WEBVTT - Simplify’s Michael Green on Passive Distortions 0:00:13.840 --> 0:00:17.079 Welcome to Inside Active, a podcast about active managers that 0:00:17.160 --> 0:00:20.160 goes beyond sound bites and headlines and looks deeper into 0:00:20.200 --> 0:00:24.920 the processes, challenges, and philosophies and security selection. I'm David Cohne, 0:00:24.960 --> 0:00:27.760 I lead mutual fund and active Research at Bloomberg Intelligence. 0:00:27.960 --> 0:00:31.360 Today my coast is James Seifert, Senior ETF analyst at 0:00:31.360 --> 0:00:34.240 Bloomberg Intelligence. James, thank you for joining me today. 0:00:34.479 --> 0:00:36.800 Yeah, happy to be back, David, and with one of 0:00:36.880 --> 0:00:38.800 my favorite guests and clients to talk to. 0:00:40.720 --> 0:00:43.440 So we all know passive investing has become the default 0:00:43.520 --> 0:00:46.680 choice for a lot of investors, but the conversation usually 0:00:46.680 --> 0:00:50.879 stops fees and simplicity. A lot less time really is 0:00:50.880 --> 0:00:53.720 spent talking about what happens when passive becomes a dominant 0:00:53.760 --> 0:00:56.480 force in the markets and what that means for active 0:00:56.520 --> 0:00:59.600 managers trying to generate alpha. So our guest today has 0:00:59.640 --> 0:01:02.280 been digging into that question for years and I'd like 0:01:02.360 --> 0:01:05.720 to welcome them. Michael Green, chief strategist and a portfolio 0:01:05.800 --> 0:01:12.080 manager at Simplify Asset Management. Thanks for joining us, Michael. So, James, 0:01:12.120 --> 0:01:13.360 why don't you start us off? 0:01:13.760 --> 0:01:14.080 Yeah? 0:01:14.160 --> 0:01:16.120 I mean where we have to start off anytime I 0:01:16.160 --> 0:01:18.480 have this conversation with Michael and usually ends up in 0:01:18.480 --> 0:01:20.120 a little bit of a debate because we don't fully agree. 0:01:20.160 --> 0:01:21.640 We agree on some of the key points, but I 0:01:21.680 --> 0:01:23.960 guess really what I think we should define for the 0:01:24.000 --> 0:01:26.919 audience is like what your definition of passive is? Because 0:01:27.560 --> 0:01:30.039 I view it as you know, a complete spectrum. There's 0:01:30.120 --> 0:01:32.080 from passive to active. There are some people who are 0:01:32.120 --> 0:01:34.240 more absolutist and how they view it everyone. It's kind 0:01:34.240 --> 0:01:35.520 of one of those things where like if you don't 0:01:35.520 --> 0:01:39.119 define it beforehand, people end up talking past each other. So, Mike, 0:01:39.160 --> 0:01:41.840 why don't you just walk through, like what your definition 0:01:41.920 --> 0:01:43.880 of passive is? When you tend to be talking about. 0:01:43.720 --> 0:01:46.679 These things, well, when I focus on passive, first of all, 0:01:46.720 --> 0:01:47.960 I just want to be clear there is no such 0:01:48.000 --> 0:01:50.280 thing as a passive strategy. That's one of the key 0:01:50.320 --> 0:01:52.520 points that I raised in my analysis of that. The 0:01:52.640 --> 0:01:55.640 concept of passive investing is a thought experiment from the 0:01:55.720 --> 0:01:59.600 nineteen sixties. It was projected forward and added, you know, 0:01:59.640 --> 0:02:02.640 given it additional depth by Bill Sharp in nineteen ninety 0:02:02.680 --> 0:02:05.280 one with a paper called the Arithmetic of Active Management, 0:02:05.360 --> 0:02:07.560 which is the source of all the analysis that you 0:02:07.640 --> 0:02:11.600 hear that you know active managers and passive managers own 0:02:11.680 --> 0:02:14.960 the same underlying securities, and therefore the only difference between 0:02:15.000 --> 0:02:18.800 them is the fee structure. That's what drives the outperformance 0:02:18.880 --> 0:02:25.280 of the passive strategies quote unquote. Unfortunately, Sharpe's definitions was 0:02:25.360 --> 0:02:29.680 highlighted by a partner at AQR Las Peterson in twenty sixteen, 0:02:29.919 --> 0:02:33.760 relies on magic because his definition of passive as somebody 0:02:33.760 --> 0:02:37.200 who never buys or sells they simply hold. That means 0:02:37.240 --> 0:02:39.240 it's impossible for them to get into the market. It 0:02:39.240 --> 0:02:41.240 means it's impossible for them to get out of the 0:02:41.240 --> 