Speaker 1: Welcome to a Trilliance. I'm Joel Wepper and I'm Eric
Speaker 1: call Tunics. So Eric and all of our time together,
Speaker 1: I think I've missed only a couple interviews and this
Speaker 1: was one of them, which I'm bummed about because you
Speaker 1: went into a research territory and uh and and talk
Speaker 1: to somebody about UM indexing. And I always like to
Speaker 1: know more about this space because it's not maybe directly
Speaker 1: linked to sort of takeaway investment advice, but it informs
Speaker 1: how e t f s are structured and how investors
Speaker 1: might need to think about the space overall. So joining us, um,
Speaker 1: Joining you on this episode of Trilliance was Martin Schmalls,
Speaker 1: who's a professor at the University of Oxford's Business School
Speaker 1: where he teaches finance and economics. He recently wrote a paper.
Speaker 1: CO wrote a paper index funds, asset prices and the
Speaker 1: Welfare of Investors. Why did you want to talk to him? Yeah, UM,
Speaker 1: passive is growing. Ets taken all this money, index fense
Speaker 1: taken all this money, and people like to study them. Um.
Speaker 1: People have been commenting on the rise of passive in
Speaker 1: the worries. You know, it's a whole chapter in my
Speaker 1: vocal book. Some worry and there's been all these worries
Speaker 1: and UM, this particular person I've met over Twitter and
Speaker 1: we've debated a little bit. Nice guy, UM, really smart.
Speaker 1: I think between the two of us, he brings up
Speaker 1: our average i Q about fifteen points. As you can
Speaker 1: see from his credentials, he knows what he's doing and
Speaker 1: he's studied in his latest paper, the idea that index
Speaker 1: funds might even be too good for their own good
Speaker 1: because they're so good and cheap. They're basically allowing more
Speaker 1: people to come into the market and that is going
Speaker 1: to decrease expected returns in the future, which UM is
Speaker 1: to the it doesn't benefit anybody going forward. It's sort
Speaker 1: of like bad for the common good. And this is
Speaker 1: one of a couple other common good arguments UM that
Speaker 1: have been made by academics. So we also discussed common ownership,
Speaker 1: which is another one which we'll go into. I won't
Speaker 1: you know ruin it now, but basically, if you are
Speaker 1: an next funder passive owner, UM, you know what what
Speaker 1: is happening with your money? Like, what are the larger
Speaker 1: ripple effects and implications? Is there anything to worry about?
Speaker 1: Do we need public policy on this and that's what
Speaker 1: we explored, and we covered a lot. You know, I
Speaker 1: know you weren't here, but we I must have asked
Speaker 1: them twenty questions. We delved into it and the deep weeds.
Speaker 1: This is probably why you're needed on this show, because
Speaker 1: I don't think we would have got as deep maybe
Speaker 1: for this episode. It was a good thing though, because
Speaker 1: we really nerded out. But I will say he was
Speaker 1: real good about being short with his answers so he
Speaker 1: doesn't go on and on. It's a it's a nice
Speaker 1: back and forth about several of these sort of concerns
Speaker 1: over the rise of index funds and passive. I think
Speaker 1: you'll enjoy it, especially if you're anybody at all interested
Speaker 1: in how markets work. Is famine Trillians Martin Schmall's alright,
Speaker 1: So Martin, welcome to the show. We've never met in person.
Speaker 1: We've interacted on Twitter here and there, and I've gotten
Speaker 1: to know you a bit over the years through digitally,
Speaker 1: I guess. So it's nice to have you on and
Speaker 1: finally meet you. And I think we have the you know,
Speaker 1: pretty nice civil debates on this, as I do with
Speaker 1: many other people. This concept of passive is a is
Speaker 1: a concept that is studied, because it's getting bigger and bigger.
Speaker 1: As you know, I tend to write off most of
Speaker 1: the worries. A lot of them come from active managers.
Speaker 1: You're an academic, so I think that gives you some
Speaker 1: objectivity that I would give you a little more attention.
Speaker 1: There's a couple issues we're going to bring up. Let's
Speaker 1: go over your latest paper, though, just give me the
Speaker 1: what's it called? Like, what is this sort of thesis called?
Speaker 1: And what is it? What is the worry here that
Speaker 1: you're looking at UM? So the papers called index funds,
Speaker 1: as at prices and the welfare off investors. And I
Speaker 1: wouldn't say that we're looking at a particular warrior. We
Speaker 1: didn't start with the warrior. We started with a question,
Speaker 1: and the question is simply how indexing textbook indexing, you know,
Speaker 1: holding the market portfolio UM would affect the level of
Speaker 1: S prices and how that would affect investor welfare. So
Speaker 1: that's what we started out with. And I suppose one
Speaker 1: could say that it leads to a warrior. I would
Speaker 1: just call it a result, which is that it raises
Speaker 1: a surprices the level of a survices and thereby reduces
Speaker 1: expected returns. That's the baseline of the finding. So Matt Levine,
Speaker 1: who's got away with words, who many people know rich
Speaker 1: for Bloomer opinion. Here's how he put it. An index
Speaker 1: fund is a good way to hold stocks. It has
Speaker 1: low fees and offers their versification. Therefore, if index funds
Speaker 1: are easy and cheap, more people will invest in the
Speaker 1: stock market. Then if there were no index funds, this
Speaker 1: will push up the price of stocks, pushing down their
Speaker 1: expected returns, and therefore index funds are bad for investors.
Speaker 1: So that is exactly accurate. Um, I think pretty much
Speaker 1: every step of the way here should be obvious and
Speaker 1: mostly un arguable, except the last. Perhaps the last one
Speaker 1: at least was not obvious to me, and it's still
Speaker 1: not to present obvious to me. That is just what
Speaker 1: the computer simulations spit out. So bad for investors in
Speaker 1: this case means reducing welfare of investors. That's a welfare
Speaker 1: part in the title. So I totally agree with the
Speaker 1: characterization of Matt Levin that the product. Well, let me
Speaker 1: ask you this, then, is this really an index fund issue?
Speaker 1: Mutual funds were introduced a hundred years ago. You could
Speaker 1: argue they brought in a ton of investors, and up
Speaker 1: until the late nineties of active mutual fund assets or
Speaker 1: mutual fund assets was an active funds. So was that
Speaker 1: a similar issue? Then, like why is it index funds
Speaker 1: and not mutual funds in general? So this is fair
Speaker 1: what you're asking here, and um, there's no distinction in
Speaker 1: the model between an active fund or UM an index fund.
