What the Rise of Passive Investing Means for Your Portfolio | Special Guest: Dave Nadig

[00:00:00] Welcome to Excess Returns where we focus on what works over the long term in the markets. Join us as we talk about the strategies and tactics that can help you become a better long term investor.

[00:00:09] Jack Forehand is a Principal at Validia Capital Management. Matt Ziegler is Managing Director at Sunpoint Investments. The opinions expressed in this podcast do not necessarily reflect the opinions of Validia Capital or Sunpoint Investments. No information on this podcast should be construed as investment advice.

[00:00:30] Securities discussed in the podcast may be holdings of clients of Validia Capital or Sunpoint Investments.

[00:00:36] Hey guys, this is Justin. In this episode of Excess Returns, we are featuring a great discussion we had on our separate podcast, Two Quads and a Financial Planner.

[00:00:41] We have talked about the impact of the rise of passive investing with many of our guests of Excess Returns, and we thought it would be good and interesting to bring those clips together into one episode to help us all make sense of it.

[00:00:50] In this episode, Matt and Jack are joined by our good friend Dave Nottig to do just that. They examine the insights from Mike Green, Asswass Dhamadoran, Rick Ferry, Cliff Assness, and Rob Arnaut, all with the goal of helping us understand what the rise of passive investing means for our portfolios.

[00:01:02] If you enjoyed this episode, you can subscribe to Two Quads and the Financial Planner on all major podcast apps. Thanks for listening.

[00:01:32] About this topic, which if you haven't figured it out from the cover is passive investing and its impact on the market. And we've been able to interview a lot of people on Excess Returns and get a really diverse set of opinions on this.

[00:01:43] So we're really excited to have Dave here and we're going to break down the different clips from the different opinions we've got and try to make sense of some of this. So Dave, thank you for joining us on this.

[00:01:51] Hey, thanks for having me. Let's get into it, man.

[00:01:54] Let's do it. So before we talk about passive and a lot of the stuff we're going to talk about came from Mike Green. I mean, Mike's done extensive work on this.

[00:02:01] There's a lot of academic research backing up what Mike's done as well.

[00:02:05] But before we get into that, we probably should start with what was the problem maybe that led to the rise of passive investing.

[00:02:11] And so this first clip is from Aswath DeModer, and he's talking about the disaster, I guess is the best word to put it, that active investing has been over time.

[00:02:18] I think there is something to the argument that passive investing makes momentum strong because basically you flow wherever the market cap is highest and you're going to see it.

[00:02:28] No, but there's a reason active and passive investing has taken off, right?

[00:02:33] Let's face it. Active investing has always been crappy, always through its entire lifetime.

[00:02:38] But for much of its lifetime, we didn't know how crappy it was.

[00:02:41] I tell people to imagine being in the 1960s, right?

[00:02:45] There were only active mutual funds.

[00:02:47] You put your money in an active mutual fund.

[00:02:50] You got one statement, maybe for a year telling you what your investment was doing.

[00:02:57] No comparisons.

[00:03:00] No idea what the rest of the world is doing.

[00:03:02] And you said, these guys are professionals.

[00:03:05] They know what they're doing.

[00:03:06] I've trusted them.

[00:03:08] This is the right thing to do.

[00:03:10] Two things happened.

[00:03:12] One is we started to get information about how badly active investing was doing on a continuous basis.

[00:03:20] On your smartphone, you could say, say, my fund is up 7%.

[00:03:24] The S&P 500 is up 12%.

[00:03:26] Second, we empowered investors to be able to move their money.

[00:03:31] Can you imagine moving your money in the late 60s from one brokerage house to another?

[00:03:36] First, you'd have to physically drive to that brokerage house.

[00:03:40] You'd have to talk to the person at that desk who was going to convince you that this was the worst decision you could ever make.

[00:03:48] I guess if you insisted, he would still have to let you liquidate.

[00:03:52] But, you know, it would have been a long, drawn-out, expensive process.

[00:03:56] Now you're sitting at lunch.

[00:03:57] You realize your mutual fund is underperforming the S&P 500.

[00:04:01] Here's what you do.

[00:04:02] You sell your fund while you're at lunch, while you're taking a bite of your tuna sandwich.

[00:04:07] You sell your fund.

[00:04:08] You move it into another fund.

[00:04:09] Two things happened.

[00:04:10] One is information about how badly active investing was doing became public information.

[00:04:16] We all knew second.

[00:04:18] It became easier for us to act on that information.

[00:04:21] The rise of index funds and ETFs can very rarely be linked to investors waking up saying,

[00:04:28] this isn't working for me.

[00:04:30] I'm paying somebody to deliver 2% less than I could have made by not paying that person.

[00:04:35] I mean, I describe active investing as the equivalent of floods or rust, a plumbing company,

[00:04:40] that if you call into your house because there's a leak, leaves a flood and sends you a bill for it.

[00:04:46] You'd never pay the guy, right?

[00:04:49] Active investing's bad performance has caught up with them.

[00:04:52] I do think, though, that as passive investing grows, and it will continue to grow.

[00:04:58] This is inexorable.

[00:05:01] It'll hit a cap.

[00:05:02] The reason it'll hit a cap, it's true that as passive investing grows, there are fewer and fewer people looking for bargains, looking for mistakes.

[00:05:11] When we talked about efficiency, the reason mistakes are so difficult to exploit in markets is because other people are also looking for them.

[00:05:19] There's a tipping point where if too few people are looking for mistakes, you could argue that the magnitude of mistakes will get larger and that active investing is going to pay off again.

[00:05:28] So there's an ebb and a flow to this, and I think there will be a point where passive investing overreaches and active investors will come back.

[00:05:37] But the steady state is going to be about a lot fewer active investors than we see today.

[00:05:44] All those floors in Boston that Fidelity has, two-thirds of them they don't need.

[00:05:52] It's not great if you're in the active investing business because the business is going to get smaller.

[00:05:57] So, yeah, I really like this.

[00:05:59] I love this flood thing.

[00:06:00] I love this idea of, like, you know, if there's a leak, you call a plumber and the plumber creates a flood.

[00:06:04] I mean, that's basically, in a nutshell, what active investing has been, right?

[00:06:08] Yeah, I mean, that's kind of what I think of that as particularly being hedge fund investing, where you get the exact opposite of what you wanted, but you still end up paying $2.20.

[00:06:17] But, look, this isn't real news, right?

[00:06:20] So the best research on this has been done by Standard & Poor's for years and years.

[00:06:24] They published something called the Index vs. Active Scorecard.

[00:06:27] We could quibble about the methodologies, but at this point they've got, I think, 30 years of data really tracking with survivorship bias how active is compared versus their own stated benchmarks.

[00:06:38] And the reality is the numbers are awful.

[00:06:41] On a 20-year basis, something like 95% of active managers have underperformed their benchmark.

[00:06:46] As you get towards narrower and narrower windows, it gets a little better.

[00:06:49] And, like, this was one of the best sort of first nine months we've ever had for active managers.

[00:06:54] And they're not quite at 50-50 yet, right?

[00:06:57] So it's still a coin flip in this amazingly good year for active management about whether they're even going to keep up with the S&P 500s.

[00:07:05] It works in some places, so small cap, emerging markets, particularly things like emerging markets debt, markets that I think we, you know, at least apocryphally always think of as inefficient.

[00:07:17] The active managers tend to perform a little bit better in the first half of this year, for instance.

[00:07:22] Small cap managers, 90% of them, roughly 87% of them, beat their benchmark, which is like Katie barred the door, you know, a win for active.

[00:07:31] But that's a bit of an outlier, right?

[00:07:33] And when we're talking about passive, for the most part we're talking about the whole market, or at least that top half of the market most of us are actually invested in.

[00:07:41] Fascinating, too, because the point that he makes about how do you feel and how is easy is to do something different about it.

[00:07:49] That's just one of those pervasive things.

[00:07:51] We can't deny it.

[00:07:52] We see it in every single aspect of our lives.

[00:07:54] We can say, how do I feel?

[00:07:56] And we can either, you know, pick up the phone and make an adjustment or, you know, pick up the zine and read something about it and sit back on our laurels and ride it out.

[00:08:06] But this is the reality.

[00:08:07] How we feel and our ability to make a change really quick has totally altered the way humans interact with the world.

[00:08:13] Of course, it's hit markets, too.

[00:08:16] What are you thinking about this, Jack?

[00:08:18] Yeah, no, that was the point that probably hit me the most about this is like we just know it's happening now.

[00:08:23] This has been happening for a long time, but we've become aware it's happening and we can do something about it.

[00:08:28] And when you put those two things together, that leads to a rise of passive investing, or at least part and part leads to a rise of passive investing.

[00:08:34] Yeah, and the long term nature of active management, he hits on this.

[00:08:38] Some of our other guests are going to hit on this, too.

