Speaker 1: Bloomberg Audio Studios, Podcasts, radio news. This is Master's in
Speaker 1: Business with Barry rid Holts on Bloomberg Radio. Hey this
Speaker 1: weekend on the podcast, I have an extra special guest.
Speaker 1: Mike Green and I have been chopping it up on
Speaker 1: Twitter arguing over passive versus active, and I thought, well,
Speaker 1: why are we wasting this on Twitter as it circles
Speaker 1: the drain. Why don't we just have a conversation in
Speaker 1: the studio about his beef with passive, Why he thinks
Speaker 1: it's a structural threat to the market, and the advice
Speaker 1: that he gave to David Einhorn about it that helped
Speaker 1: lead Einhorn to start really kicking the benchmark's butt again
Speaker 1: for the past couple of years. I found this conversation
Speaker 1: to be both interesting and surprising. Some of the things
Speaker 1: Mike said about investing, like what would you tell your
Speaker 1: friends and family to put your money into. He says,
Speaker 1: it's hard to argue against the low cost and the
Speaker 1: performance of indexing, but that doesn't mean regulators should overlook
Speaker 1: the potential threat. I'm kind of unconvinced by the argument.
Speaker 1: There have been a series of arguments over the years
Speaker 1: against passive. What makes the discussion with Green so interesting
Speaker 1: is he's the guy that identified the structural problem leading
Speaker 1: to the destabilization of the VICS. If you recall back
Speaker 1: in twenty eighteen Val mcgeddon, he was on the right
Speaker 1: side of that trade, made hundreds of millions of dollars
Speaker 1: for his firm in identifying a structural problem that was
Speaker 1: about to blow up. Now, I don't believe the market
Speaker 1: structure is subject to the same risks as a single
Speaker 1: inverse trading instrument, but he makes a really compelling case
Speaker 1: for this is important. We have to pay attention to this,
Speaker 1: and we have to understand why this is potentially a
Speaker 1: risky asset with no further ado. My discussion with simplifies
Speaker 1: Mike Green.
Speaker 2: Verry, thank you for having me.
Speaker 1: So let's start out a little bit with your background
Speaker 1: before we get into your really interesting career Wharton at
Speaker 1: the University of Pennsylvania. You're also a CFA holder. What
Speaker 1: was the initial career plan?
Speaker 2: Well, the initial career plan actually, so I grew up
Speaker 2: on a farm in northern California. My initial career plan
Speaker 2: was that I was going to go into science. I
Speaker 2: actually studied physics as a young man, and then recognized
Speaker 2: that I was not actually nearly talented enough in physics
Speaker 2: to do anything of note, and so transition, like many
Speaker 2: people did in my generation, into finance.
Speaker 1: Similar similar story. I'm always fascinating when to hear people
Speaker 1: who were great in high school at mathematics or physics
Speaker 1: and then go to university and say, oh, I'm only
Speaker 1: pretty good at that. I'm in the same camp. Camp you.
Speaker 1: You've had a fairly entrepreneurial background, not just in finance
Speaker 1: over the past decade or two, but you founded or
Speaker 1: co founded value add Software in the nineteen nineties. Tell
Speaker 1: us a little bit about that experience.
Speaker 2: Sure, so that was actually an outgrowth from my experience
Speaker 2: coming out of Wharton, And you mentioned the you know,
Speaker 2: the transition of people who tended to be skilled at
Speaker 2: math or physics into finance. We forget that there weren't
Speaker 2: personal computers on everybody's desk back then. We forget that
Speaker 2: most people didn't have the skill set around Excel et cetera.
Speaker 1: We did.
Speaker 2: Excel didn't even exist when I started. It was VisiCalc
Speaker 2: and lotus, right, and so in the nineteen nineties I
Speaker 2: developed the late nineteen eighties early nineteen nineties, I developed
Speaker 2: a skill set around valuation in particularly discount of cash
Speaker 2: flow or residual income type models. Along with a couple
Speaker 2: of peers out of the consulting industry, we built a
Speaker 2: company that was focused on valuation, initially actually targeting corporate
Speaker 2: strategic planning departments, so working with companies like PepsiCo or
Speaker 2: others that were looking to either divest business units or
Speaker 2: to make acquisitions and needed to have mechanism to think
Speaker 2: about the valuation of these. That's what value added Software
Speaker 2: was originally. It also was the path for me into
Speaker 2: the asset management space because coincidentally, Mitch Julis of Canyon
Speaker 2: Partners was researching on the Internet in the early days
Speaker 2: of the Internet for valuation engines and insights, stumbled across
Speaker 2: our stuff and reached out and said, hey, could you
Speaker 2: link this to the public equity databases like compustats so
Speaker 2: we could use it for valuing stocks. That actually is
Speaker 2: exactly what we ended up doing. We were one of
Speaker 2: the last to get what's called the value added license
Speaker 2: to the Compustat database, and so that then led to
Speaker 2: the sale of that business in the late nineteen nineties
Speaker 2: to Credit Swiss, And.
Speaker 1: Then you end up actually at Kenyon Capital. Previously I
Speaker 1: had Dominic Neil as a guest. But you stood up.
Speaker 1: They're an LA outfit. You stood up the New York
Speaker 1: office and ran about five billion dollars for them. Tell
Speaker 1: us what it was like doing that a couple of
Speaker 1: years before the financial crisis blew up.
Speaker 2: Well, it was very tight to the financial crisis, and
Speaker 2: so I'll tell you candidly that I I thought there
Speaker 2: was a very reasonable chance that I was going to
Speaker 2: be out on my so the technical term in the
Speaker 2: financial crisis. You mentioned dominicqu Miels is one of the
Speaker 2: fantastically talented people at Canyon Partners. She was based out
Speaker 2: in Los Angeles, and from kind of that nineteen ninety
Speaker 2: six introduction to Mitch and Josh, they repeatedly tried to
Speaker 2: get me to go to work for them in Los Angeles.
Speaker 2: And finally, I think it was two thousand and three
Speaker 2: or four, I ran into Mitch on the street on
Speaker 2: actually on fifty seventh, just around the corner from where
Speaker 2: we are right now, and he said, hey, you know,
Speaker 2: we're thinking about opening a New York office. Is it
Speaker 2: US or is it Los Angeles? And the answer was
Speaker 2: it was Los Angeles. I didn't want to be in
Speaker 2: Los Angeles. My wife doesn't like to drive. I actually
Speaker 2: came like within inches of accepting a Canyon Partner's offer
Speaker 2: back in nineteen ninety eight. And then I'm going from
Speaker 2: dinner at Mitch Julis's house to the airport. It's eleven
Speaker 2: o'clock at night on a Friday, but bumper to bumper traffic,
Speaker 2: and all I could think is, if I do this,
Speaker 2: I'm done. My wife is going to leave me in
Speaker 2: about two and a half minutes. And so we just
Speaker 2: made a meeting of the minds. When they decided to
Speaker 2: branch out to New York City, it provided the perfect
Speaker 2: opportunity to transition to Canyon Partners. Initially I joined to
Speaker 2: help them manage their equity portfolio. My background in the
Speaker 2: asset management space was originally going to small cap value,
Speaker 2: and Canyon Partners really gave me the platform that allowed
Speaker 2: me to branch that out into multiple different areas.
Speaker 1: How do you more from small cap value into things
Speaker 1: like derivatives and FX.
Speaker 2: So my actual background was originally in derivatives. My first
Speaker 2: job on Wall Street, when I was still at the
Speaker 2: Universit Pennsylvania, was trading crude oil futures to offset option
Speaker 2: positions for spear leads in Kellogg. So I had a
Speaker 2: background in derivatives. The opportunities to trade derivatives and be
Speaker 2: involved in the hedge fund space was something that really
Speaker 2: had not emerged, at least for me in New York
Speaker 2: until Canyon Partners provided that opportunity. But if you look
Speaker 2: at when I sold my software company in the late
Speaker 2: nineteen nineties, we had this huge disconnect where I'm a
Speaker 2: value investor, I'm somebody who's focused on evaluation and small
Speaker 2: caps and small cap value in particular, we're trading at
Speaker 2: this incredible discount, and so I actually went into small
Speaker 2: cap looking at it from the same standpoint that a
Speaker 2: macro investor might and say, this is an area that
Speaker 2: has real resources and opportunity, and the valuations are totally
Speaker 2: mispriced relative to what we're seeing in the broader market.
Speaker 2: I just got lucky, candidly that the dot com bubble
Speaker 2: broke about six months after I made that transition. If
Speaker 2: it had gone on for another two years, I might
Speaker 2: not be sitting here to talk to you today.
Speaker 1: Right Hey, listen, smart as good luck is better, luck
Speaker 1: is better, definitely absolutely true. So after a successful run
Speaker 1: a Canyon, you stand up your own fund ice Farm Capital,
Speaker 1: you're seated by Soros Fund Management. So I met him
Speaker 1: once briefly. I think I was honest at his apartment
Speaker 1: of Park Avenue for some event. But tell us what
Speaker 1: it was like working with the people at Soros.
Speaker 2: Well, So again the Soros guys, in particular Scott Bessett
Speaker 2: had actually rejoined Soros as the CIO. At that point,
Speaker 2: he was the lead analyst for a stand Ruck and Miller,
Speaker 2: and so he was returning to Soros. He basically tried
Speaker 2: to build a stable of outside managers that he thought
Speaker 2: were interesting and presented interesting ideas. Initially, same thing as
Speaker 2: canyon partner is basically meaning.
Speaker 1: A non correlated multi strategy. Let's spread it across a
Speaker 1: lot of different ideas, disciplines, approaches, and hopefully some of
Speaker 1: them are working most of the time.
Speaker 2: One hundred percent. That's exactly the idea. And so Scott
Speaker 2: actually approached me about joining Soros, and I turned him
Speaker 2: down with the observation I've already got a great job.
Speaker 2: He immediately picked up on that that the word job
Speaker 2: probably came across tapping into my entrepreneurial background, and he said, well,
Speaker 2: if you don't want to change jobs, would you be
Speaker 2: interested in running your own firm, We'll see you. That's
Speaker 2: what led to Ice Farm Capital. The name, actually, I
Speaker 2: funnily enough, comes from a vacation property that I used
Speaker 2: to own. We sold it when we moved to California
Speaker 2: to follow in the rest of the career. But I
Speaker 2: owned a nineteenth century ice harvesting operation, which sound insane
Speaker 2: until you actually stop and think about all the characteristics
Speaker 2: of what the world would have looked like in nineteen hundred.
