Speaker 1: Welcome to Inside Active, a podcast about active managers that
Speaker 1: goes beyond sound bites and headlines and looks deeper into
Speaker 1: the processes, challenges, and philosophies and security selection. I'm David Cohne,
Speaker 1: I lead mutual fund and active Research at Bloomberg Intelligence.
Speaker 1: Today my coast is James Seifert, Senior ETF analyst at
Speaker 1: Bloomberg Intelligence. James, thank you for joining me today.
Speaker 2: Yeah, happy to be back, David, and with one of
Speaker 2: my favorite guests and clients to talk to.
Speaker 1: So we all know passive investing has become the default
Speaker 1: choice for a lot of investors, but the conversation usually
Speaker 1: stops fees and simplicity. A lot less time really is
Speaker 1: spent talking about what happens when passive becomes a dominant
Speaker 1: force in the markets and what that means for active
Speaker 1: managers trying to generate alpha. So our guest today has
Speaker 1: been digging into that question for years and I'd like
Speaker 1: to welcome them. Michael Green, chief strategist and a portfolio
Speaker 1: manager at Simplify Asset Management. Thanks for joining us, Michael. So, James,
Speaker 1: why don't you start us off?
Speaker 3: Yeah?
Speaker 2: I mean where we have to start off anytime I
Speaker 2: have this conversation with Michael and usually ends up in
Speaker 2: a little bit of a debate because we don't fully agree.
Speaker 2: We agree on some of the key points, but I
Speaker 2: guess really what I think we should define for the
Speaker 2: audience is like what your definition of passive is? Because
Speaker 2: I view it as you know, a complete spectrum. There's
Speaker 2: from passive to active. There are some people who are
Speaker 2: more absolutist and how they view it everyone. It's kind
Speaker 2: of one of those things where like if you don't
Speaker 2: define it beforehand, people end up talking past each other. So, Mike,
Speaker 2: why don't you just walk through, like what your definition
Speaker 2: of passive is? When you tend to be talking about.
Speaker 3: These things, well, when I focus on passive, first of all,
Speaker 3: I just want to be clear there is no such
Speaker 3: thing as a passive strategy. That's one of the key
Speaker 3: points that I raised in my analysis of that. The
Speaker 3: concept of passive investing is a thought experiment from the
Speaker 3: nineteen sixties. It was projected forward and added, you know,
Speaker 3: given it additional depth by Bill Sharp in nineteen ninety
Speaker 3: one with a paper called the Arithmetic of Active Management,
Speaker 3: which is the source of all the analysis that you
Speaker 3: hear that you know active managers and passive managers own
Speaker 3: the same underlying securities, and therefore the only difference between
Speaker 3: them is the fee structure. That's what drives the outperformance
Speaker 3: of the passive strategies quote unquote. Unfortunately, Sharpe's definitions was
Speaker 3: highlighted by a partner at AQR Las Peterson in twenty sixteen,
Speaker 3: relies on magic because his definition of passive as somebody
Speaker 3: who never buys or sells they simply hold. That means
Speaker 3: it's impossible for them to get into the market. It
Speaker 3: means it's impossible for them to get out of the
Speaker 3: market once you realize. And he defines an active investor
Speaker 3: as anyone who is not passive. So by definition, all
Speaker 3: investment is active. What we were really referring to when
Speaker 3: we talk about passive is the attempt to replicate market
Speaker 3: cap weighted indices that largely dominates the passer world. There's
Speaker 3: lots of discussions around active ETFs, et cetera. Most of
Speaker 3: those are some variant of two times levered in video
Speaker 3: or call over writing strategies, et cetera. They aren't really
Speaker 3: active in the traditional sense. True active investing relies on
Speaker 3: the discretion of the allocator the portfolio manager to select
Speaker 3: securities on the basis of candidly whatever they want. Right,
Speaker 3: they could choose all letters, start all stocks starting with
Speaker 3: the letter A, and they could also decide that they
Speaker 3: wanted to focus their research on predicting the forward cash
Speaker 3: flows of a company. Both would be considered active. When
Speaker 3: we're talking about passive and when we talk about the
Speaker 3: scale and size and the impact what I am largely
Speaker 3: referring to as market cap weighted indices, in particular the
Speaker 3: S and P five hundred, to a lesser extent than
Speaker 3: NASDAQ one hundred and extensions thereof like the total market
Speaker 3: indices and the Russell two thousand.
Speaker 1: So if we talk about that, I mean, you've been
Speaker 1: one of the most vocal critics of these type of products.
Speaker 1: What do most investors misunderstand about the you know, how
Speaker 1: passive flows actually affect market prices?
Speaker 3: Well, I think it all starts with that label, right,
Speaker 3: they are not passive investors, So I think we actually
Speaker 3: have to start with that observation. The moment we recognize
Speaker 3: that they aren't passive and instead they regularly buy and
Speaker 3: sell securities, we know what they actually are, which is,
Speaker 3: you know they are systematic algorithms that, when given cash,
Speaker 3: will buy things in proportion to their market capitalization. When
Speaker 3: asked for cash, they will sell things in proportion to
Speaker 3: their market capitalization. That has very predictable effects on price behavior,
Speaker 3: on what's referred to as market elasticity, how prices react
Speaker 3: to changes in supply and demand. And at this point,
Speaker 3: the academic work and the theoretical work has moved so
Speaker 3: far beyond where the practitioner space is that we increasingly
Speaker 3: are aware that this is turning into the driver in
Speaker 3: markets today.
Speaker 1: So when did these products stop being a price taker
Speaker 1: and become more of a price maker?
Speaker 3: Or are we already there? Oh, we've been there for
Speaker 3: a very long time. So this is actually what I
Speaker 3: referred to as passive two point zero. Passive one point
Speaker 3: zero actually began in the early nineteen nineties. As Vanguard
Speaker 3: and other participants in the passive space grew to one
Speaker 3: to two percent market share, they began to experience the
Speaker 3: bane of passive investing's existence, tracking error versus their indices.