Speaker 1: In fact, there are no active funds in the model.
Speaker 1: The only thing that matters is whether it has become
Speaker 1: cheaper to hold a diversified portfolio. And that's obviously what
Speaker 1: index funds do, and much more successfully than active funds,
Speaker 1: which is you know why I hold inext funds. So
Speaker 1: if active funds had similarly brought down the cost of
Speaker 1: holding a diversified portfolio, they would also riise UM and
Speaker 1: enterprises and thereby reduced returns and as a result of
Speaker 1: reduced investment welfare. So in some ways it's really about financialization. Um,
Speaker 1: then about index fense. I think that's fair. So I
Speaker 1: guess we already concluded that it's not about passive versus
Speaker 1: active as much as much of the debate about passive
Speaker 1: investing really is. So a natural reaction to this would
Speaker 1: be well, some people argue not enough people are invested,
Speaker 1: like here in America only fifty of the population has
Speaker 1: any exposure to stocks and bonds, right, And this is
Speaker 1: added to the wealth gap because you know, you're getting
Speaker 1: that equity market premium and the income from bonds. And
Speaker 1: so as someone who replied to me on Twitter at
Speaker 1: economic he said this, why is it better for people
Speaker 1: to be investors in steef twelve percent return then for
Speaker 1: fifty people to be investors and receive eight percent return?
Speaker 1: I would almost go further and say, well, what about
Speaker 1: a percent investors? Like I guess your thesis almost seems
Speaker 1: like you're rooting for only some people to be invested.
Speaker 1: That's that's a really that's a brilliant question. This is
Speaker 1: really really good. Where do we start? So, first of all,
Speaker 1: it is true that without cheap index funds, you would
Speaker 1: mostly get the very rich and least risk averse people
Speaker 1: to hold the equities, and they would get them for cheap, right,
Speaker 1: because the returns are high because nobody else is buying them,
Speaker 1: And indeed that would lead to a widening of wealth
Speaker 1: and equality. And that is true in the model as well.
Speaker 1: And as you make holding a diversified portfolio cheaper, say
Speaker 1: by the introduction of an index fund, say, um, more
Speaker 1: people invest, And you're exactly right that this actually reduces
Speaker 1: the difference between the expected well of the very rich
Speaker 1: and the middle class. It reduces wealth inequality. So what
Speaker 1: I thought the intuition was going to be of this
Speaker 1: model is that the very rich get harmed by the
Speaker 1: introduction of index funds, but the middle class and you know,
Speaker 1: the poor would actually benefit. But it just turns out
Speaker 1: that this is not the case. It just turns out
Speaker 1: that the middle class had held a much smaller fraction
Speaker 1: of stocks to start with. They also get hurt, and
Speaker 1: get hurt enough by the reduction, and they expected returns
Speaker 1: that on net, they don't actually benefit. And that's a
Speaker 1: surprising part of the result. I'm not sure I like it,
Speaker 1: but that's what the math says. Are you sort of
Speaker 1: saying that index funds or mutual funds in general, especially
Speaker 1: as they get cheaper and cheaper, which again I just
Speaker 1: wrote a book about this called the Bogel Effect. I
Speaker 1: do think that high cost to low cost is the
Speaker 1: real trend, because in mutual funds to ETFs, passive to active,
Speaker 1: there's a lot of gray area there, but high cost
Speaker 1: to low cost, which I think I give Vanguard and
Speaker 1: Bogel a lot of credit for ushering that in. Is
Speaker 1: like everywhere, and clearly the lower thing cost things get,
Speaker 1: the more people will use them. I totally agree. I
Speaker 1: guess my question is, are you sort of saying that
Speaker 1: the cheaper and easier that things get or access points,
Speaker 1: the people who come in later, like in a Ponzi
Speaker 1: scheme are going to get the worst returns than the
Speaker 1: rich people who were already in here. I understand where
Speaker 1: your tradition intuition comes from, but it's not exactly what
Speaker 1: the model says. So first of all, the model is static,
Speaker 1: so there's no such thing as early investors and late investors.
Speaker 1: There's just a comparison bit between. If today you asked
Speaker 1: investors or you measured whether they would be better off
Speaker 1: UM without index funds compared to index funds costing zero,
Speaker 1: the answer would be yes, it would be better off. Okay,
Speaker 1: So it's a comparison within time. It's sort a comparison
Speaker 1: over um time. So there's no Ponzi scheme here in
Speaker 1: the sense of bubble building. It's just a boring statement
Speaker 1: about the level of asset prices being higher, so I think.
Speaker 1: But what I should explain in though, is what what
Speaker 1: exactly I mean by investors being better off without index funds,
Speaker 1: or that index funds harm investor welfare. So let me
Speaker 1: be very clear, for every individual who learns about index
Speaker 1: funds and ditches holding individual stocks and or active expensive
Speaker 1: funds and buys cheap index funds, that's good for them,
Speaker 1: There's no question about it. That's we explained that very
Speaker 1: clearly in the paper. It's a very different statement to
Speaker 1: say investors overall as a group would they be better
Speaker 1: off and the entire distribution of investors would they be
Speaker 1: better off if no index funds were around. So this
Speaker 1: is like a tragedy of the commons problem, right, So
Speaker 1: where you have you have a common resource um that
Speaker 1: gets depleted I don't know whatever fish, atlantic salmon or
Speaker 1: I don't know what, like not farm raised salmon, and
Speaker 1: if left to its own devices, um, individual fishermen will
Speaker 1: buy big, big, big ships and deplete the resource and
Speaker 1: it'd all be better off if there were restrictions on
Speaker 1: the side of ships or the size of the fleet.