Speaker 2: Ice was very much a business like cable television. Back then,
Speaker 2: you actually didn't own your ice box. You leased your
Speaker 2: ice box from the ice company. The iceman cometh right.
Speaker 2: The iceman was somebody who would deliver the ice on
Speaker 2: a regular basis, alongside cheese and various other components. And
Speaker 2: believe it or not, that was the seventh largest business
Speaker 2: in the United States in nineteen hundred and by nineteen
Speaker 2: thirty five, with the invention of air conditioning and modern
Speaker 2: refrigeration techniques, primarily by carrier, the entire industry is gone
Speaker 2: and everything files for bankruptcy. And so we actually picked
Speaker 2: up a vacation property that's just outside of exciting vacation
Speaker 2: destination just outside of Scranton, Pennsylvania, that was in the
Speaker 2: Pocono Foothills. It was effectively a property that is between
Speaker 2: two three thousand foot mountains and so in the northeast
Speaker 2: it constantly stays cool. It was fed by five artesian springs,
Speaker 2: and so this is the fantastic, most perfect place to
Speaker 2: grow ice and see ice farm. And we had like
Speaker 2: railroad tracks that went to New York and Philadelphia, et
Speaker 2: they're all abandon long since abandoned, but that was the
Speaker 2: genesis of the name. We're always looking for a name.
Speaker 2: Toron the te launcha farm.
Speaker 1: No, that's great, and there's if you look at every
Speaker 1: Greek mythological creature or god, like, all the names have
Speaker 1: been taken. It's pretty it's pretty hilarious. So let's talk
Speaker 1: about the next gig. You have Teal Macro. You're managing
Speaker 1: the personal capital of Peter Teal, which I found fascinating
Speaker 1: because people have a tendency to read into the politics
Speaker 1: of the investors. The New York Post famously does this
Speaker 1: all the time. But you know, the politics is capital
Speaker 1: is capital, whether it's coming from source management or Teal
Speaker 1: tell Us a little bit about what it was like
Speaker 1: working with Peter Teel Well.
Speaker 2: So those are pretty much the two extremes, right, one
Speaker 2: certainly perceived as you know, right wing in one way,
Speaker 2: and the others perceived is very much left wing. I
Speaker 2: don't care about the politics component. I care a lot
Speaker 2: about politics per se, but I very strongly believe that
Speaker 2: we're able to have our own opinions. There is a
Speaker 2: degree of discussion around those types of components in any setting, right,
Speaker 2: and so it is important that at least you're able
Speaker 2: to entertain that. Peter is unbelievably brilliant, right. He is
Speaker 2: one of these people who I think has a very
Speaker 2: intuitive grasp of order in the universe and tries to
Speaker 2: take positions that exploit those underlying dynamics. His you know,
Speaker 2: familiarity with Rene Gerrard and the dynamic of mimicry and
Speaker 2: people's desire to imitate what other people have or to
Speaker 2: try to obtain what other people value. I think it's
Speaker 2: kind of his underpinning philosophy and has proved to be
Speaker 2: really really powerful in terms of identifying where the puck
Speaker 2: is going. You know, Peter built a phenomenal pool of
Speaker 2: capital that it was a real privilege to have the
Speaker 2: opportunity to work with him on.
Speaker 1: And he was an early investor. People sometimes forget he
Speaker 1: was early in Facebook, he was early in I think
Speaker 1: was Uber. I mean, he was in the right place
Speaker 1: at the right time more often than we were talking
Speaker 1: about Lucky at a certain point. It's like, hey, you
Speaker 1: know once or twice as a coincidence, but at a
Speaker 1: certain point there's a certain set of insights and skills there.
Speaker 2: Yeah, I don't think Luck plays nearly as much of
Speaker 2: a role as people would like to think because it
Speaker 2: relates to Peter. I do think that a lot of
Speaker 2: the dynamics that we saw coming out of Silicon Valley,
Speaker 2: Peter was one of the first people to say, hey, wait,
Speaker 2: let's try to treat this like a business as compared
Speaker 2: to purely a scientific experiment. And so he was part
Speaker 2: of that early crop of venture capitalists in that late
Speaker 2: nineteen nineties time period. Then I think started to think
Speaker 2: about it less on the pure technology front and more
Speaker 2: on exactly as I was referring to with rhine Asia,
Speaker 2: are the aspirational dynamics, Like what do people really want? Right?
Speaker 2: Very few people want to quote unquote get onto a smartphone.
Speaker 2: They want to be able to connect with their friends,
Speaker 2: they want to be able to do math, they want
Speaker 2: to be able to get their email, they want to
Speaker 2: be able to do their work away from the office,
Speaker 2: et cetera. That awareness that that world was transitioning to
Speaker 2: the online space, I think is really what Peter's key
Speaker 2: observation was, And now it's interesting to watch him as
Speaker 2: he recognizes I think in a lot of ways that
Speaker 2: people want other things in life, not necessarily just technology.
Speaker 1: There's a whole long conversation about the evils of how
Speaker 1: we use tech. But before I leave the teal macro,
Speaker 1: I got to ask you about the famous vommageddon trade
Speaker 1: in twenty eighteen. You had identified in advance that there
Speaker 1: were some structural problems with XIV, and on behalf of
Speaker 1: that funds you made a bet that, hey, this thing
Speaker 1: is going to blow up. Tell us a little bit
Speaker 1: about that trade.
Speaker 2: Sure, so, XIV, which has been reintroduced in various forums,
Speaker 2: was just an inverse of the VIX index.
Speaker 1: Meaning when market volatility went down, that should go up.
Speaker 2: It should go up. The irony, of course, is that
Speaker 2: like most of these trades that's out there, it's not
Speaker 2: quite what people thought it was right. So the actual
Speaker 2: source of profitability in that trade is not the level
Speaker 2: of the VIX, but the shape of the vul's surface.
Speaker 1: Right, just describe define what you mean by that.
Speaker 2: So the structure of the vall's surface is generally upward sloping,
Speaker 2: meaning that people are more uncertain and priced greater uncertainty
Speaker 2: about events far off into the future as compared to
Speaker 2: events that are relatively nearby right now. When that inverts,
Speaker 2: when the VIC spikes on a risk off event, that
Speaker 2: actually means that you're suddenly if you're inverse, right, so
Speaker 2: you're shorting this dynamic. You're shorting stuff that is low
Speaker 2: priced is rolling up to high price. Right. That's really
Speaker 2: bad on the flip side of that equation. In a
Speaker 2: normal what's called a contango construction in the VIX, if
Speaker 2: you are shorting six month volatility or two month volatility
Speaker 2: and buying it back as one month volatility, you're typically
Speaker 2: selling it around fifteen and buying it back around twelve.
Speaker 2: That's a crazy return when you think about it that
Speaker 2: that's happening every single month. You're basically generating twenty close
Speaker 2: to twenty five percent right in that trade on a
Speaker 2: monthly basis. When you run that full strength, it gives
Speaker 2: the dynamics of something like the XIV, which rose six
Speaker 2: hundred percent in twenty seventeen. Right now, my observation was
Speaker 2: twofold one was that because of the growth of this strategy,
Speaker 2: it had actually gotten so large that it was consuming
Speaker 2: all of the liquidity in the UX futures, the vic's futures.
Speaker 2: On normal trading days it was about seventy percent of
Speaker 2: the daily volume. Was simply the rebalancing of these things.
Speaker 1: Wow, that's huge.
Speaker 2: So the passive component of that, which will feed into
Speaker 2: a discussion we'll have later on, had just become so
Speaker 2: large that it relied on liquidity that was not necessarily
Speaker 2: going to be there.
Speaker 1: Right, very similar to the financial crisis, where people had
Speaker 1: long term debts but it was so much cheaper to
Speaker 1: finance that with short term paper. Hey, we'll just roll
Speaker 1: it over.
Speaker 2: Every thirty days one hundred percent. That's exactly the same
Speaker 2: underlying dynamic. And by the way, the model for the
Speaker 2: trade that I built was actually going back and reading
Speaker 2: Paul Tudor Jones analysis leading into the crash in nineteen
Speaker 2: eighty seven folio insurance components. Right, it was the exact
Speaker 2: same trade. So like down to the point the portfolio
Speaker 2: insurance was consuming somewhere around thirty to forty percent of
Speaker 2: the volume on the S and P five hundred on
Speaker 2: a normal basis. Paul's observation, Paul Tuder Jones' observation was
Speaker 2: that in an event that actually exacerbated volatility, the trading
Speaker 2: quantity that they would need was far greater than the
Speaker 2: market could supply. I had the exact same insight, exact
Speaker 2: same view, and simply pointed out that, like, look, there's
Speaker 2: a misunderstanding of an inverse product. You think, like a
Speaker 2: normal stock, it's getting safer and safer and safer as
Speaker 2: it goes higher in price. But that's the exact opposite.
Speaker 2: And so what you were actually building was a bimodal distribution,
Speaker 2: meaning two homps to the distribution where there was a
Speaker 2: smaller and smaller probability that everything was okay, and a
Speaker 2: bigger and bigger probability that all I think technical term
Speaker 2: is all hell was about to break loose.
Speaker 1: Right.
Speaker 2: We basically came to the conclusion there was roughly a
Speaker 2: ninety five percent chance it was going to go to zero.
Speaker 2: Over a two year period. We ended up buying. This
Speaker 2: is one of the wonderful things about financial markets and
Speaker 2: degrees of completeness. There were options available with a two
Speaker 2: year time horizon that allowed us to.
Speaker 1: An amazing leverage. So how much how much were you
Speaker 1: putting at risk at that moment that Hey, this this
Speaker 1: analysis is correct and the timing this should happen within
Speaker 1: two years.
Speaker 2: So we were actually ultimately limited by the liquidity in
Speaker 2: the space, but it was large enough that we were
Speaker 2: able to put a sizeable amount of amount and make
Speaker 2: a meaningful.
Speaker 1: Long So you made this trade on behalf of Teal
Speaker 1: macro put any of your own capital into it also.
