Speaker 1: Hello, and welcome to another episode of the odd Lot Podcast.
Speaker 1: I'm Joe Wisenthal and I'm Tracy Halloway. Tracy, do you
Speaker 1: remember our episode a few weeks ago with Mike Green.
Speaker 1: I do, indeed. Fantastic episode. Yeah, this idea and of
Speaker 1: course for those who don't recall it or those uh
Speaker 1: maybe haven't listen to it, the topic was what are
Speaker 1: the sort of distortions in the market that are being
Speaker 1: caused by the rise of passive investing. People are just
Speaker 1: throwing money a month after month, paycheck after paycheck in
Speaker 1: the index funds. A lot of people think it's a
Speaker 1: really good trend, but there is more attention and more
Speaker 1: questions being raised by what is it really like mean
Speaker 1: for markets and market structure when so much money isn't
Speaker 1: going towards individual security selection? Right, there's this assumption that
Speaker 1: passive investing is actually good in many ways because investors
Speaker 1: are paying lower fees so over the long run they
Speaker 1: make more money. But also in the sense that passive investing,
Speaker 1: because you're just putting money into these big benchmarks that
Speaker 1: are reflective of the market as it is, that you're
Speaker 1: not actually impacting the market at all, and only now
Speaker 1: are we starting to see some real criticism of that
Speaker 1: thesis and also some academic research where people are saying
Speaker 1: that actually passive investing and benchmark index construction can impact
Speaker 1: the market itself. Right, And of course, you know passive investing.
Speaker 1: You mentioned the low fees. There is also a body
Speaker 1: of academic research on the side of passive investing, believers
Speaker 1: in efficient markets and so forth, to essentially say, look,
Speaker 1: the sum total of all active investors is just going
Speaker 1: to be the index self, and you're unlikely to beat
Speaker 1: the market with your own stocks selection, so why not
Speaker 1: just buy the market itself and then you get the
Speaker 1: same return as everyone else, but at least you didn't
Speaker 1: pay the fees. My Green's argument when we talked to
Speaker 1: him was essentially, it's creating all these distortions because the
Speaker 1: money just sort of goes to the index itself that
Speaker 1: drives the index higher, and anyone who's trying to buy
Speaker 1: individual stocks, you know, can't possibly compete with a strategy
Speaker 1: that's just put it all on the index. Right. And
Speaker 1: there's this sort of underlying theme that's running through all
Speaker 1: of this, which is what does passive investing actually imply
Speaker 1: about the functioning of the market, and I suppose, uh
Speaker 1: the state of capitalism, right, markets are supposed to be
Speaker 1: funneling money in an efficient way, and if passive investing
Speaker 1: is causing these sorts of distortions where these overvalued companies
Speaker 1: just get more and more overvalued, I guess then is
Speaker 1: capital some really working exactly right? So today we're going
Speaker 1: to explore this topic further because it's clearly something that's
Speaker 1: of growing interest, and we're gonna talk with someone else
Speaker 1: who's done research on this exact question, also making the
Speaker 1: argument that the rise of passive is creating weird, anomalous
Speaker 1: bubble type behaviors in some stocks that's clearly different than
Speaker 1: the old days. And so I think we're gonna get
Speaker 1: more granular on what we're really seeing in the market
Speaker 1: that says something is weird about how the market is
Speaker 1: behaving specifically specifically because of the rise of passive. Great,
Speaker 1: let's go granular. All right, We're gonna go granular. We're
Speaker 1: gonna be talking today with Vincent Deliad. He's the director
Speaker 1: of Global Macro for I N T l F C. Stone.
Speaker 1: UH major broker dealer recently came out with a report
Speaker 1: talking about the connection between passive investing and the sort
Speaker 1: of rise of these mega caps and the connection between
Speaker 1: the incredible performance of stocks like Apple and Microsoft and
Speaker 1: Alphabet and so on, and what that has to do
Speaker 1: with passive investing. So, Vincent, thank you very much for
Speaker 1: joining us. Thanks for having me a pleasure. First of all,
Speaker 1: before we get into the question of the distortionary impacts
Speaker 1: of passive investing, what is I mean, some people debate
Speaker 1: what that even means passive investing, and some people say, oh,
Speaker 1: it's a myth, passive investing isn't even the thing or
Speaker 1: whatever it is, or that everyone is making some sort
Speaker 1: of active decision. But when we talk about this, how
Speaker 1: do you define the phenomenon that seems to define this, uh,
Speaker 1: this sort of age and investing. Yeah. Absolutely, I mean
Speaker 1: I've been in my work. I've just define it as
Speaker 1: investing it in um market gap weighted in the season.