Speaker 1: And it's similar in this case. I'm not saying it's
Speaker 1: stupid for an individual to buy index funds. Um. I
Speaker 1: preach um since decades, and I live what I preached
Speaker 1: by buying index funds myself. But that doesn't mean that
Speaker 1: overall it's good for investors that they're around. That is
Speaker 1: really interesting, and I'm glad you admitted that, because that
Speaker 1: was gonna be one of my questions. I have found
Speaker 1: a lot of times you you get a lot of
Speaker 1: attention if you say indexing and passive is going to
Speaker 1: be a bubble, or it's a worry. The press will
Speaker 1: cover you. It's just like any other worry. People who
Speaker 1: worry get a lot of press coverage. So but when
Speaker 1: you add, when you actually ask them what do you hold,
Speaker 1: they'll say index funds, and I'm like, well, then you're
Speaker 1: part of the problem. Or because here's my big question
Speaker 1: is let's just say people listening or I agree with
Speaker 1: this premise, and we all kind of come to the
Speaker 1: inclusion that index funds probably should be somehow curbed. Nobody
Speaker 1: that holds index funds, I can pretty much say them
Speaker 1: is willing to take one for the team and jump
Speaker 1: over to a eighty basis points blend active mutual fund
Speaker 1: for their kids education. They want that money for them.
Speaker 1: So I think part of the issue is, and this
Speaker 1: is like to get your take on this, When Vanguard
Speaker 1: came out in the seventies and they started lowering fees
Speaker 1: over the next forty five years, Active mutual funds didn't.
Speaker 1: They didn't share any economies of scale. And when the
Speaker 1: world kind of turned and the Internet really spread information
Speaker 1: and Vanguard got below ten basis points man that caused
Speaker 1: this frenzy of money to move over to indexing, and
Speaker 1: it was like Active was so far behind at that
Speaker 1: point they they just missed it completely and got disrupted
Speaker 1: by Vanguard big time. And so what you're I think
Speaker 1: experiencing here is just an industry that that failed to
Speaker 1: see what was coming and recognized an opportunity. But we
Speaker 1: are seeing Active lower their fees. So as Active gets cheaper.
Speaker 1: In et F last year, they took in fourteen percent
Speaker 1: of the flows but all went to pretty low us Active.
Speaker 1: So I think the Vogel effect or Vanguard effect is
Speaker 1: actually one that could help solve this because Active gets
Speaker 1: cheaper and more appealing because a lot of people are
Speaker 1: fans of Active, just not the cost, and so as
Speaker 1: it gets lower, you might find a little more balance.
Speaker 1: What do you say about that, like just sort of
Speaker 1: let letting the market figure this out. Well, so I
Speaker 1: agree with um basically everything you said in that Vanguard
Speaker 1: is a cost leader, a price leader is responsible for
Speaker 1: the depression of fees, and every single investor is happy
Speaker 1: about that, right because every single investor has to has
Speaker 1: to pay these fees. Now, if it leads to active
Speaker 1: funds also becoming cheaper, well, that leads to more stock
Speaker 1: market participation. And as we discussed a few minutes ago,
Speaker 1: of course it's desirable on many levels because it's going
Speaker 1: to reduce wealth inequality, right, but it will not solve
Speaker 1: the problem of the essetprises being high and the return
Speaker 1: is being low because it doesn't need to more companies
Speaker 1: producing higher profits for for shareholders. It's just a greater
Speaker 1: sharehold rebays sharing these profits. And again, if you're if
Speaker 1: you just want to reduce wealth inequality, I'm all with you.
Speaker 1: And that's what the model indeed predicts that index fund's
Speaker 1: helped reduce wealth inequality and expected wealth, but every single
Speaker 1: one of the investors is still worse off. They'd be
Speaker 1: better off with the with the ad basis point mutual
Speaker 1: fund from the ninety eighties in terms of their risk
Speaker 1: return trade off compared to everybody else. Right, So the
Speaker 1: resolution of the apparent paradox is, yes, nobody is willing
Speaker 1: to give up their zero percent index fund for an
Speaker 1: ad basis point active fund, except if everybody else would
Speaker 1: do it too. And that's a statement, right, So it
Speaker 1: is not about individuals are being irrational. It is about
Speaker 1: investors as a group are harming each other by driving
Speaker 1: up the asset prices. But they're acting out of their
Speaker 1: self interest though, which it has everybody excerationally, but it
Speaker 1: has to be that way. So this expected return, right,
Speaker 1: is that also just part of the FED, right. The
Speaker 1: FED and central banks around the world kept rates very low,
Speaker 1: did qui Asset prices lifted probably beyond what valuations, you know,
Speaker 1: what earnings would suggest, and it created a little bit
Speaker 1: of a FED bubble. A lot of people thought this
Speaker 1: was the passive bubble. I said, no, it's a FED bubble.
Speaker 1: And they associated the rise of the last fifteen years
Speaker 1: with all the index funds. But now that bubble is broken,
Speaker 1: the FED is hiking. For the past year and a half,
Speaker 1: people still buying index funds, but the market's going down.
Speaker 1: Clearly index funds were not enough to wag the dog
Speaker 1: or anything, and stocks are all over the place. There's
Speaker 1: plenty of dispersion, so I think the hiking sort of
Speaker 1: show that the markets acting pretty much as it does.
Speaker 1: But I guess my bigger point to you is, is
Speaker 1: the expected return being low really more of a function
Speaker 1: of the FED and their policy over the past fifteen
Speaker 1: years rather than just the rise of index funds? Yeah?
Speaker 1: Probably yes, so Uh. The paper does not have the
Speaker 1: addition to try and explain the reasons for declining the
Speaker 1: expected returns or argue that this is primarily driven driven
Speaker 1: by nix fins. The The ambition is really just to
Speaker 1: understand what the effect of indextend an asset prices is,
Speaker 1: and I think probably also shift our thinking on how
Speaker 1: we think about certain policy tradeoffs, such as you know,
Speaker 1: people thinking that indexing necessarily benefits investors, but then there
Speaker 1: might be side effects, and maybe to rein in the
Speaker 1: side effects we would have to harm investors. And this
Speaker 1: is how the tradeoff and the policy debate gets and
Speaker 1: gets characterized. And what this paper shows, um, but the
Speaker 1: math shows is just that this is probably not the
Speaker 1: right way of thinking about it, because it's less than
Speaker 1: perfectly obvious that cheap diversification even benefits investors as a group.