[00:08:39] But, you know, if you have to be in for three or four years before your active manager really proves their salt, how many people are really going to stick around that long?

[00:08:49] We're a very short, different oriented society.

[00:08:52] Nobody hangs out for a full market cycle unless you're an institution who's truly got an infinite time horizon.

[00:08:58] And that's such an important point because I'm a value investor, at least in part.

[00:09:02] And that's the tough thing with value investing is the time frame you probably need.

[00:09:06] And Meb Faber's talked about this to judge value investing is probably a decade, but nobody's going to sit around for a decade.

[00:09:12] So it makes value investing a very tough strategy for people to follow.

[00:09:15] So let's go to Mike Green's arguments now.

[00:09:17] And now that we've kind of decided that active investing maybe hasn't worked out that well over time, this is probably the best thing I've seen from Mike about his arguments about the impact of passive investing.

[00:09:26] So the work that I've done around passive is actually just a very straightforward recognition that the definition of passive investing in the academic literature is somebody who a passive investor is somebody who holds every security.

[00:09:39] Not holds an index, not holds a subset of securities, somebody who holds every security.

[00:09:45] There's also no there's no mechanism for passive investors to buy or sell.

[00:09:50] And so the minute you start recognizing that the structure that we've actually built involves people who are buying indices, whether those are total market or the S&P 500, and we label those investors passive, we're doing ourselves a disservice.

[00:10:05] They're not passive.

[00:10:06] They are algorithmically simple investors that are choosing a very common strategy, which is to buy stocks in proportion to their float adjusted market cap weight.

[00:10:16] That can be within the S&P 500, which is a popular strategy, or it could be a much broader exposure to something like the total market index.

[00:10:25] At its core, that's where the theory of passive breaks down, because these are not passive investors.

[00:10:31] By definition, if you're putting money to work, you're doing so with your paycheck, you're doing so with your discretionary thoughts, you cease being a passive investor.

[00:10:40] And it becomes very valid to turn around and say, what is the impact of this?

[00:10:45] Now, that insight, effectively, that the key story was about transactions or the actual flows as compared to the stock is kind of the only unique thing that I've brought to this process.

[00:10:58] The really key insights around what's actually happening with passive have been fleshed out by a lot of academics over the last five years.

[00:11:07] And I just want to remind people that when I kind of stumbled across this stuff and I found my way to it through other thinkers, guys like Lasse Peterson and AQR, wrote a very important paper called Sharpening the Arithmetic of Active Management,

[00:11:21] in which he highlighted this definition of passive investing and then noted that there were periods of violation around that.

[00:11:28] So my work was simply extending that and saying, hey, wait a second.

[00:11:31] Anytime a flow is contributed, that makes you not passive.

[00:11:33] Therefore, these are never passive investors.

[00:11:36] You have to think in a slightly different way.

[00:11:38] Beginning in 2020, really 2019, academics began to start to really start to chew on this problem.

[00:11:45] And unfortunately, all their work at this point, or at least the work that I have read, is increasingly pointing in the direction that my views are correct,

[00:11:54] that ultimately we're creating a distortion in the market that is tied to the growth of passive investing,

[00:11:59] that is changing the actual features and behaviors of the market itself.

[00:12:04] Now, you can argue those are good.

[00:12:05] You can argue those are bad.

[00:12:07] But when you run through the models and you actually recognize what the long-term impact of this,

[00:12:13] it unfortunately is that we either have a total loss of utility in the markets because people can't get shares public,

[00:12:20] because people can't use the markets to raise capital,

[00:12:25] or you end up with a situation in which the attempt to withdraw from those same passive investors overwhelms the available liquidity in the market,

[00:12:34] and the market ultimately collapses.

[00:12:37] When I started doing this work, I looked around at different markets to try to find ones that had the highest fraction of passive or systematic investors,

[00:12:45] who had a defined strategy and a known response to flows into price behavior.

[00:12:51] That's where I stumbled across the XIV, which was a trade that kind of launched me into the public sphere.

[00:12:58] This is no different, right?

[00:13:00] What we're actually seeing is we're seeing a pattern of the traditional discretionary investor,

[00:13:05] a professional investor who attempts to do a discounted cash flow type analysis to figure out what something is worth,

[00:13:12] is being replaced by investors who presume that everybody else has done that work,

[00:13:17] and therefore they're not having any impact.

[00:13:20] But that's simply untrue.

[00:13:21] So the big thing for me here, and I was very skeptical of this for a long time,

[00:13:26] but this idea that passive investors aren't passive.

[00:13:29] I mean, this took me a while to get through my head,

[00:13:31] but the idea that there are flows coming in all the time from passive investors,

[00:13:36] and there is at least the potential that those flows are impacting the relative pricing of securities.

[00:13:40] Like, I'm a big believer in that, but it took me a while to get that through my head.

[00:13:44] Yeah, there's a really critical nuance here that I think is super important for people to get.

[00:13:50] So he points to some of this work, we're going to talk about it a few times in academia,

[00:13:54] to talk about elasticity in the equity markets.

[00:13:57] And the argument that he's reiterating here and that's been backed up by the academics

[00:14:01] is that when a dollar shows up in the market in a block trade, in an index for the whole market,

[00:14:07] it has a $5 impact on the market cap.

[00:14:10] And that seems impossible.

[00:14:11] If you think about it one-to-one, it doesn't seem to make sense.

[00:14:14] The thing you have to remember is most of the money that is invested in the market

[00:14:19] has to be invested in the market.

[00:14:21] Meaning, if you show up with your million dollars to buy,

[00:14:25] you are not getting it from some institution that's just decided,

[00:14:28] you know what, at this price we don't want to be in equities anymore,

[00:14:31] we're switching to bonds.

[00:14:33] That's not how the real world works.

[00:14:35] So you have to pry your index basket away from somebody who's truly ambivalent

[00:14:41] about whether they own the market or something else.

[00:14:44] There are not that many people who are ambivalent.

[00:14:46] When you're trading a single stock, somebody may say,

[00:14:48] hey, I don't really want this apple at this price.

[00:14:51] I'll swap it for Microsoft.

[00:14:52] That's a much more likely trade.

[00:14:54] So the more blocked these trades come in, the more impact it has on the market.

[00:14:59] I'm fascinated by this idea, too, of you can never talk about flow

[00:15:03] without also talking about some form of resistance and what that other thing that gets in the way.

[00:15:09] And this is such an obvious and intuitive point, but it's everywhere in life.

[00:15:14] Like, you want to go out for a run?

[00:15:15] And Jack and I were talking before we started recording here.

[00:15:18] Like, it's raining outside.

[00:15:19] I don't want to...

[00:15:20] My dog doesn't want to go for a wall.

[00:15:21] Well, he can't achieve his flow state if the act of resistance that is wet outside keeps him from doing it.

[00:15:27] So when we have in these markets, we have to talk about the flows and the way they get into the system,

[00:15:31] the way a dollar comes in, the way a dollar comes out.

[00:15:33] And we have to never, never, never assume that there's just zero resistance

[00:15:37] and that this myth of passive can be pervasive throughout all markets in humanity.

[00:15:42] That's a crazy thought to think that this doesn't matter.

[00:15:46] And I think one of the other important things to keep in mind here is

[00:15:49] these flows are pretty much always positive.

[00:15:52] You know, people are putting money into their 401ks.

[00:15:54] They're going to work in the market.

[00:15:55] I think Mike said there might be like one or two instances in history where these turn negative,

[00:15:59] but they almost are always positive no matter what's going on.

[00:16:02] Yeah, short-term vol spikes, you'll see some net negative flows into the equity markets.

[00:16:06] They don't last long.

[00:16:08] They really don't.

[00:16:08] Like, even in late 80s, you know, we had months maybe where we had negative flows

[00:16:13] and people were like, no, I don't want to own equities.

[00:16:15] But it only takes a few of those people to make the market go down a lot.

[00:16:19] And there are a lot of people who are immediately sitting there on the sidelines saying,

[00:16:22] ooh, market's down 20%.

[00:16:23] I have cash.

[00:16:25] So it really is this inexorable positive flow, which I think you have to say is a kind of momentum effect.

[00:16:32] What do you guys think are the best estimates of the amount of like the percentage passive

[00:16:36] of the market right now?

[00:16:36] Is it like 40%?

[00:16:37] Is that right?

[00:16:38] Do you think it's around there?

[00:16:40] You know, it's somewhere between 30 and 50.

[00:16:43] The challenge, of course, is that a lot of the money that's in passive strategies,

[00:16:48] especially the truly passive never trade, never move money, is in vehicles that don't report.

[00:16:54] Right?

[00:16:54] So like maybe we get a report out of the Saudi Sovereign Fund or something like that.

[00:16:58] But all of these institutions that are in collective investment trusts and SMAs that are being managed by BlackRock

[00:17:04] for a basis point or two, none of that money shows up in our markers.