Speaker 3: This is because they'd grown to a size that when
Speaker 3: they went to transact in all the individual securities in
Speaker 3: the S and P five hundred or in smaller indices.
Speaker 3: They were having a noticeable impact on those securities, creating
Speaker 3: conditions under which they would experience tracking air they were
Speaker 3: diverging from the indices. They went to Wall Street for
Speaker 3: helpful advice. How can we solve this? The Street kind
Speaker 3: of looked at them weird and said, you know, why
Speaker 3: are you buying every security? Why don't you just buy futures?
Speaker 3: And the answer to that was, well, we can because
Speaker 3: the forty Act restricts the ability of mutual funds to
Speaker 3: access leverage. Margin accounts are required to trade futures, and
Speaker 3: so we are restricted from using futures for the entry process.
Speaker 3: The Street recommendation was to lobby the sec. Vanguard did so,
Speaker 3: received what's called a no Action letter in nineteen ninety
Speaker 3: four that allowed them, somewhat uniquely, along with other index investors,
Speaker 3: to ignore the rules of the forty Act and to
Speaker 3: begin to transact in futures. That ran headlong into a
Speaker 3: market structure issue, which is, at the time the indices
Speaker 3: were market cap weighted. Most people think they still are.
Speaker 3: They're not. They're floate adjusted today. That change happened in
Speaker 3: two thousand and three, but in the early nineteen nineties,
Speaker 3: what it meant was that passive investors were trying to
Speaker 3: buy more shares than were actually freely available in low
Speaker 3: float stocks companies like Microsoft, Cisco, Dell, et cetera, stocks
Speaker 3: with high levels of insider our ownership. And we began
Speaker 3: to see the effects of this almost immediately in market
Speaker 3: structure and market behavior. Passive one point zero was really
Speaker 3: what facilitated the dot com bubble. In two thousand and three,
Speaker 3: we changed the structure of the Indussies to float adjusted
Speaker 3: that bought us additional capacity, and my work suggests that
Speaker 3: somewhere around twenty fifteen twenty sixteen, we exceeded the thresholds
Speaker 3: that that increased capacity allowed us and began to meaningfully
Speaker 3: impact markets again. And today I think it is the
Speaker 3: single most dominant force in markets.
Speaker 2: So you mentioned you talked about some of the inelasticity
Speaker 2: of this buying and selling, whether or not somebody is
Speaker 2: fully on board with your the way you think about
Speaker 2: passive investing, this is something that is, you know, more
Speaker 2: objective fact than anything else. Can you just talk about
Speaker 2: the idea of basically one hundred dollars or one thousand
Speaker 2: dollars being invested into an index or a stock having
Speaker 2: much more of an impact on the underlying valuation than
Speaker 2: you know, the one hundred or thousand dollars that's covering in.
Speaker 2: Can you explain how that works and why it happens
Speaker 2: and what the consequences are.
Speaker 3: Sure, so, the premise of elasticity within markets is something
Speaker 3: that is assumed within the efficient market hypothesis, which is
Speaker 3: really the primary underpinnings of the passive investment revolution, the
Speaker 3: idea that market prices representing all the best information that
Speaker 3: is available at any one point in time, and people
Speaker 3: are able to invest almost unlimited sums without disrupting that market.
Speaker 3: The actual specification for the efficient market hypothesis is that
Speaker 3: a dollar into the stock market, because there has to
Speaker 3: be a seller on the other side, really only changes
Speaker 3: market value by roughly the bid ask spread, so a
Speaker 3: dollar in creates about a penny of additional market cap.
Speaker 3: Is the EMH framework. In twenty twenty two, academics Zbagabe
Speaker 3: at Harvard and Ralph Coagia and at Chicago did a
Speaker 3: very disciplined analysis of this and found that the average
Speaker 3: over the time period from nineteen ninety two to twenty
Speaker 3: nineteen was actually between about five and eight dollars of
Speaker 3: market capitalization being created for each dollar that was going in.
Speaker 3: Their paper was called the inelastic market hypothesis and was
Speaker 3: really one of the primary academic revolutions that is underway
Speaker 3: and finance right now understanding this concept of elasticity and
Speaker 3: how it is changing in markets. But really importantly is
Speaker 3: that observation that it was an average from nineteen ninety
Speaker 3: two to twenty nineteen that was cited in that paper.
Speaker 3: Subsequent work by Valentine Hadad at UCLA has identified that
Speaker 3: this is actually a trending series. It is a function
Speaker 3: of passive share. And my work at this point, which
Speaker 3: Valentine would largely echo, is that we are looking at
Speaker 3: somewhere for the megacap stocks like Apple, Nvidia, Microsoft, about
Speaker 3: seventy dollars of market capitalization being created for every dollar
Speaker 3: that is going into the market. This is why you
Speaker 3: can see a three hundred and forty billion dollar market
Speaker 3: cap swing on a company like Microsoft, nowhere close to
Speaker 3: three hundred and forty billion, or more accurately on the EMH.
Speaker 3: You know, three and forty billion would be thirty four
Speaker 3: trillion in order to get that impact, it really was
Speaker 3: more on several hundred million to possibly a billion dollars
Speaker 3: in relatively thin markets that are closed that cause that
Speaker 3: type of impact. So we're discovering that markets are radically
Speaker 3: less elastic than we had assumed.
Speaker 2: So, I guess, is it just valuations that are being distorted?
Speaker 2: Are you? Are you looking at more volatility lower volatility?
Speaker 3: Like?
Speaker 2: What is actually being distorted here from your point of
Speaker 2: view in the overall markets?
Speaker 3: Well, the primary component is being distorted is what's called
Speaker 3: price discovery. Right, So we actually effectively have a market
Speaker 3: that no longer has a form of memory. We as
Speaker 3: individual humans experience the varying of this and the COVID pandemic.
Speaker 3: We'd go to the grocery store. We thought that eggs
Speaker 3: are supposed to be three dollars a dozen. They're five
Speaker 3: dollars a dozen. That creates chaos, Right, what's going on?