Speaker 1: And I do realize that people use them for short
Speaker 1: term trading as as a replacement to other vehicle and
Speaker 1: that at the end of the day there is a
Speaker 1: human behind it. But my my focus, um, I think
Speaker 1: and that's what the I think that the missing link
Speaker 1: is for for a lot of people is to ask
Speaker 1: not so much where the money is going, but where
Speaker 1: is it coming from? And I think that's what creates
Speaker 1: a distortion. So in the research note that Joe mentioned,
Speaker 1: you subtitle it as dumb alpha how to be an
Speaker 1: intelligent investor in a stupid age, which I find very
Speaker 1: amusing but maybe a lot of index investors would find
Speaker 1: kind of insulting. Why do you think passive investing or
Speaker 1: index investing is dumb alpha? Walk us through your thought
Speaker 1: process here, because, as you point out, actually following the
Speaker 1: indusicries putting money in the most overvalued stocks would have
Speaker 1: paid off in recent times. Absolutely. I mean this was
Speaker 1: the driver for for the title is you look at
Speaker 1: last year, I think the SMP five index out before
Speaker 1: maybe five sound of global stocks. So if you wanted
Speaker 1: to generate alpha, then you have this traditional framework right
Speaker 1: where you have beta, which is just buying exposure to
Speaker 1: the index, and an alpha I'm gonna, you know, pick
Speaker 1: stocks and because I'm smart and I'm going to beat
Speaker 1: the market. What I would slap on its head last year,
Speaker 1: the way to generate alpha was to own the index,
Speaker 1: and pretty much anyone who did not own Apple or
Speaker 1: Microsoft in proportion to their weights in the index ended
Speaker 1: up under performing, regardless of how skillful you were with
Speaker 1: with your trading. And you know, it's recently talking to
Speaker 1: a friend who runs a hedge phone and had a
Speaker 1: good year but underperformed the index because Apple was reclassified,
Speaker 1: and just that simple factory classifying Apple men that a
Speaker 1: great year ended up being a bad year. And I
Speaker 1: think that's an experience that's very common for for many
Speaker 1: investors last year. So you mentioned that the SMP five
Speaker 1: hundred itself is essentially where the alpha is, and that
Speaker 1: it beat the majority of stocks. Of the stocks underperformed.
Speaker 1: I was under the oppression that historically most stocks did
Speaker 1: bad and that historically the vast majority of gains in
Speaker 1: any environment, whether it's passive or whatever, are often generated
Speaker 1: by a handful of stocks, and that over time most
Speaker 1: stocks do underperform the index. How different is what you're
Speaker 1: seeing now with that level of out performance of the
Speaker 1: index versus a twenty years ago or forty years ago
Speaker 1: or long before. Just sort of buying the s P
Speaker 1: y E t F was a major thing that investors
Speaker 1: did right. So what you're referring to, I think is
Speaker 1: is Barto's law. You know, you get eighty percent of
Speaker 1: your revenue from your top customers, or the same thing
Speaker 1: with stock market returns. Uh, what's unique about last year,
Speaker 1: or maybe not unique, but at least rare, is that
Speaker 1: the larger stock in the index massively outperformed. Then you
Speaker 1: can go back. I mean, it's it's a very easy
Speaker 1: simulation to run. I mean, you can go back on
Speaker 1: the data you know up to the beginning of the
Speaker 1: twentieth century. And one of the easiest way to have
Speaker 1: generated consistent alpha would just be a void your larger
Speaker 1: stock in the index. I mean, that's the I care
Speaker 1: scurs if you want. You know, once, once I car
Speaker 1: runs too close to the sun, he falls down. Like
Speaker 1: usually stocks that become the largest in the world even
Speaker 1: face increased competition, regulated scrutiny, just ubers because you know,
Speaker 1: it's hard to grow and usually fall back. And of
Speaker 1: course last year was the big exception, with you know,
Speaker 1: Apple up like probably on a toll return basis close
Speaker 1: and then Microsoft closely behind. So all you have to
Speaker 1: do last year to a fantastic year is just on
Speaker 1: the largest two stocks in the world, which is usually
Speaker 1: not the way you make the money. So can you
Speaker 1: walk us through the mechanics of what's actually happening here,
Speaker 1: Like why are these you know, big overvalued stocks like Microsoft,
Speaker 1: like Apple? Why does money continue to flow into them? Right?
Speaker 1: And I think that's that is the part where I
Speaker 1: think the the criticism of passive is traditionally weak, and
Speaker 1: I think part of it comes from a bigger place
Speaker 1: of resentment. Like you have a lot of active managers
Speaker 1: that are the performed and and every year they read
Speaker 1: the SNP a active versus passive reports that says, oh,
Speaker 1: of the age underperform and that number rises over time,
Speaker 1: and it's a it's a very painful fit. So you
Speaker 1: have a lot of like resentment and and and he said, well,
Speaker 1: it's because you know the index functions by the larger stocks,
Speaker 1: and that's not exactly true. I mean it's very easy
Speaker 1: if you're Vanguard or black Rock to to respond, well, no,
Speaker 1: if we market gap waiting, we are not overweighting anything.
Speaker 1: We let we let the active segment of the markets
Speaker 1: at price, and we just span wagon. We don't do
Speaker 1: price discovery, So any sort of um miss pricing is
Speaker 1: not coming from us. And that's a powerful argument one
Speaker 1: that I I don't think we should take the correct
Speaker 1: argument is more, okay, passive does not create distortion, But
Speaker 1: can we think about where where the money coming into
Speaker 1: passive vehicle is coming from? And if this sector is
Speaker 1: structurally underway these megacaps, then shifting from them into market
Speaker 1: cap weight will result in net buying of the megacap stocks.