0:02:45.960 market once you realize. And he defines an active investor 0:02:45.960 --> 0:02:48.960 as anyone who is not passive. So by definition, all 0:02:49.120 --> 0:02:52.359 investment is active. What we were really referring to when 0:02:52.400 --> 0:02:56.680 we talk about passive is the attempt to replicate market 0:02:56.680 --> 0:03:00.880 cap weighted indices that largely dominates the passer world. There's 0:03:00.880 --> 0:03:05.520 lots of discussions around active ETFs, et cetera. Most of 0:03:05.560 --> 0:03:08.040 those are some variant of two times levered in video 0:03:08.480 --> 0:03:11.440 or call over writing strategies, et cetera. They aren't really 0:03:11.520 --> 0:03:16.040 active in the traditional sense. True active investing relies on 0:03:16.160 --> 0:03:20.239 the discretion of the allocator the portfolio manager to select 0:03:20.360 --> 0:03:23.160 securities on the basis of candidly whatever they want. Right, 0:03:23.160 --> 0:03:25.560 they could choose all letters, start all stocks starting with 0:03:25.600 --> 0:03:27.720 the letter A, and they could also decide that they 0:03:27.720 --> 0:03:30.800 wanted to focus their research on predicting the forward cash 0:03:30.800 --> 0:03:35.800 flows of a company. Both would be considered active. When 0:03:35.840 --> 0:03:38.720 we're talking about passive and when we talk about the 0:03:38.760 --> 0:03:41.680 scale and size and the impact what I am largely 0:03:41.760 --> 0:03:45.240 referring to as market cap weighted indices, in particular the 0:03:45.360 --> 0:03:48.000 S and P five hundred, to a lesser extent than 0:03:48.040 --> 0:03:51.880 NASDAQ one hundred and extensions thereof like the total market 0:03:51.880 --> 0:03:54.080 indices and the Russell two thousand. 0:03:55.240 --> 0:03:57.040 So if we talk about that, I mean, you've been 0:03:57.080 --> 0:03:59.880 one of the most vocal critics of these type of products. 0:04:00.160 --> 0:04:03.160 What do most investors misunderstand about the you know, how 0:04:03.200 --> 0:04:05.560 passive flows actually affect market prices? 0:04:06.120 --> 0:04:08.400 Well, I think it all starts with that label, right, 0:04:08.440 --> 0:04:10.880 they are not passive investors, So I think we actually 0:04:10.880 --> 0:04:13.720 have to start with that observation. The moment we recognize 0:04:13.760 --> 0:04:16.560 that they aren't passive and instead they regularly buy and 0:04:16.600 --> 0:04:20.520 sell securities, we know what they actually are, which is, 0:04:21.160 --> 0:04:24.480 you know they are systematic algorithms that, when given cash, 0:04:24.520 --> 0:04:28.200 will buy things in proportion to their market capitalization. When 0:04:28.240 --> 0:04:30.680 asked for cash, they will sell things in proportion to 0:04:30.720 --> 0:04:36.400 their market capitalization. That has very predictable effects on price behavior, 0:04:36.800 --> 0:04:40.400 on what's referred to as market elasticity, how prices react 0:04:40.560 --> 0:04:44.119 to changes in supply and demand. And at this point, 0:04:44.120 --> 0:04:47.240 the academic work and the theoretical work has moved so 0:04:47.400 --> 0:04:51.920 far beyond where the practitioner space is that we increasingly 0:04:51.920 --> 0:04:55.599 are aware that this is turning into the driver in 0:04:55.720 --> 0:04:56.600 markets today. 0:04:57.880 --> 0:05:01.160 So when did these products stop being a price taker 0:05:01.279 --> 0:05:03.080 and become more of a price maker? 0:05:03.360 --> 0:05:06.359 Or are we already there? Oh, we've been there for 0:05:06.400 --> 0:05:08.520 a very long time. So this is actually what I 0:05:08.600 --> 0:05:12.240 referred to as passive two point zero. Passive one point 0:05:12.279 --> 0:05:15.720 zero actually began in the early nineteen nineties. As Vanguard 0:05:15.800 --> 0:05:18.800 and other participants in the passive space grew to one 0:05:18.839 --> 0:05:22.760 to two percent market share, they began to experience the 0:05:22.800 --> 0:05:28.080 bane of passive investing's existence, tracking error versus their indices. 0:05:29.160 --> 0:05:31.320 This is because they'd grown to a size that when 0:05:31.320 --> 0:05:33.960 they went to transact in all the individual securities in 0:05:34.000 --> 0:05:36.520 the S and P five hundred or in smaller indices. 