Speaker 3: This doesn't make any sense. As we continued through that pandemic,
Speaker 3: people increasingly became unhinged from the historical price level and
Speaker 3: they basically accepted whatever price was available for eggs. That's
Speaker 3: the same phenomenon that happens with passive You effectively lose
Speaker 3: the memory of what is a meaningful price level, and
Speaker 3: you effectively adopt whatever the last price is. Passive is
Speaker 3: like an investor who has zero memory.
Speaker 1: So if we took a step back and think about
Speaker 1: the market as a whole and just thinking about systemic risk,
Speaker 1: you know, where's that risk hiding in this kind of
Speaker 1: index product dominant heavy market.
Speaker 3: Well, it is unfortunately a true systemic risk.
Speaker 2: Right.
Speaker 3: What we have actually done is we introduce an agent
Speaker 3: who we effectively in a paper clip world variant. Right,
Speaker 3: when you think about automation, we just said we'll go
Speaker 3: buy at what price, whatever price you can get. Right now,
Speaker 3: what that is actually done is inflated valuations. If you
Speaker 3: think about the impact of a growing pool of agents
Speaker 3: whose responds to at what price is whatever price, I
Speaker 3: don't care, the people selling to them will be able
Speaker 3: to extract higher and higher prices. Over time. Those prices
Speaker 3: will become increasingly disjointed from the fundamentals. We will construct
Speaker 3: a narrative around it. Right, they're better companies, they have
Speaker 3: better growth opportunities, productivity is going to surge right around
Speaker 3: the corner, et cetera. Because that's what we do as
Speaker 3: human beings. Right, Remember, we as a species, for thousands
Speaker 3: of years, believe that the sun transitd the sky being
Speaker 3: dragged behind a golden god. We will literally believe anything,
Speaker 3: including stuff that Elon Musk says. You know, this simple
Speaker 3: reality is that when you create those conditions, you set
Speaker 3: the stage for what was very well articulated in a
Speaker 3: two thousand and four academic paper by Michael Jensen called
Speaker 3: the agency cost of Overvalued Equities, and he highlights that effectively,
Speaker 3: if an equity becomes overvalued, there really is no mechanism
Speaker 3: to discipline the management team, and they have every incentive
Speaker 3: in the world to justify the existing valuation in their behaviors.
Speaker 3: If they believe that they are being rewarded for incredible
Speaker 3: growth opportunities, they will invest like they believe there are
Speaker 3: incredible growth opportunities. And unfortunately, I think that's what we're
Speaker 3: largely seeing. On flip side of it, many industries that
Speaker 3: suffer from neglect under this framework are told that capital
Speaker 3: is not available to them, and as a result, they underinvest,
Speaker 3: and that broadly is a pattern that's playing across our
Speaker 3: economy where privileged companies that happen to be large enough
Speaker 3: to be in the public equity indices are receiving differential
Speaker 3: cost of capital and in much lower cost of capital
Speaker 3: that allows them to invest, while businesses that are not
Speaker 3: privileged in that way, your local mom and pop grocery store,
Speaker 3: hardware store, are suffering from neglect and an inability to
Speaker 3: obtain investable funds.
Speaker 1: So do you think that regulators actually understand that, you know,
Speaker 1: this feedback loop that's that it's creating. I think it
Speaker 1: depends on which regulators you refer to. I like to
Speaker 1: point people to a conversation I had in twenty eighteen,
Speaker 1: soon after the events of Allmageddon, which I think you
Speaker 1: both know I was involved with, in which I met
Speaker 1: with the Bank of International Settlements and their Financial Crisis Group,
Speaker 1: and their reaction to my work was, yeah, we think
Speaker 1: you're right, and they've subsequently written a few papers on
Speaker 1: it that tread very lightly on this topic. My reaction
Speaker 1: to that was, Oh, that's fantastic. How can I help?
Speaker 1: What can we do to ameliorate this condition. I did
Speaker 1: not go public. My goal was not to incite panic
Speaker 1: in the crowds. My goal was to get regulators to
Speaker 1: change it. And their response, unfortunately, was there's nothing we
Speaker 1: can do because what you don't understand is the regulatory
Speaker 1: apparatus is controlled by black Rock and Vanguard. And if
Speaker 1: we raise the alarm and the event didn't happen immediately,
Speaker 1: we would simply be fired.
Speaker 3: And so one of the things, you know, I track
Speaker 3: active management.
Speaker 1: I've been looked over time, as you know, the amount
Speaker 1: of alpha that's being produced by you know, say mutual
Speaker 1: fund managers and now ETF managers has kind of fallen
Speaker 1: quite a bit. And so do you think that the
Speaker 1: growth of these index tracking products is making active management
Speaker 1: harder or does it actually increase the opportunity for some
Speaker 1: active managers.
Speaker 3: Well, the answer is both. But it's just a function
Speaker 3: of time skills, right, So this is a vary into
Speaker 3: what John Maynard Keynes observed. The markets can remain irrational
Speaker 3: far longer than you can remain solvent. As long as
Speaker 3: people are piling money into passive strategies, and passive continues
Speaker 3: to gain share, there's really not much prospect for active
Speaker 3: managers managers on a continuous basis to underperform. That's actually
Speaker 3: a direct byproduct of how we calculate things. So if
Speaker 3: you think about a market that has a function that
Speaker 3: causes valuations to increase over time, in other words, there
Speaker 3: we're at any unit of risk are actually rising. That
Speaker 3: creates a positively convex surface. The measures that we use,
Speaker 3: as you talk about alpha for calculating active manager performance,
Speaker 3: is actually a linear equation. Why equals mx plus b.
Speaker 3: The return on my portfolio is the beta times the
Speaker 3: market plus some idiosyncratic factor we call alpha. That alpha
Speaker 3: is simply the intercept. And if you just draw a
Speaker 3: curved surface and you run linear equations on it over time,
Speaker 3: you will actually find that those intercepts are forced negative.
