← Top Traders Unplugged
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- [00:02]
A
I feel worried about all this though, because I don't like an economy putting my free market cap on. I don't like an economy that is reliant on a small number of people to act as the watchdogs for a system that is bloated and fragile. They're very well qualified to deal with this. But still, its dependence on a small number of people to support a global financial system that impinges upon everything in society.
- [00:33]
B
Welcome to top traders unplugged. In markets, success doesn't come from predicting what happens next. It comes from being prepared for what you can't predict. In each episode, we go deep with some of the world's most thoughtful minds in investing, economics and beyond to understand how they think, how they prepare and how they decide and the experiences that shaped how they see the world. No noise, no shortcuts, just real conversations to help you think better and invest with Conf.
- [01:07]
C
Harry, welcome back to the show. Jim and I have been looking forward to this conversation. It's been a few months since you were last on the show. How have you been?
- [01:14]
A
I've been well and it's a pleasure to be back. I hope to be. I hope this will be the first of many occasions in the future.
- [01:21]
C
Yeah, so do we. Now, the reason why we're here today is to talk about a new paper that you wrote with Mike Green, Stefan Sturm called A Model for Passive that Breaks the Market. And I actually think our conversation today is perfectly timed. As we've just witnessed, equity markets around the world have an exceptionally strong performance the last month with double digit gains in the S&P 500 and the NASDAQ, whilst at the same time we have two wars going on. No clarity on where inflation is heading and what the next move from the Fed will be, as well as global alliances breaking down, which suggests that something other than fundamentals and logic is controlling the markets. Now, you can correct me if I'm wrong, but your paper is not really about passive investing. It's about what happens when markets lose enough active participants to maintain price discovery. And that is a important distinction. I think the three of you are essentially arguing that modern equity markets may be transforming from a value driven system or valuation driven system, I should say say, to a flow driven system. And once flows dominate fundamentals, markets can become reflexive and unstable. But before we get into whether that's a fair description, perhaps you can start and take us back to talking about the kind of the origins of the idea, how you got involved in the topic and why you Thought it was worth researching along with Mike and Stefan.
- [03:00]
A
Well, I have to give Mike a tip of the hat. He was kind of the driving force behind this. I think in 2018 he was one of several people, but a notable person who mapped out the Volmageddon where the Vix ETNs caused damage to the Vix futures markets very suddenly based on overcrowding effects. Now, after that, he sort of turned his attention to where the next big overcrowding or structural risk might be. And so he decided to tackle the big one, which is the rise of passive investing. And what we do know is that even though dollar flows in and out of passive vehicles have fluctuated over time, as the S and P has gone up and down, the share of dollars in the US equity market in passive have gone up pretty steadily, almost deterministically. So passive share has increased in a almost surprisingly predictable way. Now, he felt, and we felt that as passive share increases, the linkage between fundamental value, whatever that means for the S and P and price would be broken. And the reason it would be broken can be sort of described in the singular limit, to use a fancy phrase, where if there were no active investors left and everyone was passive, and whenever a dollar went into a retirement fund, it would go straight into the S and P or some fraction of it would, then the S and P could go up indefinitely with no constraints. And by the same token, if there were outflows, the S and P could collapse and there would be no active bid to defend against that. So we felt that the process which describes stock market dynamics could easily move from one with significant mean reversion and control and stabilization into one which is almost a purely diffusive process where volatility feeds back into itself and can engender really steep increases in risk. So that was the idea. Now, this was about two years ago that Mike came to us or came to me, and as may not be surprising, I did nothing because I didn't have a solution to the problem. But one day Stefan and I were chatting about something else and we figured out that we could come up with a very simplified, almost toy model of the impact of passive investing on the dollar value of the US equity market. And the model incorporates mean reversion and it also incorporates diffusion. So in other words, the larger the percentage of active investors in the market, the stronger the connection between prices and fundamentals. I should emphasize that fundamentals don't need to be specified in any particular way. You can use any measure that you like. It could be Shiller, Cape, it could be price to book, it could be some discounted cash flow model, whatever. But if the share of passive investors increased, then basically the mean reversion force between index prices and fair value would break, so that tethering would break and the dynamics would become increasingly unpredictable. Now, what I think we did, and I don't want to speak too long, is I think what we showed is that with a large enough share of passive investment, markets can become unstable even if there are no outflows from the US equity market. And that's the critical point, that it's not a flow driven argument for instability. What it is is a statement that high passive share drives market pricing from one where there is somewhat predictable mean reversion from prices to fundamentals into one where volatility dominates. And if you look at the standard options pricing models, at least for the S and P and other equity indices, what they say is that when prices go down, volatility should go up. So given a random shock to the downside and no flows, you can get wild dynamics. That was the main takeaway of the paper. It was a kind of a critical systems analysis, the sort you might do if you were in the military or something like that, showing that too high a passive share could drive wild dynamics in stock indices. That was the first part of the research. And I think I'll stop there because that's quite a lot to digest.
