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- [00:00]
A
Every single day these index funds and ETFs receive inflows or outflows occasionally. That actually means that they are continually trading, they are continually executing in markets and as a result they don't at all fit the definition that Bill Schar provided in the Arithmetic of Active Management. That number of about 83% is actually a static number that if you get to that level of passive effectively, the market becomes so impossibly volatile that it becomes an inevitable event that will eventually cause its closure. My estimate is actually we're about 54% passive by market share and we picked up about 4% last year. So, you know, if that pace continues itself, we would be looking at somewhere in the neighborhood of five years out, the world comes to an end.
- [00:53]
B
Hi Mike. Welcome back to Excess Returns.
- [00:56]
A
It feels like I was just here.
- [00:58]
B
Ah, you gotta go back more often though.
- [01:01]
C
You were also with Dave. So with Dave you're used to probably getting like highly intelligent questions. You're gonna, you're gonna get the opposite of that today from Justin and I.
- [01:08]
A
Oh, I don't agree with that at all. But not that Dave is not highly intelligent and doesn't offer highly intelligent questions, but you guys very thoroughly prepared. You sent me some really nice notes.
- [01:17]
B
Yeah, awesome. Today we wanted to sort of have you back on to talk about the topic that a lot of people know that you are pretty much become an expert in. And that's the impact of passive investing on market structure and the role that flows are playing in driving prices. You've been one of the earliest voices and one of the leading voices in explaining how markets have become more inelastic and how the growth of passive investment strategies are changing the way that kind of risk is showing up in the markets and manifest. Manifesting itself, but maybe underneath the surface in a way that a lot of investors don't fully appreciate. So that's going to be the, the bulk of the conversation today. There's been some larger firms that have come out and kind of pushed back on some of your reviews. And so, you know, to some extent we'll kind of work through those arguments and see sort of how, you know, your research plays into what some of those counterpoints have been basically saying. And so, yeah, it's gonna be a good conversation. Before we get into all of it, Mike, you can follow along at his substack, which is substack.comichael wgreen and also Mike is chief investment strategist and portfolio manager of Simplify Asset Management. That's just Simplify us where the firm runs a number of differentiated investment strategies, you know, within the ETF wrapper. So that's how you can kind of learn more about Mike if you don't know about him already. So. All right, so Mike, where we want to start with you is, I think let's just set some definitions here so our audience kind of knows a little bit about what we're going to be talking about. So a lot of times when you're talking about this passive impact, you're citing this idea of the inelastic market hypothesis. So we just thought, you know, maybe if we could briefly just start there to set the stage and then we can get into some of this other stuff.
- [03:03]
A
Well, it's interesting. So the inelastic market hypothesis refers to a paper by Xavier Gabay and Ralph Koan that came out in 2020. My work on passive actually preceded that. I started in 2016. And really, I credit Lasse Peterson at AQR for writing the paper that ultimately, in my opinion, broke the mental log jam around how passive influences markets. In 2016, he wrote a paper called Sharpening the Arithmetic of Active Management, which refers back to Bill Sharp's seminal paper in 1991, the arithmetic of active management, which is the source of all the language that you hear that active and passive, at the end of the day, own the same things in the same proportions. And therefore the only difference between the two is, is ultimately going to be the fees that active managers charge. That helped to explain or provided the fundamental explanation for the outperformance of passive strategies and encouraged people to deploy assets in that direction for the simple reason that they could become free riders onto the system. Lastly, Peterson pointed out something very, very important, which is the definition that Bill Short provided for passive versus active. His definition of passive management was somebody who never transacts. Never transacts, can't get in, can't get out. And he did it as a thought experiment where he articulated that, well, let's presume that they trade in the Limal hours when the markets aren't really open or closed. That's obviously impossible. And Lass was correct to highlight this. What he noted was that there are distinct events, index reconstitutions. In particular, he focused on where the end portfolio of the passive investor has to change and so they have to transact and during that time period they become active managers and are no longer subject to the rules that Bill Sharp articulated. That actually is absolutely correct. It's turned out to now become the largest hedge fund strategy is actually index arbitrage, basically Taking advantage of passive strategies, trying to use statistical arbitrage to protect to. I'm sorry, to project or predict what is going to go into an index or leave an index and to trade those appropriately. That's why we have things like the run up in Tesla in December of 2020 in anticipation of it joining the S&P 500. And as I said, it has become an incredibly large business for hedge funds. The second source of portfolio change, though, is actually caused by the end customer. Anytime you contribute cash to a portfolio, you're changing the composition of that portfolio and forcing it to transact to match the benchmark. That was really my contribution to the process. And recognizing that every single day these index funds and ETFs receive inflows or outflows occasionally. That actually means that they are continually trading, they are continually executing in markets, and as a result, they don't at all fit the definition that Bill Schar provided in the Arithmetic of Active Management. Basically none of his work has any theoretical framing in a world in which their portfolios are changing. That's what really set me off on that. Because all of a sudden, the minute you realize that you recognize what they actually are, which is just a systematic algorithm that operates off of the world's simplest algorithm. Did you give me cash? If so, then buy? Did you ask for cash? If so, then sell. And that becomes a much easier thing to understand in terms of how it's going to impact the markets. So that's where the whole thing starts now. By 2020, the academics began to wake up to components of this. Xavier Gabay and Ralph Koigen wrote the inelastic market hypothesis that challenged another precept to the efficient market hypothesis, which all index funds are based on. In the efficient market hypothesis, it's presumed that markets are highly elastic, that they can basically absorb nearly any amount of supply and demand change with very limited impact on either individual securities or certainly the market in its totality. The actual specification within the efficient market hypothesis is that a dollar into the market, because every buyer has a seller, really should only impact market capitalization by basically the difference in the bid ask spread, typically about a penny. Therefore, a dollar into the market only creates about a penny of additional market capitalization. Gabay and Kweijan, using some very sophisticated mathematical techniques, derived that that number wasn't even remotely close. They estimated it was between 5 and 8. They were using a time period average and so didn't actually capture the trend of that rising over time. We have subsequent research from Valentin Haddad and others and I've done my own research on this that suggests that that's actually a rising factor, that we're seeing larger and larger impacts associated with the market's loss of elasticity tied to the growth in share of passive investing.