0:05:37.080 --> 0:05:40.280 They were having a noticeable impact on those securities, creating 0:05:40.320 --> 0:05:43.240 conditions under which they would experience tracking air they were 0:05:43.279 --> 0:05:46.960 diverging from the indices. They went to Wall Street for 0:05:47.000 --> 0:05:49.280 helpful advice. How can we solve this? The Street kind 0:05:49.279 --> 0:05:52.599 of looked at them weird and said, you know, why 0:05:52.600 --> 0:05:54.960 are you buying every security? Why don't you just buy futures? 0:05:55.600 --> 0:05:57.600 And the answer to that was, well, we can because 0:05:57.640 --> 0:06:00.560 the forty Act restricts the ability of mutual funds to 0:06:00.839 --> 0:06:04.520 access leverage. Margin accounts are required to trade futures, and 0:06:04.600 --> 0:06:08.040 so we are restricted from using futures for the entry process. 0:06:08.960 --> 0:06:13.359 The Street recommendation was to lobby the sec. Vanguard did so, 0:06:13.560 --> 0:06:16.159 received what's called a no Action letter in nineteen ninety 0:06:16.160 --> 0:06:20.000 four that allowed them, somewhat uniquely, along with other index investors, 0:06:20.080 --> 0:06:23.200 to ignore the rules of the forty Act and to 0:06:23.240 --> 0:06:28.279 begin to transact in futures. That ran headlong into a 0:06:28.400 --> 0:06:31.720 market structure issue, which is, at the time the indices 0:06:31.720 --> 0:06:34.600 were market cap weighted. Most people think they still are. 0:06:34.640 --> 0:06:37.719 They're not. They're floate adjusted today. That change happened in 0:06:37.720 --> 0:06:41.400 two thousand and three, but in the early nineteen nineties, 0:06:41.440 --> 0:06:44.600 what it meant was that passive investors were trying to 0:06:44.680 --> 0:06:48.200 buy more shares than were actually freely available in low 0:06:48.240 --> 0:06:52.920 float stocks companies like Microsoft, Cisco, Dell, et cetera, stocks 0:06:52.920 --> 0:06:55.960 with high levels of insider our ownership. And we began 0:06:56.000 --> 0:06:58.640 to see the effects of this almost immediately in market 0:06:58.680 --> 0:07:02.080 structure and market behavior. Passive one point zero was really 0:07:02.120 --> 0:07:06.080 what facilitated the dot com bubble. In two thousand and three, 0:07:06.200 --> 0:07:09.039 we changed the structure of the Indussies to float adjusted 0:07:09.160 --> 0:07:12.800 that bought us additional capacity, and my work suggests that 0:07:12.920 --> 0:07:17.360 somewhere around twenty fifteen twenty sixteen, we exceeded the thresholds 0:07:17.400 --> 0:07:21.560 that that increased capacity allowed us and began to meaningfully 0:07:21.560 --> 0:07:23.880 impact markets again. And today I think it is the 0:07:23.920 --> 0:07:25.800 single most dominant force in markets. 0:07:26.360 --> 0:07:30.160 So you mentioned you talked about some of the inelasticity 0:07:31.360 --> 0:07:36.480 of this buying and selling, whether or not somebody is 0:07:36.560 --> 0:07:38.920 fully on board with your the way you think about 0:07:38.920 --> 0:07:41.680 passive investing, this is something that is, you know, more 0:07:41.720 --> 0:07:44.920 objective fact than anything else. Can you just talk about 0:07:44.960 --> 0:07:47.560 the idea of basically one hundred dollars or one thousand 0:07:47.640 --> 0:07:53.480 dollars being invested into an index or a stock having 0:07:53.560 --> 0:07:56.120 much more of an impact on the underlying valuation than 0:07:56.280 --> 0:07:58.200 you know, the one hundred or thousand dollars that's covering in. 0:07:58.240 --> 0:08:00.880 Can you explain how that works and why it happens 0:08:00.920 --> 0:08:02.600 and what the consequences are. 0:08:03.720 --> 0:08:07.360 Sure, so, the premise of elasticity within markets is something 0:08:07.400 --> 0:08:10.600 that is assumed within the efficient market hypothesis, which is 0:08:10.640 --> 0:08:15.560 really the primary underpinnings of the passive investment revolution, the 0:08:15.640 --> 0:08:19.280 idea that market prices representing all the best information that 0:08:19.360 --> 0:08:23.880 is available at any one point in time, and people 0:08:23.920 --> 0:08:28.880 are able to invest almost unlimited sums without disrupting that market. 