Speaker 1: So what do we see empirically in terms of the
Speaker 1: performance of across the spire or other indicries. So you
Speaker 1: and you made the point right in the beginning, which
Speaker 1: I think was key. It's not enough to say that
Speaker 1: the money is going into pass of it's that it's
Speaker 1: come what it's coming out of it. So what you're
Speaker 1: said in that last answer is essentially the money is
Speaker 1: coming out of active managers. The active managers were probably
Speaker 1: underweight the very largest companies, and so therefore there is
Speaker 1: this rotation of people putting money UH into funds that
Speaker 1: are are more heavily exposed to the largest companies. Do
Speaker 1: we see the reverse though? Where do we see UH
Speaker 1: Now just the upward pole on the biggest companies, but
Speaker 1: do we see drags on smaller companies relative weakness of
Speaker 1: the lower end of the five. So that's not just
Speaker 1: about the behavior of a few tech mega caps. Yeah, absolutely,
Speaker 1: I mean you have because generally it's you know, you say,
Speaker 1: an asset to buy another one, so it's not really
Speaker 1: new money. I mean, if anything, that's been one of
Speaker 1: the um peculiarities of this cycle is how little new
Speaker 1: money has gone into the market. You know, the investor
Speaker 1: mostly sides size staying on the sideline pretty much. Is
Speaker 1: really since the Vics armageddon in into January eighteen, you've
Speaker 1: seen steady outflows on equity phones, more more and more
Speaker 1: outflows some metual phones than you have from ets on
Speaker 1: net selling, which is very unusual as the market makes
Speaker 1: the top. So it's been indeed not new money but
Speaker 1: shifting money, and and so the place where the money
Speaker 1: to to MEAs of that effect, what I did is
Speaker 1: I looked at the top two d largest mutual froms
Speaker 1: in the US with management field more than one percent,
Speaker 1: and I thought that would be a very good proxy
Speaker 1: for the asset losing segment of the market obviously, uh.
Speaker 1: And I looked at the top twenty holdings and I
Speaker 1: looked whether they had any of them are called the
Speaker 1: thank plus Fang plus Microsoft testline. So for fact that
Speaker 1: the big megacaps have been driving the rally. And what
Speaker 1: I found is that more than half of these mutual
Speaker 1: forms do not have the Fank plus in their top
Speaker 1: ten holding UH, and the vast majority of them who
Speaker 1: own these stocks have them in a much more proportion
Speaker 1: than they were in the index. So to me, that
Speaker 1: is the source of this distortion, as these guys lose money,
Speaker 1: and as that money flows into market cap waiting index
Speaker 1: the way UM in terms of of net flow, it
Speaker 1: means net selling of these guys on which is primarily
Speaker 1: value oriented small cap stocks into large growth And to
Speaker 1: answer finally answer your your question, UM, you certainly see
Speaker 1: that enormous valuation discrepancy that has open between you can
Speaker 1: growth and value. Um. Actually it's higher today than it
Speaker 1: was back at the peak of two thousand if you
Speaker 1: get the FAMI French data that goes back all the
Speaker 1: way to the twenties. The slope of the market meaning
Speaker 1: how how expensive your most decides, which is your cheapest decide,
Speaker 1: has never been greater and she's consistently we being seeing
Speaker 1: What do you say to two people who would argue that, UM,
Speaker 1: the price on something like an Apple or a Microsoft
Speaker 1: is justified by the amount of dividends or buy backs
Speaker 1: that they've been doing in the market. So if you
Speaker 1: can't get a massive growth in the share price, maybe
Speaker 1: you can get growth through the dividend for instance. So
Speaker 1: that would be one argument for buying these things even
Speaker 1: at inflated levels. What do you say to that, right, Well,
Speaker 1: first of all, I wouldn't exactly define the dividend deals
Speaker 1: as extremely high. I mean, you could probably have made
Speaker 1: that argument in December December twenty four eighteen when went Apples,
Speaker 1: you know, trading at a UM I don't like eleven
Speaker 1: twelve p something like that. After last year, it becomes
Speaker 1: a lot harder, especially and again as as I explained
Speaker 1: that the money is coming from forms that have a
Speaker 1: value tilt to them, So if anything, they're probably selling
Speaker 1: stock to the higher dividion deild to go into into
Speaker 1: lower dividient deal. But the buyback question is is also
Speaker 1: quite interesting um and I think it adds to this
Speaker 1: kind of supply and demand demanding balance. If you look
Speaker 1: at last year, it's no surprise at the best performing
Speaker 1: stock where Apple and Microsoft the two large gap texts
Speaker 1: with the largest buyback programs. So you have this rotation
Speaker 1: that resulting kind of structural buying at these stocks, and
Speaker 1: then on top of that you have a I mean,
Speaker 1: I don't have the exact number, but I think for
Speaker 1: Apple it was a closed to five to s person
Speaker 1: on the market gab that they brought back last year.
Speaker 1: And I mean, I hate to sound to say it,
Speaker 1: but sometimes the market goes up because there's mobiles and
Speaker 1: set us what about Okay? So one of the things
Speaker 1: that you point out is that historically speaking, you could
Speaker 1: generate alpha simply as easily as avoiding the biggest companies
Speaker 1: in the index, and that you know, there's just sort
Speaker 1: of like a natural I guess maybe the icarous effect
Speaker 1: following too close to the sun or some sort of
Speaker 1: natural diseconomies of scale where there's always so forth so
Speaker 1: far you can go. What about the idea though, that
Speaker 1: tech is unique and the way it's unique is that
Speaker 1: the competitiveness of data driven companies goes up as they
Speaker 1: get bigger. So if you're a Facebook and you have Instagram,
Speaker 1: you can serve a higher quality of ads with a
Speaker 1: billion users than a company that just has a million
Speaker 1: users because you have so much more data and your
Speaker 1: business runs better. And of what you could make the
Speaker 1: argument that these megacaps are better and more competitive and
Speaker 1: more in a position to grow organically, setting aside share
Speaker 1: price then big companies in the past, because there are
Speaker 1: returns to scale and that maybe you just can't compare
Speaker 1: a really large tech company that has the advantage of
Speaker 1: all this data versus I don't know, a big steel
Speaker 1: company from fifty years ago. Yeah, that is a very
Speaker 1: white u K argument, which you know, coincidently that the
Speaker 1: last time we saw this this phenomenon was you remember
Speaker 1: when when Cisco in the in the fourth quarter. You know,
Speaker 1: I think triple quadrupled in just three months, and I
Speaker 1: think it end up at a close to sixion market gap,
Speaker 1: and and then that was the top of the market.