- [08:18]
B
So the latest numbers that I've seen is that right now the market is roughly 50% passive. And I know that you and.
- [08:33]
A
One.
- [08:33]
B
Of your peers are working on a new paper, and we were talking about it before we started here, where you're sort of trying to get at the number that would, if we got to this number, in terms of the percentage of the market being dominated by passive, you know, it should strike fear in the minds of equity investors sort of everywhere. So can you just talk to sort of where I know this research is preliminary, it's not public yet, but where is this research sort of bringing you and do you have any insights into, you know, the rough range of what that number might be where it would be very problematic for the markets?
- [09:14]
A
Yeah. So Hari shared some of our initial findings over Twitter and it's important to specify the characteristics that we assumed in that. So one of the assumptions is actually that's not having any inflows or outflows. And so that number of about 83% is actually a static number that if you get to that level of passive, effectively, the market becomes so impossibly volatile that it becomes an inevitable event that it will eventually cause its close closure. In an unrestricted market like xiv, where we were at very similar levels, you had the capacity to go to zero with the circuit breakers in place and the restrictions on that type of trading in place. On the U.S. equity markets, you know, our underlying presumption is effectively that the markets would stop clearing, they would close the markets and that this would happen over repeated, you know, period of days as people tried to get make redemptions in response to the market being closed. You know, that's a very conservative model. I want to emphasize a couple of features that are being put in there. One is that we are assuming that anyone who is not passive is fully active, effectively having a historical elasticity of about 0.75 to 0.8. Secondly, we are presuming no flows, as I mentioned. So that doesn't include any redemptions, it doesn't include any contributions, et cetera. It's simply an endogenous feature that plays out in the market. And some of this work was actually replicated, is effectively a replication of work that was done by Andrew Lowe on a similar topic where he came to a very similar conclusion. Between 75 and 80% passive, the market would effectively cease functioning. If we make some assumptions about declines in elasticity for active managers, which have absolutely happened, I'll share a few slides on that. That number moves significantly lower if we start incorporating components of flow into that, that number also begins to fall dramatically. And so we basically treat that 83% as an outer limit limit. To your point about where we are right now, my estimate is actually we're about 54% passive by market share and we picked up about 4% last year. So, you know, if that pace continues itself, we would be looking at somewhere in the neighborhood of five years out, the world comes to an end. Again, this, this is, you know, we, we have high confidence in the outer limits of the model. Again, it replicates some of the work that I did with Peter Thiel. It also replicates some of Andrew Lowe's work. And so, you know, I would consider this basically the starting point, not our end point.
- [12:07]
C
How do you think this plays out? Like, if we ever got near that, how does this play out in the real world? Like, like you said, there'll be curbs put in place, the government will intervene. Like, do you think, like a major decline, like that is something that's probable, or do you think probably a bunch of other things are going to happen and it wouldn't play out that way?
- [12:24]
A
Well, this is part of the problem, right? Is once it becomes a mathematical certainty, if you actually have built a closed form solution that says this is just what the math says will happen, then we're effectively debating math. And to my knowledge, math doesn't fail. The assumptions could certainly fail. And so that's kind of the point that I would emphasize. Could they change the rules? Could the Federal Reserve inject trillions of dollars into the US Equity markets? Could we have a fiscal package that includes an exchange stabilization fund, etc. Those are all legitimate, you know, responses. It is also legitimate to close the market and say everybody has to deal for a while. We've done that before. We did it at the start of World War I. You know, regardless, the point I guess I would emphasize is, you know, do I think it will happen? Yes, I do. Do I think that there will be extraordinary responses in response to extraordinary events? Yes, I do.
- [13:30]
B
Is, is the pace that 4% increase over the last 12 months, is that, is that picking up relative, relative to where maybe, you know, we've been over the last, let's say five to seven years with passive, or is that kind of slowing and plateauing based on what's in the data?
- [13:48]
A
No, so what the data suggests is an acceleration, which unfortunately makes sense because we know that more than 100% of the marginal flows that are coming in are passively managed assets. You know, effectively what that means is that the active managers are facing a shrinking pool of assets. Their resources are deteriorating. I think there's going to be an imminent restructuring of the active management space as the reality of trying to manage significantly less assets at much lower fees begins to clash with the business models that have historically had this as a highly remunerative industry where, you know, you were willing to spend a significant amount of money.
