Has Passive Investing Broken the Market? | Mike Green

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[00:00:19] Hey, guys, this is Justin. In this episode, Jack and I sit down with Mike Green, chief

[00:00:23] strategist at Simplify ETFs to discuss the influence of passive flows on the markets, And Einhorn basically made the statement that markets were fundamentally broken by passive. And actually some of the thoughts I think that he had actually came off of a conversation he had with you a few years ago. And so I think that comment, along with how different people are thinking about that,

[00:01:42] as well as the fact that the market, I guess in the last 12 months, has been led by maybe

[00:01:45] a handful of stocks, got us thinking, when you rebalance an index, when you change the index, you actually have to transact, and therefore you can't be passive in that environment. He was 100% correct, but candidly,

[00:03:01] nobody had really thought to challenge footnote number four

[00:03:04] in the Bill Sharp paper and say,

[00:03:06] are there conditions under which

[00:03:07] this footnote makes no sense? types of strategies. The first thing we recognized was that what we were really describing was systematic strategies. And so we began looking for opportunities in which systematic strategies had become so large that it was apparent to us that the market structure was actually truly broken, as David describes, right? That you were going to see behaviors that you should never have seen

[00:04:22] before. That's where I stumbled across the XIV seven years. So it's, I know, it's been a long time. Yeah. We're going on eight years, actually, crazily enough. You know, the things that change the most. So we actually went into the initial decline or the initial withdrawal out of passive was in the fourth quarter of 2018. I'm pretty

[00:05:41] firmly convinced that the behavior that we saw in the US equity markets. That's a combination that's not the hardest definition.

[00:07:01] So that's not everybody that needs to transact on a day when they rebalance indices, for example,

[00:08:03] I think it's slightly higher than that because they're not including things like futures, etc., which admittedly are relatively small component, but still quite significant.

[00:08:08] We're going to talk about some of the risks of this in a minute, but is there a level

[00:08:11] where you become way more worried about the risks?

[00:08:14] I mean, we're going up 3% a year.

[00:08:17] Are we there now?

[00:08:18] Is it something, if we go up another 10%, it becomes way more risky?

[00:08:21] Yeah, I mean, there is because if you think about it, right? Imagine an open outcry system, right? Take yourself back to the movie Trading Places and the open outcry pits or the New York Stock Exchange where it used to be people shouting at each other. Just imagine you put earplugs in half of their ears, right? That's effectively what passive is.

[00:09:40] They're blind and immune to the signals

[00:09:42] that are coming through the market

[00:09:44] because they are tied to something external to the market.

[00:10:45] of this, where the largest buyer, you know, and the largest holder of the name, effectively has no insight into what's actually happening.

[00:10:49] There's nobody at Vanguard who's looking at Supermicro and saying, you know, with the advent

[00:10:53] of AI, their rack servers are going to be so much better than everybody else.

[00:10:57] So they've partnered with Nvidia, right?

[00:11:00] They're completely blind to that.

[00:11:02] And yet, ironically, when other people try to pursue if you look at the behavior of the Russell 2000 on a year to day basis, I wanna say, I can pull up the data in a second, but I wanna say it's something like, more than 100% of the recent gains that we've seen in the Russell 2000 are actually tied to the behavior of names like Super Micro. Since January 17th,

[00:12:22] which is kind of the recent bottom for the Russell 2000,

[00:13:26] So we're seeing these sorts of impacts play through and I would argue is not that similar to what we saw in February of 2021.

[00:13:29] It's interesting.

[00:13:30] One of the things I heard references is sort of this vicious cycle, where money comes into

[00:13:33] passive, it drives up those stocks, value managers underperform, they get redeemed,

[00:13:38] they have to sell their stocks, that money cycles back into passive, drives those stocks

[00:13:42] up again.

[00:13:43] I mean, is that sort of the dynamic we're seeing?

[00:13:44] Well, it's's the case. We can do all sorts of studies around this. But the irony is that we've always assumed that financial markets don't work off of changes in supply and demand because somewhat by definition, supply and demand are always in balance things like the efficient market hypothesis. What they're not familiar with, the equivalent of that footnote number four in the Bill Shark paper, are the assumptions that are embedded in that. The efficient market hypothesis, this idea that people react to news flows,

[00:16:22] requires a number of conditions for it to hold understand the implications of that transaction. And Gebedne and Coitra's estimate is that it's about a dollar into the market Einstein's theory of relativity world. They both can't actually be true, even though the approximations of both can be useful up to a point. You don't use quantum mechanics to try to get something to the moon because they're

[00:19:01] two very large objects.

[00:19:03] You could basically use slide rules in Newtonian physics to calculate the trajectory that's

[00:19:07] required. can be caustic and damaging to a much broader population. Everyone acting in their own self-interest is part of the message and part of the signaling in capitalism. But if everybody decided to pollute, right? Or if everybody decided to defecate in the streets,

[00:20:20] we would have to actually step in and say,

[00:20:21] well, that may be locally optimal for you,

[00:20:24] but the rest of us are gonna get typhus infections

[00:20:27] if you keep defec participant to the market. I have to figure out how to generate returns

[00:21:42] without involving the market.