Speaker 1: But the argument was exactly the same. It was it
Speaker 1: the network effect, right, I mean, as we enter in
Speaker 1: this dematalized world, we no longer have the you know,
Speaker 1: the low of the mission return, which from montl principle
Speaker 1: of economics no longer applies because you're dealing with we
Speaker 1: with data instead of things, and the more people are
Speaker 1: are on your network, the more valuable it becomes. Today,
Speaker 1: there is more of a big data AI uh tweak
Speaker 1: to the argument, but it's definitely the same one. Um
Speaker 1: I mean, I'll just point to the experience of of
Speaker 1: two thousand. You know, it didn't work out all that
Speaker 1: wealth for Cisco, uh, and then for the companies for
Speaker 1: which I think there was indeed some sort of a
Speaker 1: natural monopoly, like Microsoft, Eventually the regulators caught on with it.
Speaker 1: Because if reality is the way you describe it, and
Speaker 1: I think then we have a almost a social and
Speaker 1: political problem that you know, wealth just accrues to the
Speaker 1: one that have the most powerful platform, and competition becomes impossible, right,
Speaker 1: which is when you would expect regulatory pressure to come
Speaker 1: into the play as well. And that's exactly what happened
Speaker 1: to Microsoft back in you know, with the various and
Speaker 1: probe in the both Europe and the US in the
Speaker 1: late nineties. One of the really interesting things in your
Speaker 1: report is you talk a little bit about demographics and
Speaker 1: different approaches to investing between baby boomers and millennials, who
Speaker 1: are you know, really just starting to accrue wealth in
Speaker 1: the stock market. Can you talk about how that plays
Speaker 1: into your thesis about you know, money flowing into certain things,
Speaker 1: but also money coming out of certain things, right, I
Speaker 1: mean overwhelmingly, um, you know, baby boomers are in you know,
Speaker 1: they came of age, you know, really started saving in
Speaker 1: the nineties at the time when you had the Peter Lynch,
Speaker 1: the big you know mutual from managers and they were
Speaker 1: happy to pay you know, one percent management fee to
Speaker 1: invest with an exceptional type at the time active manager
Speaker 1: actually did perform quite well and anywhere returns were higher,
Speaker 1: so people were not less constensitive. And as as as
Speaker 1: I'm sure everybody knows here that the medium baby boomer
Speaker 1: is somewhere around six sixty five. As you head into retirement,
Speaker 1: you reduce your allocation to risk as that increased that
Speaker 1: of bonds, which in many way explains the floor paraducts
Speaker 1: that I was highlighting before, where we see the market
Speaker 1: making you high, but money coming out of major funds.
Speaker 1: So boomers are selling their holdings which are primarily made
Speaker 1: of high fee value tilted small cap tilted mutual funds.
Speaker 1: And to the extent that millennials are building wealth, which
Speaker 1: you know, as you all know, is not as fast
Speaker 1: as everyone would wish, um, that that money is primarily
Speaker 1: invested yeah, you know, robot advisor or even directly in
Speaker 1: local CITF and it's a very it's very hard to
Speaker 1: see the strength change, um, in two thousand twenty two one.
Speaker 1: As much as like and you know, someone who believes
Speaker 1: in market based allocation of capital and and and the
Speaker 1: value of price discovery, it's very hard to see this
Speaker 1: change in the near or even medium term. I want
Speaker 1: to go back real quickly to the question of, uh,
Speaker 1: comparing mega caps today versus back of the day when
Speaker 1: it was a big steel company. So as if the
Speaker 1: day were recording this just for people's uh, you know knowledge,
Speaker 1: we're recording this a few weeks before it comes out.
Speaker 1: But the day before we recorded this, we got earnings
Speaker 1: from one of those mega caps, Alphabet the core advertising
Speaker 1: business up seventeen percent, the cloud business, I mean whatever,
Speaker 1: it was, the biggest company in or whatever. I don't
Speaker 1: know what it was, but probably some big industrial right
Speaker 1: like they were growing like this, were they you had
Speaker 1: such incredible like I just want to push I mean,
Speaker 1: these are like incredible numbers. That's what would say, okay
Speaker 1: forgetting passive, forgetting all of this, Like it's just it's uh,
Speaker 1: they're incredible juggernauts that make more and more money every year.
Speaker 1: And it's funny you should bring up the sixties and
Speaker 1: seventies because you actually had something very similar, which is
Speaker 1: the nifty fifties, right. Um, so at the time it
Speaker 1: was your your IBM, your Coca Cola, American Express McDonald's, UM.