- [14:28]
C
How does more and more people retiring play into this? Because I would think that, you know, a lot of these regular 401k flows are a huge portion of the money into passive. And then when people, if we do get some sort of, you know, larger number of people retiring, you could see these reversed. I mean, will that, will that be slowing these flows over time or is that not the way it works?
- [14:44]
A
Yeah, it is slowing these flows. Right. And so this is actually one of the interesting features that happens as more and more of those approaching retirement actually own passive vehicles and start to sell those passive vehicles to finance their retirements. Those flows will slow and they will begin to reverse. I think it's actually really critical to understand, you know, across the mutual fund complex, and mutual funds are the predominant vehicles in 401ks as the retirement assets that we talk about, when we talk about 401ks are almost inevitably in mutual funds. You are seeing growing use of ETFs in there. And so I do want to be very cognizant that there is a difference there. So that. So there is a degree of inevitability to those flows turning and beginning to decline. That doesn't mean money is going to flow into active management, though, just to be very, very clear. Right. It actually means that you're going to see simultaneous redemptions out of active management and passive management. And that's the scenario that concerns me most effectively. Those who should be searching for value are deprived of capital at the same time that those who are trying to gain capital, convert equities into cash face very challenging situation because they are trying to sell to people who don't have cash to meet those redemptions. Let me pull this up here quickly. What we're seeing is we're actually now starting to see redemptions coming from passive mutual funds. This is a change, right? This tells you that those retirements are beginning to accelerate. What's happening to the positioning is that you're seeing Vanguard index mutual funds get redemptions. Now. That is an indicator that the boomers are retiring. At the same time, we have more than offset flows into, into the. We, we have more than offset flows into the ETF currently. If you look at something like the positioning in Nvidia or the positioning in Apple or Microsoft, you're, you're seeing evidence that there are redemptions coming out of these funds. And the net right now is getting quite a bit closer to zero. If that flips, then that changes that calculus we talked about before. I want to be very, very clear. It's possible that Vanguard is losing share. It's possible that other firms are taking share from them given Vanguard's relatively sparse representation within ETFs. But I don't think that's what's going on. I think we're actually starting to see indications that we are actually beginning to see outflows and that, that, that should be concerning. That pulls those numbers closer, that pulls those dates closer.
- [17:38]
C
So that also decelerates the 4% a year growth of passive over time.
- [17:42]
A
You think it depends on what happens. It depends on what happens to active manager. It depends on what happens to active managers, right? Because if they continue to lose at the pace that they have been losing last year, active managers lost assets somewhere in the neighborhood of $600 billion worth of redemptions, while passive pulled in somewhere in the neighborhood of a trillion dollars worth of inflows. That 600 billion is a larger share of the active manager share at this point than the change that we would expect to see within the passive vehicles. So it continue to show share gain.
- [18:19]
C
And I would also assume like the.
- [18:20]
A
Bucket in the past becomes leakier.
- [18:22]
C
And I would also assume the younger investors who are the younger investors who are contributing are more passive and the older investors that are selling, at least in general are more active. Right. I would like pretty much most young people today are just contributing to passive funds. So is that, is that a fair way to look at it?
- [18:38]
A
Yeah, we actually know that. So, you know, somewhere in the neighborhood of 95% of the contributions that are coming in through the younger generation are flowing straight into target date funds through their 401k retirement plans, which they are automatically defaulted into. That's less true for the boomers. That's, you know, if you basically go from boomers who never really had forced allocations to 401ks and hence where the source of the active manager flows into mutual funds all the way down to the current crop of Those entering the labor force. Those entering the labor force. Today, it's almost exclusively passive.
- [19:15]
C
Vanguard wrote a piece, I think it was late last year where they tried to challenge a little bit about the impact of passive investing. And I wonder. You wrote a great response on your blog and I just wanted to go through maybe some of the main points they made because I think it'd be good to hear you refute these and how you think through these. So I'm just going to tick these through one at a time and I'll put up some charts too as we go here from your blog about this. But the first one was that passive only represents a small portion of overall trading volume. So how do you think about that?
- [19:42]
A
I think that's stupid. So you can pull up the chart that I have that shows the composition of trading volumes. What they are ignoring and focusing on is strictly the direct trading that is going into passive vehicles. You had figure six from their paper, which shows the index trading volume adjusted for cash flows, which means the inflows that I was talking about. Right. So all they're capturing when they adjust for cash flows is basically the index reconstitution trading, which by definition only happens three or four times a year and is effectively meaningless. Right. These are very small changes that they're capturing in their data where they are effectively looking at things like new issuance or share repurchases that may modestly change the overall positioning, new index inclusion, etc. What they're excluding is those inflows. Right. That's what the cash flow, you know, the, the cash flow adjustment means. And so they know the impact that they're having. They are being intentionally misleading in this chart, if you go to the one before that From Hagstrom in 2013, that and market structure edge. You know, you can get a much more holistic view of what ultimately is going on here, which is the passive trading now makes up roughly 80% of market volume on a daily basis. That's tied to the direct trading, the market making that facilitates ETFs and index funds trading close to fair value, their navs, the options that need to be traded, and the hedging around options that are struck against indexes, etc. You know, I, I candidly think that Vanguard should be held liable for misleading people at this point, but that's what I think they're doing.
- [21:32]
C
And that, that 80% of trading volume that's also rising over time as passive increases.