0:08:28.920 --> 0:08:33.800 The actual specification for the efficient market hypothesis is that 0:08:33.840 --> 0:08:37.480 a dollar into the stock market, because there has to 0:08:37.520 --> 0:08:41.120 be a seller on the other side, really only changes 0:08:41.160 --> 0:08:43.720 market value by roughly the bid ask spread, so a 0:08:43.800 --> 0:08:46.720 dollar in creates about a penny of additional market cap. 0:08:46.840 --> 0:08:52.439 Is the EMH framework. In twenty twenty two, academics Zbagabe 0:08:52.440 --> 0:08:56.240 at Harvard and Ralph Coagia and at Chicago did a 0:08:56.400 --> 0:09:00.560 very disciplined analysis of this and found that the average 0:09:00.640 --> 0:09:03.600 over the time period from nineteen ninety two to twenty 0:09:03.760 --> 0:09:07.800 nineteen was actually between about five and eight dollars of 0:09:07.880 --> 0:09:11.680 market capitalization being created for each dollar that was going in. 0:09:12.240 --> 0:09:15.520 Their paper was called the inelastic market hypothesis and was 0:09:15.559 --> 0:09:20.160 really one of the primary academic revolutions that is underway 0:09:20.160 --> 0:09:23.680 and finance right now understanding this concept of elasticity and 0:09:23.720 --> 0:09:28.240 how it is changing in markets. But really importantly is 0:09:28.280 --> 0:09:31.240 that observation that it was an average from nineteen ninety 0:09:31.280 --> 0:09:34.200 two to twenty nineteen that was cited in that paper. 0:09:35.080 --> 0:09:38.720 Subsequent work by Valentine Hadad at UCLA has identified that 0:09:38.760 --> 0:09:41.360 this is actually a trending series. It is a function 0:09:41.520 --> 0:09:45.800 of passive share. And my work at this point, which 0:09:45.880 --> 0:09:49.160 Valentine would largely echo, is that we are looking at 0:09:49.280 --> 0:09:53.880 somewhere for the megacap stocks like Apple, Nvidia, Microsoft, about 0:09:53.920 --> 0:09:57.640 seventy dollars of market capitalization being created for every dollar 0:09:57.760 --> 0:10:00.280 that is going into the market. This is why you 0:10:00.280 --> 0:10:02.960 can see a three hundred and forty billion dollar market 0:10:03.080 --> 0:10:07.120 cap swing on a company like Microsoft, nowhere close to 0:10:07.160 --> 0:10:10.400 three hundred and forty billion, or more accurately on the EMH. 0:10:10.720 --> 0:10:13.200 You know, three and forty billion would be thirty four 0:10:13.280 --> 0:10:17.959 trillion in order to get that impact, it really was 0:10:18.040 --> 0:10:21.520 more on several hundred million to possibly a billion dollars 0:10:21.559 --> 0:10:25.800 in relatively thin markets that are closed that cause that 0:10:25.840 --> 0:10:28.640 type of impact. So we're discovering that markets are radically 0:10:28.720 --> 0:10:30.680 less elastic than we had assumed. 0:10:33.480 --> 0:10:37.880 So, I guess, is it just valuations that are being distorted? 0:10:37.920 --> 0:10:41.040 Are you? Are you looking at more volatility lower volatility? 0:10:41.520 --> 0:10:41.600 Like? 0:10:41.720 --> 0:10:45.280 What is actually being distorted here from your point of 0:10:45.360 --> 0:10:47.160 view in the overall markets? 0:10:47.960 --> 0:10:50.160 Well, the primary component is being distorted is what's called 0:10:50.240 --> 0:10:53.360 price discovery. Right, So we actually effectively have a market 0:10:53.360 --> 0:10:56.679 that no longer has a form of memory. We as 0:10:56.720 --> 0:11:00.320 individual humans experience the varying of this and the COVID pandemic. 0:11:00.400 --> 0:11:02.280 We'd go to the grocery store. We thought that eggs 0:11:02.280 --> 0:11:04.240 are supposed to be three dollars a dozen. They're five 0:11:04.280 --> 0:11:07.320 dollars a dozen. That creates chaos, Right, what's going on? 0:11:07.440 --> 0:11:11.680 This doesn't make any sense. As we continued through that pandemic, 0:11:11.800 --> 0:11:15.559 people increasingly became unhinged from the historical price level and 0:11:15.600 --> 0:11:20.200 they basically accepted whatever price was available for eggs. That's 0:11:20.240 --> 0:11:23.360 the same phenomenon that happens with passive You effectively lose 0:11:23.440 --> 0:11:27.120 the memory of what is a meaningful price level, and 0:11:27.160 --> 0:11:30.960 you effectively adopt whatever the last price is. Passive is 0:11:31.080 --> 0:11:33.199 like an investor who has zero memory. 