Speaker 1: And I don't have off the top of my head
Speaker 1: down on on how fast they grew. But it also
Speaker 1: seemed like, you know, they had these kind of new
Speaker 1: methods of management that had been you know, invented after
Speaker 1: the war. They were the first multinational. They had you know,
Speaker 1: some sorts, you know, Europe was recovering Asia. It seemed
Speaker 1: that they also had endless growth. And the argument that
Speaker 1: was made at the time, you know, they were one
Speaker 1: decision stock, don't worry but the valuation they'll grow into it,
Speaker 1: which is exactly what we hear today about you know,
Speaker 1: Google and the other the other mega captain. The one
Speaker 1: thing I would point on on the the earning side
Speaker 1: these well actually two things. Uh one watch for margins
Speaker 1: and cogs um actional salary costs. I mean, that's that's
Speaker 1: an area that's been really painfully growing much faster than
Speaker 1: earning the revenues. And people cannot focus oh, you know,
Speaker 1: you know top line revenue. Look at how much SARAH
Speaker 1: expenses are growing, especially stock based compensation and I think
Speaker 1: that's a that's a huge advantage that these companies have
Speaker 1: over traditional companies. You know, you look at a typical
Speaker 1: sary package at Google or Facebook or Amazon. First of all,
Speaker 1: it's very very high inter I was reading a piece
Speaker 1: that I think it was in Bloomberg. Interns at Facebook
Speaker 1: start at eight thousand, eight thousand dollar a month. Entry
Speaker 1: level jobs are probably more round two hundred, and then
Speaker 1: mid level you're looking at four hundred. But half of
Speaker 1: that is paid in stock, so you don't really feel
Speaker 1: the pinch, right because if you pay, if you pay
Speaker 1: your new employees in stock or half of your camping stock, hey,
Speaker 1: you can steell end up with the cash at the end,
Speaker 1: so you can do a buy back. You can you know,
Speaker 1: invest in the next big startup. You can. I guess
Speaker 1: if employees assume that the stock is going to keep
Speaker 1: going up year, that's the sumplicitly worth more than cash,
Speaker 1: even if it's the same award and in to some
Speaker 1: extent it also adds to my my supply and Amanda
Speaker 1: argument before, and that's only. Another peculiarity about a lot
Speaker 1: of these TEX stocks is that the float is actually
Speaker 1: smaller than the market gap because well, in many cases,
Speaker 1: you have a found that that has a significant stake.
Speaker 1: I mean you can think of Amazon with Bazos and Mackenzie,
Speaker 1: and then you have employees who have also been given
Speaker 1: stocks over the year and sometimes been quite reluctant to sell.
Speaker 1: So if you have a base of investor that's not
Speaker 1: willing to sell the stock and you have index ones
Speaker 1: that are trying to buy in proportion to the market gap,
Speaker 1: that kind of add to that squeeze that we're describing earlier.
Speaker 1: So there's this sort of virtuous cycle at play. It
Speaker 1: sounds like where as long as your share price is
Speaker 1: going up, and it probably is if you're one of
Speaker 1: these big successful companies like Pole, you can reduce your
Speaker 1: expenses by paying your employees with stock, and the assumption
Speaker 1: is it will keep going up. And you can also
Speaker 1: embark on big buy back or dividend programs because your
Speaker 1: shares are going up and your cost of funding in
Speaker 1: the debt market is probably pretty low as well, and
Speaker 1: all of that just combines again to flatter your bottom
Speaker 1: line and maybe increase the share price. Again, Uh, when
Speaker 1: does the cycle actually stop, not just that virtuous cycle
Speaker 1: of flattering share prices encouraging better share prices, but also
Speaker 1: the cycle of passive money flowing into overvalued stuff. To
Speaker 1: say the truth, the passive rotation. I don't know. I
Speaker 1: don't know whether it will. I I mean there's always
Speaker 1: this hope, like every year mom active managers, it's like, oh, well,
Speaker 1: you know typical investment outlook from an active manager. Well,
Speaker 1: last year was bad, but it was because of this
Speaker 1: unique brexit, the FED hiking rate, the FED cutting rates,
Speaker 1: correlations being higher, correlations being low. But next year, because
Speaker 1: there's going to be that other than that, I'm uniquely
Speaker 1: positioned to take advantage of, it will be different. And
Speaker 1: and then I mean we've seen it for twenty years,
Speaker 1: so I don't know. I mean, maybe you'd have to
Speaker 1: maybe have a Black swanlike event, like like some sort
Speaker 1: of like you know, massive panic, and then the E E
Speaker 1: T they the T starts selling and and and but
Speaker 1: I really can't imagine the market going back to the
Speaker 1: structure that it is at twenty years ago. What what
Speaker 1: I will? I will rebound on on what you said
Speaker 1: about the virtue cycle, because I have done a bit
Speaker 1: of work on that. I looked at the about two
Speaker 1: hundred companies that are incorporated in the San Francisco Bay
Speaker 1: area plus Silicon Valley, and then I created index of
Speaker 1: these companies and I looked at their weighty average costs
Speaker 1: of equity, the cost of debt, and their effective tax rate,
Speaker 1: and how much of their compensation was going in the
Speaker 1: form of stock. And what I found was, you know,
Speaker 1: the cost of equity effective cost of equity was very,
Speaker 1: very low because most of them don't pay dividends, uh
Speaker 1: mostly don't buybacks. If they do have buybacks is to
Speaker 1: offset delusions, so that on net it's very low. The
Speaker 1: cost of debt is extraornarly low because either they are
Speaker 1: verial debt or that debt is really pushed far away
Speaker 1: so they don't really need to to service at any point.