- [21:39]
A
Yeah. If I go back to 1995, active management made up 80% of the trading activity. My estimate today is it's around 6 or 7%. And part of that is also happening because the active managers themselves have shared work on this. The mechanics of this type of motion where money is flowing into a very specific algorithmic allocation is effectively pushing those securities at higher at rates that exceed the overall market. I'm not the only one who've identified this. Jang at Michigan State, for example, wrote an entire paper on it. You know, the, the, the implications of that are quite profound. But one of them, of course, is that from an active manager perspective, in order to maintain performance close to the benchmark and not run the risk of losing their jobs, are themselves becoming more and more index like and closet indexers. That's driving reduced elasticity amongst the active managers. I could share a chart with you on that as well. But before, before I do that, the other component that I would just emphasize on it is this is mechanically why active managers are underperforming more and more. Even as theoretical frameworks like Grossman Stiglitz suggest that it, you know, this should be a field day for active managers because we have all these non thoughtful investors that are going out and going, you know, out and buying things at ridiculous. You know, if I. Let me just quickly show you the chart. This is again from Haddad. This is looking at, this is looking at the change in elasticity for those they continue to designate as active managers. And so this is another one of these interesting pieces of research that talks about how much larger the passive share actually is than is measured. But they are treating anyone who doesn't have elasticity effectively of zero as an active manager. And so the active managers themselves used to have elasticities in the range of 0.75 to 0.8. Today that number is well below 50%. Part of what's happening here is more and more active managers like Fidelity are emphasizing index funds. One of the reasons why that's happening is the regulatory framework changed radically in 2006. It was implemented in early 2008 that required 401ks to default into passive vehicles. And any selection of non passive vehicles actually exposed the sponsor of the 401k to liability. This has become one of the nice businesses for trial lawyers. And so we're seeing firms basically become more and more passive in their construction, effectively mimicking the successful species if we think about it in evolutionary terms.
- [24:28]
C
Yeah, it's funny, we, Matt and I just did an episode where we went through all the market outlooks for this year and like, we just want to understand what the consensus Was. And one of the consensus things people were saying is this is going to be the year for active management. Oh yeah. I guess they've been saying that for years and I guess based on your research, we may not want to hold our breath for that.
- [24:43]
A
Yeah, no, it's. By the way, I would say the same thing about forecasts for small caps, you know, resurging and rotations into emerging markets, etc. There's a lot of people who are hanging their hat. Well, a very substantive change. One of the points I would make is if people do decide to rotate their portfolios and pursue alternative approaches, that also is a mechanism effectively of reasserting flows out of passive vehicles and just pulling that point closer and closer.
- [25:15]
C
So another point Vanguard made in the piece was this idea. They were arguing that basically index funds own a higher percentage of mid cap stocks than they do large cap stocks. So I think their point there was, you know, we should, if this is true, we should be seeing this impact in mid cap stocks. So how do you think through what they're saying there?
- [25:31]
A
I think that there's, there's a couple of things and again, I think they're being intentionally misleading. So when they're describing index funds in this concept, in this context, they're taking a slightly different approach. They're including index funds that would be like the REIT index or nuclear power index, right? Those push the ownership, you know, of, quote unquote passive strategies that are not at all passive strategies, not even remotely close to what we're talking about in a market cap weighted framework. And many of those are actually being forced into mid caps by virtue of concentration limits that exist within portfolio construction. And so often you'll see something like a REIT index that has a modified cap weighted exposure where if they were to simply buy in proportion of the market cap, it would be three stocks for all intents and purposes, by conforming to the modified cap weighting formulas to meet the diversification requirements of the 40 act, it pushes them into large ownership of some mid cap companies. Those absolutely have an impact on those mid cap companies. But Nobody in their 401k has the, you know, the REIT ETF as their default investment vehicles. So almost everything that we're talking about they are intentionally avoiding and obfuscating with this analysis.
- [26:59]
C
So the other point they made is one that we've talked about a lot with you on the podcast, but this idea that the biggest companies, Apple, they can handle the flows, yet they're getting flows, you know, in proportion to their market Cap, they can handle them. So the relative positioning of companies shouldn't really change based on these flows. So could you just address that one?