0:11:35.960 --> 0:11:37.760 So if we took a step back and think about 0:11:37.760 --> 0:11:41.640 the market as a whole and just thinking about systemic risk, 0:11:42.120 --> 0:11:44.240 you know, where's that risk hiding in this kind of 0:11:44.640 --> 0:11:47.600 index product dominant heavy market. 0:11:49.760 --> 0:11:52.040 Well, it is unfortunately a true systemic risk. 0:11:52.120 --> 0:11:52.240 Right. 0:11:52.280 --> 0:11:54.560 What we have actually done is we introduce an agent 0:11:54.840 --> 0:11:58.240 who we effectively in a paper clip world variant. Right, 0:11:58.280 --> 0:12:00.880 when you think about automation, we just said we'll go 0:12:00.960 --> 0:12:04.520 buy at what price, whatever price you can get. Right now, 0:12:04.520 --> 0:12:07.720 what that is actually done is inflated valuations. If you 0:12:07.720 --> 0:12:10.600 think about the impact of a growing pool of agents 0:12:11.120 --> 0:12:13.880 whose responds to at what price is whatever price, I 0:12:13.880 --> 0:12:16.640 don't care, the people selling to them will be able 0:12:16.679 --> 0:12:20.280 to extract higher and higher prices. Over time. Those prices 0:12:20.320 --> 0:12:24.480 will become increasingly disjointed from the fundamentals. We will construct 0:12:24.520 --> 0:12:27.080 a narrative around it. Right, they're better companies, they have 0:12:27.120 --> 0:12:30.400 better growth opportunities, productivity is going to surge right around 0:12:30.400 --> 0:12:32.080 the corner, et cetera. Because that's what we do as 0:12:32.160 --> 0:12:35.480 human beings. Right, Remember, we as a species, for thousands 0:12:35.559 --> 0:12:38.080 of years, believe that the sun transitd the sky being 0:12:38.160 --> 0:12:41.560 dragged behind a golden god. We will literally believe anything, 0:12:41.640 --> 0:12:46.800 including stuff that Elon Musk says. You know, this simple 0:12:47.080 --> 0:12:52.240 reality is that when you create those conditions, you set 0:12:52.280 --> 0:12:55.720 the stage for what was very well articulated in a 0:12:55.760 --> 0:13:00.720 two thousand and four academic paper by Michael Jensen called 0:13:00.720 --> 0:13:05.120 the agency cost of Overvalued Equities, and he highlights that effectively, 0:13:05.679 --> 0:13:09.280 if an equity becomes overvalued, there really is no mechanism 0:13:09.360 --> 0:13:13.600 to discipline the management team, and they have every incentive 0:13:13.840 --> 0:13:18.920 in the world to justify the existing valuation in their behaviors. 0:13:19.559 --> 0:13:22.479 If they believe that they are being rewarded for incredible 0:13:22.480 --> 0:13:25.920 growth opportunities, they will invest like they believe there are 0:13:25.960 --> 0:13:29.360 incredible growth opportunities. And unfortunately, I think that's what we're 0:13:29.400 --> 0:13:31.719 largely seeing. On flip side of it, many industries that 0:13:32.160 --> 0:13:36.040 suffer from neglect under this framework are told that capital 0:13:36.120 --> 0:13:39.480 is not available to them, and as a result, they underinvest, 0:13:40.240 --> 0:13:43.000 and that broadly is a pattern that's playing across our 0:13:43.080 --> 0:13:46.760 economy where privileged companies that happen to be large enough 0:13:46.760 --> 0:13:50.359 to be in the public equity indices are receiving differential 0:13:50.440 --> 0:13:53.400 cost of capital and in much lower cost of capital 0:13:53.440 --> 0:13:56.600 that allows them to invest, while businesses that are not 0:13:56.720 --> 0:13:59.640 privileged in that way, your local mom and pop grocery store, 0:13:59.720 --> 0:14:03.360 hardware store, are suffering from neglect and an inability to 0:14:03.400 --> 0:14:05.080 obtain investable funds. 