Speaker 1: The customer employees is low. I mean it's high in
Speaker 1: absolute number, but it's very low if you look at
Speaker 1: what is actually paid in cash. The taxes, of course
Speaker 1: are non existent. And then most of them, actually a
Speaker 1: majority of them, don't have earnings. So then if you
Speaker 1: start thinking about it that way, I think, okay, well,
Speaker 1: you know, if you want to run a business and
Speaker 1: you don't have to turn earnings, you don't have to
Speaker 1: pay dividends. You don't have to pay taxes, you don't
Speaker 1: pay interest on your debt to artistic and postpone it.
Speaker 1: And even better you can pay you only pay half
Speaker 1: of your employee saries. Yeah, I think it could be
Speaker 1: the competition too. I want to get into a little
Speaker 1: bit more soon about how you think investors should be
Speaker 1: position to sort of prepare for the end of this
Speaker 1: and or take advantage of this. But before we do that,
Speaker 1: I'm curious in your work, have you looked at non
Speaker 1: spicas to see if there's the same effect as a
Speaker 1: result of market cap waiting, Like if you look at, say,
Speaker 1: people putting um money in the i w M, which
Speaker 1: tracks the Russell two thousand, do you see a similar
Speaker 1: distortionary effect there were the larger companies within the small
Speaker 1: cap sector benefit disproportionately from some people from the existence
Speaker 1: of these vehicles. Right. What I've done is, you know
Speaker 1: how the the sp index is not a he's not
Speaker 1: a truly market cap waiting index. I mean it has
Speaker 1: a bunch of other the requirements. The SNB found is
Speaker 1: not the largest five right exactly because they have some
Speaker 1: requirement about about earnings I believe, and liquidity, which I
Speaker 1: guess it should. That's another reason to write this about
Speaker 1: here you go. That was a joke, But yes, I
Speaker 1: was looking at companies that are h should have qualified
Speaker 1: based on their market gap. The other question I was
Speaker 1: gonna ask, like SNP five s companies that weren't in
Speaker 1: the SMP exactly, and it's about like thirty to forty
Speaker 1: companies that quality found a market gap segment. But for
Speaker 1: what other reason they don't? They don't match the other
Speaker 1: rules that by the SNP comedy and yeah, indeed they
Speaker 1: having to perform massively because they're not attracting the same flow.
Speaker 1: I mean, if you're not in the SMP five frontally,
Speaker 1: you don't get the spy V or flow. So you're
Speaker 1: structurally let's underbod what are some of those other names?
Speaker 1: I mean, Tesla is the weird one, but what are
Speaker 1: some other companies that, uh if you remember them off
Speaker 1: the top of your head, that are like should be
Speaker 1: almost fit the sp five hundred, but they're not quite
Speaker 1: in there. I think there's a I forget it's it's
Speaker 1: named are the big casino companies in there? Um? And
Speaker 1: I think it's it's a an anomaly where the founder
Speaker 1: owns that that that that sorts off. In the case
Speaker 1: the founder owns a bunch of the flow, then the
Speaker 1: phote requirement is not met. Okay, I'm gonna do Joe's
Speaker 1: quite And then uh, it's the age of dumb alpha.
Speaker 1: And you think that the flows into passes probably aren't
Speaker 1: ending anytime soon. So what should investors actually do? Should
Speaker 1: we just be following the herd? You know? This is
Speaker 1: how like chillions of wealth were lost, right. I think
Speaker 1: it's stupid, but everybody's doing it, so I'm going to
Speaker 1: do it anyway, right, I mean, this is how you
Speaker 1: get the you know, if you pay a lot of
Speaker 1: money for two leaps or the you know, the Dutch,
Speaker 1: the south Sea company. So it feels horrible to say that.
Speaker 1: I think eventually, I don't know when, I don't know how.
Speaker 1: But markets have a way of fixing things that are unsustainable.
Speaker 1: I mean, things that are unsustainable cannot last forever um,
Speaker 1: So you know, I think over the long term, if
Speaker 1: what we're describing is indeed happening, what this means is
Speaker 1: that the expected return on on these you know, over
Speaker 1: own stock is gonna fall, and the expected return on
Speaker 1: the kind of small gap value that are under owned
Speaker 1: by the index crowd should be higher, DID and as
Speaker 1: a result, the return to investors should be higher. So
Speaker 1: in general, the DID the idea would be to look
Speaker 1: for uh, you know, kind of opportunities outside of the index.