- [27:16]
A
Yeah. Again, they're being intentionally obfuscating. Right. What they're highlighting here is, is that after they trade, they own the same share of every company. There's no discussion about the impact of that trade on the price and the market capitalization of the individual companies. They intentionally avoid that. They're simply showing us the math of market cap weighting. What we know, and you have this directly below in. Below that in the notes that you sent me, is the work of JP Bouchard on market impact. Market capitalization plays no meaningful role in the provision of liquidity. What matters for liquidity is the dollar value of trading and the size of the order relative to the idiosyncratic volatility of the individual name. If you actually pull that formula up on screen, which I assume you're going to do in the edit of this, the impact of an order, the I, the impact of an order of size Q is going to be a function of the volatility of that either market or individual security times the square root of the quantity, the dollar quantity traded divided by the average daily volume that's traded. This makes intuitive sense. If I go into a market that on average trades $1 million and I try to execute $1 billion trade, I'm going to have a big impact on that market. That impact is going to be larger for highly volatile stocks because they have effectively less anchor to them. So what this tells us is that we should be looking at dollar volume of the size of the order relative to the dollar volume of the trading liquidity. This is part of what I actually ran through on one of my substacks. Let me just pull that up quickly. This was in a piece that's on my sub stack called Pay attention to your privates. If you take the example of Apple and CarMax, which at the time that I wrote this were respectively close to the largest and close to the smallest stocks in the S&P 500. If you put in a billion dollar order to buy the S&P 500 and not a typical order for an index fund, about $70 million of that order is going to go to Appleapple and about $100,000 is going to go to CarMax. Right now their trading volumes are such that that differential, that 700 to 1 differential isn't even close. This is about a 60 time differential. So it's a roughly order of magnitude difference as a share. Their volatilities are somewhat similar. The volatility of CarMax is slightly higher. So if we run through this formula, what we discover is on a daily basis, Apple is receiving a positive impulse. And again, you know, Vanguard's inflows last year were about $350 billion. The that would suggest about a billion dollar order every day. So we're looking at every single day. Vanguard gets inflated by that order by 0.167. Right. CarMax gets inflated by 0.06%. If you scale that to an annual number, that works out to about a 6% increase in CarMax and about a 23% increase in Apple. By the way, that's actually more than Apple gained last year. So there are offsetting components to it. Among them, the fact that, candidly, Apple is not growing anymore. It doesn't have superior profitability or investment opportunities. It's failed in almost all of its new product introductions. Sure, there may be something fantastic out there, but that's a really big leap to make at the scale that we're talking about with Apple. So what we should be seeing in Apple is lower multiples. We should be seeing lower valuations, reflecting the fact that the law of large numbers has largely caught up to Apple, and it should be trading at lower valuations. Instead, it's trading near the highest valuations in its history. And I would ascribe that to the impact of passive investing. Vanguard, of course, would say we have no role in it whatsoever.
- [31:25]
C
I wonder, are there active managers out there trying to figure this out in terms of trying to model liquidity? And then the flow is relative to liquidity, and say, here are the companies I should most own because of this. Or, I mean, is owning the S and P really the best way to take advantage of something like this?
- [31:39]
A
My hunch is that there are people smarter than me that have taken my research and converted it into this. I'll be totally candid with you. It took me basically nine years to get here, which reinforces why I call myself the dumbest man alive on a regular basis. And it really was kind of a breakthrough where I realized, wait a second, the s and P500 isn't a single security. When I did my initial trades around this, I did it on the xiv, which was a security that referenced a single underlier, two underliers. But that's. That's splitting hairs. You know that this is. There's 503 securities within the S&P 500. And so it actually turns out that there's much more impact occurring at the individual stock level. And that's driving behaviors within the index that will ultimately turn the index into something that looks like a single stock, which is increasingly what we've seen with the rising concentration. Again, a forecast that I made all the way back in 2017 that everybody thought was insane at the time, but has continued to play out.
- [32:40]
D
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- [33:11]
C
And I know even active managers who are not trying to necessarily take advantage of this are definitely altering their strategy because of this. I know. Like, you did a great interview with David Einhorn at your annual event for Simplify. Like, active managers are taking note of this and understanding that parts of their strategy may not work anymore the way it has in the past.
- [33:26]
A
I think that's exactly right. And again, for those who are paying attention to that chart, you'll also notice that I had a line for the median stock in the S and p getting about 9 basis points impact every day. The market cap weighted average gets about 13 basis points every day. Those don't sound like small numbers, but you compound those over the course of a year and you're talking 6, 7% differentials, which is exactly the differentials that we keep seeing between an equal weighted S P and a market cap weighted S P. So these numbers just unfortunately have very strong backing in terms of both the theoretical frameworks and what we're experiencing in an empirical framework. But hey, Vanguard's free to publish anything they want. I just hope they're held liable for it later.
- [34:07]
C
How does AS fees get cut here? Like, how does that impact this? Because it was interesting. There was like sometime last year there was an announcement that Vanguard was cutting fees in like 10 funds or something like that. And pretty much across Twitter, everybody was very excited. You know, this is fantastic. This is great for the individual investor. And then Mike was saying, this is actually terrible.
- [34:23]
B
Like, this is not good at all.
- [34:24]
C
So can you explain why that is?
- [34:27]
A
Yeah. So first of all, it was touted as Vanguard's largest fee cut ever, right? They cut them by 30, 30% from 3 basis points to 2 basis points. Right now the reality is that has absolutely no impact on the investor portfolio, one basis point per year, differential and management fee has no impact on your return. I don't care how long of a period that you're talking about. So it's really not any meaningful savings for investors. So then you have to ask yourself why they're doing it. And the answer is very straightforward. The legal framework that was adopted under the fiduciary rule and under many court rulings is that a firm will be held liable if they select investments as the default investments that are higher cost. And so all this is, is Vanguard saying, well, we don't really care about the fees anyway because we make all of our money off of securities lending and, you know, the ancillary products that we sell at slightly higher fees, we're just going to raise the barriers to entry even further. And that's what they did. And so, you know, yes. Is it a short. Is. Is it an admirable thing to cut fees? Absolutely. Is it an admirable thing for the market leader to use price to drive out competition? Ooh, that's a little bit more debatable.
- [35:49]
C
I just wanted, before I switch it to Justin for some macro stuff, I just wanted to ask you about the response to this, because I know you've thought about this a lot, and it's very interesting to think about, you know, on one side, for every individual, it is very, very rational to continue to invest in passive funds. But you create a societal problem as more and more people do it. So it seems like it's a very challenging thing to tackle. And I know you've talked to regulators, you've talked to people around, like, potential solutions. So I'm just wondering, like, do you. Do you have any solutions that you think would work in the real world to potentially address this?