[00:21:44] I need to have the ability for that

[00:21:46] to be generated endogenously. I have to just pretend the market doesn't exist. Occasionally it'll swing my way, but for the most part, I have to pretend that this thing doesn't exist and I need to identify things that I would be comfortable holding forever. And that's, you know, there's parts of that that are really positive. The irony is, is as he's correctly pointing out, there's very few names that meet that criteria.

[00:23:00] And ironically, there's a player out there

[00:23:02] in the form of Vanguard and BlackRock

[00:23:04] who's taking Americans dollars the Grossman-Stiglitz paradox that highlights why people are still incentivized to try to find opportunities to invest. Their point was, look, even if markets were efficient, if everybody believed markets were efficient, that would result in overlooking opportunities exactly as David's describing.

[00:24:21] The problem with that model is just like that footnote number four in Bill Sharp's paper. in a world in which passive strategies now have 40% or anywhere close to 40% of the voting power, you've actually broken that wisdom of crowds type market. And as a result, you can get really terrible guesses about what stuff is worth. I want to ask you about some of the pushbacks you get. I actually went on your Twitter before we did this, just to look at some of the things people were saying

[00:25:41] to you like in response to this.

[00:25:42] And one of the things I saw is somebody had sent you

[00:25:44] like a chart of Google or something and said,

[00:25:46] basically here's the stock price performance,

[00:25:47] here's the earnings growth. I'm also wondering, is there a way to measure this? Is there a way to measure? Obviously, the market cap part's easy, but the liquidity parts probably a lot harder. Is there a way to identify the companies that are most likely to be affected by this because their liquidity is lower as a function of their market cap? There's a couple of different ways this can be done. This is actually drawn from a paper by Valentin Haddad

[00:27:01] called How Competitive is the Stock Market?

[00:27:04] What they're highlighting here is

[00:27:05] that the larger the market capitalization, in there. I don't care. They're kind of the same thing. Right. But you can't replace Apple. The second component is actually tied to market microstructure, how market makers work. And so when you think about what a market maker is doing, they're effectively trying to cross the bid and the ask spread in any given stock, and do so repeatedly and put that extra money

[00:28:20] into their pocket. In order to conduct those transactions, they have to put up a certain

[00:28:25] amount of capital that facilitates them buying and see this phenomenon. But it unfortunately means that market cap weighted indices lead to the types of distortions that we're actually talking about. Does that make sense? Yeah. So if you were going to run a strategy based on this to try to take advantage of it,

[00:29:40] you almost would just run a market cap weighted index rather than trying to figure out,

[00:29:43] like, is this stock going to be more influenced relative to a different stock?

[00:30:42] are trying to look at shareholder-friendly policies and practices and how companies are structured.

[00:30:45] But I'm just thinking that if more and more money

[00:30:48] continues to go passive, how that shakes out

[00:30:50] from a governance perspective?

[00:30:52] And are we just going to be walking around with companies

[00:30:55] with management that can do anything?

[00:30:57] Because there's really no oversight.

[00:31:00] So I think there's certainly an element of that.

[00:31:04] A lot of people have highlighted this dynamic,

[00:31:06] in particular John Coates at Harvard Law School I do think that we need to acknowledge that these entities are in many situations willfully ignoring components of what we're describing. The voting part, I think there's actually relatively easy solutions to, particularly on the public side. The market structure impact, the price dynamics, the impact on capital formation, that's the

[00:32:23] part that I think that people are not paying attention to. participation rates in the 70s prior to the pandemic is currently printing participation rates in the 30s. The way that you behave, 30% of survey recipients actually respond with the data, right? The way that you conduct an analysis of that is very different if it's 30% response rates

[00:33:42] than if it's 70% response rates.

[00:33:45] And I'll give a really simple example Is my boss going to pop his head and say, what are you doing? Probably not nearly as much. Like there's just, nor do they necessarily, and a lot of these surveys are conducted by telephone. How do I reach the person? It's just a lot harder to actually do these things. If you call the front desk at a business where everybody is operating and you say, hey, can you put me in touch with the person who's charge of hiring?

[00:35:02] It's a lot easier if they're physically co-located in the same place,

[00:35:06] and if they're spread out across multiple individual homes. It implies that there's some logic to this. Why is this happening? If I try to explain to you, no, I actually think that we're largely captured by entities that I think the technical term is don't care anymore. That's just a much harder conversation. It's really a difficult one for a lot of people to accept. But in terms of the inflation data, do you think the real level of inflation in the economy

[00:36:23] is lower than what we're getting reported?

[00:36:25] Yes.

[00:36:26] Okay.