Speaker 2: Well, that's one of the funny things that everybody discovers
Speaker 2: is you go through this industry, is that when your
Speaker 2: compensation is tied to the outcome of the trade, you
Speaker 2: can absolutely express components of it. But the reality is
Speaker 2: is that we're all massively underinvested in things like equities,
Speaker 2: et cetera.
Speaker 1: Because so much of your income is that you know,
Speaker 1: I've had that exact conversation, Hey, why don't you own
Speaker 1: more common stocks? You talk about passive investing this and that,
Speaker 1: I don't know, how about ninety five percent of my
Speaker 1: net worth is up in market related investments.
Speaker 2: You're in the same leg one hundred percent, and it's
Speaker 2: hard for people to understand that. So it's great to
Speaker 2: have the opportunity to actually share that. I mean, our
Speaker 2: industry tends to be among the most conservative investors out there,
Speaker 2: precisely because we look at it and we're like, wait
Speaker 2: a second, if this risk goes wrong, not only do
Speaker 2: I lose my assets, but I lose my job.
Speaker 1: Right, it's double concent trade risk. There were lots of
Speaker 1: rumors about that trade at the time. Some people said
Speaker 1: it was fifty million, one hundred million, two hundred million.
Speaker 1: I don't know what you're allowed to talk about, but
Speaker 1: it's safe to say this was a big eight or
Speaker 1: nine figure trend profit, right, this was a giant win.
Speaker 2: Yeah, the notional amount of the trade was about a
Speaker 2: quarter billion dollars and we did well.
Speaker 1: I'm going to guess you don't have to sit. You
Speaker 1: don't have to admit or deny the following. But if
Speaker 1: the if that was your notational one hundred isn't a
Speaker 1: ridiculous profit margin. That's Barry saying it. That's not Mike.
Speaker 1: So any compliance people listening, I'm just spit bowling here.
Speaker 1: A couple of months ago, I had David Einhorn on
Speaker 1: and he made some news basically saying passive has broken
Speaker 1: the markets, and kind of snuck by after he dropped
Speaker 1: that bomb. Was he credited you with helping him understand
Speaker 1: how passive has changed market structures and forcing him to
Speaker 1: become as a value investor, more of a let's call
Speaker 1: it a deep value investor, and his performance has since rebounded. So,
Speaker 1: given that Einhorn has credited you with this insight, tell
Speaker 1: us how you came about to this belief.
Speaker 2: Sure, so the XIV trade was actually part of a
Speaker 2: broader research into the dynamics of passive And if I'm
Speaker 2: going to run through that language and help explain it,
Speaker 2: the single biggest contributor to that research was actually a
Speaker 2: twenty sixteen paper by Los A. Peterson at AQR Brilliant individual.
Speaker 2: He wrote a paper called sharpening the Arithmetic of Active Management. Right.
Speaker 2: That paper refers back to the foundational literature of Bill Sharp,
Speaker 2: who wrote the famous paper in nineteen ninety one the
Speaker 2: Arithmetic of active management, which is the source of any
Speaker 2: statement that you hear which is active simply owns the
Speaker 2: same stocks as passive because it charges less. Therefore, passive
Speaker 2: will outperform over time. Right, The argument is very straightforward.
Speaker 2: There's an assumption of completeness and markets. What Lasse pointed
Speaker 2: out in his paper was that passive had to transact
Speaker 2: during periods in which there was index rebalancing, and so
Speaker 2: in that period they ceased to be passive investors. They
Speaker 2: became active investors, and that became an opportunity for outperformance. Now,
Speaker 2: the reason that that became interesting to me was I
Speaker 2: recognized one additional feature that Lasse had not highlighted, which
Speaker 2: is that passive investors are always transacting because of the
Speaker 2: dynamics of flow. So you get your paycheck, you put
Speaker 2: six percent aside that flows into various Vanguard funds. There
Speaker 2: transacting on a daily basis, And just to put it
Speaker 2: in perspective, over the past couple of years, Vanguard has
Speaker 2: averaged somewhere in the neighborhood of three hundred billion dollars
Speaker 2: worth of inflows every single year. That's the equivalent of
Speaker 2: a large hedge fund every single day having to deploy
Speaker 2: its capital into the market. And so when you think
Speaker 2: about this dynamic of is passive actually passive, it's really
Speaker 2: important to understand that the definition of passive as it stated,
Speaker 2: and this is true for the XIV, it's true for
Speaker 2: the S and P five hundred, in any form of
Speaker 2: index fund the definition of passive is somebody who never transacts.
Speaker 2: If they transact every single day, then they're actually a
Speaker 2: different animal.
Speaker 1: So let me push back on that definition a little bit,
Speaker 1: because I don't want us because you and I are
Speaker 1: going to disagree about some things, but I want us
Speaker 1: to have some fundamental agreement. My definition of passive is
Speaker 1: rather than trying to time the market or pick specific stocks,
Speaker 1: or have a concentrated portfolio, meaning a high active share
Speaker 1: so you don't look like the index, you're just going
Speaker 1: to default to a broad index, whether it's the S
Speaker 1: and P five hundred or the Vanguard Total Market, which
Speaker 1: I think is eight hundred, and then there's an even
Speaker 1: larger one that's a few thousand, and I'm going to
Speaker 1: own the whole market. And what that will allow me
Speaker 1: to do is have minimal trading costs, minimal tax costs,
Speaker 1: and avoid all the behavioral problems that comes with active management.
Speaker 1: And so I'm going to own this in a four
Speaker 1: oh one k. It'll be a mutual funds in a
Speaker 1: taxable account, it'll be an ETF and I'll let that run.
Speaker 1: So I don't think you're that disagreeing with that definition
Speaker 1: or how far off is my definition from yours.
Speaker 2: Well, the only difference in our definitions is actually the
Speaker 2: process of how you get to hold it. Right, So
Speaker 2: the natural conclusion that you're making is actually consistent with
Speaker 2: Sharp's paper, which is the idea that passive investors hold
Speaker 2: every security. The problem is how do you get in
Speaker 2: to hold those securities and how do you get out
Speaker 2: when the time comes to sell them.
Speaker 1: No, you're not disagreeing at all. You set up your
Speaker 1: four o one K, or you set up your investment plan,
Speaker 1: and whether you're making a purchase and putting it away
Speaker 1: or dollar cost averaging in your four oh one K
Speaker 1: or in any other My partner Josh calls this the
Speaker 1: relentless bid. The constant flow of money into four oh
Speaker 1: one k or iras have operated as a little bit
Speaker 1: of a floor on the market. You know, the dot
Speaker 1: com financial crisis and pandemic crash is notwithstanding. Most of
Speaker 1: the time there you can count on positive inflows to equities.
Speaker 2: Well, yes, right, I think that's correct. And I do
Speaker 2: think you used a term that I think is really interesting,
Speaker 2: the relentless bid.
Speaker 1: Yeah.
Speaker 2: Absolutely, And so when you start thinking about each of
Speaker 2: those individual components that you're talking about, first of all,
Speaker 2: just it's really important to understand that all the literature
Speaker 2: that exists around active versus passive, and the idea that
Speaker 2: passive doesn't meaningfully change markets actually presumes that it's simply
Speaker 2: a hold that there is no transaction activity.
Speaker 1: It goes I mean other than I mean, obviously, it's
Speaker 1: not like, Okay, everybody in nineteen ninety nine buy stocks
Speaker 1: and then no one buys stocks for the next thirty years.
Speaker 1: There's a continual the economy continues to grow, people earn wages,
Speaker 1: whether it's a retirement account or a tax deferred account
Speaker 1: or just an investment account. The average mom and pop
Speaker 1: investor throws money into the market on a regular basis
Speaker 1: and takes money out of the market when it's needed
Speaker 1: for other purposes.
Speaker 2: So the fascinating thing about that is, first, I completely agree, right,
Speaker 2: and I think that's actually part of the language that
Speaker 2: gets confused and lost on this. And so again, anytime
Speaker 2: you're transacting, you're not passive. When you decide to buy
Speaker 2: with your weekly contributions. You're not passive. What you're actually
Speaker 2: doing is you're transacting in a systematic fashion. So you
Speaker 2: are a systematic algorithmic investor that has a very simple rule,
Speaker 2: what do I buy? I buy everything? What price? Should
Speaker 2: I buy it? At? Whatever price the market is offering
Speaker 2: me that's presumed to be the right price right now.
Speaker 2: Anytime you buy, you've traded portfolios that are several hundred
Speaker 2: million to billion dollars in size. Anytime you attempt a
Speaker 2: transaction like that, you're going to influence the prices. And
Speaker 2: that's really what distinguishes the difference. That's what David is highlighting.
Speaker 2: As more and more investors transition to this systematic algorithmic
Speaker 2: investment that simply says did you give me cash? If so,
Speaker 2: then buy? Did you ask for cash? If so, then sell?
Speaker 1: That starts to.
Speaker 2: Change the market behavior in a measurable and meaningful fashion.
Speaker 2: It actually causes two things to happen. One is it
Speaker 2: creates a momentum bid because what do I choose to buy?
Speaker 2: I choose to buy whatever the market is pricing it at.
Speaker 2: So things that went up since I had my last purchase,
Speaker 2: I buy more of as a proportion of my assets,
Speaker 2: I buy less of things that went down. The second
Speaker 2: thing that it ultimately does is it creates conditions under
Speaker 2: which a transition from cash rich portfolios that are ultimately
Speaker 2: option like in their characteristics. So I, as a discretionary
Speaker 2: portfolio manager, if you hand me cash, I can look
Speaker 2: at the market and say, you know what, thank you
Speaker 2: for the cash. I'm going to hold it in my portfolio.
Speaker 2: I'm going to use this as an opportunity for me
Speaker 2: to reduce my exposure to the market. Or I could
Speaker 2: choose to use it to buy something without having to
Speaker 2: sell something.
Speaker 1: Given that, what are the risks to the US economy
Speaker 1: and to the markets from too much passive investments flowing
Speaker 1: in to equities?