Speaker 1: Of course, it benefits every individual investor, but it's not
Speaker 1: clear that it benefits and as a group. So one
Speaker 1: thing I think that you're talking about and that I
Speaker 1: see in the flows and I want to get your
Speaker 1: take on, is it seems like we're going to move
Speaker 1: into this new world where passive takes up the core
Speaker 1: of most portfolios, and then people are going to look
Speaker 1: for something that's very, very different than passive to sort
Speaker 1: of decorate with almost like adding a little hot sauce
Speaker 1: and otherwise boring meal. This is the lane that like
Speaker 1: Cathy Wood lives in an arc even crypto um. And
Speaker 1: I think active managers over time are either gonna have
Speaker 1: to get cheap or shiny. They're going to have to
Speaker 1: be really producing some high returns two A attract investors
Speaker 1: attention and be get used as a compliment. And so
Speaker 1: could you argue that over time that active slice will
Speaker 1: start to produce some really big winners and you will
Speaker 1: see some money go to those more active active managers,
Speaker 1: and the net result will be a rooting out of
Speaker 1: the bad managers giving money to the good ones, um,
Speaker 1: and you still will have active setting prices. Is there
Speaker 1: anything wrong with that world. I don't see that there's
Speaker 1: anything particularly wrong with that world. Nope. I think that's
Speaker 1: that's probably a reasonable prediction. But I would have to
Speaker 1: admit that I have not done a whole lot of
Speaker 1: research on how enterprises get set when active and passive
Speaker 1: managers coexist. I find that that distinction I think you
Speaker 1: alluded to it. I find that distinction not super useful
Speaker 1: these days. Whereas you know, it qualifies as a passive
Speaker 1: fund to follow an index that is a bespoke index
Speaker 1: just designed to follow a particular portfolio. And so when
Speaker 1: when I say passive, I really mean, you know, market
Speaker 1: level indexing like in the textbook, which is different from
Speaker 1: what passive means in in the real world these days.
Speaker 1: But just to be clear, I think what has happened
Speaker 1: because the S and P isn't even passive. I mean
Speaker 1: there is run by a committee. Um, there's rules, and
Speaker 1: then you get to other indexes like the Russell one
Speaker 1: thousands a little different. I mean, I think really your
Speaker 1: point is more about just people in funds rather than
Speaker 1: you know, people buying funds today holding them because they're
Speaker 1: cheap and good rather than passive and active. Um yeah,
Speaker 1: I think so, yeah, very much. The true benchmark would
Speaker 1: be you holding a market value waited portfolio of all
Speaker 1: the world's risky assets, right, And I think we can
Speaker 1: all agree that the S and P five is not
Speaker 1: that Not even you as equities is that, right. So
Speaker 1: in theory you have to have exposure to Chinese real
Speaker 1: estate or I don't know what, right, So this is
Speaker 1: true passive in the textbook, and anything that's labeled passive
Speaker 1: these days is very far removed from that. So for
Speaker 1: for that reason alone, I don't think a lot of
Speaker 1: the headline discussion and the public discussion about passive verse
Speaker 1: effective makes a whole lot of sense, because look, if
Speaker 1: I build a portfolio of passive funds, but every of
Speaker 1: these passive funds contains one stock, then this is literally
Speaker 1: the same thing as active investing. So I don't think
Speaker 1: that that these labels are as meaningful as they perhaps
Speaker 1: used to be fifteen years ago. I agree, Um, there's
Speaker 1: just too much gray area. I still use it because
Speaker 1: you have to communicate quickly sometimes, but that's very totally
Speaker 1: That's why I again I go back to our phrase
Speaker 1: the great cost migration. Most of this is just high
Speaker 1: cost low cost. What makes pass passive was ninety basis points,
Speaker 1: it would be fringe at best. Um, it's because it's free.
Speaker 1: That's why it's a big deal. Um, let's let's move
Speaker 1: to to what should be done here? I mean, is
Speaker 1: there any real solution here or is it just Hey,
Speaker 1: there's more people invested. The FED lowered rates for fifteen years.
Speaker 1: It's created It created a little bit of a of
Speaker 1: a bubble. And now look, returns are gonna be low
Speaker 1: for a while because of the you know, sort of
Speaker 1: a return to the mean, Like you can't escape the mean,
Speaker 1: so you're gonna have lower turns. Is that generally the take?
Speaker 1: Or is there a way to solve this? So I
Speaker 1: don't think that there is immediate policy implications from this paper,
Speaker 1: but rather that we should think of it as a
Speaker 1: stepping stone to towards thinking more accurately about what other
Speaker 1: policy tradeoff should be about. So, um, you know, I
Speaker 1: did a bunch of research on how diversified ownership of
Speaker 1: firms might affect competition, and these policy trade offs look
Speaker 1: completely different. Um, once you endotonize, a survises, So what
Speaker 1: I mean by that is once you take it into
Speaker 1: account the effect of diversified ownership on asset prices, then
Speaker 1: if you basically ignored that link. So I don't think
Speaker 1: the paper itself has a problem that needs to be
Speaker 1: solved and therefore no policy implications, but I think it
Speaker 1: informs how we should think about other side effects that
Speaker 1: people have debated in passive. So let's talk about one
Speaker 1: of those, which you wrote about and I covered in
Speaker 1: my book as well, which is called common ownership, which
Speaker 1: is very communist, communist side term. That's basically I'll summarize it.
Speaker 1: You correct me um or clean clean it up at all. Okay,
Speaker 1: So common ownership. What this says is that like, hey,
Speaker 1: if if index funds own, say all of the airlines,
Speaker 1: or they own all the carmakers, there's a vested interest
Speaker 1: or a motivation for those all those car companies two
Speaker 1: raise prices because if you own them all, there's no
Speaker 1: reason to care about who wins or loses. You want
Speaker 1: them all just to have higher prices. And that's the
Speaker 1: danger of having only a few firms, especially diverse. But
Speaker 1: index funds owned, say of each stock. Is that about right?
Speaker 1: That is about right? This is not this is not
Speaker 1: terribly wrong. But let me point out to two things
Speaker 1: that we could gain an even more nuanced understanding about.
Speaker 1: Then perhaps I will also offer you my story of
Speaker 1: what I think is going on. So the first part
Speaker 1: is about index funds. The research I did does not
Speaker 1: single out index funds at all, has really nothing to
Speaker 1: do with index funds. So we call a common ownership.