Speaker 3: That perfectly matches the experience of the active manager community
Speaker 3: so very quickly. This is actually proprietary research that I
Speaker 3: did back in twenty seventeen. I asked the question of
Speaker 3: portfolio managers. You're a portfolio manager, you are given new capital,
Speaker 3: or capital is taken away from you. What's the likelihood
Speaker 3: that you'll deploy funds or sell securities to meet redemption
Speaker 3: given some type of valuation. Valuation is on the x AXI,
Speaker 3: your marginal propensity to either buy or sell is on
Speaker 3: the Y axis. These are the cumulative results across roughly
Speaker 3: four hundred and fifty responses, and unsurprisingly, you find a
Speaker 3: marginal propensity to sell as valuation rises, and a marginal
Speaker 3: propensity to buy as valuations fall. That's not surprising. Those
Speaker 3: are standard downward sloping demand curves and economics. It's this
Speaker 3: intersection between the two that's actually really interesting. The two
Speaker 3: cross and remember this is just a random survey by
Speaker 3: an idiot at the market's historical valuation average. That's actually
Speaker 3: really important because if you build an agent based model,
Speaker 3: feed these responses in them, then randomly give them cash
Speaker 3: and take cash away, which you discover as a mean
Speaker 3: reverting valuation in markets. This is why things like the
Speaker 3: Shiller pe have historically worked. If you introduce passive investors
Speaker 3: into the mix, remember that they have a hundred percent
Speaker 3: marginal propensity to buy and sell. Did you give me cash,
Speaker 3: If so, then buy? Did you ask for cash if so,
Speaker 3: then sell. That pushes the marginal propensity to both buy
Speaker 3: and sell off of that mean reversion towards what's called
Speaker 3: mean expansion. That takes the form of rising valuations over time,
Speaker 3: which unfortunately perfectly matches the underlying data that we see.
Speaker 3: This is the valuations rising. This is the median stock.
Speaker 3: This is the market cap weighted stock, which again plays
Speaker 3: into theoretical frameworks. So why the largest stocks are more
Speaker 3: impacted on this, so we see rising valuations over time.
Speaker 3: If we then think about that in the context of
Speaker 3: how we measure manager performance. Historically we're used to thinking
Speaker 3: about a mean reverting market. The reality is now we
Speaker 3: have a mean expansionary market that causes those valuations to rise.
Speaker 3: If I take that same linear equation and I run
Speaker 3: it at various points in time against different passive share
Speaker 3: my alphas are pushed negative. And that is, unfortunately exactly
Speaker 3: what we're seeing. So contra to the argument that most
Speaker 3: people focus on, which is this idea under a Grossman
Speaker 3: Sigletz type framework, that the opportunity tunity set for active
Speaker 3: managers is growing, the path to that is actually very
Speaker 3: destructive to the process of price discovery and market functioning
Speaker 3: and ends up killing the active managers along the way.
Speaker 3: That creates a feature that's been very well documented what's
Speaker 3: called effectively defection. Active managers increasingly become closet indexers, basically
Speaker 3: trying to preserve their career by minimizing their tracking error
Speaker 3: against that benchmark. So two things on that.
Speaker 2: I wasn't gonna ask this question, but you've just brought
Speaker 2: it up. So how when I talk to active managers.
Speaker 2: In many cases, it's like risk departments that don't allow
Speaker 2: you to deviate too far from an underlying benchmarks. It's
Speaker 2: been a thing for in fixed income for forever, like
Speaker 2: you can't devaate too far from duration, you can't deviate
Speaker 2: too far from credit risk metrics, and the same thing
Speaker 2: in large cap you know, active management picking and things
Speaker 2: along those lines. So how much of it is like
Speaker 2: like I guess, my question is how different is this
Speaker 2: from a couple of decades ago where the active managers. Yes,
Speaker 2: they were trying to outperform here and there, but for
Speaker 2: the most part they were still, you know, hamstrung within
Speaker 2: a bandwidth of where, where and what they can invest in.
Speaker 3: It's largely a byproduct of regulation and the repeated experience.
Speaker 3: So in two thousand and six we passed the Pension
Speaker 3: Reform Act, the Pension Protection Act. I'm sorry that changed.
Speaker 3: Four oh one K is from an opt in framework
Speaker 3: where you would get a job and then choose to
Speaker 3: participate in a four oh one K to an opt
Speaker 3: out framework where you would choose, you would get a job,
Speaker 3: and you would automatically default it into a four oh
Speaker 3: one K. When you created that, you had to establish
Speaker 3: what you were going to automatically default them into the
Speaker 3: established what was called the qualified default investment alternative. Initially
Speaker 3: that was balanced funds. There was some competition from active managers,
Speaker 3: but very quickly over time we established legal precedent that said,
Speaker 3: if you choose anything other than the lowest cost passive
Speaker 3: exposure as the sponsor of a four oh one K,
Speaker 3: you run an inordinate risk of being sued by your
Speaker 3: own employees. My favorite example is a class action lawsuit
Speaker 3: by Fidelity employees against Fidelity for offering them actively managed
Speaker 3: Fidelity products. So, unfortunately, what you're describing, James, is exactly
Speaker 3: what you would expect because of two features. One, fewer
Speaker 3: and fewer active managers have access to that pool of capital.
Speaker 3: Because of the QDIA, about eighty five percent of four
Speaker 3: oh one K participants never change their designation away from
Speaker 3: that qualified default investment alternative, and as a result, there's
Speaker 3: really no new entrant customers into the active manager space,
Speaker 3: or very small fraction of it. The second feature is
Speaker 3: is that that then means because there are no new customers,
Speaker 3: the worst thing that can happen is losing an existing customer,
Speaker 3: and the easiest way to lose an existing customer is
Speaker 3: by underperforming versus your benchmark. Outperformance will retain it. But
Speaker 3: underperformance guarantee is that you're going to get fired and
Speaker 3: your business moves rapidly into a terminal stage. This has
Speaker 3: driven a very clear defection that's actually well documented by
Speaker 3: the work of Valentine Hadad and Paul Hubner in the
Speaker 3: behavior of active managers themselves. They have shifted from being
Speaker 3: historically highly elastic and sensitive to valuation. Today they're effectively
Speaker 3: very close to passive investors in many ways.