[00:36:27] Yeah. look at the stuff that's coming through that's happening now, what's called new tenant indices, for example, those are actually printing strongly negative numbers. They're printing numbers that are more negative than what we actually saw during the global financial crisis. And I will tell you, somebody who's actually currently looking for housing, this is very much what I know, if you talk to somebody who's in the bottom quartile, for example, they will tell you I'm at the breaking point, right? I don't have any money in savings. My car payments going up. My insurance bill is going up. The food prices are not coming back down.

[00:39:00] I'm not making that much more money associated with it Right. This is like, you know, I feel like these people are gaslighting me, which is exactly the social behavior that you would expect. Right. Because this is the equivalent of like somebody coming to you and saying, oh, I totally understand your position. But, you know, Jack, if you had just bought Bitcoin, you'd be so well off that you wouldn't have to worry

[00:40:22] about anything. So let's focus on Bitcoin instead of like paying your

[00:40:25] bills this month. You know, like, that actually mean? Does that mean drivers are working more hours in the day? No, it means there's more people driving for Uber. Why would there be more people driving for Uber? Uber environment improves. Now the next person loses their job or the next two to 3% of people lose their job and suddenly they can't be absorbed into the Uber universe and at the same time they stop using Uber. So it creates the potential for a very brittle

[00:43:01] and fragile rapid deceleration

[00:43:05] that is unlike anything we've that are refusing to refinance, because if they refinance, they're actually going to be in a situation in which they basically are, you know, entering a death spiral. They've increased their coupon payments so much,

[00:44:22] they no longer able to actually run their businesses

[00:44:25] they would like to, that causes had to walk it back, but he was saying, if we wait until they see all the data they need to see, it's going to be too late. He was getting in front of that from a trend standpoint, and now here they are walking it back again. Interesting. I think this is one of the real challenges, because again, we've defined financial conditions.

[00:45:44] How do we know loose financial conditions?

[00:45:47] Markets are at highs. In particular, I'm extremely sensitive to this issue of flows and the origination of flows tied to employment characteristics. Because what I know is we have outflows associated with retiring baby boomers that are tied to asset levels. Whereas contributions are always going to be a function of incomes. Well, you know, my expectation was that we would have

[00:47:04] a larger response to financial crisis as interest rates began to rise, people were unable to refinance. They were then forced to refinance by a combination of maturity components. This is where we are today. We

[00:48:22] are less than five years of maturity for the index interest expense. And so many, many of these companies are actually now looking at their increase in interest expense associated with refinancing, creating conditions under which they can no longer deduct that interest against their taxes.

[00:49:41] Their after-tax cost capital goes up a lot.

[00:49:45] That puts them at a competitive disadvantage. dance. You have to remain invested, you have to remain exposed to risk assets and equity markets, even as you fully acknowledge that there is an impending event that's going to show up as a significant credit cycle, that you can't possibly price until the event actually happens. It's a little bit like the COVID dynamics. Anyone who was paying attention knew about COVID in January.

[00:51:04] The markets tried to correct. They then went right back in everybody's face.

[00:52:03] It just gives you somewhat of a convex payout if you want to flip that in reverse

[00:52:08] Do the opposite right belong the individual but go by protection, right? But nobody wants to do that right now because that means your portfolio lags, which means you get fired

[00:52:14] Which means well, what was the point?

[00:52:16] All right, that's really what Chuck Prince was saying when he's saying, you know when the music's playing you got to dance

[00:52:21] It's all well and good to say that the you know to lean back against the wall of the party and be like

[00:52:26] Oh, look at those sharply. I think that's going to, exactly as we're discussing, I think the Fed is going to be slower to move. The Fed is going to be less willing to be perceived as soft on inflation because we had

[00:53:40] this inflationary episode. It just makes it harder Siegel, and then I should get returns delivered to me that allow me to achieve those objectives is to meet very deterministic. Because if everybody just kind of throws up their hands and they say, oh, it's just the fourth turning, this is what happens. Well, then you're never making the hard decisions that get you out of the fourth turning.

[00:56:21] You're never making the hard choices

[00:56:22] that actually allow you to accomplish an objective.

[00:56:26] But I would argue you're starting to see this change. savings that Americans experience in terms of reduced asset management fees. I think the answer is no. They think the answer is yes, but everything I'm seeing in discussions with them suggests the reason that they believe that to be true is because while they will acknowledge the passive is influencing the market, they don't think that it's really that big of a deal. I think it's a really big

[00:57:42] deal. I think the implications of it's going to be much more severe consequences. Thank you very much, Mike. Always super thoughtful. Uh, appreciate having you on and sharing your wisdom with our audience. Absolutely a pleasure, Justin. I appreciate you and Jack having me on. This is Justin again. Thanks so much for tuning into this episode of excess returns. You can follow Jack on Twitter at practical quant and follow me on Twitter

[00:59:04] at JJ Carbono.

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