- [08:05]
C
Sure.
- [08:05]
A
And you can pick at that.
- [08:08]
C
And I'm sure we will, and I will bring in Jim very shortly and I'm sure we're going to go down a few rabbit holes. But before we do that, I think what could be useful for the audience when you bring out such kind of a paper is maybe to understand some or all of the key assumptions you had to make in order to, to write the paper so people can kind of get a feel for. Yeah, we kind of agree with that. Or no, that's, you know, that's a bit radical. So what were the assumptions you had to make to do this work?
- [08:40]
A
Yeah, the first assumption was that the fundamental value of the S and P index or the US equity markets rises over the long term. Now if it didn't, nobody would buy equities. I presume it doesn't even have to rise as quickly as the risk free rate, but it must rise. The second one is that in aggregate, through their collective wisdom, so to speak, active investors push prices at least somewhat toward fundamental value. That's debatable, but it is part of the academic canon. So we felt justified in including that the third one is that mean reversion decreases as passive share increases. Now this was a thorny one that would have been harder to defend in the ivory tower until recently because there's a well known theorem that Mike has talked about a lot of called the Grossman Stiglitz theorem. And what that says is that if there are price insensitive investors who come into the market and start buying or selling without regard to fair value or fundamental value, then the active managers will pick up the slack and they'll use as much leverage as they need to drive prices back to some notion of fair value. Now that was academic orthodoxy until maybe two or three years ago. There were various papers. A notable one was by Haddad, Valentin Haddad and various co authors that suggested that empirically active managers don't have the ability to do that or they don't actually do that. They only correct for some fraction of the mispricing generated by price insensitive actors. And once we saw that paper, even though it made no difference in our view of the world, because we're pragmatists, we're not academics, we felt more justified in stating that as an explicit assumption, namely that as passive share increases, and note that passive is kind of a price or value insensitive agent in the market, mean reversion should decrease. We made the simplest assumption that that decreasing function is linear. You'd have to defend anything harder. So as passive goes up, mean reversion strength goes down proportionally. The final assumption we made is one. For the quants, there are various models. The Cox Ingersoll Ross model, which goes way back and talks about interest rates, tries to describe interest rates and the constant elasticity of variance. Models in the modern day basically boil down to this without using too much quant speak. As index values go down, volatility tends to go up. That's the whole reason why there's a put skew in the S and P or one of the main reasons, and so on. So we made that assumption as well. But I would argue that all of those assumptions are A defensible and B falsifiable. So what we hope we've done, what we think we've done, is put this problem on a sound footing where there can actually be a debate, where even in the no net flows case we argue for instability and we challenge the audience to try and dispute that. Now we could be wrong, but at least we put the problem in the science, in the falsifiable realm.
- [12:17]
C
Okay, now just one more thing before I hand over to Jim, so just staying on the passive side. You mentioned the, I think it was called the Pension Protection Act 2006. Is that where things start to change? Now? We're not noticing anything initially, I guess, but. But is that where things start to change? And maybe you can describe what that change was when that got approved or introduced.
- [12:49]
A
Okay, well, if I look at the dynamics of passive share, they were below. Passive share was below 1% in the US around 1994. Now we have varying estimates where passive share may be 50%, 60% or perhaps even higher if you think of the closet indexers in the market, but let's say it's around 50, 55%. Now, in 2006, there was a Pension Protection Act, I think in Australia, if I'm not mistaken, that set thresholds on performance or lower bounds on performance and fees, more notably fees for active managers. In Australia, that pushed pension funds or superannuation funds even more in the direction of allocating to passive. And so that's an example of a non US important factor that's related factor that's driven an increase into passive investing across the board. Passive investing has one of those great attractive features for an allocator. It's easier to defend your position if you did nothing else, you cut the fees. And if everyone else is doing it, that's fine too. I've often talked about this in other contexts, but maverick risk is tricky. And as soon as passive gained significant force or significant share, it became an easy position to take. And so our goal isn't to say that the world is wrong, that passive is bad. It has many good features, it's cheap, it's transparent at some level, even though it does involve active rebalancing, it's somewhat cost efficient overall. It's relatively cost efficient overall. So it has a lot of good features. But we would argue that when any agent becomes excessively large, and I point back to Mike's analysis of the Volmageddon, it has the potential to cause harm. And that's the position we're taking. Now, I can drill down further into what's going on under the hood at the individual security level, but I'll leave that for a moment.