Speaker 1: But what we mean by that is simply a measure
Speaker 1: of the extent to which, um, the largest and most
Speaker 1: influential investors of one firm also hold the competition, whether
Speaker 1: that's index funds or whether it's Bill Gates family office,
Speaker 1: or whether it's Berkshire Headaway. UM. We don't make a
Speaker 1: distinction in that paper about that, right, And empirically, I'm
Speaker 1: sure the listeners of this podcast have noticed that Warren
Speaker 1: Buffett was one of the largest or actually the largest
Speaker 1: shareholder of whole bunch of airlines until the pandemic hit
Speaker 1: UM and he's clearly not an index fence, right. So
Speaker 1: that that is the first piece of nuance that it's
Speaker 1: really not about index funds at all, but the public
Speaker 1: commentary has very much been about it. And then the
Speaker 1: second nuance is about whether the Carmakers or airlines or
Speaker 1: what not have an incentive to raise prices once they
Speaker 1: figure out that their investors are really the same as
Speaker 1: the investors of the competition, as opposed to whether the
Speaker 1: managers simply get lazy, but the managers get lazy because
Speaker 1: they don't get monitored quite as actively as if I
Speaker 1: don't know, Elon Musk was the largest shareholder of Jeff
Speaker 1: bahos Or or Mark Zuckerberg, and therefore simply don't reduce
Speaker 1: costs quite as effectively as they otherwise wouldn't, right, And
Speaker 1: that's basically my story. My story is. Look, and I
Speaker 1: think I would think that you and I probably agree
Speaker 1: that the governance activities of Vanguard or black Rock do
Speaker 1: differ in some ways of Elon Musk's governance activities. Yeah,
Speaker 1: and that those could ostensibly lead to differences and how
Speaker 1: aggressively management costs costs. That seems kind of obvious too.
Speaker 1: That's basically the entire story. All I'm saying is that
Speaker 1: um I, Vanguard doesn't do anything. I mean, they do something,
Speaker 1: but if they did absolutely nothing to hold management accountable,
Speaker 1: then probably this firm's costs would be higher. Well, the
Speaker 1: firm's costs is the firm's costs are higher than it's
Speaker 1: going to set higher prices. So that's my story. My
Speaker 1: story is, look, index once are probably not the best. UM.
Speaker 1: You know, activists investors to hold management accountable, and you're
Speaker 1: going to see that in the firm's productivity and therefore
Speaker 1: in product prices. Okay, so it's not a giant conspiracy.
Speaker 1: Go ahead, Yeah, I agree. I agree because UM one
Speaker 1: quick anecdote here and I just love this story. Eric Posner,
Speaker 1: who did he? Did you work with Eric Posner of Chicago?
Speaker 1: I didn't work with him my home very well, but
Speaker 1: we we haven't worked together yet. So he also wrote
Speaker 1: about this, and I um went and when I was
Speaker 1: researching the Bogel book, I found a video of Jack
Speaker 1: Bogel in a little Princeton office with Bert Malchiel, Cliff Fastness,
Speaker 1: Andrew Low of m I t there was like seven
Speaker 1: or eight heavyweight thinkers in there, and Eric and Jack
Speaker 1: just wanted to talk this out because it was getting
Speaker 1: some media attention. This is like six months before he
Speaker 1: passed away. That's how hardcore Bogel was and how passionate
Speaker 1: he was towards this stuff. But I I watched the
Speaker 1: whole video. They didn't really come to any conclusion. I
Speaker 1: felt that the passive side one, but I might have
Speaker 1: been rooting for that side. I don't know. Um, but
Speaker 1: people should go just google it. It's um on the
Speaker 1: Princeton website and you can watch it and make up
Speaker 1: your own mind. But one of the things that was
Speaker 1: in there was this Gus Souter, who was c i
Speaker 1: O at the time when Vanguard was getting bigger and bigger.
Speaker 1: He was like, we've we do not collude with black Rock.
Speaker 1: We we're we're honestly trying to vote in a way
Speaker 1: that's you know, for the benefit of the of the
Speaker 1: company's long term health. And if you look, they have
Speaker 1: corporate governance teams that pay attention to this stuff and
Speaker 1: they do vote differently. Even black Rock differs from Vanguard
Speaker 1: in certain votes. Um, we've studied it. I would I
Speaker 1: would agree it's not aggressive, it's not active. So given that,
Speaker 1: you know, knowing their voting to try to keep the
Speaker 1: company honest and do a good job, you still think
Speaker 1: this common ownership is a problem. Yeah, So, um again,
Speaker 1: I agree with everything you said. Um. So, the most
Speaker 1: important part is that none of this this theory that
Speaker 1: is being discussed here really has anything to do with collusion,
Speaker 1: actually explicitly not not collusion between firms, not collusion between
Speaker 1: different types of shareholders. Whenever an industry representative talks about
Speaker 1: how they don't collude, that's a complete strong man. None
Speaker 1: of these series is about collusion. Again, the theory is
Speaker 1: just about they are probably not as active owners as
Speaker 1: other investors. So let me tell you a story, and
Speaker 1: I'm want to get your take on this. Two or
Speaker 1: three years ago, this small company called Tanger Outlets. I
Speaker 1: might even be pronouncing it wrong, that's how small this
Speaker 1: company was. There was a time when it had fifty
Speaker 1: five or sixty percent of its shares owned by index
Speaker 1: funds and ETFs. It's a long story, but this dividend
Speaker 1: fund owned because that stock was going down and it
Speaker 1: kicked out a big dividend. But Active was selling off
Speaker 1: the stock, but Passive liked the yield, so Passive ended
Speaker 1: up buying it from Active over like two years, and
Speaker 1: all of a sudden, Passive I called the I R
Speaker 1: woman and I and I asked her, you know, what,
Speaker 1: what do you think of this? Like? Is this um? Uh?