[00:17:08] Right?

[00:17:09] We don't get a Bloomberg report that has all that in it.

[00:17:12] So the best guess is I've seen 35%, 45%.

[00:17:14] Somewhere in there is probably about right.

[00:17:16] The big question is how much is too much?

[00:17:19] Yeah.

[00:17:20] And we're going to get into that, I think, a little bit later.

[00:17:21] I'm just curious, Nat, before we get into Rick Perry's counter arguments,

[00:17:24] are you seeing like when you try to put a client in an active strategy,

[00:17:27] do you see a lot more resistance these days because of all this?

[00:17:30] I think this goes back to the point that Dave made earlier about know where you want to be active.

[00:17:36] So there's lots of stuff where you just go passive is fine.

[00:17:39] Or an index approach is fine on the approach to get my beta, get my exposure.

[00:17:43] Like U.S. large cap growth or something like that.

[00:17:46] If you even paint a style box around anything or attempt to at this point in time,

[00:17:50] you're probably going to go, it's actually really frigging hard.

[00:17:52] We've got the SPIVA report cards to prove it.

[00:17:55] But then when you get into some of the other areas, there's lots of reasons to choose active.

[00:18:01] But oftentimes that means going either out of public markets and into private,

[00:18:04] or it includes going into a weird corner of the investment universe where somebody might

[00:18:08] actually be able to demonstrate that edge over time.

[00:18:13] Increasingly, that conversation comes down to, I want more growth.

[00:18:16] Why do you want more growth?

[00:18:17] Well, I want more potential for upside.

[00:18:19] Okay.

[00:18:19] Are you willing to accept more potential for upside, more potential for downside?

[00:18:22] Yes or no?

[00:18:23] Yes, I am.

[00:18:24] Okay, great.

[00:18:25] Let's look at some private vehicles to do that.

[00:18:27] Well, why?

[00:18:27] Because can I pick if NVIDIA is going to do better than Microsoft next year realistically?

[00:18:33] Because all these managers can't.

[00:18:35] So let's go look at something else.

[00:18:36] And that conversation has been my entire career for the last 15, 20 years in this business.

[00:18:41] That more and more often.

[00:18:43] So we've looked at Mike's arguments.

[00:18:44] Now let's look at the other side of this.

[00:18:45] So we had Rick Ferry on the podcast.

[00:18:47] And here's him talking about the counter argument to Mike's arguments.

[00:18:50] Well, indexing doesn't set valuation.

[00:18:52] I mean, indexing just takes the market as it is and buys everything.

[00:18:57] So with indexing, it's the amount of money coming into the market through index funds.

[00:19:04] Let's call it a total stock market index fund.

[00:19:06] You've got money coming into that fund.

[00:19:09] They go out and buy everything.

[00:19:10] So they're not overbuying the big stocks or underbuying the small stocks.

[00:19:17] They're buying everything.

[00:19:20] And same thing when they sell, it's across the board.

[00:19:22] They sell everything in equal proportion.

[00:19:26] So indexing is not setting prices.

[00:19:29] What's setting prices are earnings from different companies, companies doing buybacks, hedge funds

[00:19:36] that are coming in and doing various things.

[00:19:38] Remember, the amount of trading on the stock exchange that's from index funds is only 5% of the daily volume.

[00:19:51] I'll call it the New York Stock Exchange.

[00:19:53] 5%.

[00:19:53] The other 95% of the daily volume on the New York Stock Exchange is something else.

[00:20:01] It's not index funds.

[00:20:03] Index funds only trade when there's money that comes into the fund or money that comes out of the fund.

[00:20:09] And that's not that much on a daily basis that comes in and out of the indices or at least the funds.

[00:20:15] So, you know, the idea that it's distorting markets, it really doesn't.

[00:20:20] I don't get that.

[00:20:21] I mean, it sounds good.

[00:20:22] It sounds like a sound bite if I was an active manager for a reason to say, oh, you don't want to do this.

[00:20:27] This is dangerous.

[00:20:30] This is worse than Marxism or whatever all these crazy things that you hear about indexing.

[00:20:35] But in fact, it's not true.

[00:20:37] There's no evidence of it at all.

[00:20:39] You look at the dispersion of S&P 500 stocks.

[00:20:42] This is individual S&P 500 stocks.

[00:20:44] You look at the dispersion of returns between S&P 500 stocks.

[00:20:48] That hasn't changed to 50 years.

[00:20:51] So indexing isn't doing anything to the market.

[00:20:55] People will argue that it is, but I don't see it.

[00:20:59] And it'll never happen in our lifetime where it's really going to have any effect.

[00:21:03] I don't.

[00:21:03] Yeah.

[00:21:03] And I think this is the most common thing you hear when you hear the counter argument to this, which is I am buying the market.

[00:21:08] I can't influence the market.

[00:21:10] I'm just buying everything in their relative proportion.

[00:21:12] So what do you think about that, Dave?

[00:21:14] Yeah.

[00:21:15] There are a couple of things there.

[00:21:16] First of all, he leans hard on this idea.

[00:21:18] We haven't had any more dispersion in the S&P 500, which means nothing could have happened.

[00:21:22] He's actually just wrong here.

[00:21:24] And I hate to say this because Rick, I consider Rick a friend.

[00:21:26] But if you look at pretty much any dispersion chart, unless you're looking at like over one year return period, big, long blocks of returns.

[00:21:34] And in fact, we have seen dispersion in the market consistently climb slowly, but definitely uphill since the late 80s.

[00:21:42] The bigger issue, though, is that when you get to shorter time cycles, we've seen huge dispersion.

[00:21:48] And Chem doesn't talk about this in the quote we're going to come up with, but he talks about this quite frequently in the options market, where you end up with all of these forces that pin the prices of the index itself because people are trading the index itself.

[00:22:01] And then the underlying actually explodes with variance underlying that when you get to these pinpoints, when you get to options expiration.

[00:22:09] So the dynamics of the market have shifted so that just saying dispersion as it moves doesn't really answer the question.

[00:22:16] And the other thing is, I honestly don't know why I can't get Rick to actually read any of the academic papers, because he actually just seems to think that all of the academic research here is wrong and that the market is perfectly efficient and there's no inelasticity at all.

[00:22:29] I got to say, is it worse than Marxism?

[00:22:33] I'm going to go with Rick Ferry more like Rick Troll.

[00:22:38] No, I say that lovingly.

[00:22:40] Respect the hell out of Rick Troll.

[00:22:41] That's from a great old piece, though.

[00:22:42] That's Stanford Bernstein's piece.

[00:22:44] A guy named Inigo Frazier Jenkins wrote that about a decade ago.

[00:22:48] And I actually agree with this argument.

[00:22:49] If you're talking about the purpose of capitalism being allocating capital to the things that are most important to society, a purely indexed market no longer does that at all.

[00:22:59] So central planning would actually be better.

[00:23:01] That was his argument.

[00:23:03] That's sort of what Rick's talking about.

[00:23:04] Rick's referencing there.

[00:23:06] But no, I don't think that capitalism is worse than Marxism.

[00:23:09] Well, what?

[00:23:11] We're all on that page, at least.

[00:23:13] So I take this seriously.

[00:23:15] So I take this unseriously because this is my modus operandi.

[00:23:18] The Groucho market is Marxism of I never forget a face.

[00:23:22] But in your case, I'll be glad to make an exception.

[00:23:25] We can't forget that passive, if we want to say passive doesn't determine valuation because it doesn't care, we're also saying that we're moving that function.

[00:23:34] We're moving the job evaluation elsewhere.

[00:23:37] And we have to ask, where are we moving that to?

[00:23:40] Because it's still an important question to ask.

[00:23:43] And that's my...

[00:23:44] Does price discovery happen?

[00:23:45] Yeah.

[00:23:45] Yeah.

[00:23:45] Where does price discovery happen if we do this, even if it's in a shrinking piece of the world?

[00:23:51] Jack, what do you think about this and especially Rick Perry's framing of it?

[00:23:56] Yeah, no, I think the big key for me in understanding like why I don't think Rick's right about this.

[00:24:00] And the big key for me was understanding that liquidity might not scale with size.

[00:24:05] And so, yes, the money is going into Apple and NVIDIA in relation to their float adjusted market cap.

[00:24:11] But if their liquidity is not scaling with that properly, you can get impact.

[00:24:15] And I think that's the big thing.

[00:24:17] That was the big light bulb moment for me was when I recognized that.

[00:24:20] Yep, totally agree.

[00:24:22] What did you think about the...

[00:24:24] I wasn't sure about Rick's idea that only 5% of the daily volume is index based.

[00:24:28] I mean, is that right?

[00:24:29] And is that a valid argument against this?

[00:24:31] What he's talking about there is the amount of index trading, the amount of orders that come in as like we are trading the whole index right now.

