0:16:53.800 --> 0:16:56.720 period of time. Any sample that I draw, as long 0:16:56.760 --> 0:16:58.240 as I'm drawing from a deck, is going to have 0:16:58.280 --> 0:17:01.240 the same distribution and probability. All right. That's what in 0:17:01.320 --> 0:17:04.399 our godic system is. It's what the tools that we 0:17:04.480 --> 0:17:08.000 use when you talk about Monte Carlo type simulations. They 0:17:08.000 --> 0:17:10.640 presume the exact opposite of what you said. Past performance 0:17:10.680 --> 0:17:12.760 is not a guarantee of future success, because we know 0:17:13.359 --> 0:17:16.639 that a blackjack table, or a poker table, or a 0:17:17.320 --> 0:17:19.840 um game of craps roulette is going to have the 0:17:19.840 --> 0:17:23.760 exact same probability distribution at any point in time. Alright, 0:17:23.800 --> 0:17:26.280 That's not how markets work. Markets have an infinite and 0:17:26.800 --> 0:17:29.720 infinite number of combinations, and they also have a singular 0:17:29.720 --> 0:17:31.399 direction in terms of the era of time. We have 0:17:31.520 --> 0:17:34.720 no certainty as to what the forward distribution is. The 0:17:34.800 --> 0:17:55.680 Michael's premise is fundamentally wrong. I want to ask you 0:17:55.760 --> 0:18:00.440 about another potential impact that you're if you're correct your 0:18:00.520 --> 0:18:03.679 thesis around the impact of passive investing on the market, 0:18:03.720 --> 0:18:07.000 another potential impact that could be playing out, and that's 0:18:07.119 --> 0:18:11.439 in the arena of volatility. So presumably if you have 0:18:11.560 --> 0:18:17.440 close chasing clothes, then the market becomes much quieter, I suppose. 0:18:18.080 --> 0:18:20.000 I don't think that's true, actually, so I just want 0:18:20.000 --> 0:18:23.240 to be very clear on that, right, certain types of 0:18:23.640 --> 0:18:27.840 behaviors of volatility become very different. Right, So when you 0:18:27.880 --> 0:18:30.040 have a market that is I would describe it as 0:18:30.040 --> 0:18:34.720 more accurately continually providing liquidity because you've removed the restrictions 0:18:34.800 --> 0:18:37.480 you you mentioned earlier. The idea that valuation or a 0:18:37.560 --> 0:18:41.280 focus on valuation creates self regulatory or self limiting behavior. 0:18:41.320 --> 0:18:43.919 People eventually will stop buying and hold cash as an 0:18:43.920 --> 0:18:47.440 alternative to holding securities because they find them unattractively valued 0:18:48.040 --> 0:18:52.200 and guaranteeing or virtually guaranteeing a negative return in forward 0:18:52.359 --> 0:18:57.120 expected space. Right, when you remove that restriction and instead 0:18:57.200 --> 0:19:00.560 you place the investments with the world's simplest algorithm, right, 0:19:00.600 --> 0:19:04.040 which passive is right. Passive is literally an algorithm that says, 0:19:04.080 --> 0:19:06.880 if you give me cash, then buy, if you ask 0:19:06.960 --> 0:19:11.080 for cash, then sell. Right. You remove those limits right 0:19:11.320 --> 0:19:15.359 and simultaneously, as long as the money coming in is positive, right, 0:19:15.400 --> 0:19:18.840 the flows are positive, you're providing liquidity to the market, 0:19:18.920 --> 0:19:21.679 which dampens volatility to a certain extent. Now, there's a 0:19:21.720 --> 0:19:25.080 host of extenuating factors that have been created through what 0:19:25.119 --> 0:19:27.880 are called yield enhancement strategies, basically strategies that are built 0:19:27.880 --> 0:19:32.120 around selling volatility that further influenced this dynamic. What we're 0:19:32.119 --> 0:19:36.439 actually seeing is daily volatility in terms of the point 0:19:36.520 --> 0:19:40.399 change is significantly less than weakly volatility, which is significantly 0:19:40.480 --> 0:19:44.840 less than monthly volatility, which is significantly less than annualized volatility. 