Speaker 1: She goes, I don't think of it at all. I said,
Speaker 1: she goes. I will say that the passive owners are
Speaker 1: a little less engaged. But we're trying to like make payrolls,
Speaker 1: like we're trying to make money here, We're not really
Speaker 1: we don't really care who owns us. We are we
Speaker 1: have bigger fish to fry. So isn't it true that
Speaker 1: just business and capitalism also just kind of solves this
Speaker 1: and we don't have to worry about that much? Have
Speaker 1: you talked to a Twitter employee lately? I mean, it
Speaker 1: doesn't It strikes me that the change in ownership that
Speaker 1: came with Elon Musk buying a large stick in the
Speaker 1: firm and putting a huge amount of pressure on that
Speaker 1: thing becoming profitable rather changed the cost cutting incentives um
Speaker 1: off the CEO or of the firm. No, so, I'm
Speaker 1: not saying Mega doesn't do anything. I'm saying they do
Speaker 1: less right, And perhaps a better comparison is um berta
Speaker 1: had Away. Right, So let's think of Warren Buffett. Warren
Speaker 1: Buffett occasionally by his firms and gets engaged in governance. No,
Speaker 1: so we all immediately think of Coca Cola presumably or
Speaker 1: American Express. Right, So, Warren Buffet ocation would put himself
Speaker 1: on the board. Now, let's take the other situation. Warren
Speaker 1: Buffett by is huge steaks in the three or four
Speaker 1: largest airlines in the US. Did he put himself on
Speaker 1: the board as well? And the answer is no, right,
Speaker 1: so he did not put himself on the board. There
Speaker 1: he gets less actively engaged UM with companies where he
Speaker 1: also buys the competition. And that's exactly what economic theory
Speaker 1: would predict. You simply don't have an incentive to engage
Speaker 1: strongly with one company with part of the one company's
Speaker 1: success comes at the expense of another company that you
Speaker 1: own as well. So my point as well, there's a
Speaker 1: reason Vanguard and Black Rock have governance teams, but the
Speaker 1: governance teams are nowhere close to um, you know, the
Speaker 1: intensity of the Bill Ackman or you know, any type
Speaker 1: of activist investor who's the alternative largest shareholder of the firm. So, yeah,
Speaker 1: that is something, But is it good enough? Well, I
Speaker 1: mean it's less right. And if management is held to
Speaker 1: account less actively UM, then the costs are going to
Speaker 1: be higher and the price is going to be higher.
Speaker 1: So that's it. It's a very boring story in some ways.
Speaker 1: You know, it has nothing to do with collusion, has
Speaker 1: nothing to do with evil motives. It just has something
Speaker 1: to do with incentives to engage in corporate governance and
Speaker 1: you know costs being a little higher when the shareholders
Speaker 1: basically let management room free. So with that said, you know,
Speaker 1: Vanguard and black Rock and Schwab have all announced initial
Speaker 1: pilot programs to decentralize the share voting so that it's
Speaker 1: not so centralized it's just them now. I would say
Speaker 1: that the individual voters, like the thirty million Vanguard and voters,
Speaker 1: many may just opt to have Vanguard do it, but
Speaker 1: many may opt to have a third party to it.
Speaker 1: Schwab is looking at polling just to get there where
Speaker 1: their head is at and then vote that way, because
Speaker 1: I don't think an individual investor. What's the deal with
Speaker 1: all of these proxy votes? It's really boring and time
Speaker 1: consuming and most of them are not really consequential. Um,
Speaker 1: do you think that decentralized trend could help this at all?
Speaker 1: I think you just said it right. Um. So, first
Speaker 1: of all, it's a it's an interesting question, it's a
Speaker 1: very interesting question. But if the problem is that Vanguard's
Speaker 1: governance team with the cloud of all these assets and
Speaker 1: the associated votes if they don't use that very effectively
Speaker 1: because they don't have incentives, and now you give it
Speaker 1: to shareholders that are equally diversified, but having even lower
Speaker 1: incentive and less expertise to be engaged. It's not clear
Speaker 1: that this is going to help the problem. Right, So
Speaker 1: I'm doubtful that this would be a solution to the problem.
Speaker 1: But and let's go to the problem one more time.
Speaker 1: I lam a sniff test guy, you know, and I
Speaker 1: think that matters. I haven't really seen anything that I
Speaker 1: can touch or feel that has been a byproduct of
Speaker 1: this concern. Like, it seems like competitions alive, and I
Speaker 1: haven't seen one industry where prices just got crazy. I mean,
Speaker 1: I know inflation went up recently, but that was largely
Speaker 1: a function of you know, the lockdown and the FED
Speaker 1: and whatnot. So have you seen anything specific that is
Speaker 1: a direct result of this or is it just a
Speaker 1: little too hard to measure or a little too early
Speaker 1: to measure? Yeah, So look, that's a that's the crux
Speaker 1: that theory that I'm pronouncing here that's been around for decades.
Speaker 1: It was actually a Princeton guy as well, Prince Princeton
Speaker 1: graduate who came up with that in his first job
Speaker 1: at a M I. T Um. And if you try
Speaker 1: to test that using the time series of our overall
Speaker 1: price levels higher or lower, you can't get very far right,
Speaker 1: because there's all these alternative explanations. But the claim to
Speaker 1: fame of that first paper is that we study differences
Speaker 1: in particular roots. So say you know, some airlines become
Speaker 1: more owned by say the black Rocks and bang Ards
Speaker 1: and perhaps the Berkshire Hathaways over time, so they become
Speaker 1: more commonly owned. And in the theory, that would make
Speaker 1: those and the roots where they compete set higher prices
Speaker 1: whereas other airlines don't. Right. So there's Richard Branson owning
Speaker 1: Virgin America and being behind the CEO and cost cutting
Speaker 1: and going to the media all the time promoting the
Speaker 1: products and so forth, right, And the test um the
Speaker 1: proof of the pudding of the theory here was in
Speaker 1: seeing how say, the Virgin America has compete with the
Speaker 1: Deltas in the United's of this world. And what you
Speaker 1: see very clearly there is that the prices go up
Speaker 1: when the airlines become more commonly owned, compared to price
Speaker 1: changes in routs where there's less common ownership, and the
Speaker 1: common ownership does not go up. Yeah it doesn't. That
Speaker 1: is where the proof of the pudding is. Yeah, it doesn't.