Speaker 2: So the key risk ultimately lies in that very simple language, Right,
Speaker 2: did you give me cash? Ift? So then buy? Did
Speaker 2: you ask for cash? Iifts? So then sell? And I
Speaker 2: just want to pause for a second and go through
Speaker 2: a little bit of financial history here, because I think
Speaker 2: it's really important for people to understand this. Things that
Speaker 2: we think of as having always been there, things like
Speaker 2: four to oh one ks and iras are actually very
Speaker 2: recent inventions, and there have been dramatic changes around on
Speaker 2: their implementation within your investment career and my investment career,
Speaker 2: which are roughly similar in duration.
Speaker 1: It actually predates US, but had not become popular like
Speaker 1: it had existed for about twenty years before people start
Speaker 1: to figure out, wait, I could put this money away
Speaker 1: and have a grow tax free. It really took a
Speaker 1: few decades before the market kind of came to grips
Speaker 1: with that.
Speaker 2: Yeah, I mean so just very quickly. Iras were actually
Speaker 2: created in nineteen seventy two to facilitate a key risk
Speaker 2: that nobody had ever imagined before, which is, if you
Speaker 2: were a union employee who was fired in the nineteen
Speaker 2: seventy one recession and you received a lump sum settlement
Speaker 2: of your pension, you suddenly that was treated as earned
Speaker 2: income in that year, you were subject to the seventy
Speaker 2: five percent marginal attacks ray. It was absolutely insane and
Speaker 2: devastating to many individuals, and so the IRA was created
Speaker 2: to facilitate the rollover of those on a tax deferred basis,
Speaker 2: so you could maintain those assets even if you lost
Speaker 2: your job. Right. The second tool that was introduced was
Speaker 2: the four one K, which refers to a specific provision
Speaker 2: of the tax code that created the defined contribution. Right,
Speaker 2: if you launch yourself all the way back to nineteen
Speaker 2: eighty one and the start of the Bowl market in
Speaker 2: nineteen eighty two, the start of the Bowl market in
Speaker 2: US equities following the election of Reagan. The total assets
Speaker 2: in those two were about one hundred billion dollars in each. Right, today,
Speaker 2: iras I believe are around seventeen trillion and four oh
Speaker 2: one k's are somewhere in the neighborhood of eight to
Speaker 2: nine trillion. Right, these are the single largest pools of
Speaker 2: assets on the planet. Is the American retirement system. There
Speaker 2: is a subsequent change in two thousand and six called
Speaker 2: the Pension Protection Act that one tried to push more
Speaker 2: and more people into four oh one k's, right by
Speaker 2: making it what's called an opt out framework as compared
Speaker 2: to an opt in right.
Speaker 1: You can blame Dick Taylor and Nudge for that.
Speaker 2: One hundred percent the Nudge dynamics and trying to create
Speaker 2: the ownership economy, and those have been on net quite
Speaker 2: positive components to them, but they have meaningfully changed the
Speaker 2: structure of how flows enter the market.
Speaker 1: Cause to the QFIDS right.
Speaker 2: So QDIA is is what QDI is so the qualified
Speaker 2: default investment alternative. If you're going to default somebody into participating,
Speaker 2: you no longer leave it up to them to say, hey,
Speaker 2: what do you want to buy? You actually have to
Speaker 2: select something that you're going to put them into. And
Speaker 2: so the Pension Protection Act also introduced this idea of
Speaker 2: qualified default investment alternatives that provided a liability protected mechanism
Speaker 2: for HR managers or CFOs to declare, this is where
Speaker 2: we're going to default people into. Initially those were balanced funds,
Speaker 2: so this is part of the key growth of PIMCO,
Speaker 2: which had skill set in both in both equities and
Speaker 2: fixed income. So the growth of balanced funds was a
Speaker 2: really really key characteristic of that two thousand and six
Speaker 2: to twenty twelve market. And then in twenty twelve they
Speaker 2: changed the QDIA to what's called a target date fund,
Speaker 2: which is what about eighty five percent of Americans now
Speaker 2: default into in their retirement assets.
Speaker 1: Right. What the way it used to be is you
Speaker 1: would start out a company, even if they had a match,
Speaker 1: you had to go out and do the paperwork. You
Speaker 1: had to go out and choose a fund, even if
Speaker 1: they said as joining a company, you automatically get a
Speaker 1: four oh one K. Cash would just pile up in
Speaker 1: there if you didn't give some form of diffraction. So
Speaker 1: essentially what was designed to say, Hey, you got to
Speaker 1: get off your button, do something. We're gonna make it.
Speaker 1: We're gonna make sure you're investing in something. It's up
Speaker 1: to you to go in and change it to what
Speaker 1: you want. It's kind of shocking and in some ways
Speaker 1: just reminding us of the strength of behavioral finance that
Speaker 1: people are so lazy, just like would you put me
Speaker 1: in okay, great, and they don't even think twice about
Speaker 1: it one.
Speaker 2: Hundred percent, And that actually is exactly what we see.
Speaker 2: So it's also a very bifurcated experience where those who
Speaker 2: were older and who already defaulted into four oh one
Speaker 2: K plans and made the choice to go into those
Speaker 2: one K plans, they typically would choose from a universe
Speaker 2: of active managers. Right. That's the world that largely existed
Speaker 2: prior to two thousand and six. The passive share at
Speaker 2: that point was still quite low when I entered the industry,
Speaker 2: when I first started, you know, cutting my teeth on
Speaker 2: this stuff. It's hard for people to remember, but passive
Speaker 2: was still roughly one percent market share in nineteen ninety two.
Speaker 1: Vanguard formed in nineteen seventy four. They didn't get to
Speaker 1: a trillion dollars till pretty much after the financial crisis.
Speaker 1: I have a thesis that have said, you know, from
Speaker 1: the nineties implosion and then are just a raft of scandals,
Speaker 1: the accounting scandal, the Anaal scandal, the IPO spinning scandal,
Speaker 1: the just go down the whole list, and then burning
Speaker 1: made off and then the financial crisis. My general sense
Speaker 1: has been lots of mom and pop investors have said,
Speaker 1: we just don't want to get involved in that mess.
Speaker 1: Just let me buy the market and forget about it.
Speaker 1: And for those folks, it's worked out. And those folks
Speaker 1: are very often my clients. So let me pose this
Speaker 1: question to you. If you're having a discussion with a
Speaker 1: fiduciary who runs a few billion dollars in client assets,
Speaker 1: convince me to shift those accounts away from either broad
Speaker 1: indexes or passive generally to something more active. Why should
Speaker 1: I move their accounts elsewhere?
Speaker 2: Quick answer is you shouldn't. And that's actually a part
Speaker 2: of the problem is that the individual choice should be
Speaker 2: to bypassive right the problem is is when all of
Speaker 2: the individuals bypassive, we actually change the structure of the
Speaker 2: market and so it no longer represents what it historically did.
Speaker 1: And by the way, let me interrupt you and just say,
Speaker 1: we obviously have huge swaths of fixed income and muni
Speaker 1: bonds as part of that portfolio, and we also own
Speaker 1: a variety of non passive holdings, some with a value tilt,
Speaker 1: some with a momentum tilt, some international. So it's not like,
Speaker 1: all right, we're going to try a fee and just
Speaker 1: load up on the S and P five hundred. It's
Speaker 1: obviously a lot more significant than that. But given what
Speaker 1: you're saying that fiduciary should be looking for low cost
Speaker 1: at least in a COREN satellite setup, how do you
Speaker 1: go about reducing the risks to what you see as
Speaker 1: market structure problems caused by a simple default to passive.
Speaker 2: So this is actually the core of the issue, and
Speaker 2: it's part of the reason why I spend so much
Speaker 2: time talking about it, and it's part of what I
Speaker 2: made David aware of in that conversation. To go back
Speaker 2: to it is there's very little the individual or the
Speaker 2: individual ria can do to change this. This is a
Speaker 2: regulatory framework, and it is controlled by the vanguards and
Speaker 2: black rocks who are spending far more on lobbying than
Speaker 2: the rest of the industry combined. So part of what's
Speaker 2: really happening is the political choice to push you into
Speaker 2: these vehicles. The political choice to make it the only
Speaker 2: acceptable alternative under the rubric of offering safe, low cost
Speaker 2: investments to people is understandable. We all want that desire. Certainly,
Speaker 2: that's your desire as well.
Speaker 1: I mean, is it an overwhelming amount of academic literature
Speaker 1: that says, you know, some active managers managed to outperform,
Speaker 1: but by the time you get to ten years and
Speaker 1: take in taxes and costs and fees, you would have
Speaker 1: been better off impassive. The more people who find their
Speaker 1: way into passive vehicles, doesn't that create more opportunities for
Speaker 1: people like David Einhorn. Isn't the greater the percentage of
Speaker 1: passive ownership, the more inefficiencies there are, And therefore shouldn't
Speaker 1: we see active sort of reassert itself, perhaps at a
Speaker 1: lower fee than the past. But aren't there more and
Speaker 1: more opportunities for people who have a skill set to
Speaker 1: identify inefficiencies Wherever they pop up.
Speaker 2: So I'm really glad you asked me that question, because
Speaker 2: this is the traditional model and the way that people
Speaker 2: think about it, and it's exactly what I focused on
Speaker 2: with David Right. The immediate reaction to the idea of
Speaker 2: the growth of this non thoughtful entity passive right makes
Speaker 2: it seem like those who are thoughtful should have an advantage.
Speaker 2: The problem is is in the theories that lead you to
Speaker 2: that articulation. So what you're referring to is broadly called
Speaker 2: the Grossman Stiglitz paradox, the dynamic that the more people
Speaker 2: choose not to put an effort into the market and
Speaker 2: divining prices, the greater the incentive and the opportunity set
Speaker 2: is for those who are choosing to put that into
Speaker 2: the market. It's what they call the impossibility of perfectly
Speaker 2: efficient markets. The problem again goes into the details of
Speaker 2: the assumption of the model. So really what Grossman Stiglitz
Speaker 2: is all about is the wisdom of crowds. You're familiar
Speaker 2: with the micromobison examples of these, or the articulation that
Speaker 2: we're all familiar with. You go to the county fair,
Speaker 2: the giant jar of jellybeans, and you're supposed to guess
Speaker 2: how many jelly beans there are in there? Right, any
Speaker 2: individual has a very low probability of success. But when
Speaker 2: we aggregate all the guesses and we take the mean
Speaker 2: of that, it tends to be pretty darn close to
Speaker 2: that answer. And that's composed of absolute nerds like me
Speaker 2: who are like, well, what's the diameter and how big
Speaker 2: as a jelly bean and all that sort of stuff, right,
Speaker 2: and people who are making just total wild guesses. Right.