0:19:44.960 --> 0:19:46.760 And that's the sort of behavior that you would expect 0:19:46.760 --> 0:19:49.360 to see if you're seeing this dampening on a localized basis, 0:19:49.760 --> 0:19:53.760 but the ability to inflate valuations over time. So I 0:19:53.800 --> 0:19:56.159 want to get to soon how this could all go 0:19:56.240 --> 0:19:58.920 bad and belly up and all the grim stuff that 0:19:58.960 --> 0:20:02.200 I'm I'm sure people are waiting for. But before we 0:20:02.320 --> 0:20:04.200 do that, I want to talk a little bit about 0:20:04.280 --> 0:20:06.400 what you identified up front is the sort of second 0:20:07.160 --> 0:20:10.240 key dynamic, which are these sort of other factors just 0:20:10.280 --> 0:20:14.640 sort of driving this trend overall, And you mentioned, uh, 0:20:14.840 --> 0:20:18.760 lobbying efforts and regulation. It also feels like, I don't 0:20:18.760 --> 0:20:20.959 want to say propaganda, but there's also been just a 0:20:21.000 --> 0:20:23.880 lot of media coverage about how nobody should ever time 0:20:23.960 --> 0:20:27.480 the market, nobody should ever pick stocks, nobody should ever 0:20:27.880 --> 0:20:30.119 just just keep investing, writing it out kind of the 0:20:30.640 --> 0:20:35.200 fire belief. Talk a little bit more about how this emerge, 0:20:35.280 --> 0:20:38.720 This sort of consensus around just if you have cash, 0:20:38.760 --> 0:20:42.160 put it in stocks, if you need cash, cell stocks, Well, 0:20:42.320 --> 0:20:45.160 I mean, we've heard this repeatedly before, and it's part 0:20:45.160 --> 0:20:47.320 of what I think gives rise to a little bit 0:20:47.320 --> 0:20:50.199 of sanctimony from the active manager space of this is 0:20:50.200 --> 0:20:53.159 all craziness, this is a cycle, it will end. I 0:20:53.160 --> 0:20:56.080 think it's a deep under appreciation for how we've structurally 0:20:56.160 --> 0:20:58.359 changed the system in terms of those dynamics, and the 0:20:58.400 --> 0:21:01.640 regulatory framework is a great one. You know. We tend 0:21:01.720 --> 0:21:04.240 to take for granted the underlying structure of a market, 0:21:04.280 --> 0:21:07.280 the underlying dynamic, but vehicles like four oh one case 0:21:07.320 --> 0:21:11.800 and iras, which represent the vast majority of individual American 0:21:11.880 --> 0:21:14.520 savings and actually are can be thought of colloquially as 0:21:14.680 --> 0:21:17.600 the world's largest sovereign wealth fund. Roughly sixteen trillion dollars 0:21:17.600 --> 0:21:20.800 in assets across the American public in four oh one 0:21:20.840 --> 0:21:23.920 case and I ras, people tend to think of stock 0:21:23.960 --> 0:21:27.760 ownership is heavily concentrated amongst the extremely wealthy. The reality 0:21:28.320 --> 0:21:31.200 is that four one case and iras are actually mechanisms 0:21:31.240 --> 0:21:33.679 by which the vast majority of Americans are capable of 0:21:33.720 --> 0:21:37.879 saving relatively small sums. The median investor, once they hit retirement, 0:21:37.920 --> 0:21:39.760 has somewhere in the neighborhood of two or fifty thousand 0:21:39.760 --> 0:21:41.399 dollars in their four oh one K and those funds 0:21:41.400 --> 0:21:44.199 need to be spent right so to fund retirement. So 0:21:44.560 --> 0:21:47.320 this is not a story of concentration of wealth. What 0:21:47.440 --> 0:21:50.680 it is the story is the mechanisms that are available 0:21:50.720 --> 0:21:52.560 for people to invest in their four oh one case 0:21:53.000 --> 0:21:57.880 have increasingly been directed to passive assets. There's a passing 0:21:57.920 --> 0:22:01.000 familiarity with something that's called the Department of Labor fiduciary 0:22:01.080 --> 0:22:03.680 role right, which came into being in April of two 0:22:03.680 --> 0:22:07.280 thousand sixteen. This actually changed the structure of for a 0:22:07.400 --> 0:22:10.800 one case quite significantly. Any corporation that offered a four 0:22:10.840 --> 0:22:14.960 oh one K had to offer passive strategies, had to 0:22:15.119 --> 0:22:19.520 offer low cost passive index alternatives to their employees, or 0:22:19.600 --> 0:22:23.359 they became liable to their employees for the excess fees 0:22:23.680 --> 0:22:25.399 that they were charged they were being charged to them 0:22:25.440 --> 0:22:29.320 and therefore oh one K and even more crazily potentially 0:22:29.359 --> 0:22:32.159 becoming liable for the under performance of the investments that 0:22:32.200 --> 0:22:34.760 they were offering right now. So corporations aren't in the 0:22:34.800 --> 0:22:37.800 business of guaranteeing a return relative to the SMP five 0:22:38.400 --> 0:22:41.600 or the Vanguard Total Market Index. They are in the 0:22:41.640 --> 0:22:44.720 business of trying to quickly and easily to spend benefits 0:22:44.720 --> 0:22:47.439 to their employees to keep them happy, right, And so 0:22:47.520 --> 0:22:51.920