Speaker 1: The common ownership self police itself because if you are
Speaker 1: a common owner of all the airlines, you're also a
Speaker 1: common owner of, like I don't know, all of the
Speaker 1: tech company season all of the industrial companies. And if
Speaker 1: airline prices go up, then it's gonna hurt business travel,
Speaker 1: which might just end up hurting a lot of the
Speaker 1: other sectors that you own. So doesn't higher prices ruin
Speaker 1: other things? Therefore, you would, as as an index fun owner,
Speaker 1: not want that because you're you're looking after all the sectors,
Speaker 1: not just this one. Yeah. I think that's an argument
Speaker 1: that makes sense in in some cases more so than
Speaker 1: in others. Right, So airlines, most of the tickets get
Speaker 1: sold to the end, to the end consumers and not
Speaker 1: to other businesses. But you could say, well, what about
Speaker 1: oil companies. A lot of the airlines cost is oil,
Speaker 1: So what if you have common ownership between the oil
Speaker 1: companies and the air line companies. And indeed there's evidence
Speaker 1: that this leads to lower prices. So more common ownership
Speaker 1: between vertically related firms so suppliers and customers actually tends
Speaker 1: to lower prices, which is one more reason why it's
Speaker 1: really not about indexing. Right, So the problem for competition
Speaker 1: is not come from indexing, or at least nobody has
Speaker 1: shown that it does. The problem with competition comes from
Speaker 1: the same investors holding horizontal competitors. And what the overall
Speaker 1: effect on indexing or passive is on competition. Nobody has
Speaker 1: even started to properly address that. And that's actually where
Speaker 1: you know, that first paper we talked about comes in again.
Speaker 1: You know, when you look at the airlines alone and
Speaker 1: then just say look and the economy consists of a
Speaker 1: whole bunch of industries, they become more commonly owned. Let's
Speaker 1: fix the problem that's prohibit indexing. Well, let does not
Speaker 1: take into account that there are vertically related firms. It
Speaker 1: does not take into account that, hey, asset prices might
Speaker 1: go up. And here's the thing that was missing from
Speaker 1: the first paper. When asset prices are up and expected
Speaker 1: returns are low, well, uh, that actually reduces the cost
Speaker 1: of capital firms. And wouldn't that be something that potentially
Speaker 1: makes some expand output, right, And those are things that
Speaker 1: are simply not present in the economic theories um of
Speaker 1: the day, and those are just directing limitations one has
Speaker 1: to acknowledge when debating these policy proposals. So in the
Speaker 1: common ownership last question on this, is there a public policy?
Speaker 1: I know the first one you said, there's really no
Speaker 1: policy recommendation. Would you have a policy recommendation on the
Speaker 1: common ownership issue? Is like maybe, um, you can't own
Speaker 1: more than three or of the industry. I mean, would
Speaker 1: you before instituting something like that, which would also ultimately
Speaker 1: make index funds illegal. So that's a good one, right, So, UM,
Speaker 1: there are policy proposals. I'm saying I have not myself
Speaker 1: endorsed any or or made any but in the legal scholarship,
Speaker 1: the journals are full in the last five years of
Speaker 1: all the policy proposals that go from anywhere from you know,
Speaker 1: let's just take all the voting rights away from index funds,
Speaker 1: or let's say we provide a safe haven for any
Speaker 1: investor who holds less than one percent of all the firms, um,
Speaker 1: and otherwise you know, the antitrust laws apply. So other
Speaker 1: people have made these proposals, and I have, and basically
Speaker 1: for the reasons that I just that I just mentioned, Um,
Speaker 1: there's a whole bunch of open questions that I think
Speaker 1: have to be addressed. But another reason is there's much
Speaker 1: more low hanging fruit. Why why do we focus on
Speaker 1: the black rocks and the vanguards of this world? Why
Speaker 1: nobody takes any issue with Berkshire Hathaway buying in the
Speaker 1: competing airlines. Nobody raises an eyebrow or and this is
Speaker 1: a that's a literal example, Bill Gates family office buying
Speaker 1: thirty percent stakes in the publicly traded waste management companies,
Speaker 1: Like why why do we debate whether Vanguard has an
Speaker 1: effect on passive? Why we just tolerate that and not
Speaker 1: even scrutinize it. So I think the there's much more
Speaker 1: low hanging fruit. And and there's no none of these
Speaker 1: concerns that we just mentioned about vertically integrated firms and
Speaker 1: equilibrium effects and all this good stuff. We don't have
Speaker 1: to debate that when it's about a particular relatively small
Speaker 1: investor basically deliberately buying shares and competitors um, then I
Speaker 1: don't really understand why why we're putting so much attention
Speaker 1: on the big index funds. So I think there's lower
Speaker 1: hanging fruit for the policy makers than debate these structural proposals. Uh, yeah,
Speaker 1: I know those are good points. Um. And I brought
Speaker 1: these worries up with Bogel and um one of my
Speaker 1: interviews with him just before he passed away, and he
Speaker 1: addressed Eric Posner specifically that you know, you get these
Speaker 1: worries all of a sudden, they get into the New
Speaker 1: York Times, and they get written about the wrong way
Speaker 1: straw man, as you would say, and all of a sudden,
Speaker 1: you know, he specifically mentioned Elizabeth Warren sees it as
Speaker 1: something she can run on because it's like her versus
Speaker 1: the big guys, and all of a sudden, bam, you
Speaker 1: just ruined this golden goose for small investors, which is
Speaker 1: a cheap index fund. And that's the worry of the
Speaker 1: some worry articles. So so look, I'm laughing because this
Speaker 1: is where the circle closes. And that makes me a
Speaker 1: little happy. Right. The policy trade of as it is illustrated,
Speaker 1: is being thought of as diversification is good for the
Speaker 1: small investors. But if we inter emed, then we would
Speaker 1: take that away from them. And that's what's so important
Speaker 1: about the first paper, the first paper which says, wait,
Speaker 1: it's actually much less obvious than we thought whether cheap
Speaker 1: indexing is actually good for small investors. All right, So
Speaker 1: my point is I think that first paper doesn't have
Speaker 1: policy implications on its own, but it does make you
Speaker 1: think differently about the policy trade offs that are to
Speaker 1: be considered when it goes when we're talking about these
Speaker 1: other side effects, like the effects on competition. There's a
Speaker 1: lot of layers to this. You own passive, right, This
Speaker 1: is where I really like, I just want to close
Speaker 1: with this. What what what would you need to see
Speaker 1: to make you take one for the team and move
Speaker 1: over to a high cost or a higher cost active
Speaker 1: fund or something different with your money, because I think
Speaker 1: that's sort of what other people would need to see
Speaker 1: because if you, who looks right at this closest, is
Speaker 1: still in index funds, it's gonna take a whole lot
Speaker 1: more to convince anyone else to leave. No. So, um, yeah,
Speaker 1: you're not gonna get me to divest from passive until
Speaker 1: you make it expensive. Now, So that's what regulation is for. Look,
Speaker 1: I'll tell you a story of little Martin being in
Speaker 1: the grocery store when I was I don't know, seven
Speaker 1: years old, and my mom showed me how the flowers
Speaker 1: were flown in from I don't know, South America or
Speaker 1: Africa or I don't know where, and how that bad
Speaker 1: was that for the climate, and therefore we should just
Speaker 1: shun that and not buy these products and so forth. Look,
Speaker 1: what I see is that despite these effects, these efforts
Speaker 1: by my mom um to get people to not buy
Speaker 1: what is attractive to them, somehow they took over and
Speaker 1: flowers are still being grown and flown around the globe.