[00:24:39] The problem is that the market doesn't actually see it that way.

[00:24:42] Most of those orders are actually broken up long before they get to the market.

[00:24:47] So fundamentally, I mostly think he's just wrong there.

[00:24:50] Although it's worth pointing out that the vast majority of volume on particularly large cap U.S. stocks is intraday volume, right?

[00:24:58] It is day trading market making volume.

[00:25:01] If you scooped out all of that intraday activity that frankly doesn't care what it owns when it goes home tonight and is just going to trade the trading sardines,

[00:25:09] if it was 70% of the market, I wouldn't be surprised.

[00:25:12] So he is right in that sense.

[00:25:14] But I would argue that a lot of that high frequency trading stuff is also not setting fundamental prices.

[00:25:19] It's making markets.

[00:25:22] So let's shift to Jim Crisson here because one of the things we always know is that people are going to chase performance.

[00:25:26] And Jim makes an argument here about why that might eventually be the thing that derails the rise of passive.

[00:25:31] Mike and I have talked about this for years.

[00:25:34] I completely agree with the process and the framework.

[00:25:40] It's very much true.

[00:25:43] You know, there is a natural momentum factor to passive investing and that passive investing has grown to such a scale that it is one of the primary drivers of momentum in this market.

[00:26:00] Now, the part where I kind of differ or disagree is with the idea that, hey, this is inevitable and this will just continue and markets have changed forever.

[00:26:09] I really think it's a function of, and I'm going to back up here, I think passive investing, as much as it's been sold to the world in the narrative is that passive investing is some new innovation.

[00:26:21] It is the new way to invest.

[00:26:24] It's low cost, you know, great.

[00:26:27] Just set it and forget it.

[00:26:29] Like easy.

[00:26:29] Why wouldn't you just set your money away and passively invest?

[00:26:34] Indexing, to be clear, was introduced about 150 years ago.

[00:26:38] So this idea of passive investing is not a new idea.

[00:26:41] The reason it's become popular is because interest rates went from 20% to zero and we saw a massive boom in equity performance.

[00:26:50] You know, 60-40 is the easy, set it and forget it.

[00:26:54] Everybody just assumes that's how you invest now.

[00:26:56] Actually, if you ask your average person, how do you invest?

[00:26:58] You buy assets for the long term and you keep buying.

[00:27:01] That's the viewpoint.

[00:27:03] Again, 1968 to 82, my period right before passive investing started, there was a lot of passive investing.

[00:27:09] You know why?

[00:27:10] Because it didn't work.

[00:27:11] Because 1968 to 82, you lost 70% of your money in the equity market.

[00:27:16] If you had any duration over 14 years, not over one years, two years, five years, 10 years, over 14 years, you lost 70% of your money.

[00:27:24] And in the bond market, you did just as poorly if you had any duration in the portfolio, right?

[00:27:29] You had cash, by the way, you probably did as poor.

[00:27:31] So passive investing didn't happen.

[00:27:34] What came about during those periods?

[00:27:36] Hedge funds, right?

[00:27:38] Value investing, big Warren Buffett.

[00:27:41] You know, a lot of things that not really talked about as much.

[00:27:44] Active investing broadly was very popular because it worked.

[00:27:48] But guess what?

[00:27:50] That's not what you hear from people now.

[00:27:52] You hear about passive investing.

[00:27:53] So tell me what's going to happen if we see a 15-year period where the market net goes nowhere and in real terms loses 70% of its value.

[00:28:01] If that were to happen, what happens?

[00:28:05] Well, that's the incentive.

[00:28:07] If we're right and we think that's what's likely to happen, what happens to passive investing?

[00:28:11] And my view is that, you know, Mike's view is, and I think it's a defensible view, like who knows, let's see, is that the powers that be at Vanguard are so entrenched and politically connected that all the 401k flows and everything will continue to flow to all these passive vehicles.

[00:28:29] And it's going to change.

[00:28:30] I do.

[00:28:31] I think we'll have maybe passive investing, but maybe more passive investing in active vehicles.

[00:28:37] That's interesting, right?

[00:28:38] Those are working.

[00:28:39] That's what's working.

[00:28:40] Guess what?

[00:28:40] People go to what's working.

[00:28:42] If they go five years and they're not making money in the market, but they see an active manager who's making 10%, 15% a year, guess what?

[00:28:51] Those things are going to get the assets.

[00:28:53] And so I think we're right as everybody is proclaiming active investment dead.

[00:28:58] Instead, my view is that active investment is actually right on the verge of a new bull market.

[00:29:06] And I think, personally, I think people, unfortunately, will be 10, 15 years from now primarily investing in that, right?

[00:29:12] When they should be passively investing in 60, 40, I guess.

[00:29:15] It's just the way markets work.

[00:29:16] What do you guys think about this?

[00:29:17] I mean, Gem is a big believer that we might have a 70s-type period in the market here where we don't go anywhere for a long time.

[00:29:23] And if we don't go anywhere for a long time, passive may not look as good, both relative to maybe relative to something like value or something like your average stock,

[00:29:32] but also relative to these things that have multiple asset classes in them.

[00:29:36] You know, you might not do as well with the S&P 500 as you've done.

[00:29:39] So do you think that's something that could eventually derail the rise of passive?

[00:29:43] I think he's right in the sense that if we had that lost decade, that, yes, I think you would see there be a real opportunity,

[00:29:51] not so much for people to actively pick U.S. stocks better, but to find pockets of performance and value elsewhere in the ecosystem,

[00:29:59] whether it's international stock to crypto or whatever it is, people will look elsewhere, try to beat inflation, which is effectively what he's saying.

[00:30:06] I happen to think he's wrong in the sense that I don't believe we're headed for that, like, imminently.

[00:30:11] He's much smarter than I am on the macro stuff, so he's probably right.

[00:30:15] My reasoning for thinking he's wrong is that the markets, as our friend Ben Hunt says all the time,

[00:30:21] the markets are now political utility, right?

[00:30:23] They're too important for the government to allow them to fail.

[00:30:27] And so things like the government investing directly in junk bonds, which they did during the crisis,

[00:30:34] and, you know, what Japan does and choose to directly investing in their own stock market,

[00:30:38] those strike me as extremely likely reactions from a populist government over the next four to 12 years.

[00:30:46] So I don't, I literally don't think the government will allow the market to have a sustained bear market,

[00:30:52] even if it's only on a relative, you know, on a real basis.

[00:30:57] I think that point of just the, like the last lost decade we have, and just think about it.

[00:31:05] Did we have the great advent of active investing's resurgence from 2000 to 2010 in the U.S.?

[00:31:11] We did it.

[00:31:12] What did we see?

[00:31:14] We saw the advent of, like, three different emerging market ETFs, and then some, like, you know,

[00:31:19] crappy bank lending funds, and all the things that come out of it.

[00:31:22] People look elsewhere.

[00:31:23] And a lot of people moving to a new asset class, like a lot of the big capital moving towards real estate.

[00:31:29] We all know how that ended up, right?

[00:31:30] Exactly.

[00:31:33] So he may be right in the sense that, sure, there was active management return to be had until the GFC.

[00:31:41] And I do think it's interesting, and maybe this is just the meta layer of this,

[00:31:44] but this is, it's such a recurrent theme that I feel like I can't ignore it more on a social commentary level than anything else.

[00:31:51] There is a desire for tangible stuff in periods like this.

[00:31:54] So in periods of all, like, hope and promise and whatever else, there is a return to a seeking of the tangible.

[00:32:00] And when I think about his example of, you know, the Berkshire Hathaway of 66 to 82 or whatever else,

[00:32:06] and you think about can tangible investments return in a different way?

[00:32:09] And I don't know if that just produces a new version of the Koch brothers down the road or something.

[00:32:14] But it does say the attention will shift, and it doesn't just mean it's going to shift into some type of broad-based insane speculation.

[00:32:22] It could do.

[00:32:23] Like, broad speculation is the new act of investing when passive doesn't work for me.

[00:32:28] Sports betting is the new act of investing.

[00:32:29] Maybe it is.

[00:32:30] Maybe it is.

[00:32:31] Who is the Bill Miller of sports investing right now?

[00:32:35] And I do wonder how long passive would not have to work for, like, money to actually shift.

[00:32:40] I mean, it's been so ingrained in so many people to invest passively.

[00:32:43] I mean, I would think it would have to be a very extended period of underperformance before people would shift and do something else.

[00:32:47] And think of what that even means, right?

[00:32:49] So you have to imagine a world where, say, we have three years in a row of negative S&P 500 returns,

[00:32:55] which would be a wild outlier in history.

[00:32:57] But even if they're just small downturns, you have to imagine that while that's going on,

[00:33:03] there are enough managers with enough liquidity that could absorb the money that might come out of passive in that environment.