Speaker 2: The problem is that model the wisdom of crowds actually
Speaker 2: requires everybody to have what's called equal endowment or the
Speaker 2: same number of votes. And that's actually what Grossmuns Stiglitz
Speaker 2: relies on as well, is the idea that the wisdom
Speaker 2: of crowds is caused by the dynamic of each individual
Speaker 2: making those choices and the market in its totality being
Speaker 2: able to guide towards that and so that incentive where
Speaker 2: prices get pushed off. If I'm the same size and
Speaker 2: I have the same number of votes as everybody else,
Speaker 2: I can guide the market back to that. That's the
Speaker 2: opportunity set.
Speaker 1: Why wouldn't that work in equity markets where people with
Speaker 1: more votes more dollars have a greater incentive to get
Speaker 1: the number of jelly beans correct.
Speaker 2: So that's actually exactly what isn't the case. So what's
Speaker 2: actually happening is we're giving more, We're in more of
Speaker 2: a vote to somebody who doesn't care right. As a result,
Speaker 2: Vanguard and Blackrock, because of their daily transactions, the size
Speaker 2: of those transactions has gotten to the point, even though
Speaker 2: they're not actively trading on a day to day basis,
Speaker 2: that relentless bid that your partner refers to is actually
Speaker 2: changing the structure of the market. It's changing that price behavior.
Speaker 2: It's the same thing as if we went to the
Speaker 2: county fair and they said everybody guesses, and then the
Speaker 2: mayor gets to guess ten thousand times whose vote's going
Speaker 2: to count.
Speaker 1: So I did a lot of prep work for this.
Speaker 1: You and I have had disagreements on Twitter about passive
Speaker 1: versus active. I think our disagreements are less than I
Speaker 1: previously realized. I think we both understand the advantages of
Speaker 1: low cost indexing. But let's talk about some of the
Speaker 1: recent data that's come out. I know you're a big
Speaker 1: fan of a lot of research that's out there. Last week,
Speaker 1: Eric Balchunis, who is the etf. Wizard at Bloomberg Intelligence
Speaker 1: put out a report Passive investing worries appear overblown as
Speaker 1: active as in control, and his key takeaway was when
Speaker 1: you looked at the S and P five hundred stocks
Speaker 1: and you broke them into quintiles with the most or
Speaker 1: the least passive ownership, the least owned quintile beat all
Speaker 1: the rest over one three and five years. So if
Speaker 1: that's the case, doesn't that prove the active managers are
Speaker 1: still doing okay and the struck market structure is behaving
Speaker 1: as it should.
Speaker 2: So it'd be nice if that was the case. Unfortunately,
Speaker 2: the analysis was deeply flawed. I pointed this out in
Speaker 2: responses to Eric. Would you discover if you actually dig
Speaker 2: into that analysis? This is that the least passively owned
Speaker 2: stocks are the Apples, Microsoft, in videos, et cetera, the
Speaker 2: world the largest company, meaning the.
Speaker 1: Active managers are buying those big magnificent seven socks.
Speaker 2: Except that or not. And so the reason why that
Speaker 2: disconnect comes.
Speaker 1: Is because you hold on, I have to stop you there, Sure,
Speaker 1: every concentrated portfolio I've looked at, every active manager, you
Speaker 1: have to really go down the list to get to
Speaker 1: people who don't have some combination of Nvidia, Microsoft, Netflix, go,
Speaker 1: you know, go down the list of the top ten.
Speaker 1: They all seem to own United Health. Now, if they're
Speaker 1: not closet indexers, if they don't own three hundred stocks,
Speaker 1: maybe they stop after ten or twenty. But those big
Speaker 1: big cap dare I call them nifty to fifty stocks,
Speaker 1: they seem to be the favorites of the active managers.
Speaker 1: Make the other case.
Speaker 2: So it actually turns out that the active managers, and
Speaker 2: this is almost exactly why we see some of the
Speaker 2: dynamics that we talk about active managers skew towards smaller stocks.
Speaker 2: Simply by definition, right, the Russell two thousand has two
Speaker 2: thousand out of the roughly thirty five hundred stocks available
Speaker 2: publicly traded, it's about four percent of the toll market cap.
Speaker 2: So somebody has to actually go out and own that.
Speaker 2: We know it's not Vanguard, we know it's not Black Rock.
Speaker 2: They're not owning it in any different proportion or any
Speaker 2: meaningfully different proportion to what they're owning everything else. Through
Speaker 2: a total market type index. There are some wrinkles around that,
Speaker 2: but in rough terms, that's the case. You are absolutely
Speaker 2: correct that there is representation of Apple or Microsoft. But
Speaker 2: that actually hits on a slightly different component, which is
Speaker 2: if you are going to compete with the S and
Speaker 2: P five hundred. Paradoxically, you do have to own those names.
Speaker 2: You don't have to own Delta Airlines nobody cares, right,
Speaker 2: but you do have to have exposure to the Apples,
Speaker 2: microsofts etstead of their world. But almost no active manager
Speaker 2: can carry them in the size that a passive vehicle
Speaker 2: can because of concentration limits.
Speaker 1: Why how much is Tesla in the S and P
Speaker 1: five hundred, or Netflix or Nvidia? None of them are
Speaker 1: more than ten percent. Didn't the SMP and the Nasdaq
Speaker 1: one hundred change those rules like ten fifteen years ago?
Speaker 2: So ten to fifteen years ago they changed to you
Speaker 2: market from market cap weighted to float adjusted weights. I
Speaker 2: think that's what you're referring to. But actually, interestingly enough,
Speaker 2: this is part of the dynamic and where regulation plays
Speaker 2: a role. Entities like the S and P five hundred
Speaker 2: Growth Fund are far more concentrated than is legally allowed
Speaker 2: by the forty Act by which they're governed. They are
Speaker 2: too concentrated relative to that they've been given dispensation by
Speaker 2: regulators because they're index investors. And this is where the
Speaker 2: analysis that Eric was highlighting is flawed, because what's actually
Speaker 2: happening when you see the high levels of index ownership
Speaker 2: for an individual name, what's happening is that you're picking
Speaker 2: up a sector fund for example. This is very notorious
Speaker 2: in rets. It's also very clear in things like a
Speaker 2: technology index, the XLK for example, or the xl in
Speaker 2: the energy space XLE is I believe forty percent Exonomobile,
Speaker 2: forty percent Chevron, right, nobody can actually run an active
Speaker 2: portfolio that looks anything remotely are that's pretty crazy?
Speaker 1: Yeah? That that that that's absolutely ridiculous.
Speaker 2: Just very quickly. That is actually what Eric is picking up.
Speaker 2: And I would argue that those are not actually what
Speaker 2: we're talking about when we talk about passive precisely the
Speaker 2: definition you and I were talking about. If you're a
Speaker 2: passive or systematic index investor, you're not saying, well, I'm
Speaker 2: going to overweight energy, I'm going to allocate to an
Speaker 2: individual indust industry and sort of turn around and then
Speaker 2: say that those stocks that are most passively owned don't
Speaker 2: exhibit this type of behavior. Is to confuse those two dynamics.
Speaker 1: So also with an Eric's research piece was something that said, hey,
Speaker 1: we went back and looked at draw downs of ten
Speaker 1: percent or more of the components in the S and
Speaker 1: P five hundred. The stocks with the highest passive ownership
Speaker 1: didn't weren't subject to greater volatility or larger draw downs
Speaker 1: than any of the rest of the ownership, which is
Speaker 1: a big part of the argument that hey, the structure
Speaker 1: is damaged and when it finally breaks, these passively owned
Speaker 1: vehicles are going to be a disaster.
Speaker 2: So there's two separate components. So one is that again,
Speaker 2: the issue is how you're defining the passively held. So
Speaker 2: if by definition I've already gravitated to saying the least
Speaker 2: passively held are the Microsoft Apples, etc. The world, I'm
Speaker 2: going to come to that conclusion. But the unfortunate answer.
Speaker 1: Well, what about the most passively held?
Speaker 2: Those actually, ironically are the most passively held. And the
Speaker 2: reason that they're actually the most passively held is precisely
Speaker 2: this issue of concentration risk. Most active managers can't hold
Speaker 2: those names in the size that's required. If I'm a
Speaker 2: small cap manager or I'm a diversified fund manager, I
Speaker 2: typically have to run with one hundred names in my portfolio.
Speaker 2: One hundred names in my portfolio to be equal weight
Speaker 2: to Apple, for example, in the index, it have to
Speaker 2: far outweigh everything else in my portfolio I offer as
Speaker 2: an active manager, typically very little value added to the
Speaker 2: insights on something like Apple, and so the institutional space
Speaker 2: or most asset selectors, asset allocators are going to look
Speaker 2: for managers that are trying to add value. Otherwise, why
Speaker 2: not just bypassive? Why not go with a low cost solution.
Speaker 1: So that kind of raises the question about what is
Speaker 1: the solution to this. I brought up Balchunis, but I recall, oh,
Speaker 1: maybe it's ten years ago. He wrote a column that
Speaker 1: he eventually turned into a book called the Vanguard Effect,
Speaker 1: and he figured out that over the course of the
Speaker 1: previous twenty thirty years, Vanguard has taken about a trillion
Speaker 1: dollars in fees out of the market. Now, it didn't
Speaker 1: all go to Vanguard. They got took about one hundred
Speaker 1: billion dollars in fees, but it forced everybody else to
Speaker 1: compress their fees, to lower their fees in order to
Speaker 1: be competitive, and ultimately saved. Ultimately saved investors are trillion dollars.
Speaker 1: So the question is, how do we not go back
Speaker 1: to the bad old days of expensive, underperforming active managers
Speaker 1: given the the alternative that we've created. And keep in mind,
Speaker 1: Vanguard and Blackrock didn't you know, they weren't born whole
Speaker 1: cloth into a vacuum. They came about following a lot
Speaker 1: of academic research and a lot of pricing underperforming active
Speaker 1: managers in the seventies, eighties, nineties. So how do we
Speaker 1: not go back to those days and yet still have
Speaker 1: an opportunity to fix the market structure?