- [36:18]
A
Oh, I have lots of solutions that I think will work. Do I think anyone will adopt them? No. And so like that, you know, candidly, there's a degree of fatalism for me at this point that the, you know, I was described in an institutional investor as the Cassandra of passive investing. Understand, Cassandra's curse was that she would be right, but nobody would listen to her, and that ultimately drove her insane. So I have a choice. I can go insane, which I might have already, or I could choose to just resign myself to it and figure out how we're going to pick up the pieces afterwards. And increasingly, that's what I'm finding myself focused on, both building products that try to take advantage of this in some, to protect portfolio, to protect investor portfolios, in others, to Try to enhance return. A lot of this work is actually making its way into various simplified products to try to take advantage of these insights. But the reality is that we're in a very, very dangerous situation and regulators are not going to change anything.
- [37:20]
C
This is a broad question, but how would you think about building products that would take advantage of this? Like on one hand, just owning The S&P 500 takes advantage of this. I mean, I guess you could say own the S&P 500 and do something to handle the tails of what could possibly happen. Like how do you think, at a broad level, like how someone might even think about constructing products to take advantage of this?
- [37:39]
A
I'm going to plead the fifth on that one. Right now. We're too in the middle of things right now for me to really. Okay, cool about it.
- [37:46]
C
Maybe some stuff, maybe some stuff coming for the future there.
- [37:48]
A
Yeah. Hari and I are collaborating on some of the downside work. I'm spending a lot of time working on the upside work of the team at Tier One Alpha.
- [37:56]
C
Okay, well we'll get you back if that ever turns into anything in the future.
- [38:00]
A
Most likely will not, but we'll see. As I said, like we've deployed elements of this in some of the products I directly manage at Simplify, we are using some of these insights already. In the CDX high yield product that I manage, it's actually been pretty incredible. It's added, you know, even as we run over hedged against a ridiculously low credit spread environment in the credit markets. We've been able to mitigate the impact of the cost of that hedge through some of these insights over the past couple of months.
- [38:34]
B
We want to get your perspective on how you're thinking about the current state of the US markets. But the one thing that this conversation got me thinking of is so far this year we've come out of the gate pretty strong and I'm wondering to some extent if you have. Even though this wouldn't necessarily happen in like the regular 401k flows, I mean, you know, you have reallocations, rebalancings, you know, kind of new money being allocated possibly into equities, you know, at the beginning of the year. So I wonder if some of the strength so far this year, I mean, it's clearly a function of flows because stocks are up across the board for the most part. But yeah, I'm just wondering if that sort of has something to do with the strength we're seeing so far this year. And I mean, any comments on that and just Generally where you think we are at right now in the markets, in the economy?
- [39:26]
A
Well, I think we're absolutely seeing that in the rotation that is going on in the small caps right now. So, you know, basically we ended 2025 and every call that went out was in some form or another. Okay, this is going to be this year for the stock pickers. This is going to be the year for the mean reversion between, you know, between value and growth. This is going to be the year for the conversion between small and large. And that engenders flows in a, you know, portfolio rebalancing framework. There still are many funds out there, many portfolios out there that are systematically rebalanced into a particular representation of small caps. 10% is not an uncommon allocation of small caps because they have historically outperformed. People keep trying to place those bets. That tends to play out in the December to January time period. My hunch is, is that that's this is going to end prem really and in a, you know, for me, unsurprising fashion, but, but I could be surprised. I want to be very, very clear about that. But I think that's really what's driving it. I mean, that's why the Russell is up 8%. That's why the S P is only up 1 1/2% is some of that rotation. But I would would highlight that within the Russell. You're not seeing value work. Right. You, you know, people chose to buy the Russell. That means crazily enough, they're out there buying, you know, companies like OCLO or, you know, these highly, highly speculative stuff. And really what's running is the unprofitable technology names, the speculative names, the small caps that are highly volatile, which fits with my price impact models. But I don't think it's fundamental. I really don't think it's fundamental.
- [41:06]
C
So should I hold off on my small caps or back tweet? I've got my drafts folder.
- [41:12]
A
You know what, put it out there because it'll probably help my cause.
- [41:15]
C
So you'll probably, you'll probably retweet and.
- [41:16]
B
Be like, look at this idiot.
- [41:18]
A
No, no, I wouldn't. I try not to do that with people I know who are not idiots.
- [41:23]
B
That's Jack's annual the January effect prediction.
- [41:27]
C
That's right.
- [41:29]
A
By the way, it's a great prediction to make because as small caps get smaller and smaller as a fraction of the total market, that incremental inflow as people try to rebalance in those portfolios that, you know, basically are saying, well this time it's going to be.
- [41:45]
C
You.
- [41:45]
A
Know, that that works. It generates extraordinary movements as markets become more inelastic. Small caps are experiencing this as well. They are not at the same level that you see within the large caps, but they are more inelastic than they used to be. And so as a larger pool of aggregate dollars tries to rebalance into those names, you can get some pretty extraordinary moves. We've certainly seen that.
- [42:11]
B
What's your view on the underlying economy like right now? Like I think the last GDP print we got was like, you know, whatever, 4% annual growth. But you know, you could talk to some people and they could poke holes in that and you know, there's sort of some weakness under the surface that may not be reflected in some of that data. So how are you looking at that currently?