Speaker 2: If you just take a face value everything you're saying, right,
Speaker 2: if you're viewing this as something that's just storying the markets,
Speaker 2: and theoretically you should be propping up the largest names
Speaker 2: in the index. Like if you're an adept active manager
Speaker 2: and you accept and see that this is happening, Like
Speaker 2: why wouldn't active managers just lean into it and take
Speaker 2: advantage of this theoretical framework that you're laying out here,
Speaker 2: Like why wouldn't an active manager who sees this happening,
Speaker 2: understands it just lean into it and take full advantage
Speaker 2: of it.
Speaker 3: Well, first, we just described actually that they are right
Speaker 3: as they move to become more benchmark like and less elastic.
Speaker 3: They are mimicking the behaviors of passive and usters. Secondly,
Speaker 3: the largest and most successful active managers have done exactly that.
Speaker 3: By far, the largest business in the hedge fund space
Speaker 3: is a single distinct strategy is index arbitrage, effectively trying
Speaker 3: to front run the passive investors on events like index inclusion.
Speaker 3: Going beyond that, if you look at the production of
Speaker 3: research and where value is created in research today, the
Speaker 3: single most valuable piece of research is not ten k's
Speaker 3: or analyst reports. It's what's called payment for order flow,
Speaker 3: which effectively gives details of what the noise traders, the
Speaker 3: remaining retail traders, who now outnumber active managers roughly two
Speaker 3: to one, what they are doing. Citadel pays on the
Speaker 3: order of four and a half billion dollars a year
Speaker 3: for access to transparency and the order books of Robinhood
Speaker 3: and other participants precisely so they can position and trade
Speaker 3: ahead of that and maximize the value that they're creating
Speaker 3: in their option models and option market making. So, James,
Speaker 3: the quick answer is they are doing it right. There's
Speaker 3: also a lot of people out there that are still
Speaker 3: unaware of this phenomenon and really don't understand how to
Speaker 3: exploit it. And then finally, there's a lot of people,
Speaker 3: myself somewhat included, who are basically saying, look, you know,
Speaker 3: this is a systemic risk that we are creating. Your
Speaker 3: question to me, James, is some variant of you know, well,
Speaker 3: if everybody's getting high, why don't I get high with them? Right?
Speaker 3: Somebody has to keep an eye out for the cops.
Speaker 1: So you kind of just answered my next question, which was,
Speaker 1: you know, the active strategies that actually do benefit But
Speaker 1: you know, you mentioned a hedge fund with index arbitrage,
Speaker 1: but if we think of just reektail and you know,
Speaker 1: when I say traditional active, I'm talking about actual stock pickers,
Speaker 1: not the leverage or the defined outcome, but actual stock pickers.
Speaker 1: Is there anything that they can do to change the
Speaker 1: process to kind of benefit from this aside from being
Speaker 1: benchmark huggers.
Speaker 3: Yeah, I mean effectively you can isolate. Like then, this
Speaker 3: is a lot of my more recent work, and it highlights,
Speaker 3: you know, just how dumb I actually. It took me
Speaker 3: almost a decade to get to the point that I
Speaker 3: fully understood some of the mechanics at the single stock
Speaker 3: level and I'm still learning. I want to be very
Speaker 3: very clear on that, but you know, the simple reality
Speaker 3: is is that the only thing you can do is
Speaker 3: basically build predictive models to understand the impact and how
Speaker 3: that is changing. And again that leans right into the
Speaker 3: index arbitrage, which I would highlight is happening not only
Speaker 3: in equity markets, but it is also actually the story
Speaker 3: behind the emergence of the basis trade, which is simply
Speaker 3: index arbitrage happening in fixed income markets, where in many
Speaker 3: ways I would argue the current impact is equally if
Speaker 3: not more distorted.
Speaker 2: Okay, so this brings me to my next question, which
Speaker 2: is like a lot of these and will put quotes
Speaker 2: around passive products, they a lot of, like more and
Speaker 2: more at least in the ETF world in our research,
Speaker 2: they are definitely being used actively. So like you want
Speaker 2: to lean into something for because you're betting on it
Speaker 2: coming up, or most recently software stock software as a
Speaker 2: service people where it's going to get killed. So like
Speaker 2: IGV for example, is getting crushed, which is the iceher
Speaker 2: software ETF. So what ends up happening is like I
Speaker 2: know you specifically see the S and P five hundred,
Speaker 2: but what we find is happening in the market is
Speaker 2: like these things are being used actively, They're being used
Speaker 2: as like pseudo future, so they're betting on shorter term
Speaker 2: bets on like these things. So theoretically, if you're betting
Speaker 2: on these baskets of stocks, there should be idiosyncrasies where
Speaker 2: something is getting bid up that shouldn't in that basket
Speaker 2: or in the theory of like the software stocks, there's
Speaker 2: probably some babies getting thrown out with the bathwater, Right,
Speaker 2: So theoretically, with things like this in markets like this,
Speaker 2: wouldn't you think, like in my mind, I'm like, as
Speaker 2: an active manager, I'd be looking into those trying to
Speaker 2: figure out what's getting sold that shouldn't or bought that
Speaker 2: shouldn't and trying to bet on those and reversions to
Speaker 2: the mean, Like shouldn't this create some opportunities for active
Speaker 2: managers that are outside of just being benchmar huggers like
Speaker 2: we just spoke about.
Speaker 3: I Mean, the quick answer is, at scale, it's incredibly hard,
Speaker 3: and you're asking people to develop a skill set within
Speaker 3: a lack of understanding of the mechanisms, right, And so
Speaker 3: you know, we're ostensibly having a debate about whether this
Speaker 3: is actually happening if your assertion is it is definitely happening,
Speaker 3: and you're willing to go out and make that claim.