Speaker 2: Yeah? I know. So there's a whole bunch of different
Speaker 2: components to what you hit on. The first is this
Speaker 2: idea of cost savings associated with Vanguard. First of all,
Speaker 2: I absolutely agree with Eric's analysis that the low cost introduction,
Speaker 2: the introduction of the mutual structure was absolutely part of
Speaker 2: the success of Vanguard, and the push towards lower fees
Speaker 2: has been absolutely critical. But remember the vast majority of
Speaker 2: the time that Vanguard was actually running, fifty basis points
Speaker 2: would have been considered really cheap fees, right, that's right, right,
Speaker 2: And initially introduced, I believe the fees on the Vanguard
Speaker 2: funds were about seventy five basis points zero point seventy
Speaker 2: five percent as compared to most active managers who are
Speaker 2: between one and a half and two percent, right, So
Speaker 2: that pulling down was absolutely critical. Today you're at a
Speaker 2: point where the three basis point candidately, it just doesn't
Speaker 2: mean it's free, it's factally free. It's effectively free. And
Speaker 2: one of the reasons that it's able to be effectively
Speaker 2: free is because they are hidden subsidies within the industry,
Speaker 2: which ironically are affecting things like the CPI numbers that
Speaker 2: we see where securities lending is actually what's paying for Vanguard, right, meaning.
Speaker 1: People want to short stocks, they borrow it, they borrow
Speaker 1: paying a feele. You go to black Rock and Vanguard, Absolutely,
Speaker 1: those are the two that you go to. That's that's
Speaker 1: you know, it's real money when you're running trillions of dollars,
Speaker 1: but when you're three or four basis points or five
Speaker 1: basis points and don't forget, Vanguard is about thirty percent
Speaker 1: active funds. Black Rock is a little more forty something
Speaker 1: percent active funds. So they have an abandon that space.
Speaker 1: And when you look outside of their core or you know,
Speaker 1: S and P five hundred or for Vanguard, it's VTI
Speaker 1: or Voo, or you have a run of total markets
Speaker 1: or total global markets. US are global. There are some
Speaker 1: higher fee products ten twenty thirty basis points, but it's
Speaker 1: the scale, trillions and trillions of dollars that have allowed
Speaker 1: them to take a fund like that down to three
Speaker 1: basis points or four basis points.
Speaker 2: So that's actually exactly the point that I would emphasize,
Speaker 2: which is that we have allowed the industry to change
Speaker 2: so dramatically from that thought experiment of Grossmann Stiglus, in
Speaker 2: which everybody was roughly the same size. Marril was bigger,
Speaker 2: but it was a whole bunch of individual brokers who
Speaker 2: were able to do whatever they individually wanted to. Right now,
Speaker 2: what you've effectively done is you've created an industry that,
Speaker 2: like so many other industries, has become remarkably concentrated. And
Speaker 2: so one of the iron news is when Eric is
Speaker 2: talking about passive share, the way that that calculation is
Speaker 2: done is simply by adding up Vanguard, Black Rock, et cetera.
Speaker 2: Right now, that actually was the focus of a research
Speaker 2: piece that I actually inspired. I challenged to Harvard professors,
Speaker 2: actually a Harvard professor and a PhD candidate. Alex Chinko
Speaker 2: was the PhD candidate. Marco Salmon was the Harvard professor.
Speaker 2: I was the adjudicant on a paper that they'd written
Speaker 2: where they did an analysis on the impact of passive.
Speaker 2: I very much agreed with the work that they had
Speaker 2: done this public record, but they had done their scaling
Speaker 2: of the impact by looking at it and saying the
Speaker 2: share of passive is fifteen percent roughly what Eric was
Speaker 2: working off of.
Speaker 1: Right. In other words, when you look at ETFs mutual funds,
Speaker 1: passive is about fifty percent of mutual funds. Now it's
Speaker 1: over fifty percent, but the non funds, the direct ownership
Speaker 1: is primarily active. You're saying that is somewhat overstated.
Speaker 2: It is very much overstated. So it actually turns out
Speaker 2: the statistics that people are using for that is very quickly.
Speaker 2: The mutual fund or forty act industry is about thirty
Speaker 2: five percent of the equity market in total. A little
Speaker 2: bit more than half of that, as you're pointing out,
Speaker 2: is passive in its structure, and so we can multip
Speaker 2: plates round up to right. That's the quick answer in
Speaker 2: terms of how much is passive. But remember passive actually
Speaker 2: got started even before Bogel, it got started in the
Speaker 2: institutional space as well as Fargo that was first in
Speaker 2: the passive space. And so it actually turns out that
Speaker 2: away from the retail space, passive is even larger in
Speaker 2: the institutional space, and that's the area under the iceberg
Speaker 2: that you're missing, right. So Marco Salmon and Alex Chinko's
Speaker 2: work focused on exactly that they went and they did.
Speaker 2: They did an actual experiment where they tracked what fraction
Speaker 2: of shares had to trade in response to an index rebalancing,
Speaker 2: and the answer is around forty percent.
Speaker 1: Right now, I've seen some pushback to that that says
Speaker 1: there's a lot of end to day trading, there's a
Speaker 1: lot of people who are either front running or piggybacking
Speaker 1: those trades, and you can credit all of that forty
Speaker 1: percent rebalance number to passive and so that's how they
Speaker 1: end up with. Fidelity had to study. I want to
Speaker 1: say it was twenty twenty seven or twenty eight percent.
Speaker 1: Somebody else had another study that twenty three percent. But
Speaker 1: let's give you thirty percent. So if it's thirty percent
Speaker 1: going to forty percent, going to fifty percent, when fifty
Speaker 1: percent of the market is purely passive. Doesn't that mean
Speaker 1: that folks like David Einhorn are just going to clean up?
Speaker 1: Doesn't it create? Isn't it homeostatic and going back and forth?
Speaker 2: So if it were a stable situation, absolutely the case.
Speaker 2: The problem is is that when you talk about going
Speaker 2: from thirty percent to thirty five percent to forty percent,
Speaker 2: what you actually have is the scenario that we have
Speaker 2: in markets today. We're more than one hundred percent of
Speaker 2: the flows, which is actually what determines the majority of
Speaker 2: transaction activity is passive in its construction. Right Again, the
Speaker 2: active space is losing assets, it's seeing net redemptions. The
Speaker 2: passive space is actually receiving more than one hundred percent
Speaker 2: of the inflows. And if you go back and you
Speaker 2: think about the dynamics of Andrew Lowe stating ninety percent
Speaker 2: or John Bogel himself highlighting the between eighty and ninety percent,
Speaker 2: markets begin to break down, it's important to recognize that
Speaker 2: ninety percent of the trading activity no longer has a
Speaker 2: fundamental component to it. That's actually research that was done
Speaker 2: by JP Morgan as of twenty seventeen, and all the
Speaker 2: components that you're talking about the arbitrage, the normalization, et cetera.
Speaker 2: All of those are done in the facilitation of that
Speaker 2: end of day market on closing balance is tied to
Speaker 2: the mutual fund, ETF orders, et cetera.
Speaker 1: So what do you think about not traditional passive, but
Speaker 1: some of the concentrated portfolios. I had andrews Lemons of
Speaker 1: Morgan Stanley on not too long ago. He runs a
Speaker 1: twenty or a thirty name portfolio that has done pretty well.
Speaker 1: We continue to see people like Bill Miller slag the
Speaker 1: active side of the industry, calling them mostly closet indexers,
Speaker 1: and said, if you want to beat the market, you
Speaker 1: have to look different from the market. You have all
Speaker 1: sorts of things like smart beta and thematic investing, and
Speaker 1: I know simplify as an India based ETF. There's a
Speaker 1: lot of choices for people who want to run let's
Speaker 1: call it a core and satellite type of portfolio, where hey,
Speaker 1: our core is going to be look very similar to
Speaker 1: the market, but we're going to put our own stink
Speaker 1: on it because we want to have exposure to Japan,
Speaker 1: exposure to India, exposure to momentum, blah blah blah. Isn't
Speaker 1: that the sort of the direction things seem to be heading.
Speaker 2: In, not at all. So yeah, so there's a lot
Speaker 2: of highlight around the growth of active ets. For example,
Speaker 2: they're about twenty five percent.
Speaker 1: Become used right now, and they are capturing some flow.
Speaker 2: They are capturing some flow, but they haven't become huge.
Speaker 1: Let's actually be really become bigger. So I'm overstating it.
Speaker 1: They're much bigger today than they were five years.
Speaker 2: Ago, with the offset being that the mutual fund and
Speaker 2: hedge fund spaces are much smaller. Fair, right, So what
Speaker 2: you've actually had is a net decrease in the quantity
Speaker 2: of active but it's instructive. Everybody points out like, oh
Speaker 2: look how robust the space is and how wonderful it is. Right.
Speaker 2: The simple reality is is that nobody can actually afford
Speaker 2: to acknowledge many of the concerns that I'm highlighting. It's
Speaker 2: really very straightforward. There is no such thing as passive investing.
Speaker 2: Everybody is an active investor.
Speaker 1: Well, they're an active trader when they're deploying the capital,
Speaker 1: but they're not actively selecting stocks. They're relying on an index.
Speaker 2: Which actually is a decision process as an of course.
Speaker 1: Right, right, I did a column a couple of years ago,
Speaker 1: how passive? How active is you're passive? Where Hey, even
Speaker 1: the S and P five hundred, someone decided it's going
Speaker 1: to be market cap weighted. Someone decided what the rules are,
Speaker 1: and there's regularly additions and deletions that seem to be
Speaker 1: You remember when Tesla was added, that seemed to be
Speaker 1: an editorial decision, not a systematic algorithm deciding.
Speaker 2: Well, it actually technically was a very systematic decision, right,
Speaker 2: And so we actually Tesla was a fascinating example on
Speaker 2: this because we actually had received a lot of speculation
Speaker 2: and around it. The rules for inclusion in the S
Speaker 2: and P. Five hundred are pretty straightforward. You need to
Speaker 2: be all of sufficient size and you need to have
Speaker 2: at least five consecutive quarters of profitability. So once Tesla
Speaker 2: began actually reporting profits and then moving towards that fifth quarter,
Speaker 2: it became very clear that on a pure size basis,
Speaker 2: they were going to be the next player to be included,
Speaker 2: and the size that they were going to be included
Speaker 2: in was going to require an insane amount of passive buying.