0:14:05.920 --> 0:14:09.200 So do you think that regulators actually understand that, you know, 0:14:09.240 --> 0:14:12.760 this feedback loop that's that it's creating. I think it 0:14:12.760 --> 0:14:15.480 depends on which regulators you refer to. I like to 0:14:15.520 --> 0:14:19.040 point people to a conversation I had in twenty eighteen, 0:14:19.920 --> 0:14:22.040 soon after the events of Allmageddon, which I think you 0:14:22.040 --> 0:14:25.520 both know I was involved with, in which I met 0:14:25.520 --> 0:14:28.480 with the Bank of International Settlements and their Financial Crisis Group, 0:14:28.760 --> 0:14:32.240 and their reaction to my work was, yeah, we think 0:14:32.240 --> 0:14:34.920 you're right, and they've subsequently written a few papers on 0:14:34.960 --> 0:14:38.880 it that tread very lightly on this topic. My reaction 0:14:39.040 --> 0:14:41.200 to that was, Oh, that's fantastic. How can I help? 0:14:41.240 --> 0:14:43.880 What can we do to ameliorate this condition. I did 0:14:43.920 --> 0:14:46.480 not go public. My goal was not to incite panic 0:14:46.560 --> 0:14:49.800 in the crowds. My goal was to get regulators to 0:14:49.880 --> 0:14:52.800 change it. And their response, unfortunately, was there's nothing we 0:14:52.880 --> 0:14:55.600 can do because what you don't understand is the regulatory 0:14:55.640 --> 0:14:59.280 apparatus is controlled by black Rock and Vanguard. And if 0:14:59.280 --> 0:15:02.160 we raise the alarm and the event didn't happen immediately, 0:15:02.280 --> 0:15:03.520 we would simply be fired. 0:15:05.720 --> 0:15:07.160 And so one of the things, you know, I track 0:15:07.240 --> 0:15:08.040 active management. 0:15:08.080 --> 0:15:10.280 I've been looked over time, as you know, the amount 0:15:10.280 --> 0:15:12.560 of alpha that's being produced by you know, say mutual 0:15:12.600 --> 0:15:15.600 fund managers and now ETF managers has kind of fallen 0:15:15.680 --> 0:15:17.400 quite a bit. And so do you think that the 0:15:17.440 --> 0:15:21.360 growth of these index tracking products is making active management 0:15:21.440 --> 0:15:24.600 harder or does it actually increase the opportunity for some 0:15:24.880 --> 0:15:25.720 active managers. 0:15:26.680 --> 0:15:28.760 Well, the answer is both. But it's just a function 0:15:28.840 --> 0:15:30.960 of time skills, right, So this is a vary into 0:15:31.040 --> 0:15:34.280 what John Maynard Keynes observed. The markets can remain irrational 0:15:34.360 --> 0:15:37.720 far longer than you can remain solvent. As long as 0:15:37.760 --> 0:15:41.760 people are piling money into passive strategies, and passive continues 0:15:41.800 --> 0:15:45.400 to gain share, there's really not much prospect for active 0:15:45.400 --> 0:15:48.880 managers managers on a continuous basis to underperform. That's actually 0:15:48.920 --> 0:15:52.760 a direct byproduct of how we calculate things. So if 0:15:52.840 --> 0:15:55.480 you think about a market that has a function that 0:15:55.680 --> 0:15:59.640 causes valuations to increase over time, in other words, there 0:15:59.640 --> 0:16:03.960 we're at any unit of risk are actually rising. That 0:16:04.000 --> 0:16:08.800 creates a positively convex surface. The measures that we use, 0:16:08.880 --> 0:16:12.600 as you talk about alpha for calculating active manager performance, 0:16:12.920 --> 0:16:16.440 is actually a linear equation. Why equals mx plus b. 0:16:17.360 --> 0:16:20.320 The return on my portfolio is the beta times the 0:16:20.400 --> 0:16:24.480 market plus some idiosyncratic factor we call alpha. That alpha 0:16:24.520 --> 0:16:27.320 is simply the intercept. And if you just draw a 0:16:27.560 --> 0:16:32.000 curved surface and you run linear equations on it over time, 0:16:32.160 --> 0:16:35.560 you will actually find that those intercepts are forced negative. 0:16:36.400 --> 0:16:40.160 That perfectly matches the experience of the active manager community 0:16:40.280 --> 0:16:42.800 so very quickly. This is actually proprietary research that I 0:16:42.800 --> 0:16:45.600 did back in twenty seventeen. I asked the question of 0:16:45.800 --> 0:16:50.160 portfolio managers. You're a portfolio manager, you are given new capital, 0:16:50.280 --> 0:16:52.680 or capital is taken away from you. What's the likelihood 0:16:52.720 --> 0:16:55.520 that you'll deploy funds or sell securities to meet redemption 0:16:55.640 --> 0:16:59.920 given some type of valuation. Valuation is on the x AXI, 0:17:00.480 --> 0:17:02.960 your marginal propensity to either buy or sell is on 0:17:03.000 --> 0:17:07.119 the Y axis. These are the