Speaker 1: At the same time, I would caution that by saying,
Speaker 1: you know, you should be happy we've basically dividend deal
Speaker 1: traditional um you know, Ban Graham style analysis, and not
Speaker 1: worry about under performing the index. By well, I was
Speaker 1: gonna say, it seems like in this environment, and it's
Speaker 1: kind of um like insult to injury because we're just
Speaker 1: we're talking about all the money coming out of active
Speaker 1: and the the the pool of mutual funds that are
Speaker 1: greater than one percent fees and so forth. But it
Speaker 1: seems like in an environment like this, you really don't
Speaker 1: want to have the job of having to write a
Speaker 1: letter at the end of a quarter. So that like,
Speaker 1: if you're like a sort of normal individual investor, you
Speaker 1: can diversify. You could say, look, maybe I didn't I
Speaker 1: wasn't overweight Apple and Amazon last year, and I underperformed
Speaker 1: the SSP five hundred in a little bit in my
Speaker 1: personal account. But it's fine because it was a great
Speaker 1: year and a bunch of stuff went up, but you
Speaker 1: know that the individual doesn't have to write a letter
Speaker 1: to some other limited partners saying explaining why they underperformed
Speaker 1: or coming up with some excuse. So it kind of
Speaker 1: feels like that is a I really wouldn't like. That
Speaker 1: is not a very desirable job in this environment. They
Speaker 1: have to pick stocks um and explain. You know, it
Speaker 1: either be in this situation where you have to really
Speaker 1: lean into the megacaps and risk blowing up when it
Speaker 1: all turns around, or avoid the megacaps and underperform on
Speaker 1: the way up. No, No, I mean, indeed, it's been
Speaker 1: a pretty terrible environment for active manager research channel. It's
Speaker 1: um and it's I mean, it is probably things you
Speaker 1: can do to metigates. Did this I mean in the
Speaker 1: report I was mentioning, Uh, again, it's it's somewhat of
Speaker 1: an expensive strategy. But maybe one way to play this
Speaker 1: is too cannot have your your traditional value oriented, you know,
Speaker 1: and stick by the book and hope that eventually things
Speaker 1: fall into place and I own good company that I
Speaker 1: understand and I do my DCF work and all that
Speaker 1: good stuff that's been completely useless for ten years. And
Speaker 1: at the same time to hedge against the risk of
Speaker 1: this kind of blow off top by co options on
Speaker 1: the big names. I mean, one worry that I have
Speaker 1: is that this rotation would actually accelerate partly as as
Speaker 1: people open up their r and statement in I think,
Speaker 1: you know, a lot of the money that's invested in
Speaker 1: in these um hi fi muture from this kind of
Speaker 1: sticky money that has been then forever, you know, great
Speaker 1: years in the nineties. People don't really know how much
Speaker 1: are paying that, but then like if they realize, I mean,
Speaker 1: two thousand nineteen was so brutal. I mean because basically,
Speaker 1: if you didn't have Apple of Microsoft, I me're gonna
Speaker 1: be up like you know five. You know, you know,
Speaker 1: when the market is of thirty five, that kind of
Speaker 1: delta could be the kind of thing that you know,
Speaker 1: I'm giving up And I worry that. And you can
Speaker 1: certainly see that in the first weeks of the year
Speaker 1: when basically you had UM I think Google was up,
Speaker 1: like app of Tla was even even out of this world.
Speaker 1: But it could have been just people opening the say okay,
Speaker 1: I dumb, this guy, let me go in the index,
Speaker 1: and that rotation actually accelerating in some sort of a
Speaker 1: feedback loop right, trade about the virtuous cycle, but this
Speaker 1: is the vicious cycle. Yes. For so I alluded to
Speaker 1: this in the intro, which is basically that there is
Speaker 1: a strain of thought that if passive investing is misallocating
Speaker 1: capital in some way, then it poses a giant question
Speaker 1: mark over the economy and the way capitalism works in general.
Speaker 1: What's your view of that particular argument. Is there a
Speaker 1: particular area where you see passive investing misallocating capital and
Speaker 1: impacting the economy in a negative way? But I think
Speaker 1: you see it anecdotally in you know some E t
Speaker 1: F related distortions. I think there was one like last week.
Speaker 1: It was a a high dividende of stock that was
Speaker 1: owned by a high diven in E t F. I
Speaker 1: forgot to take it right now, but and then the
Speaker 1: the stock kept getting cheaper or the division increased, and
Speaker 1: then it nonger met the market gap requirement of the
Speaker 1: t F. So the phone hat told dump it, and
Speaker 1: that result in a kind of a really large down
Speaker 1: there for a stock that was actually doing well. And
Speaker 1: you can find many of these uh distortion. You see
Speaker 1: it also in the gold minor et F, for example,
Speaker 1: the junior gold minor et F owning the senior gold
Speaker 1: minor ITTF because there's not enough shares to buy UM.
Speaker 1: So you know, and you know these are anecdotes, but
Speaker 1: it tells you that this this starts to matter in general. Um.
Speaker 1: You know, the question is what is the tipping point
Speaker 1: for for the passive share? I mean you can almost
Speaker 1: think as a almost like a Laugher curve, you know,
Speaker 1: like if you if you tax people up to a
Speaker 1: certain point, then you revenue start decreasing as the passive
Speaker 1: share arise and economic efficiency starts starts to to be suffering.
Speaker 1: The first that point you need for that is, okay,
Speaker 1: what is the actual passive share? Um? And And it's
Speaker 1: a hard one to answer, going back to your first question,
Speaker 1: like what is passive if you just go by you know,
Speaker 1: adding UM then Guard, black Rock, and State Street. I
Speaker 1: think it's about of the market, uh, for the the
Speaker 1: average stock. Basically that the third larger the three larger
Speaker 1: shareholders for most stocks are in that order, Van Guard,
Speaker 1: black Rock, State Street. It's probably even at higher because
Speaker 1: you have a lot of This company is also of
Speaker 1: index replications. They're not explicitly index poons, but they replicate
Speaker 1: the index ferences clients. You you don't see that money
Speaker 1: into the trading vehicle, but it is act So my
Speaker 1: understanding is close to forty percent in terms of the
Speaker 1: ownership of of the US equity market, and probably when
Speaker 1: it comes to trading and flows, which I think matters most,
Speaker 1: because that's where price discovery is set right. Price is
Speaker 1: discovered by people trading with one another. So even though
Speaker 1: the ownership share is just if you know, trading at
Speaker 1: the end of the day is driven by by passiving vehicles,
Speaker 1: you get to this potential problem that the price discovery
Speaker 1: mechanisms do not work well. On that uh, on that
Speaker 1: cheery note of our price discovery mechanisms ceasing to work. Vincent,
Speaker 1: thank you very much for joining us. It was great.