[00:33:11] So in that environment, when the market's down 3% or 5%, guarantee you there will be a dozen managers we'll all look at like heroes,

[00:33:17] and they'll be on CNBC.

[00:33:18] Just coin flipping.

[00:33:19] We know that there will be people who just get it right.

[00:33:23] Whether they're smart or whether they're lucky is sort of irrelevant.

[00:33:25] The question is, can they absorb a trillion dollars in passive assets over the course of a year or two?

[00:33:30] Of course not.

[00:33:31] They then become the market.

[00:33:33] These broken clock moments are so important to remember,

[00:33:36] and that the next broken clock commentator moment is right around the corner.

[00:33:40] And I'll also posit this.

[00:33:42] I'm sure, I'm curious if you're seeing this in your own circles.

[00:33:45] We've had two boom years for index returns, at least, or for passive returns.

[00:33:50] Something that always happens when we have multiple boom years in a row

[00:33:53] is people might not be going out and hiring the active manager,

[00:33:56] but people are like, oh, well, I did really good on these like three stocks I have.

[00:34:01] So maybe I'm not going to go hire the next active manager,

[00:34:03] but I'm going to get extra overweight.

[00:34:06] Stock of choice XYZ that's gone up more than the benchmark in those years.

[00:34:09] And those variants are real.

[00:34:11] Well, and we've seen this, the entire ETF market is now awash in products

[00:34:16] just to express those opinions of why would I go hire, you know,

[00:34:20] Cliff Asnes to run my money?

[00:34:21] I can go buy triple leverage more than, you know, micro strategy myself.

[00:34:27] Yeah, it's funny.

[00:34:28] Corey Hosting had a tweet the other day about like this idea that he,

[00:34:30] they've built an amazing thing with return stacking,

[00:34:33] but he's like, I looked at the, you know,

[00:34:34] the two times micro strategy ETF and it has way more assets than our whole group.

[00:34:38] At a higher free point, right?

[00:34:41] It probably doesn't end well for the people that are in the two time micro strategy ETF,

[00:34:47] but nonetheless, it's pretty crazy how big it got.

[00:34:50] Make hate while the sun shines, right?

[00:34:52] I also want to bring Oswalt's point back in here.

[00:34:55] This idea that, because I think this is a good clip to relate it to,

[00:34:58] this idea that passive will eventually hit a cap and then active will work better.

[00:35:03] Like once it hits that cap and that'll be something that'll derail passive.

[00:35:06] What do you guys think about that?

[00:35:08] I, and I've heard this argument a lot, right?

[00:35:10] The idea is that if you've got, I mean, it's,

[00:35:13] if you've got fewer and fewer people looking for mistakes,

[00:35:17] then people who find those mistakes will make more money.

[00:35:19] I think the challenge is those, the pockets of under, of, you know,

[00:35:24] things that are undervalued for lack of a better term are going to be small, right?

[00:35:28] Because by definition, the big stuff's in the index.

[00:35:33] I agree with you completely on that.

[00:35:34] The big stuff's in the index.

[00:35:36] So if it opens up any pockets at all, it's either at the margin or it's away from the index,

[00:35:40] which is, goes back to this tangible idea.

[00:35:43] The most conceivable thing I could see is people figuring out ways to do better in that.

[00:35:47] And almost by definition, that also means all the ways you're probably going to make the biggest money,

[00:35:52] but if you want the best returns, you're still going to look smaller.

[00:35:56] Yep.

[00:35:56] So the big stuff is in the index leads very well into our next point here,

[00:35:59] which is Rob Arnott talking about the difference between stocks that are in the index and stocks that are not.

[00:36:04] I think there's definitely truth in that.

[00:36:07] I think one of the main forces at work here is the move towards indexation,

[00:36:13] which is a very powerful force in the markets these days.

[00:36:19] If money goes from non-indexed portfolios to index portfolios, much of the money doesn't move because the index owns the market.

[00:36:32] But it really doesn't.

[00:36:34] It owns most of the market.

[00:36:36] So what happens is that the non-members in the index get sold and the members in the index get bought.

[00:36:45] So every $100 that goes into an index fund, about $80 stays more or less where it is because the index spans 80% of the market.

[00:36:58] And about 20% of the portfolio moves from non-members to members.

[00:37:01] Well, that pushes up the relative valuation for members.

[00:37:06] And we saw that just two weeks ago.

[00:37:11] S&P made a blunder.

[00:37:14] A blunder.

[00:37:15] They reported a list of holdings for a narrow niche dividend index that they maintain that didn't include one of the stocks that's supposed to be in the index.

[00:37:30] And so the index trackers for that strategy, and these aren't big index trackers because it's a niche index.

[00:37:40] Actually, it was the other way around.

[00:37:42] They added a stock to the list that wasn't supposed to be there.

[00:37:46] And then a couple of days later, they realized their mistake and they took it out.

[00:37:50] Well, the stock went from 84 to 90 and then back down to 84.

[00:37:55] That's a 7% move for a little niche index strictly because the stock was added and then dropped.

[00:38:04] And that's a big turnaround.

[00:38:06] So the spread in valuation for members versus non-members of the big indexes like the S&P and the Russell is much bigger.

[00:38:16] By our measure, it's in the 30% to 50% range.

[00:38:19] Membership has its privileges.

[00:38:21] You're worth more if you're a member.

[00:38:23] And that in turn, with the flow of money into index funds can push the valuation of these companies up.

[00:38:33] Higher valuation means lower future long-term returns.

[00:38:37] You're more front-end loading the return in the run-up in price.

[00:38:42] And so non-members ought to have higher long-term forward returns than members of the index.

[00:38:51] But that's more than offset by the flow of money into indexes as long as that flow is enough to push the prices higher and higher and higher.

[00:39:01] So that's a long-winded way of saying this value cycle, this anti-value cycle from 2007 to 2020,

[00:39:11] was undoubtedly augmented by the flow of money into index funds and augmented in a big way.

[00:39:17] So what do you guys think about this?

[00:39:18] I mean, this is, to some extent, like I've been one of these value guys, like shaking my fists at anything I can shake my fists at

[00:39:24] for the underperformance of value for like a long period of time.

[00:39:27] I mean, is the rise of passive and the fact that nobody's paying attention to these smaller stocks that are outside the index,

[00:39:32] is that one thing we can shake our fists at?

[00:39:33] Wait, before Dave tells me his insight, we just got to just like slow clap,

[00:39:37] like the active fashion investing on Rob Arnot alone.

[00:39:41] That shirt and jacket.

[00:39:42] I love it.

[00:39:50] Always looks so good.

[00:39:51] Dave, what were you going to say?

[00:39:52] Well, what was funny too, when Rob came on this, by the way, because like, I think that was the clip.

[00:39:55] I'm not sure.

[00:39:56] One of his interviews, he didn't wear a tie.

[00:39:57] Like he was dressed impeccably, but without a tie.

[00:39:59] And like he was worried he was underdressed.

[00:40:01] And then he looked at the two of us, like Justin and I interviewed him.

[00:40:03] He's like, oh, I'm in good shape.

[00:40:05] Right?

[00:40:12] He doesn't actually mean.

[00:40:13] And so he did some academic research with his very sharp team and came up with this theory that turns out it plays out in the back test,

[00:40:21] that if you invest in things that had been ejected from the index over the long term, you actually do better.

[00:40:27] And the theory here is that there's a premium associated with being in the index.

[00:40:32] And if you pay a premium to get into something, by definition, your long term expected returns are over.

[00:40:37] Right?

[00:40:37] I mean, that's just math.

[00:40:39] And the portfolio that he's built here actually does have that quality.

[00:40:43] As we said earlier, the challenge is, is anybody going to really hang out for the three to seven years it takes for that fundamental outperformance to show up?

[00:40:51] But he's put it.

[00:40:52] I mean, he put his own money in it.

[00:40:53] Right?

[00:40:54] He launched a fund, made it available to everybody and plowed a bunch of his own cash into it, which is the Rob Arnott way.

[00:40:59] I think he's right here in that there's a huge body of research at this point that shows being in an index gives you a juice to your return that you did not quote unquote.

[00:41:08] Right?

[00:41:09] It's not like your company suddenly got better.

[00:41:11] This is the whole reason we see stocks sort of launch on NYSE and then move to NASDAQ when they get big enough for consideration in the NASDAQ 100 because it just matters if you're in the NASDAQ 100.

[00:41:23] I'm going to invoke another Groucho Marxism on this one.

[00:41:26] It's the, I wouldn't want to belong a club that would have me as a member.

[00:41:31] And man, put your money where your mouth is.

[00:41:33] If that's the case, look for those non-members who have, and I think this is what you're saying in this, and this deserves the highlighter.

[00:41:40] It's the higher long-term return potential by not being in the index.