cumulative results across roughly 0:17:07.160 --> 0:17:10.439 four hundred and fifty responses, and unsurprisingly, you find a 0:17:10.480 --> 0:17:14.280 marginal propensity to sell as valuation rises, and a marginal 0:17:14.359 --> 0:17:18.440 propensity to buy as valuations fall. That's not surprising. Those 0:17:18.440 --> 0:17:21.760 are standard downward sloping demand curves and economics. It's this 0:17:21.880 --> 0:17:24.880 intersection between the two that's actually really interesting. The two 0:17:25.000 --> 0:17:27.359 cross and remember this is just a random survey by 0:17:27.359 --> 0:17:32.600 an idiot at the market's historical valuation average. That's actually 0:17:32.600 --> 0:17:35.160 really important because if you build an agent based model, 0:17:35.280 --> 0:17:37.880 feed these responses in them, then randomly give them cash 0:17:37.920 --> 0:17:39.840 and take cash away, which you discover as a mean 0:17:39.880 --> 0:17:42.560 reverting valuation in markets. This is why things like the 0:17:42.600 --> 0:17:47.639 Shiller pe have historically worked. If you introduce passive investors 0:17:47.680 --> 0:17:51.399 into the mix, remember that they have a hundred percent 0:17:51.520 --> 0:17:54.560 marginal propensity to buy and sell. Did you give me cash, 0:17:54.600 --> 0:17:56.600 If so, then buy? Did you ask for cash if so, 0:17:56.680 --> 0:18:00.800 then sell. That pushes the marginal propensity to both buy 0:18:00.840 --> 0:18:03.720 and sell off of that mean reversion towards what's called 0:18:03.760 --> 0:18:08.359 mean expansion. That takes the form of rising valuations over time, 0:18:08.920 --> 0:18:14.240 which unfortunately perfectly matches the underlying data that we see. 0:18:15.480 --> 0:18:18.240 This is the valuations rising. This is the median stock. 0:18:18.320 --> 0:18:20.600 This is the market cap weighted stock, which again plays 0:18:20.600 --> 0:18:23.159 into theoretical frameworks. So why the largest stocks are more 0:18:23.200 --> 0:18:26.360 impacted on this, so we see rising valuations over time. 0:18:26.440 --> 0:18:28.600 If we then think about that in the context of 0:18:28.640 --> 0:18:32.280 how we measure manager performance. Historically we're used to thinking 0:18:32.280 --> 0:18:36.440 about a mean reverting market. The reality is now we 0:18:36.480 --> 0:18:40.200 have a mean expansionary market that causes those valuations to rise. 0:18:40.480 --> 0:18:43.200 If I take that same linear equation and I run 0:18:43.240 --> 0:18:45.960 it at various points in time against different passive share 0:18:46.560 --> 0:18:50.520 my alphas are pushed negative. And that is, unfortunately exactly 0:18:50.600 --> 0:18:54.160 what we're seeing. So contra to the argument that most 0:18:54.200 --> 0:18:57.360 people focus on, which is this idea under a Grossman 0:18:57.400 --> 0:19:01.360 Sigletz type framework, that the opportunity tunity set for active 0:19:01.400 --> 0:19:06.359 managers is growing, the path to that is actually very 0:19:06.400 --> 0:19:10.320 destructive to the process of price discovery and market functioning 0:19:10.840 --> 0:19:13.680 and ends up killing the active managers along the way. 0:19:14.480 --> 0:19:17.920 That creates a feature that's been very well documented what's 0:19:17.960 --> 0:19:24.320 called effectively defection. Active managers increasingly become closet indexers, basically 0:19:24.320 --> 0:19:27.680 trying to preserve their career by minimizing their tracking error 0:19:27.680 --> 0:19:31.760 against that benchmark. So two things on that. 0:19:32.359 --> 0:19:34.040 I wasn't gonna ask this question, but you've just brought 0:19:34.040 --> 0:19:37.840 it up. So how when I talk to active managers. 