Speaker 1: Thank you so much for having me. Thanks Vincent, that
Speaker 1: was really good. Tracy. I really feel like this is
Speaker 1: just gonna be a bigger and bigger topic. One thing
Speaker 1: that has come up recently that we haven't even talked
Speaker 1: about since we've explored the effect of index funds and
Speaker 1: passive investing is all like the antitrust angle, and of
Speaker 1: course that's becoming a bigger and bigger deal. This idea,
Speaker 1: as Vincent pointed out, like, Okay, if every company is
Speaker 1: owned by that same basket of like three investors, more,
Speaker 1: there's more and more scrutiny just on the question of,
Speaker 1: like what does it even mean for the companies to
Speaker 1: compete with each other anymore? Yeah, I think we need
Speaker 1: to get Matt Levine on again to talk about that
Speaker 1: particular angle. But I know that's yeah, that's one of
Speaker 1: his big that's one of his recurring themes in his newsletter. Yeah, exactly.
Speaker 1: But one of the things that really interests me from
Speaker 1: that conversation is the notion of how all of this
Speaker 1: is actually influencing the wider economy. And I keep thinking
Speaker 1: about deflation and you know, the mystery of missing inflation
Speaker 1: of the past ten years or so, and you can
Speaker 1: kind of see if markets are funneling money in an
Speaker 1: inefficient way or doing it in a way that means
Speaker 1: the biggest players just keep getting bigger, and those players
Speaker 1: have more and more pricing power, market more ability to
Speaker 1: dictate wages. That that might be one reason why, for instance,
Speaker 1: wages are staying so low. Yeah. Absolutely, there's all kinds
Speaker 1: of sort of interesting ramifications. Hearing Vincent describe that feedback loop,
Speaker 1: the incredible natural competitive advantages of the two d companies
Speaker 1: are so headquartered in Silicon Valley or the Bay Area,
Speaker 1: tons of different avenues to explore about just the incredible
Speaker 1: amount of money that's accruing to a fairly uh small
Speaker 1: group of players. There's one other thing that I really
Speaker 1: like about Vincent's research and the way he's approaching this topic,
Speaker 1: which is that he's looking at investor behavior and he's
Speaker 1: looking at it on a relative basis. So of course
Speaker 1: it's not enough to have you know, five percent returns
Speaker 1: in a given year if someone else is up ten percent, right,
Speaker 1: which I think is reflective of how most people actually
Speaker 1: think and view their portfolios. And certainly you saw Donald
Speaker 1: Trump do this, uh not too long ago, where he
Speaker 1: was talking about the stock markets up and your portfolio
Speaker 1: is only fifty up? What have you been doing wrong?
Speaker 1: And I think that's also a point that sort of
Speaker 1: missed in a lot of the analysis here. Yeah. No,
Speaker 1: I love that point about the sort of sticker shock
Speaker 1: at the beginning of the year, because all anyone heard
Speaker 1: is such an amazing year for this not market, one
Speaker 1: of the most incredible ones on record. But there are
Speaker 1: a lot of investors who I don't think had such
Speaker 1: a great year, and essentially like either Okay, if you
Speaker 1: owned the spy, you matched it. But you know, if
Speaker 1: you like had any sort of normal diversified portfolio of equities,
Speaker 1: unless you happen to be like a really long Apple
Speaker 1: and Microsoft, you're looking at your portfolio or you look
Speaker 1: at your manager and what do you what's wrong? And
Speaker 1: it could be the type of year or if you know,
Speaker 1: as that dispersion between the biggest and the rest grow
Speaker 1: so big, as he points out, that could be a
Speaker 1: catalyst for even more acceleration from UM from active to passive.
Speaker 1: So you know, kind of like we were saying, it's
Speaker 1: a it's a tough time obviously an active management sympathy
Speaker 1: for the fun managers, that's for sure. I need to
Speaker 1: write another song about I should write a song about that.
Speaker 1: Do it for our next live episode? Wait? Is it
Speaker 1: going to be a Rolling Stones cover? No? I gotta
Speaker 1: write a new I gotta I gotta write a new one.
Speaker 1: I gotta create something totally originally. Fine, Okay, well, we
Speaker 1: look forward to that. This has been another episode of
Speaker 1: the All Thoughts podcast. I'm Tracy Halloway. You can follow
Speaker 1: me on Twitter. At Tracy Halloway and I'm Joe Wisn't all.
Speaker 1: You could follow me on Twitter at the Stalwart, and
Speaker 1: be sure to follow Vincent on Twitter. He's at Vincent Delard.
Speaker 1: Great follow there. Be sure to follow our producer on Twitter,
Speaker 1: Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg
Speaker 1: head of podcast, Francesca Levy. She's at Francesca Today. And
Speaker 1: for the whole family of Bloomberg podcasts, you can find
Speaker 1: them all under the handle at podcasts. Thanks for listening.