[00:41:45] Because that return potential gets sucked in once you've been included in the index, and we want to understand what premium is baked in.

[00:41:52] Fascinating commentary in the math that he has on what that actually is worth and what that means, to your point of like NYSE to NASDAQ alone.

[00:42:00] But also, back to this thing that I'm going to keep on hammering on.

[00:42:03] You got to look small.

[00:42:03] You got to look outside the index if you want that higher return potential.

[00:42:06] Doesn't mean it works.

[00:42:08] Doesn't mean it's going to show up.

[00:42:10] But theoretically, that should exist.

[00:42:12] And the timing.

[00:42:13] Right?

[00:42:13] The timing is just like, he talks about 2007.

[00:42:15] I love this phrase.

[00:42:16] I think he coined the 2007 to 2020 was the anti-value cycle.

[00:42:20] Anti-value cycle.

[00:42:21] Brilliant.

[00:42:22] Love it.

[00:42:22] Great.

[00:42:23] Brilliant turn of phrase there.

[00:42:24] But like, there's real truth to that.

[00:42:25] I mean, that's what you're saying.

[00:42:26] It's like, you have to be willing to say, okay, I'm willing to invest for the next value cycle whenever that is.

[00:42:32] Is it going to be another 13 years?

[00:42:34] Which is what it was for the anti-value cycle.

[00:42:36] That's a lot to stomach.

[00:42:37] I don't know whether I got, well, I don't know whether I personally have that kind of stomach.

[00:42:41] I'm thinking of the anti-value teenager.

[00:42:43] You can have it on your leg.

[00:42:45] Like, that's a miserable growth curve right there.

[00:42:47] What do you think, Jack?

[00:42:49] You know, another thing he mentioned that I thought was interesting.

[00:42:52] It wasn't in this clip, but Rob mentioned this idea that if you like take the S&P 500

[00:42:55] and you just delay the rebalancings, you get like something like 20 or 30 basis points a year.

[00:43:00] Like, I wonder, I mean, Dave's the ETF product expert.

[00:43:02] I wonder if somebody will ever try to do that and like charge 10 basis points instead of five

[00:43:06] and like delay the S&P 500 to try to get a better return or something.

[00:43:09] You've already invoked our friend Corey Hofstein from Return Stack and got the little things right here on my desk.

[00:43:14] He did an amazing paper called Rebalance Timing Luck, which looks at historically like the impact of when you do these rebalances

[00:43:22] and how much variance in your potential return stream you have based on like doing it monthly or doing it monthly on the 15th or the 30th or quarterly.

[00:43:30] And the short answer is there's an enormous amount of variance that shows up just by when you do the rebalance.

[00:43:37] Now, what he's talking about is specifically gaming a big well-known rebalance, also known as the Russell trade, which we used to do for decades.

[00:43:45] I don't think those really work that much anymore.

[00:43:49] Scooping 20 to 30 basis points off a trade, you lose so much opportunity for a beta move in there.

[00:43:54] And I think that's a little too clever by half.

[00:43:58] I'm just curious, what do you guys, because I think it relates to this.

[00:44:00] What do you guys think about David Einhorn's arguments here?

[00:44:02] This idea that a lot of these stocks that are not in the index, nobody really cares about their fundamentals.

[00:44:06] Nobody's paying attention.

[00:44:07] They might get good news and then they go up a little bit, but then everybody just disappears again.

[00:44:11] Do you think like it makes those stocks much harder to invest in?

[00:44:14] Like people aren't seeing that value and, you know, getting that multiple expansion you've seen in the past?

[00:44:18] A hundred percent.

[00:44:19] Right.

[00:44:19] I mean, I think that what I took from Einhorn's comments, and this is probably you're referencing the Barry Ritholtz Masters in Business he did with David a while ago.

[00:44:28] He talks about, you know, if before I could buy a stock at 10 and know I could sell it at 20, eventually now I have to buy that stock at five.

[00:44:35] Right.

[00:44:36] Because the opportunity, I need such a bigger window of confidence that I'm right and the market's wrong because there's so many things that the market can do against you that have nothing to do with the underlying stock.

[00:44:45] It can be something as simple as somebody makes a big rebound straight into the Russell and all of a sudden your small cap stock that you were really sure was not going to go anywhere pops or vice versa.

[00:44:55] Somebody, you know, the Russell has a really bad week and a half and the stock that you're sure is worth a million dollars more than it is gets tanked having nothing to do with the fundamentals.

[00:45:04] I think that that's correct.

[00:45:05] And all it really means is active managers who are successful are going to be the ones that take and consistently win big bets.

[00:45:12] It reminds me too of the, and this is like an older conversation, but I feel like an older conversation I used to hear way too often.

[00:45:19] So 10 plus years ago, and it was just talking about the difference between the, you know, like the closed end funds where there's no ARB opportunity and the ETS where there is an ARB opportunity.

[00:45:30] And you have to understand how, what closes the gap and a closed end fund.

[00:45:34] What's going to close the premium discount gap.

[00:45:37] It's not there.

[00:45:38] There's, there's nobody to do it.

[00:45:40] So you're either waiting to shut the thing down or, and I know there's a whole wave of them converting to interval funds again now in credit.

[00:45:46] That's just about to go on.

[00:45:47] And it's just, who's going to close that gap for you?

[00:45:50] So Einhorn's thing of how can I be there, but just understand how much of the gap am I hoping somebody eventually shows up in close?

[00:45:56] Or do I ultimately want this thing to go fully private?

[00:46:00] Do I want this company to just keep on buying back shares to finally just be like, you know what public markets?

[00:46:05] You're not worth the filing fee anymore.

[00:46:07] And that's a very different methodology.

[00:46:09] Go ahead.

[00:46:10] To the point we started at the very beginning of this with, right.

[00:46:13] This, this idea of like, who's going to take you out of this position, right?

[00:46:16] Even if you're right, the single stock buyer of your mid or small cap stock that you're really right on.

[00:46:23] There's a, there's a kind of person who has to buy that from you at some point.

[00:46:27] And it's not the market maker has to be a price setter.

[00:46:30] And if we're having fewer and fewer of those price setters, you have to expect that, that gap to get wider.

[00:46:36] I also think it's fascinating.

[00:46:37] And I'm thinking about like Richard Gere and pretty woman having to come to moment to, you know, come to Jesus moment at the end where he's like, I don't want to kill this third generation company.

[00:46:46] We're going to build boats together.

[00:46:48] And I wonder if like David Einhorn is just racing towards that, you know, without the pretty woman perhaps in that scenario.

[00:46:54] But you know what I mean?

[00:46:55] Like, are we, is there a new era of, it almost feels like there should be a new era of Buffett's who can do stuff like this and taking companies right in it.

[00:47:03] It's a Buffett angle, right?

[00:47:05] And the original pretty woman, which took Gere character probably more ways than one.

[00:47:12] It was good at all.

[00:47:13] Gord.

[00:47:14] All right.

[00:47:14] Get me out of trouble, Jackson.

[00:47:16] We'll go to the next clip to get you out of trouble.

[00:47:18] So the, uh, the last one comes from Cliff Aspen.

[00:47:20] I said, we actually just posted this interview the day before recording this.

[00:47:22] And our guests are probably getting sick of me because I pretty much asked this passive question to everybody because I'm so interested.

[00:47:27] I think of like everything we're talking about in the podcast, this is probably the topic I'm the most interested in.

[00:47:32] So I wanted to get Cliff's take and he had kind of a balanced take.

[00:47:34] It's somewhere in between the Rick Ferry and the Mike Green take.

[00:47:36] So here's what Cliff had to say.

[00:47:37] Now, here's where I think the rise of passive can matter.

[00:47:42] There is one number when, let's ask the question, what percent of the market could actually be Jack Bogle style passive?

[00:47:51] And still have some degree of an efficient market or not?

[00:47:56] I don't know.

[00:47:56] You haven't hit inflection point where it gets really crazy.

[00:48:00] Well, there's only one number we know for sure that can't be a hundred percent.

[00:48:05] This is something I joke in the paper that PhD students drunk at 2 a.m.

[00:48:10] And then I admit it's one wine cooler at 930 p.m.

[00:48:16] You know, it's almost like a cone, like a, like a, where you, how do you, how do you even think about a world where everybody is trying to free ride off?

[00:48:26] Everybody else is literally nobody doing the work of saying is NVIDIA worth more or less than the corner drugstore.

[00:48:34] We're all just assuming the other person did it and copying them.

[00:48:37] So let's just say that would be nuts.

[00:48:39] I don't know what it would look like.

[00:48:40] It's hard to think about.

[00:48:42] We, this is funny.

[00:48:43] We once had Jack Bogle himself on a podcast we were doing.

[00:48:48] We did a podcast for a while because as you know, legally in America, everybody must have their own podcast at some point.

[00:48:54] Um, and I was lucky enough to be friends with Jack.