0:19:37.880 --> 0:19:40.520 In many cases, it's like risk departments that don't allow 0:19:40.600 --> 0:19:43.160 you to deviate too far from an underlying benchmarks. It's 0:19:43.160 --> 0:19:46.159 been a thing for in fixed income for forever, like 0:19:46.200 --> 0:19:48.679 you can't devaate too far from duration, you can't deviate 0:19:48.760 --> 0:19:51.720 too far from credit risk metrics, and the same thing 0:19:52.080 --> 0:19:54.880 in large cap you know, active management picking and things 0:19:54.880 --> 0:19:58.320 along those lines. So how much of it is like 0:19:58.320 --> 0:19:59.959 like I guess, my question is how different is this 0:20:00.040 --> 0:20:02.360 from a couple of decades ago where the active managers. Yes, 0:20:02.400 --> 0:20:04.119 they were trying to outperform here and there, but for 0:20:04.160 --> 0:20:07.000 the most part they were still, you know, hamstrung within 0:20:07.400 --> 0:20:10.119 a bandwidth of where, where and what they can invest in. 0:20:12.119 --> 0:20:15.639 It's largely a byproduct of regulation and the repeated experience. 0:20:16.480 --> 0:20:18.320 So in two thousand and six we passed the Pension 0:20:18.359 --> 0:20:22.359 Reform Act, the Pension Protection Act. I'm sorry that changed. 0:20:22.400 --> 0:20:24.520 Four oh one K is from an opt in framework 0:20:24.520 --> 0:20:26.240 where you would get a job and then choose to 0:20:26.280 --> 0:20:28.399 participate in a four oh one K to an opt 0:20:28.440 --> 0:20:30.800 out framework where you would choose, you would get a job, 0:20:30.880 --> 0:20:33.320 and you would automatically default it into a four oh 0:20:33.359 --> 0:20:37.240 one K. When you created that, you had to establish 0:20:37.280 --> 0:20:40.360 what you were going to automatically default them into the 0:20:40.440 --> 0:20:46.320 established what was called the qualified default investment alternative. Initially 0:20:46.520 --> 0:20:50.240 that was balanced funds. There was some competition from active managers, 0:20:50.280 --> 0:20:53.760 but very quickly over time we established legal precedent that said, 0:20:53.800 --> 0:20:56.400 if you choose anything other than the lowest cost passive 0:20:56.440 --> 0:20:58.680 exposure as the sponsor of a four oh one K, 0:20:59.400 --> 0:21:02.040 you run an inordinate risk of being sued by your 0:21:02.080 --> 0:21:06.240 own employees. My favorite example is a class action lawsuit 0:21:05.640 --> 0:21:10.520 by Fidelity employees against Fidelity for offering them actively managed 0:21:10.560 --> 0:21:17.280 Fidelity products. So, unfortunately, what you're describing, James, is exactly 0:21:17.560 --> 0:21:21.120 what you would expect because of two features. One, fewer 0:21:21.200 --> 0:21:24.880 and fewer active managers have access to that pool of capital. 0:21:24.960 --> 0:21:28.280 Because of the QDIA, about eighty five percent of four 0:21:28.320 --> 0:21:31.400 oh one K participants never change their designation away from 0:21:31.440 --> 0:21:35.280 that qualified default investment alternative, and as a result, there's 0:21:35.359 --> 0:21:39.399 really no new entrant customers into the active manager space, 0:21:39.520 --> 0:21:43.560 or very small fraction of it. The second feature is 0:21:43.560 --> 0:21:46.640 is that that then means because there are no new customers, 0:21:46.680 --> 0:21:49.800 the worst thing that can happen is losing an existing customer, 0:21:49.840 --> 0:21:52.960 and the easiest way to lose an existing customer is 0:21:53.000 --> 0:21:58.280 by underperforming versus your benchmark. Outperformance will retain it. But 0:21:58.520 --> 0:22:01.520 underperformance guarantee is that you're going to get fired and 0:22:01.560 --> 0:22:05.199 your business moves rapidly into a terminal stage. This has 0:22:05.280 --> 0:22:08.760 driven a very clear defection that's actually well documented by 0:22:08.760 --> 0:22:11.879 the work of Valentine Hadad and Paul Hubner in the 0:22:11.880 --> 0:22:15.680 behavior of active managers themselves. They have shifted from being 0:22:16.000 --> 0:22:20.600 historically highly elastic and sensitive to valuation. Today they're effectively 0:22:20.960 --> 0:22:23.200 very close to passive investors in many ways. 0:22:23.480 --> 0:22:25.440 If you just take a face value everything you're saying, right, 0:22:25.800 --> 0:22:28.520 if you're viewing this as something that's just storying the markets, 0:22:28.520 --> 0:22:31.760 and theoretically you should be propping up the largest names 0:22:31.760 --> 0:22:35.720 in the index. Like if you're an adept active manager 0:22:35.720 --> 0:22:37.679 and you accept and see that this is happening, Like 0:22:37.960 --> 0:22:40.560 why wouldn't active managers just lean into it and take 0:22:40.560 --> 0:22:46.120