Speaker 1: There was a ton of front running, also a ton
Speaker 1: of active running.
Speaker 2: The exact same thing just happened with SMCI, for example.
Speaker 1: Well, they're a lot smaller.
Speaker 2: It doesn't really matter, though, So I'm glad.
Speaker 1: You brought up Tesla. We're recording this on the first
Speaker 1: day of May of two months ago. Tesla, originally part
Speaker 1: of the Magnificent seven, down sixty five percent from its
Speaker 1: recent highs. Doesn't seem like active flows or passive flows
Speaker 1: were helping Tesla. And then over the last month, you know,
Speaker 1: they cut a deal in China, they kind of explained
Speaker 1: away some issues with the self driving problems. They cut prices,
Speaker 1: and suddenly they're back to only down fifty percent, which
Speaker 1: is a big move when you're down sixty five percent.
Speaker 1: Doesn't that belie the whole argument that passive is destroying
Speaker 1: price discovery. Obviously, a bunch of active managers figured out
Speaker 1: Tesla was way too richly priced back in twenty one,
Speaker 1: and after it got whacked by two thirds, someone else
Speaker 1: turned around and said, all right, this has gone too far.
Speaker 1: This is not a worthless company heading to bankruptcy. We
Speaker 1: want to own it. Isn't there plenty of price discovery
Speaker 1: going on?
Speaker 2: So, unfortunately, I think the answer to that is no, Right,
Speaker 2: there's always going to be a subjective component to that
Speaker 2: I would highlight. When you look at something like Tesla,
Speaker 2: there's a couple of things that are really interesting. One
Speaker 2: is who is the largest seller of Tesla besides Elon? No,
Speaker 2: that's exactly the right. Oh okay, so well, I did
Speaker 2: Tesla go down over that time period in which he
Speaker 2: was acquiring Twitter because he had to sell a ton
Speaker 2: of Tesla shares.
Speaker 1: There are a lot of other reasons, Like I will
Speaker 1: make a fundamental case for you, the yeah, Elon sold some,
Speaker 1: he didn't sell enough to whack it two thirds. Their
Speaker 1: cars are kind of along in the tooth that they
Speaker 1: haven't really introduced an upgraded Even the X and Y
Speaker 1: look very much like the models, and I'm sorry, the
Speaker 1: Model three and the Model Y look like the S
Speaker 1: and the X. China has become an ongoing problem. Five
Speaker 1: years ago, they were a decade ahead of everybody in
Speaker 1: the software. Now they're I don't know, three, four or
Speaker 1: five years ahead of everybody. And there's a boat ton
Speaker 1: of competition. It's not just for GM, BMW, Mercedes, Audi, Volkswagon, Volvo,
Speaker 1: Renault go down the list. You could buy an Evy, Rolls,
Speaker 1: Royce and Maserati if you want. Everybody is piled into
Speaker 1: the space. So fundamentally, you can make a case Elon
Speaker 1: sold a bunch of stock, but suddenly it's a more
Speaker 1: challenging environment and the stock had become overpriced. That's the
Speaker 1: argument I would make that that that Tesla had become overvalued,
Speaker 1: and it seems like the market picked up on a
Speaker 1: lot of it, especially what did a peak at at
Speaker 1: one point two one point three trillion. That kind of
Speaker 1: suggested we're going to own the EV space for the
Speaker 1: next decade.
Speaker 2: It wasn't even just own the EV space. So first
Speaker 2: of all, I actually agree with you, and I think
Speaker 2: most fundamental managers would agree with you that Tesla was overvalued.
Speaker 2: But the simple reality is overvaluation doesn't actually affect anything.
Speaker 2: What affects things is people actually executing trades. Right.
Speaker 1: The only so how much did Elon sell? I mean it,
Speaker 1: it didn't seem like he sold what did he overpaid
Speaker 1: for Twitter?
Speaker 2: Right?
Speaker 1: And he didn't pay for that wasn't all Tesla stock
Speaker 1: it was I think he had to pay ten or
Speaker 1: twenty percent of it. It's called ten billion out of
Speaker 1: one point two trillion. Shouldn't have crushed the stock.
Speaker 2: So let's use Bitcoin as an example for a second,
Speaker 2: how much money has flowed into the Bitcoin ETFs.
Speaker 1: I don't know, sixty billion dollars over the past decade.
Speaker 2: Well, not over over the past decade, but in particular
Speaker 2: since the introduction in January.
Speaker 1: Oh god, you look at the blackrock ETF It was
Speaker 1: at five billion dollars in a month, and it's probably
Speaker 1: close to ten billion dollars now.
Speaker 2: Right, So this's been about forty billion dollars worth of
Speaker 2: inflows against a bitcoin valuation or a market cap of
Speaker 2: bitcoin going into it of about four hundred billion dollars
Speaker 2: and it costs US sixty five percent appreciation, So forty
Speaker 2: billion dollars non linear? Yeah, that's fair. Same thing's true
Speaker 2: on Tesla, right, Everything happens at the margin. By the way,
Speaker 2: why did Amazon sell off so firmly over the past
Speaker 2: couple of years.
Speaker 1: Sous Bezos departed and the company is a shell of
Speaker 1: the delightful retailer it once was.
Speaker 2: Wouldn't that be awesome if it was true? Accept It
Speaker 2: really boils down to Mackenzie Scott selling her shares.
Speaker 1: There's a lot of that. So let me shift gears
Speaker 1: on you. Since we're talking about structure, I want to
Speaker 1: change things up and for a one more thing at
Speaker 1: you about structure, because I'm enjoying this conversation. So a
Speaker 1: couple of years ago we started working with the folks
Speaker 1: at O'Shaughnessey Asset Management, who rolled out a product called Canvas,
Speaker 1: which was a direct indexing product. Directly indexing has been
Speaker 1: around for decades. It to me, it's never been particularly impressive.
Speaker 1: And O'Shaughnessy had a couple of things going for them
Speaker 1: that nobody else did. They over their course of twenty
Speaker 1: thirty years, created their own incredibly clean database that they
Speaker 1: had built out that was you know, you have to
Speaker 1: look at CRISP maybe as the or compustat in the
Speaker 1: old days is and the only thing that's close. But
Speaker 1: it was really very specific to them. And second, you
Speaker 1: know the team at O'shaughnessee and I've had all these
Speaker 1: folks on between Patrick O'Shaughnessy and Jim who famously wrote
Speaker 1: the book What Works on Wall Street are really a
Speaker 1: first quant book for the public. They created a form
Speaker 1: of direct indexing that as someone who's been a skeptic,
Speaker 1: Dave Nottig and I have disagreed about this for years
Speaker 1: when we first saw this, and I want to say
Speaker 1: twenty nineteen, it's like, oh, I get it. You can
Speaker 1: do so much more now. And of the four point
Speaker 1: whatever billion dollars we run, over a billion is on
Speaker 1: the Canvas platform now owned by Franklin Templeton. And what
Speaker 1: we have discovered is if you have any sort of
Speaker 1: this is a long way to go, but I'll get there.
Speaker 1: If you have any sort of potential capital gains, you've
Speaker 1: inherited a portfolio, you've sold to business, you have a
Speaker 1: bunch of founder's stock, you have a bunch of IPO stock,
Speaker 1: and you want to diversify out of that core portfolio.
Speaker 1: But the capital game are going to be fairly weighty.
Speaker 1: You could use direct indexing to tax loss, harvest and
Speaker 1: order of magnitude better results than if you own half
Speaker 1: a dozen ETFs or mutual funds. Just and first quarter
Speaker 1: of twenty twenty, anytime you have a thirty plus percent
Speaker 1: decrease that fits nicely in the range of the calendar quarter.
Speaker 1: You know, instead of being seventy five eighty basis points,
Speaker 1: it's three hundred O'Shaughnessy has case studies four hundred, five
Speaker 1: hundred based points. Giant game changer. Long ask question, short
Speaker 1: conclusion is do things like direct indexing, which have always
Speaker 1: been a small part of the market, but seem to
Speaker 1: be catching a bid now? Might this interfere with that
Speaker 1: relentless bid of passive? Can something like this change the
Speaker 1: game for what you see as a structural problem in passive?
Speaker 2: So it is a very long question with a lot
Speaker 2: of different components to it. First, direct and next thing
Speaker 2: is almost by definition always going to be relatively small.
Speaker 2: It's a tax arbitrage strategy. It requires people to start
Speaker 2: with a lot and then try to maintain most of
Speaker 2: it right, And so the return differentials that you're quoting
Speaker 2: there are obviously a tax advantaged return differential. It's not
Speaker 2: the absolute levels of performance.
Speaker 1: That's right, understand. Let me let me clarify. I'm referring
Speaker 1: to the tax al for returns yep over and above
Speaker 1: what you get from the market, and it's not aimed
Speaker 1: at market performance in its own way. It is a
Speaker 1: form of I don't want to call it passive because
Speaker 1: it's not, but it apes passive investments or whatever funds
Speaker 1: you want to put.
Speaker 2: What it's doing is it's seeking diversification, right, So it
Speaker 2: really doesn't. What you're doing is you're taking heavily appreciated
Speaker 2: individual positions and you're then diversifying it into a market.
Speaker 2: Expos's exactly right. The ability to arbitrage your individual tax
Speaker 2: positions falls way outside the dynamics of market efficiency. Right,
Speaker 2: every individual is going to have their own components. We
Speaker 2: could get into tons of conversations around exactly that issue,
Speaker 2: and that actually almost perfectly fits with what the critical
Speaker 2: point that I would make is. It's not so much
Speaker 2: that passive itself is a terrible thing. It's actually the
Speaker 2: idea of a systematically algorithmic investment in which the simple
Speaker 2: determining algorithm is did you give me cash? If so,
Speaker 2: then buy? Did you ask for cash? If so, then sell?