- [42:33]
A
Well, I think there's a couple of things to keep in mind. One is when we talk about gdp, we are typically quarterly, quoting the quarterly data. That quarterly data is annualizing by basically multiplying it by 4. And so the, the quarter over quarter GDP in Q3, which is the latest one that we have, was as you pointed out, about 4%. The year over year was only about two and a half percent. So you know, we're seeing a much more restrained metric if we look at, you know, the year over year components which capture both an element of residual seasonality that continues to be there from the COVID we will start to lose that in the next year, you know, and part of it also is just somewhat of an increase in volatility of GDP as we've seen political uncertainty play its way through the system. The institution of tariffs caused people to build inventories in advance. The drawdown of those inventories detracts from gdp. The rebuilding of those inventories adds to gdp. And if you're doing that in relatively short order, you can get highly high variability in the quarterly data. But the year over year is much more muted.
- [43:48]
B
What are your current bs? We've been talking a lot about obviously AI. Everyone's talking about it, but what about the massive amount that's being kind of put into this capex build out? Are you, you know, generally, do you see that as this is just over excess? You know, a lot of the value here isn't going to be realized. Or do you have a different sort of take on what's happening, you know, within AI in general and the money that's flowing into all this CapEx and stuff?
- [44:15]
A
Well, I, I think that there's a number of things that are going on. One is something that I've highlighted repeatedly in the aftermath of the dot com cycle. Michael Jensen, who is a phenomenal academic and was a creator of the Social Science Research Network, which, you know, all of us who read white papers regularly turn to for low cost access to academic or other insights. He wrote a paper in 2003 or four, I can't remember which year it was called the Agency Costs of Overvalued Equities. And what he highlighted is, is that if you enter into a period of perennial overvaluation, management teams have an incentive to basically adopt that view that their stock is worth what it is trading at and to behave accordingly. And so if you're Microsoft or your Apple or your Google or your, you know, in private markets, open AI, the incentive is extraordinarily high to basically say we're going to make these crazy giant investments that are going to create this total addressable market that the world has never seen before and you're going to get malinvestment. The only way that you can counteract that is by shorting the security to try to drive the price lower. And in an environment in which passive is causing securities to rise at an accelerating rate, certainly relative to their fundamentals, it damages the short world. Right. And you, I mean, I've said this to you guys before on an individual basis. I may have said it on camera with you, but like I've literally spent the last five years, you know, basically playing therapists to short, you know, to short sellers, saying, you know, a variant of the Robin Williams interaction with Matt Damon. It's not your fault. Right? It's not your fault, son. You know, the reality is they're still trying to, to fight the good fight. And it's, it's really challenging.
- [46:09]
C
How do you think about AI though? Like from an overall economic impact standpoint? You know, you've got people in the tech world who think it's going to result in like doubling GDP growth. You know, you could argue it'll increase productivity, but it also might, you know, lead to job loss. It seems like there's so many different factors at play here that it's hard to think about, like what the overall impact this will have on the economy as we move forward, you know, in the future.
- [46:30]
A
So this is what a lot of my most recent macroeconomic stuff is focused on. My substack this week will actually hit specifically on this issue. Look, what we're trying to do is we're trying to shift away from a world in which it was centered around the production of energy for human usage and human consumption, which meant that things like fossil fuels, about a third of which go to fertilizer, animal feed, transportation of food for humans, heating humans, et cetera, another third goes to the transportation of humans. That fossil fuel represents, you know, somewhere in the neighborhood of 75 to 80% of our total power production. Another 10% or so is going into nuclear. And only about 15% of the realized power, because there's heat loss during electrical power generation, et cetera, comes through as our electrical grid. In another 20, 30 years, I would expect that to have completely flipped that effectively electricity will in one form or another be the mechanism by which we receive energy for probably 75 to 80% of our usage. That's going to require an extraordinary amount of investment and innovation for it to be realized. And it's a bit of a pig in the python component. And so when you ask me what is the impact of it one from an individual, right? Like, like, you know, it's funny, people talk about Warren Buffett or Howard Marks or others, you know, I unfortunately now fall into that camp that my job basically is very similar to a journalist in a lot of ways, right? I spend a lot of time writing, I spend a lot of time thinking, I spend a lot of time building models and exploring theoretical frameworks. And LLMs are an extraordinary tool in that context. I use them nonstop, right? I use them non stop. I have, you know, multiple pro level subscriptions to Claude, ChatGPT, Gemini, Grok. I just expanded my, my usage of for the very simple reason that I view them effectively as first year and increasingly second year analysts. I would probably say that Gemini has now become a second year analyst and is probably my favorite quad is still my favorite for writing. But from an analysis standpoint, Gemini is really, really good. You need a ton of domain specific knowledge to use them effectively though. And so as I, you know, I, I highlighted this internally at Simplify. It's like, you know, look, there was, There was a 33 year accelerated learning curve associated with how to utilize LLMs for financial markets. And I'm probably not even beginning to scratch the surface, right? There are, there are programmers out there that can do things with LLMs that I can't even begin to imagine doing, but they don't have the domain specific knowledge to say, okay, well what are the implications of this? How do we think about this in the context of this research paper that was written in 1973? They don't have that capability. And so, you know, I continue to see myself as becoming more productive in many ways. I would argue that the introduction