Speaker 3: And I identified that Vanguard and Blackrock and the growth
Speaker 3: of passive investing is having a clearly caustic effect on
Speaker 3: the historical functioning of markets, and Bloomberg would stand behind that.
Speaker 3: I would bet that many more people would actually do it.
Speaker 3: But that's not where we are today, and so I
Speaker 3: think it's unsurprising that most managers try to continue doing
Speaker 3: what they were doing before.
Speaker 2: So the next thing I had to ask, like, if
Speaker 2: you look over the last we can call it a
Speaker 2: year a few months. Like we talked about the largest
Speaker 2: names outperforming, but like if you just use the eye
Speaker 2: test on some of this stuff, where are constantly names
Speaker 2: being removed from the index getting sold off, constantly names
Speaker 2: being added. If you look at just the mag seven
Speaker 2: right now, there's a massive dispersion in their performance. I mean,
Speaker 2: if you just look at a video over the last
Speaker 2: couple of years, So there is still some sort of
Speaker 2: price discovery where videas of the world are getting to
Speaker 2: be the largest names. Things are being sold off. Microsoft
Speaker 2: is unperformed, underperforming the S and P five hundred over
Speaker 2: the last few years, like there is dispersion. So like,
Speaker 2: from my point of view, I think what you're saying
Speaker 2: makes sense, like the it's the whole flows over pros argument,
Speaker 2: where things are distorting over shorter time periods. But when
Speaker 2: I look at it, for the most part, things are
Speaker 2: selling off or being affected by what's going on with
Speaker 2: the underlying stocks and the earnings and some of these
Speaker 2: valuations and these you know, these big name tech stocks
Speaker 2: probably deserve premium valuations over you know, any company in history,
Speaker 2: considering the margin expansion, the size and growth at which
Speaker 2: they're achieving despite being multi trillion dollar company. So I
Speaker 2: guess my question would be, like, what is your pushback
Speaker 2: on the you know, eye tesk argument. I mean, even
Speaker 2: if we go to like all the money still coming
Speaker 2: as far as US ets go into US domestic equity ETFs,
Speaker 2: I mean, we're seeing record inflows and still smaller caps
Speaker 2: are doing more better, equal weighting is doing well over
Speaker 2: the last few months, International is outperforming over the last
Speaker 2: year or so. So like these eye test arguments, like,
Speaker 2: what is the main pushback I guess from your research, Well.
Speaker 3: First of all, you know, when you think about the
Speaker 3: eye test component, recognize that you're actually trying to look
Speaker 3: at it and disprove the theory, So you're looking for
Speaker 3: confirmatory evidence as compared to actual evidence. That is, you know,
Speaker 3: confirming your point of view as compared to mine. Secondly,
Speaker 3: an eye test chart is absolutely not appropriate when we
Speaker 3: start thinking about these components for the very simple reason
Speaker 3: we're talking thousands and thousands of securities. Finally, when you
Speaker 3: talk about the largest stocks outperforming, that is largely a
Speaker 3: function of a misunderstanding of how passive impacts markets. We
Speaker 3: have formulas for market impact. Yes, size is a factor
Speaker 3: and that, but more importantly is actually the scaling of
Speaker 3: size relative to liquidity and the idiosyncratic volatility of the
Speaker 3: individual security. And once we started adjusting for that, James like,
Speaker 3: the quick answer is there's nothing else really matters. Right, Yes,
Speaker 3: an individual security can have a holder decide that they
Speaker 3: no longer want to own it and sell it, and
Speaker 3: in that time period, particularly if it occurs during something
Speaker 3: like an earnings report in which there is an absence
Speaker 3: of trading by the passive indices, they don't change their
Speaker 3: trading pattern on the basis of that change in earnings report.
Speaker 3: That information that flows through. That means that the market
Speaker 3: is going to be more volatile or the stock is
Speaker 3: going to be more volatile in response to that earnings report,
Speaker 3: as the remaining active managers effectively are forced to trade
Speaker 3: amongst themselves with wildly divergent opinions. I can only buy
Speaker 3: from somebody who is short, I can only sell to
Speaker 3: somebody who was long or who is short, right, And
Speaker 3: so that process of idiosyncratic volatility has a meaningful impact
Speaker 3: on it then is immediately ignored as that memory machine
Speaker 3: shuts off, and the next day you walk in and
Speaker 3: Vanguard or black Rock says, this is the right price
Speaker 3: for that next incremental dollar. I want to be very
Speaker 3: very clear, we would experience idios and credit volatility even
Speaker 3: in a market that was one hundred percent passive, for
Speaker 3: the very simple reason that there would be order books
Speaker 3: that would be of different depths across different securities. So
Speaker 3: it's you know, the answer to it is is that
Speaker 3: it's not actually the smoking gun that you think.
Speaker 2: And then my last thing before I pass it back
Speaker 2: to David, which is something we actually, I think completely
Speaker 2: agree on. I think a lot of this and some
Speaker 2: of the issues you highlight in this, you know, demanding
Speaker 2: of solely investing in the cheapest index from ARISA plans
Speaker 2: and you name it, even investment advisors. Part of it
Speaker 2: has to do with the fact that, like, active managers
Speaker 2: were doing so well in the eighties and nineties and
Speaker 2: there was no passing on on the economies of scale,
Speaker 2: Like I don't think Vanguard would have grown to be
Speaker 2: as big as it was if active managers actually adjusted
Speaker 2: their fees, did things so they got rid of twelve
Speaker 2: B one fees like I think a lot of this
Speaker 2: has to do with the greed of the astet management
Speaker 2: industry and active managers overall over the preceding day decades,
Speaker 2: where they just it was easy for a passive fund
Speaker 2: to outperform by simply, you know, cutting the fees down
Speaker 2: to cost plus type of basis. Do you agree with that, like,
Speaker 2: do you think that was made worse? Do you think
Speaker 2: it matters? What are your thoughts there?
Speaker 1: Well?
Speaker 3: I think, unfortunately that there are two separate phenomenon thats
Speaker 3: you highlight there right. One is this question of is
Speaker 3: it greed to not pass on the economies of scale?