[00:48:58] Uh, it was an odd friend, 85 year old godfather of passive.

[00:49:03] And at that point, a 50 year old long, short, active quant.

[00:49:07] Um, but Jack was a wonderful man.

[00:49:09] Um, I think the fact that his son was a long, short, active quant probably softened everything about me to him.

[00:49:16] Uh, you know, I know anything one of my kids do.

[00:49:19] I'm predisposed to maybe think isn't the devil.

[00:49:21] Um, actually one of my kids, I would assume it was the devil, but I'll, I'll keep that to myself.

[00:49:27] Had Jack on the podcast.

[00:49:28] We got into this discussion and Jack like Gene Fama.

[00:49:31] I'm going to say this about another famous person.

[00:49:33] He's incredibly intellectually honest guy.

[00:49:35] He's like, of course, a hundred percent of the market can't be passive.

[00:49:39] I think my marginal recommendation to most investors to be passive is the right one, but a hundred percent, everything breaks down.

[00:49:47] He freely admitted that.

[00:49:48] And I said, Jack, so how much of the market can be passive before it starts to get weird?

[00:49:54] Um, and he said 75%.

[00:49:57] And I'm like, oh, that's really cool.

[00:49:58] That's, you know, where'd you come to that, Jack?

[00:50:00] Uh, and he just looks and goes, and he gets a little twinkle in his eye and goes, oh, I completely made it up.

[00:50:06] And when you're, I don't know, he was 85 at the time and you're Jack Bogle, you can get away with that.

[00:50:11] I think those of us who didn't create Vanguard, um, and probably shouldn't make that joke.

[00:50:16] Uh, but, but his point, even that has a point.

[00:50:20] No one really knows.

[00:50:21] Uh, a lot of people are very histrionic about this and think passive is the devil and everything has fallen apart.

[00:50:27] Um, I think it is unlikely to me that all the craziness that I admit happens at a hundred percent passive.

[00:50:36] Happens magically at 99.999% uh, passive and a hundred.

[00:50:41] Most things in life are some continuum.

[00:50:44] Um, so the idea that we're much more passive now than we used to be has contributed to maybe some, uh, some smaller tethered to reality.

[00:50:54] I find fairly intuitive, but assigning a magnitude to it.

[00:51:01] And particularly, you know, again, I think markets are less efficient than they, than they used to be, but I, I don't think I've proven they're inefficient to where you can drive a truck through.

[00:51:10] And just as the rational investor make free money all the time.

[00:51:14] Uh, I don't think it's that far gone.

[00:51:16] Um, so I think passive is part of the story for the reasons I outlined, but I, I, I think, and I admit this is all as it's still in the realm of hard to prove.

[00:51:26] I believe that putting a magnitude on it is difficult.

[00:51:29] And my instinct is those who are absolutely freaking out about it are overstating its role and have kind of made it their life's work to be kind of anti-passive.

[00:51:41] Yeah.

[00:51:41] So, I mean, Cliff is acknowledging here that there is some impact.

[00:51:44] I mean, I don't think he believes he doesn't take it to the level of Mike.

[00:51:46] I don't think he thinks there's that much impact.

[00:51:48] And I don't think he believes maybe some of the big negative outcomes for the market could happen.

[00:51:52] But Dave, what was your take on Cliff's owner?

[00:51:54] So I, I think I probably agree with Cliff almost more than anybody else here.

[00:51:58] Right.

[00:51:58] And I, and I, I would, I would tease that apart.

[00:52:00] I think Cliff is acknowledging that there's been an impact, but then not willing to go the next step and say the end thus of this is uniformly bad.

[00:52:09] It changes the market.

[00:52:10] I mean, this is just sort of my opinion.

[00:52:12] I think I'm echoing what, what Cliff said too.

[00:52:14] It's like, yes, this has changed the market.

[00:52:16] And as we increase passive, it will continue to change the market.

[00:52:21] But the, the, the downside from that is not necessarily number go down.

[00:52:27] Right.

[00:52:27] That what it means is that the way information moves in the market changes, the way liquidity moves in the market will change.

[00:52:34] How we think about what things are worth will be different.

[00:52:37] And we already, we were just talking about that, like whether you're in the index or not, like that's not a fundamental concern, but it's an important one that we, I think even, even Rick Ferry would acknowledge that one.

[00:52:47] That's just inarguable.

[00:52:48] And so I think that's probably the healthy attitude for like a financial advisor and investor to have.

[00:52:55] So this rise of passive does not mean everything's going to come crashing down in a quick hurry.

[00:52:59] And you better, you know, hedge yourself into zero performance, right?

[00:53:03] What it means is market dynamics have changed.

[00:53:06] And therefore, when you see things that seem weird, don't just assume that means, aha, I found something I can arbitrage.

[00:53:12] They're probably good reasons for it.

[00:53:14] That's part sort of Chum's point too, was there are reasons these things are moving around that have nothing to do with whether it's a good stock or a bad stock.

[00:53:23] One of my favorite things about all these clips, and I think Cliff, Cliff captures it when he makes that comment of who's left figuring out, you know, if Nvidia is worth in the corner drugstore.

[00:53:34] Just all of these guys, what they're doing is saying there's some direction of this, but how can I set up the most extreme counterexample I can think of to look back down the other, the other way?

[00:53:45] And I'm given no more Groucho Marxism jokes, but I will make an Oscar the Grouch reference for Cliff on this one, which if you've never Googled Oscar the Grouch quotes, let me just say they're, they're fantastic.

[00:53:57] So Oscar the Grouch on the topic of rain, when it rains, it rains trash out of heaven. Every yucky cloud contains trash out of heaven.

[00:54:05] I love that quote, number one, but I also think it's that point. Like we're on Sesame Street. We're surrounded by Big Bird here.

[00:54:11] We got to take this whole other take and look for the complete other angle and say, what if somebody thinks this crap is positive? Then how do I look at it?

[00:54:18] And Cliff reminding us, if we don't take that complete contrarian view and try to argue it through the logic of that complete contrarian view,

[00:54:25] we have no hope for explaining what is going on here. And they all agree something weird is going on.

[00:54:30] They're all fumbling from how do I understand the logic from the opposite direction? That's capital market, baby, right?

[00:54:35] Exactly.

[00:54:37] And by the way, Matt, I would say Cliff has probably never been asked about having a buddy movie with him and Jack Bogle.

[00:54:42] I want that movie. I want that movie.

[00:54:46] I love it.

[00:54:47] I love it. I want it.

[00:54:48] You're the way of bringing these things in, which is great.

[00:54:51] So just to wrap up, I want to touch on two other points because I think the thing people always ask about this is,

[00:54:56] and Dave, you and I have had discussions offline about this.

[00:54:58] And this was the question you asked too is like, what do I do about this?

[00:55:01] Like it's something people ask all the time.

[00:55:03] And so I want to touch on two things.

[00:55:04] One you touched on a little bit already, which is this idea of the market meltdown.

[00:55:08] So you're not a big believer because the big risk here or the big concern Mike has is what if these passive flows do go negative at some point?

[00:55:14] And, you know, they could go negative due to some market event or they could go negative because people are retiring and suddenly they're pulling money,

[00:55:20] more money out of the market than they're putting in.

[00:55:22] I mean, do you think that's do you think there's any major risk here that people need to be worried about?

[00:55:27] So here's where Mike and I disagree a little bit.

[00:55:29] So Mike is a little more concerned about the generational wealth transfer, right?

[00:55:33] All the baby boomers die.

[00:55:34] They leave their $30 trillion to all their millennial kids, which is, you know, we're in the middle of that cycle.

[00:55:40] I think we're like $8 trillion of the way through the $30 trillion that paper originally talked about.

[00:55:44] The reason I don't think this is a problem is you have to ask yourself, what's the actual like financial advisor pathway that happens here?

[00:55:54] Your 83-year-old client dies and leaves $100 million estate.

[00:55:58] They leave it to their millennial children.

[00:56:00] This is a classic financial advisor situation, right?

[00:56:02] You're dealing with a big inheritance and a wealthy family.

[00:56:05] That money, that $100 million, sure, a big chunk of that is probably in the S&P 500 on aggregate.

[00:56:12] But actually what it probably looks like is the last five years of a target date fund.

[00:56:16] That's what the average person on their way out, that's what their core holdings tend to look like.

[00:56:21] A lot of bonds, a little bit of real estate over here, maybe some private investments.

[00:56:25] So then the question is when that retirement, I mean, when that estate happens, does the millennial all of a sudden de-risk?

[00:56:33] Probably not.

[00:56:35] They probably up-risk, right?

[00:56:37] They've just inherited this, like, beat all these corporate bonds they never wanted from their grandfather or whatever.

[00:56:42] They don't just turn around and say, yep, I'm re-upping on treasuries.