of LLM subtracted 10 years from my chronological age in terms of the decay of my gray matter. And so, you know, the world has to be prepared for a 45 year old Mike Green again. That said, I also think that we're in a period of extraordinary hype and there's going to be negative ramifications which we're already seeing across a wide variety of assets as we exhaust the electric grid capacity and capability in the United States that is forcing the incremental power to come on in much larger, discrete and much more expensive configurations. The price of natural gas combined cycle turbines, the installation of those has roughly doubled in price in the last five years. We are now talking about nuclear, which has extraordinary upfront costs that we genuinely don't know what those are going to be if we're building traditional nuclear. If we start approving things like small modular reactors, the installed costs will fall, but the ultimate permitting demonstration, et cetera, costs are going to be very, very high. And that means that power bills are going up in American households. We're paying more for electricity. And since the vast majority of people don't do the type of work that I do, they're not experiencing a meaningful ancillary benefit from the growth of LLMs. They're just seeing their electricity bills go higher. And that's going to be an interesting sociological phenomenon to see how that plays out. You're already seeing Donald Trump start to mention this and Microsoft is going to have to pay for its own data center power. We're not going to allow it to rely on the grid. If that's the case, then all of a sudden Microsoft has to become both a utility and a software provider. And at the end of the day, Ben, utilities don't generate a lot of profits. Right. It tends to be a pretty rough business with very high fixed costs and maintenance costs and depreciation costs associated with it. And you know, I would be surprised if the market on a fundamental basis believe that the right multiple for a utility, simply because it has the Microsoft logo emblazoned on the outside, is the same as, you know, for Microsoft's software as a service business.
- [52:08]
B
You mentioned Matt Damon earlier. Did you guys see that? Him and Ben Affleck have this new movie on Netflix called the Rips.
- [52:14]
A
I have not seen it. I, you know, I, I enjoy both of their acting and so I'll probably check it out.
- [52:21]
B
Yeah, no, it's supposed to be, and the premise is, and it's Kind of sort of ties into some of this. It's. They're on like this, like, law enforcement, like special forces, drug team, and they come across this huge pot of money, and then it becomes like, cops skimming off the top and the, you know, dynamic between maybe the good cops and the bad cops, and supposedly it's really good. But anyways, just kind of got me thinking. So, Mike, what. One last one for you here before, and we really appreciate your time. I wanted to. I don't know if this is a good place to end, but we were talking before and you had mentioned that, you know, you're soon going to be moving into a home, buying a house. You've been, you and your wife have kind of been moving around, following your kids and following their sports and, and wherever that, you know, whenever they would have you into, you know, to, to their schools to watch, whatever. But I'm wondering, do you think some of this stuff that Trump is doing on the possible side of, like, home ownership and trying to make things more affordable will actually get things moving in the housing market? Do you have any opinion on that? What are your thoughts?
- [53:28]
A
Yeah, I mean, you know, first of all, Trump's announcement that the, you know, the agencies were going to buy back significant quantities of mbs from the market has now been thwarted by the Fed announcing that they're going to sell the identical amount into the market. Right. So, like, really part of what we're watching is ineffective tribal government that is, you know, basically fighting. Right. That tends to resolve itself with either the emperor or the counselor losing their head. I think that'll take some time. My hunch is, is that unfortunately, the emperor is going to lose his head on this one. I wrote, you know, I wrote two weeks ago about the housing market and the challenge that we have. We actually don't have a meaningful shortage of housing. What we have is the wrong housing in the wrong places. And so effectively, what's happening is that the baby boomers have chosen to age in place because they saw the homes, the nursing homes that they put their parents do, and those are not for them. And so they're doing everything they can to age in place. And they are also funding the development of assisted living facilities that they occupy for much longer periods of time than the traditional nursing home type regime. That's creating temporary shortages that unfortunately, is going to look a lot like the stock market. Eventually, the baby boomers are going to sell. The quantity of housing in this country is not particularly short relative to the number of people and certainly not the population growth that we're now anticipating. But a lot of it's in the wrong place, and a lot of it is the wrong size and the wrong caliber, et cetera. And that will slowly sort itself out through price and liquidity frameworks. My hunch is that we will eventually announce a major building program and the government is going to do the same thing, which is basically put the wrong type of housing built for the needs of today, it'll be completed five years from now when we no longer need that type of housing. It'll be built in the wrong places, you know, and that's why you don't want the government to get involved in these things. The reality is, what we should be doing is radically reducing the regulatory framework that's required for the construction of new housing, removing a lot of the restrictions on residential construction that exist in false terms, facilitating the conversion of office real estate into housing or commercial real estate, and reestablishing effectively the value of a city is a safe place to live where people consume far less energy than when they live in a rural environment. But as I said, I don't think we're going to do that in a thoughtful way.
- [56:12]
B
All right, Mike, thank you very much for these deep thoughts and for spending this time with us and our audience. We really appreciate it.
- [56:19]
A
My pleasure. Thank you for having me, guys.
- [56:20]
B
Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess Returns network@excessreturnspod.com. if you have any feedback or questions, you can contact us@xsreturnspodmail.com no information on.
- [56:40]
C
This podcast should be construed as investment advice. Securities discussed in the podcast may be.
- [56:45]
A
Holdings of the firms of the hosts or their clients.