Speaker 3: I think one that misunderstands the cost of launching investment
Speaker 3: strategies and actively managed investment strategy as a fixed cost.
Speaker 3: Don't don't smirk.
Speaker 2: I'm always smirking because I mean Bill Gross was getting
Speaker 2: paid hundreds of hundreds of billions.
Speaker 3: Of Again, let me actually finish the point before you. Yeah, yeah,
Speaker 3: you know. The simple reality is is that to launch
Speaker 3: an actively managed product requires you to put an initial
Speaker 3: expense forward a minimum, hiring a portfolio manager, filing all
Speaker 3: the fees associated with listing the security, going through the
Speaker 3: profit of obtaining distribution, and then you roughly have a
Speaker 3: three year penalty window in which you operate in which
Speaker 3: nobody's going to invest with you until you've proven the results.
Speaker 3: If your results don't work, that's a sunk costs that
Speaker 3: you've lost, right, is somebody returning that capital to you? No,
Speaker 3: you've lost it, right, So you need to regain that
Speaker 3: through the economist of scale. Should you prove to be successful? Now,
Speaker 3: should they have been more aggressive in terms of offering
Speaker 3: those returns of scale? And you highlight things like twelve
Speaker 3: B one fees which are largely actually distribution platform fees.
Speaker 3: Those are not the greed of the portfolio manager, that
Speaker 3: is the greed of the broker who is distributing the product.
Speaker 3: It has nothing to do with the portfolio manager. That
Speaker 3: greed has completely retained itself. We now see platforms on
Speaker 3: a regular basis charging active managers, in particular access fees
Speaker 3: to the platforms that require us to effectively share a
Speaker 3: diminished revenue source with them. Larger firms like Vanguard Blackrock
Speaker 3: are of size and scale that they can actually tell
Speaker 3: those guys to go take a hike. So the simple
Speaker 3: reality is is that the system is actually biased against
Speaker 3: new entrants into the space. And were people over the greedy?
Speaker 3: Did too many people make too much money? Honestly, that
Speaker 3: sounds like the sort of lament that only a socialist
Speaker 3: would make. James, we can't possibly know. Wow, you have
Speaker 3: any comment, James?
Speaker 2: There?
Speaker 1: Should I jump in the next question? No?
Speaker 3: Not on that.
Speaker 2: I don't okay, I'm definitely not on the socialist bandwagon here.
Speaker 2: I have one comment after your next question, but that's it.
Speaker 3: I'm sure.
Speaker 1: So all right, So if we look ahead five ten years,
Speaker 1: do you see a natural limit to the growth of
Speaker 1: these intro I guess index tracking products or does something
Speaker 1: have to break first?
Speaker 3: I mean, the quick answer is we already have more
Speaker 3: than one hundred percent of the flows coming through these vehicles, right,
Speaker 3: So to continue to gain scale simply means the status
Speaker 3: quo is in place. You know, James and others have
Speaker 3: highlighted the growth of active ETFs. Again, I think the
Speaker 3: vast majority of those are mislabeled. They aren't actually active.
Speaker 3: There are very few actively managed ETFs in the traditional
Speaker 3: mutual fund sense. And so we actually are seeing accelerating
Speaker 3: share gain from passive strategies as I described them, the
Speaker 3: market cap weighted strategies. We've accelerated to picking up roughly
Speaker 3: four percentage points last year. In terms of market share,
Speaker 3: we're now well past fifty percent market share. This is
Speaker 3: actually setting up conditions for a purging not of the
Speaker 3: passive space, but of the active space, as the economies
Speaker 3: of scale are rapidly running in reverse for active managers. So,
Speaker 3: if anything, I actually think that we will see a
Speaker 3: purge of active managers prior to the event. We'll see
Speaker 3: an acceleration in many of these symptoms in terms of
Speaker 3: is there a limit? Yes, right, So that was actually
Speaker 3: the intent and observation behind the XIV trade what became
Speaker 3: the Volmageddon trade. I recognize that there was a point
Speaker 3: at which the size and scale of these strategies would
Speaker 3: exceed the available liquidity in the markets, and that that
Speaker 3: became an instantaneous go to zero event for that product. Unfortunately,
Speaker 3: it's the exact same math for the S and P
Speaker 3: five hundred. The difference is, instead of a two and
Speaker 3: a half billion dollar ETF, we're talking a seventy two
Speaker 3: trillion dollar market that has far more important societal implications.
Speaker 3: And I'm far more loath to actually put myself in
Speaker 3: a position where I'm encouraging that to happen. But candidly,
Speaker 3: I'm a little annoyed that nobody actually wants to paying
Speaker 3: attention to this, and so maybe I'll have to Yeah,
Speaker 3: the last thing I would say, I agree.
Speaker 2: A lot of the active products coming to market right
Speaker 2: now are like kind of we call them active in
Speaker 2: name only. You got like cover call products on SMB
Speaker 2: five hundred and NASDAC there are technically active. You have
Speaker 2: buffer products that are based on same indices or some
Speaker 2: other indices, and technically active. You have single stock celebrity
Speaker 2: tfs that are technically active. But that isn't to put
Speaker 2: down what's actually happening. There is a lot of growth
Speaker 2: happening on the active ets side, there is the likes
Speaker 2: of Capital Group, DFA and others, but it is not
Speaker 2: as big as like the headlines would make it seem.
Speaker 2: And from what we from my point of view, what
Speaker 2: I'm seeing more happen in the ETF space. You can
Speaker 2: see this when you look at the average fees being
Speaker 2: charged for the most part, like you said, beta has
Speaker 2: become to S and P five hundred has like basically
Speaker 2: become commoditized. But people are willing to pay up for
Speaker 2: those premium fees for people who aren't hugging the benchmark
Speaker 2: right there. So I think ultimately, I think the market
Speaker 2: at some point will sort this itself out if it's
Speaker 2: not if it's not sorted out regulatory in a regulatory
Speaker 2: way the way that you're kind of hinting at, might
Speaker 2: be needed, just because I think people are like, I
Speaker 2: don't want to pay, you know, one hundred basis points
Speaker 2: for exposure to the S and B five hundred plus
Speaker 2: or minus a little bit, But I will pay one
Speaker 2: hundred basis points or ninety basis points for somebody that's
Speaker 2: truly active and going out there on the risk spectrum.