Speaker 2: That actually can diversify a market, It creates a different mechanism,
Speaker 2: and it can actually lower volatility. And candidly, I think
Speaker 2: we saw that up to a certain point of market share,
Speaker 2: around twenty five percent market share. It actually turns out
Speaker 2: perversely that passive is beneficial to the market. It's once
Speaker 2: you go past that point that it starts contributing to
Speaker 2: higher volatility, much higher correlations, and the risk of severe
Speaker 2: left tail events, which brings us full circle back to
Speaker 2: the XIV type dynamic.
Speaker 1: So then let me ask you one final question before
Speaker 1: we jump to our favorite questions. Who has the burden
Speaker 1: for dealing with the challenges of passive attracting so much
Speaker 1: in assets? Shouldn't it be on the active managers to
Speaker 1: reduce their costs, put up better performance numbers over longer
Speaker 1: periods of time, and take advantage of all of these
Speaker 1: inefficiencies passive creates. Isn't this a system that should heal
Speaker 1: itself if active managers start to perform, lower their fees
Speaker 1: and attract more capital.
Speaker 2: So the answer is very quickly no. And unfortunately this
Speaker 2: brings us back to the question you had asked of,
Speaker 2: doesn't it get easier? And ironically what ends up happening mathematically?
Speaker 2: What occurs That constant bid that you're describing perversely changes
Speaker 2: the return profile of the market and it actually turns
Speaker 2: it into a This is difficult for people to see
Speaker 2: over radio, but I'm drawing a convex upward sloping curve right.
Speaker 2: It pushes valuations higher over time. Now, perversely, what we
Speaker 2: call alpha in the industry, which is typically how we
Speaker 2: evaluate individual managers, it turns out, is actually over time,
Speaker 2: just the intercept on a Y equals mx plus p
Speaker 2: and linear equation. Right, So I know this is hard
Speaker 2: for people, just like mentally, imagine your back in high school.
Speaker 2: It's your freshman year and you're doing a Y equals
Speaker 2: mx plus bograph and algebra. Right, what happens? That's the
Speaker 2: same thing as saying the portfolio return equals the market
Speaker 2: return x times of beta plus alpha. The residual in
Speaker 2: that the intercept in that if I curve that surface
Speaker 2: and I try to use a linear equation to solve it,
Speaker 2: it actually mechanically pushes the alpha's negative. The intercepts get
Speaker 2: pushed negative.
Speaker 1: Right.
Speaker 2: You can run this experiment with yourself. Just draw a
Speaker 2: positively curved line and then draw a series of straight
Speaker 2: lines that bisect it or intersect it. Understand how hard
Speaker 2: this is?
Speaker 1: Over No, by the way I see the curve, I
Speaker 1: see the intersect. Okay, where I would just push back
Speaker 1: on the algebras simply and he seated one of your
Speaker 1: early accounts. Soros's concept of reflexivity should say that the
Speaker 1: bigger passive gets it creates the more opportunities for active
Speaker 1: and therefore.
Speaker 2: It does in exactly the way that the XIV did,
Speaker 2: and that's why I chose the XIV for that trade,
Speaker 2: because it had already gotten to the levels of passive
Speaker 2: that I could very clearly see it happening almost immediately.
Speaker 1: So last question before I we do a speed round
Speaker 1: of my favorite five questions, what's the trade that will
Speaker 1: capitalize on the damage that passive is doing to market structure.
Speaker 2: So the quick answer is, unfortunately, if I'm right, you'll
Speaker 2: have an XIV type event for the S and P
Speaker 2: five hundred. I realize, how ridiculous. So you want to.
Speaker 1: Buy out of the money puts on the SPX going
Speaker 1: out as far as the leaps.
Speaker 2: Somebody will eventually win on that. But it is very
Speaker 2: stochastic in its framework.
Speaker 1: Meaning you don't know if this is next year, five
Speaker 1: years from now. You look at it as an eventuality.
Speaker 1: I look at it as a tail risk that the
Speaker 1: market itself hopefully corrects.
Speaker 2: And I would absolutely agree with you if that, if
Speaker 2: it could correct it, the problem is, and I'll share
Speaker 2: this with your audience, right. I presented this type of
Speaker 2: work to the FED. I've presented it to the IMF
Speaker 2: Financial Stability Group every single time, going in and saying
Speaker 2: please tell me why I'm wrong, And unfortunately the answer
Speaker 2: is you're right right. They actually acknowledge that. My reaction
Speaker 2: to that was fantastic. How can I help? What can
Speaker 2: we do? And their answer is there's nothing we can do.
Speaker 2: That's both the Vanguard and Blackrock control the regulatory apparatus.
Speaker 2: If we raise an alarm prior to the event happening,
Speaker 2: all that happens is we get fired.
Speaker 1: Huh. So let me ask you one or two other
Speaker 1: questions then related to those entities. So you said some
Speaker 1: of the models that BLS and NBR use are flawed.
Speaker 1: I'm a big fan of George Box's statement all models
Speaker 1: are wrong, but some are useful. NBER should declare a
Speaker 1: recession in first quarter twenty twenty three. I'm kind of
Speaker 1: paraphrasing something you said. Tell us why you think last
Speaker 1: year should have been declared a recession or NBR might
Speaker 1: declare to recession.
Speaker 2: I think in hindsight we might ultimately declare because we
Speaker 2: did see a combination of an increase in unemployment, we
Speaker 2: saw a decrease in industrial production, and we saw broad
Speaker 2: deterioration in terms of the economy. Things like leading economic indicators, etc.
Speaker 2: Are all consistent with historical recessions. Now, whether we choose
Speaker 2: to acknowledge that really boils down to the depth at
Speaker 2: which it occurred. And so the NBR looks at three
Speaker 2: separate components. They talk about how broad it is, how
Speaker 2: long it's occurring, and how deep the draw down is,
Speaker 2: And so the debate can be around how deep the
Speaker 2: draw down was at that point. I think the bigger
Speaker 2: issue that most people are struggling with is actually around
Speaker 2: things like the employment numbers, where there's been a very
Speaker 2: substantive change in how we calculate that data. What's called
Speaker 2: the birth death adjustment model, which was designed to reduce
Speaker 2: the need for periodic reassessments of what the levels of
Speaker 2: employment were in the economy tied to new business formation.
Speaker 2: There was an attempt to do that in a statistical framework,
Speaker 2: and unfortunately that statistical framework is now broken down now.
Speaker 1: I remember the two thousands BLS was showing some quarters
Speaker 1: where one hundred percent of the job creation for the
Speaker 1: month was due to birth death adjustments, and a lot
Speaker 1: of people called them out on it, and they subsequently
Speaker 1: made adjustments to their model. I've seen in certain reports,
Speaker 1: in certain commentary, Hey, you look at the past twelve months,
Speaker 1: it's all been adjustments. I'm not seeing that in the data.
Speaker 1: I'm seeing a lot of new job creation. Yeah, if
Speaker 1: you look at the household survey, it's slipped and there's
Speaker 1: a lot of new part time jobs. But the new
Speaker 1: work from home remote hybrid model lets a lot of
Speaker 1: people work part time and still do childcare. Whatever. Tell
Speaker 1: me what's wrong with the BLS model.
Speaker 2: Well, so the biggest issue with the BLS model is
Speaker 2: actually the conversion of those new businesses to jobs. Right, So,
Speaker 2: in particular, if you take a job in let's just
Speaker 2: say food service, right, or you create a job for
Speaker 2: yourself in food service by forming an independent company so
Speaker 2: that you can deduct some of your expenses for tax
Speaker 2: purposes for your job as a door dash driver. Right. Ironically,
Speaker 2: that falls into a category food service that's treated as
Speaker 2: high propensity to create additional jobs. And so this's a
Speaker 2: statistical model that then turns around and says, well, you
Speaker 2: started this DoorDash business called mike LLC, what's the prospect
Speaker 2: that that's going to create new jobs? Because of its
Speaker 2: sac code, it's actually treated as a high perpen city
Speaker 2: job formation, and it's assigned additional jobs in the establishment payroll.
Speaker 1: What about all the Uber drivers and Lyft drivers out there.
Speaker 2: So I actually think this is actually a fascinating dynamic.
Speaker 1: Because what you said we used to call those people unemployed.
Speaker 2: We did actually used to call those people unemployed. And
Speaker 2: so again, these are revisions that have happened within the
Speaker 2: data sets, and it's all very similar to this type
Speaker 2: of discussion that we're having, where it's in the details
Speaker 2: that ultimately matter. In two thousand and eight, we didn't
Speaker 2: have Uber, right, It's important to recognize that. So if
Speaker 2: you wanted to go drive New York City taxi, that
Speaker 2: was an entirely different job. You didn't even have Uber
Speaker 2: in twenty ten. What you really had was the Uber
Speaker 2: X introduced in competition. Would Lyft in twenty twelve. This
Speaker 2: or way out of the recession at this point. That
Speaker 2: changes the dynamics. But you used to be able to
Speaker 2: be unemployed and go get a cash paying job. I
Speaker 2: could go bartend at your bar, for example. You'd be like, Hey,
Speaker 2: I'm an LPIOD. I'll pay you under the table, right, Okay,
Speaker 2: you pocket some of your receipts, you sell some beer
Speaker 2: for cash, you pay me with it. Nobody knows anything
Speaker 2: from the government standpoint, those rules actually began to change
Speaker 2: quite significantly. In twenty twelve, we introduced what's called the
Speaker 2: ten ninety nine I think it's kay that changed the
Speaker 2: reporting crew requirements around that type of business. It made
Speaker 2: it much easier and much more electronic. And then in
Speaker 2: twenty twenty one we actually substantively changed the rules. We
Speaker 2: went from being able to treat up to twenty thousand
Speaker 2: dollars in income as independent and not requiring filing taxes
Speaker 2: to six hundred dollars. Well, when you go from twenty
Speaker 2: thousand to six hundred, you catch a whole bunch of
Speaker 2: new businesses and that's really what's showing up in the
Speaker 2: employment numbers.
Speaker 1: Huh, really fascinating stuff. Thank you, Mike for being so
Speaker 1: generous with your time. We have been speaking with Mike Green.
Speaker 1: He is the chief strategist at Simplify Asset Management, helping
Speaker 1: to oversee twenty eight funds with over four billion dollars
Speaker 1: in assets. If you enjoy this conversation, check out any
Speaker 1: of the five hundred we've had over the past ten years.
Speaker 1: You can find those at iTunes, Spotify, YouTube, wherever you
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