Speaker 1: Perhaps that's bad for the for the climate. But it's
Speaker 1: not the job of individual consumers to fix that. That's
Speaker 1: the job of policy makers. So you know, that's a
Speaker 1: broader point. But the entire structure of the problem that
Speaker 1: I'm talking about is that for individual investors, it is
Speaker 1: perfectly rational to keep buying passive funds. And that's what
Speaker 1: I do, because you know, I try to be a
Speaker 1: rational person most of the time. But that doesn't mean
Speaker 1: that it's good for you know, societies. And that's what
Speaker 1: the role of the role of policymakers is, which is
Speaker 1: why you know, I see it so critically or with
Speaker 1: so much concern when politicians lean back and go like, look,
Speaker 1: let's just hand over world world government to you know,
Speaker 1: the big asset managers. Surely they care about the world
Speaker 1: just as much as you know people do. And so
Speaker 1: I think that's just faulty logic. That is literally the
Speaker 1: role that politicians are supposed to play in an economic system,
Speaker 1: and not the investors. So I don't think the investors
Speaker 1: are to blame, nor should they change anything. The ball
Speaker 1: is in the court of the politicians here. Okay, So
Speaker 1: let's say the politicians said they reversed the Vanguard effect
Speaker 1: from forty five years and said index funds can exist,
Speaker 1: but they can be no cheaper than ninety basis points.
Speaker 1: How would you as an individual investor that hold index funds,
Speaker 1: feels like, what would your reaction to that be. I mean, look,
Speaker 1: I'm kind of rich, so I would probably still hold
Speaker 1: funds and make way higher returns, So I'd probably benefit
Speaker 1: from that policy, and you're probably among that camp as well.
Speaker 1: But well, I would feel bummed because I've looked at
Speaker 1: the numbers. If you pay even one percent more over
Speaker 1: fifty years of compounding, we're talking hundreds of thousands of
Speaker 1: dollars that go to the industry and not you. It
Speaker 1: adds up over time, and so even ninety basis points
Speaker 1: or a hundred and fifty even ten over enough time
Speaker 1: can be a lot of dollars and cents. And I
Speaker 1: think that's where if you're an individual investor who's looked
Speaker 1: at those charts, you'd be like, wow, what a bummer.
Speaker 1: Absolutely so look, um, we were on the same page
Speaker 1: on that. I just started a bunch of college savings
Speaker 1: accounts for my kids, and in Europe you do not
Speaker 1: get excess necessarily to these fantastically cheap index products. I
Speaker 1: got one for what like ad basis points from some
Speaker 1: local German bank and it makes me amazingly upset. It's
Speaker 1: basically a rip off, and I'm very upset at that.
Speaker 1: I get even more upset when I think about how
Speaker 1: many millions of German savers there are UM that are
Speaker 1: being ripped off without understanding that it could be so
Speaker 1: much cheaper. We're totally on the same page about that.
Speaker 1: But the reason for that is because um, here's a
Speaker 1: few UM you know that's called it less sophisticated or
Speaker 1: more heavily regulated UM investors that don't have access to
Speaker 1: the cheap funds, but they still suffer from the lower
Speaker 1: expected returns. So this is where the that's where the
Speaker 1: trucks comes in. Of course, everybody agrees that cheaper funds
Speaker 1: are better than more expensive funds at the same time,
Speaker 1: but if nobody else was able to invest um at
Speaker 1: such low costs, and therefore asset prices would be lower,
Speaker 1: I think a lot of people would be happy. You know,
Speaker 1: it's the same thing about houses, right, So I mean,
Speaker 1: go in the street and talk to a twenty five
Speaker 1: year old about whether they are happy or unhappy about
Speaker 1: high house prices. Look, I mean, it's it's kind of
Speaker 1: obvious that we're unhappy about that. That we spend a
Speaker 1: greater fraction of our savings on assets that have a
Speaker 1: particular dollar return. If we have to pay more for it,
Speaker 1: we're clearly worse off. Right, So if you told them, hey,
Speaker 1: let's um institute a reform that makes housing prices lower,
Speaker 1: surely they would be happy about that, even though in
Speaker 1: the face of it you can't immediately see it because
Speaker 1: made you think about the fee that you're paying, but
Speaker 1: you don't immediately understand that the equilibrium effect would be
Speaker 1: that the prices are lower and you you get to
Speaker 1: benefit from higher returns. All right, Well, Martin, we have
Speaker 1: a fun way of closing the show. Um, we ask
Speaker 1: everybody on here, what is your favorite e t F ticker.
Speaker 1: It's VT the Vanguard Total World, which is a that's
Speaker 1: total World stock index, fundily tax book indexing. That's what
Speaker 1: I do. Nice that is that is as close to
Speaker 1: pass of as you can get with an et F.
Speaker 1: So that's it. Beautiful irony here that that that's your
Speaker 1: favorite figure. It is good place to end anyway, Martin,
Speaker 1: thank you for joining us on Trillions. Thank you very
Speaker 1: much for the opportunity. Thanks for listening to Trillions until
Speaker 1: next time. You can find us on the Bloomberg terminals,
Speaker 1: Bloomberg dot com, Apple Podcast, Spotify, and wherever else you
Speaker 1: like to listen. We'd love to hear from you. We're
Speaker 1: on Twitter. I'm at Joel Weaper Show. He's at Eric Caltuness.
Speaker 1: This episode of Trillions was produced by Magnus Hendrickson. Bye