Speaker 2: And we're seeing that in the flows in like this
Speaker 2: core satellite type approach. But as you said, passive is
Speaker 2: gaining share, though I do see somewhat of a slowing
Speaker 2: stance from the acceleration that we had recently seen. But
Speaker 2: Passive is going to be sixty percent of the market
Speaker 2: before the end of the decade. As far as you
Speaker 2: look at mutual funds and need taps on an AM basis.
Speaker 3: Yeah, so you know unsurprising that I push back against
Speaker 3: a few of those observations. One the highest fews that
Speaker 3: are actually being extracted in the active manager space are
Speaker 3: for exactly those types of levered exposures. That's largely because
Speaker 3: you're taking advantage of the ability to access leverage within
Speaker 3: the institutional space that is unavailable to the retail trader.
Speaker 3: So if you wanted to have two x levered Nvidia
Speaker 3: as a retail trader, it would be impossible. You'd have
Speaker 3: to use your margin account. Your margin account would charge
Speaker 3: you somewhere in the neighborhood of ten to eleven percent
Speaker 3: against a fifty percent increase potentially in your portfolio. You
Speaker 3: would be subject to individual margin calls, et cetera. It's
Speaker 3: far cheaper for them to access it. It's effectively an
Speaker 3: arbitrage phenomenon in which they access that same leverage through
Speaker 3: an ETF that charges them one and a quarter percent
Speaker 3: to buy a single stock two times levered. Right. So
Speaker 3: you know, one, I think it's a little disingenuous. Two,
Speaker 3: I think it's actually really important to highlight that if
Speaker 3: you go on many platforms and you try to buy
Speaker 3: an actively managed product my high yield fund CDX, for example,
Speaker 3: on some of these platforms, you will actually be asked
Speaker 3: to sign a waiver of liability before they will allow
Speaker 3: you to buy them. Because despite the fact that my
Speaker 3: high yield fund, which has done extraordinarily well and is
Speaker 3: designed to actually limit exposure to widening credit spreads, runs
Speaker 3: significantly lower volatility than the index while matching or exceeding
Speaker 3: their returns to the index, that product is perceived as
Speaker 3: risky under the regulatory framework and they don't want to
Speaker 3: get sued. Now, imagine your customer comes to you and says, hey,
Speaker 3: I was just asked to sign a waiver of liability
Speaker 3: in order to buy your product. When I can go
Speaker 3: buy the underlying product without that waiver of liability, what's
Speaker 3: the deal here? Right, You're creating a friction into the
Speaker 3: process that is absolutely retarding the growth of those actual
Speaker 3: active managers which you highlight. James, I actually really strongly
Speaker 3: disagree with your observation.
Speaker 2: Wait, so I was I was talking absent those single
Speaker 2: stock leverage ones. I was talking more along the JP
Speaker 2: Morgan's of the World Capitol Group DFA American Center.
Speaker 3: Jane. Let's be let's be really simple, right, So DFA
Speaker 3: is not active. DFA is a systematic strategy in which
Speaker 3: they overweighth a particular factor, right as it worked very well.
Speaker 2: No.
Speaker 3: Is it largely based on a misunderstanding of what drives
Speaker 3: that factor? Yes? Can they do? They have a cult
Speaker 3: that they've built up over the course course of the
Speaker 3: past thirty years that allows them to transfer their mutual
Speaker 3: fund business into their ETF business, resulting in no net
Speaker 3: and actually negative aggregate growth to the active manager community. Yes.
Speaker 3: Is it showing up as growth in active ETFs. Yes,
Speaker 3: that's not the same thing.
Speaker 2: I would I mean my pushback would be a lot
Speaker 2: of the active mutual funds from the nineties were doing
Speaker 2: largely the same. They weren't really that different from the
Speaker 2: benchmark and the finals.
Speaker 3: James, that's just factually incorrect. I can actually show you
Speaker 3: the data on.
Speaker 2: That like, So is it your like, is it your
Speaker 2: view that the detriments of the things that you talked
Speaker 2: about with like putting things into balance funds and passive
Speaker 2: cheap products? Is your view that the detriments outweigh the
Speaker 2: benefits of people that were forced to put money to
Speaker 2: work in the market versus people just sitting in cash
Speaker 2: at the time, because there are like, there's a there
Speaker 2: are definitive costs and downsize that you've highlighted here, but
Speaker 2: there are also definitive benefits to end investors who are
Speaker 2: getting exposure to the markets at much cheaper prices and
Speaker 2: actually being invested.
Speaker 3: Much cheaper prices for what much cheaper prices for management
Speaker 3: services or much cheaper.
Speaker 2: Price man service managers management services.
Speaker 3: Right, so they are radically overpaying for the securities but
Speaker 3: receiving subsidized access through management services. Asking the question, which
Speaker 3: is worse? I would much rather pay one percent and
Speaker 3: actually buy securities they're fairly valued so that I captured
Speaker 3: the expected forward return this historically been embedded in markets,
Speaker 3: is compared to participate in a rapidly inflating Ponzi scheme
Speaker 3: at very low cost.
Speaker 1: Okay, great, On that note, I think We need to
Speaker 1: end here unfortunately, but this was a lot of fun.
Speaker 3: Michael, thank you for joining us. It was a pleasure.
Speaker 3: Thank you for having me. David and James. Thanks James,
Speaker 3: thank you for being.
Speaker 2: My cost Yeah, thanks for having me, David.
Speaker 3: I also want to thank our listeners.
Speaker 1: If you like the episode, please share it, subscribe and
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Speaker 1: of our research on the terminal, go to BI fund,
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Speaker 1: for ETF research until on next episode.
Speaker 3: This is David Cone with Inside Active