[00:56:45] They turn around and they go, and index funds.

[00:56:48] So while, yes, there may be a transition moment here where stuff moves out of markets and then back in, and that could create some real hiccups,

[00:56:57] the reality is there's not really anywhere else for that wealth to go.

[00:57:02] You can say maybe it goes into privates, maybe it goes into real estate, but the reality is it's going to go somewhere.

[00:57:07] So you have to imagine a world where the only answer people are willing to survive with is cash.

[00:57:13] We're dealing with a bigger problem, if that's true.

[00:57:16] I love this because not only do I live this in my day job all the time and regularly point this out, but this is the ultimate counterexample.

[00:57:24] Like, what kid is inheriting the money and just going to cash?

[00:57:29] De-risks, yeah.

[00:57:31] Nobody's de-risking.

[00:57:32] If anything, most of the time-

[00:57:33] Some of it goes to consumption, sure.

[00:57:34] Like, that I'm willing to buy.

[00:57:36] But then again, you're inheriting a portfolio which is almost guaranteed not to be 100% long.

[00:57:42] The bigger the assets in that cycle passing, which then you got to figure it out too.

[00:57:46] It's like, okay, well, is, you know, $100 million inheritances worth a single $100 million inheritance?

[00:57:53] Like, you got to ask these questions too.

[00:57:54] Right.

[00:57:55] And think about how the math plays out all the way through the system.

[00:57:57] But then this reality still exists where even after the frictions of like taxes and whatever else, the reality is every dollar, and still one of my favorite interviews, Jack, you and I, that we ever did was the Peter Mladino one.

[00:58:10] Where he's just like, nope, gifter, it's a gifter consumption.

[00:58:13] Every single asset will either be gifted or consumed.

[00:58:17] Can't separate it any other way.

[00:58:19] And when that gift happens, the consumption question happens again.

[00:58:23] And if it's not all going to be consumed, then they're thinking about it as a gift.

[00:58:27] And if they're thinking about it as a gift, they're upping the risk.

[00:58:29] There's an offset here.

[00:58:30] Might take a while to work its way out through the curve.

[00:58:32] Might take a while here for people to figure out, I want to be tangible in a different way.

[00:58:36] I inherited mom and dad or grandma and grandpa's real estate portfolio.

[00:58:41] And maybe I really got into real estate.

[00:58:43] And maybe I did a different type of real estate or housing.

[00:58:46] Or maybe I totally went out of that and I went into a mix of passive and privates or whatever else.

[00:58:50] But in almost every case, that younger generation is going to look at it.

[00:58:54] That's more than I'm going to consume.

[00:58:56] How am I going to think about a gift for my kids or some future generation?

[00:59:00] That's a snowball you can't really stop.

[00:59:02] The only place that I think there's legitimate concern is on the geopolitical front.

[00:59:08] There's an enormous investment in the United States equity markets from people who don't live in the United States, surprising nobody, right?

[00:59:13] And if all of those Nordic sovereign funds and the Saudi wealth fund and retirement systems in France and everywhere else,

[00:59:20] they all decide that America is a declining star that we're setting.

[00:59:25] And they want to re-globalize their portfolios and they start massively reducing their U.S. equity exposures because they don't believe in America.

[00:59:34] Okay, I can create that scenario too.

[00:59:36] But again, as an investor, I think you're going to know that's coming.

[00:59:40] Like it's not like that's going to happen on a Tuesday.

[00:59:44] And it's also fascinating to hear that when you talk to like you talk to Bogomil Baranowski,

[00:59:49] just like coming from Poland and his life and family experience, you talk to a Perth toll on the freedom stuff.

[00:59:54] You talk to all these people who have other world, other country, Yuri Kajimarian that we've got an interview coming out soon.

[01:00:01] And like all these people who have other world experiences and that look at the U.S. markets and hold it up on that pedestal, yes, that could change.

[01:00:08] But that level of awareness of those long-term investments, especially for things that aren't meant to ultimately be consumed,

[01:00:15] there's a profound geopolitical global psychology that you have to think through here.

[01:00:19] I agree with you completely on that, Dave.

[01:00:21] Really interesting.

[01:00:22] So my last question is about the practical implications because this is the other question you get all the time.

[01:00:26] And one of the things that struck me is if I listen to Rick Ferry's advice, I should probably buy the S&P 500.

[01:00:31] If I listen to Mike Green, who thinks the exact opposite on this issue, I should probably also buy the S&P 500.

[01:00:36] And then you guys were with me at the Epsilon Connect conference.

[01:00:39] There was a panel called Markets Are Broken.

[01:00:41] And the conclusion of that was I should buy the S&P 500.

[01:00:44] So does this really not change anything in terms of how people should invest?

[01:00:49] In the short term?

[01:00:50] Yeah, I think that's correct.

[01:00:51] I think the main thing that I would like people to walk away from the active passive discussion thinking about is using it as a framework to evaluate the market.

[01:01:01] Right?

[01:01:02] That's the important thing.

[01:01:03] Right?

[01:01:03] Just like if you'd never heard of price to earnings ratio and I was like, hey, you know, here's an interesting way of looking at two different stocks.

[01:01:09] Right?

[01:01:10] You take their price.

[01:01:11] You divide it by their earning.

[01:01:12] Now they're sort of the same.

[01:01:13] Ha ha.

[01:01:14] Right?

[01:01:14] That's a light bulb moment for some investors when they're 11.

[01:01:19] Thinking about passive market, thinking about flows, particularly in the short term, like the stuff that Chem does, I think doesn't get enough play in most average advisor or investor's world.

[01:01:29] Not because you should be trying to do what he does, but because so much of the short term stuff, which I know is what a lot of advisors would have to deal with.

[01:01:37] My client calls me up.

[01:01:38] The market's down 3%.

[01:01:39] Where the market, you know, Bitcoin's up 20%.

[01:01:40] Why am I not in it?

[01:01:41] So much of that noise is driven by the kind of flows-driven stuff that Chem is working with on a day-to-day basis.

[01:01:48] Being aware of that makes you a smarter investor and means that when there is something to do, when there is a giant policy shift, we have a huge change in regulation or something like that.

[01:01:59] Putting it in that context of how does this impact active versus passive and flows makes you a smarter investor.

[01:02:06] But right now, I'm long.

[01:02:09] I think that point about flows, and I think it's you actually want to apply everything we had in this conversation across your entire balance sheet.

[01:02:16] Like you don't want to just think about this in terms of your stock allocation on your balance sheet.

[01:02:21] You want to think about how do flows impact not just my stock allocation, but my real estate, even if it's the house you own or whatever else.

[01:02:27] Or think about Bitcoin, which is all anybody wants to talk about.

[01:02:31] The ultimate supply-constrained asset, you know.

[01:02:35] They're all...

[01:02:36] And for Bitcoin, it's flows.

[01:02:37] So they all become flow stories.

[01:02:40] And back to that original point of like, you can't talk about flow without understanding what those natural resistances are.

[01:02:45] And you want to be able to argue it from the other direction.

[01:02:48] So as a mental construct, and I love the PE multiple example, like these are first principles and foundational things that have...

[01:02:55] Have broader philosophical value to you.

[01:02:58] You could be really smart in a narrow niche.

[01:03:00] You can have that Chim Carson knowledge of like one weird place.

[01:03:03] But we want to be doing...

[01:03:05] Having this lattice work of these things connected for ourselves to go, how else can we apply them?

[01:03:10] And it makes this conversation so important.

[01:03:14] That's probably a great note to wrap up on.

[01:03:15] Dave, thank you so much.

[01:03:17] Anytime, man.

[01:03:18] I'll chat with you guys about anything anytime.

[01:03:20] And it's also great having somebody around who understands Matt's pop culture references.

[01:03:23] Because I typically...

[01:03:24] Matt's always like, did you hear this movie?

[01:03:25] Or do you know anything about that song?

[01:03:27] Didn't you just watch Pretty Woman, Jack?

[01:03:29] Can't you relate that to Warren Buffett?

[01:03:31] Thank you, everybody, for joining us.

[01:03:32] We'll see you next time.

[01:03:33] Hi, guys.

[01:03:33] This is Justin again.

[01:03:34] Thanks so much for tuning into this episode.

[01:03:37] You can follow Jack on Twitter at Practical Quant.

[01:03:41] You can follow me on Twitter at JJ Carbono.

[01:03:43] And follow Matt on Twitter at Cultish Creative.

[01:03:46] If you found this discussion interesting and valuable, please subscribe in either iTunes or on YouTube.

[01:03:52] Or leave a review or a comment.

[01:03:54] Also, if you have any ideas for topics you'd like us to cover in the future,

[01:03:58] please email us at excessreturnspod at gmail.com.

[01:04:01] We would like this to be a listener-driven podcast and would appreciate any suggestions.

[01:04:05] Thank you.