- [15:03]
C
Let's see where Jim wants to go on.
- [15:05]
A
Yeah, we'll let Jim jam riff on this because I think he can take the lead pretty effectively.
- [15:12]
D
I have 10 different angles I can go here and we will hit all of them, I'm sure. Just thinking about where to begin. Before I do, I have to note that Hari was the way this all started. You, Hari and I did an interview, I think it's now five years ago, where you interviewed me as a host on Top Traders Unplugged. And that's kind of what started this whole progression. So it's fun to be here together, kind of on the other side of the table talking to you today. Tremendous respect for what you've done and all the, and all the stuff you, you, you do to help teach people. So just want to start there. But before we dive in here, I want to kind of think about the big picture. I think it's always great to start big and then drill down. One thing that I've been talking about that you obviously been talking about, Mike Green's been talking about before we could dive into just passive, right, Is the overwhelming reality that the size and leverage of markets themselves have been so critical, become so critical to both the economy and the whole system at large. This is no longer just about the market. The market is not just some reflection of the economy anymore. And there was a time, I believe that more, much more than not that the markets were more a representation, more of a feed, a ticker of what the world and the realities of the world were expressing. The voting machine, the weighing machine were much more aligned. I think we have a world now where the voting machine and the weighing machine. Benjamin Anybody who's followed us will know those terms, but essentially the short term buyers and sellers is the voting machine, the weighing machine are the fundamental realities and cash flows of the businesses and the economy. We're in a world where those two things have departed at such scale that to even look at the weighing machine in any period less than a year or so seems trivial. And I think that's what we're just trying to put this in layman's terms. What we're really talking about, the gamification of the market, the fact that the market itself has become essentially in any reasonably short period of time, untethered from the fundamental basis of the economy. I would take one more level up from that, that it's not only become untethered, but it's reflexively become a primary driver as opposed to just a representation. I'd say its primary role. Sorry, just to finish this thought, its primary role is no longer a representation. It is actually its primary role is the liquidity and what it does to drive the economy and the outcomes of the economy. Given the size of the financialization,
- [18:20]
A
one could argue that The S&P 500 is driving all sorts of social changes, whether it's wealth inequality or any Number of things. And that the markets are so untethered and unleashed that they're basically driving everything else. That politics are almost a byproduct of what markets do and markets can almost forecast simply because of the belief system that's in place, what will happen in the future. And this is worrisome about prediction markets, but we can shelve that for now.
- [18:54]
D
I think the word forecast is the wrong word. They drive.
- [18:57]
A
Right. Drive is a better word.
- [18:59]
D
It's not forecasting if it's actually the thing causing the outcome. And I think that's the part that people get so confused about.
- [19:07]
A
Yep.
- [19:08]
D
You know, CNBC is still out there talking about what drove after, you know, ex post facto, what drove it. An outcome based on fundamentals. When we all know that. I mean, all you have to do is look at the last six weeks of market outcomes to realize that kind of the fundamental big picture of news and the drivers that are changing the world are. Are no longer right. Changing the outcomes are no longer what's driving. And by the way, reflexively, you can see the narratives of peace and all these things that are clearly not true coming out of that market outcome.
- [19:44]
A
Well, I was a slow believer in this because I used to read the stories as to why. And then I stopped asking the question why? And I thought, well, the market has a random shock that may be fundamentally driven, and then the flows take over. And now I think the random shock is almost an afterthought. It's the flows take over.
- [20:04]
D
Yeah, this wisdom of crowds piece is real, but I think it's been meaningfully overcome by the crowd driving the price of these, that the crowd votes on driving the outcome at the end of the day. So I want to start there. And I think that's an important thing, place to start, because the more you see this as the vehicle driving the outcomes, this has much greater implications than just reflexivity in the market. It. It now begins to be about reflexivity of society, reflexivity of. Of. Of global economic outcomes. I talk in passing often of a very simple set of numbers, but I want to expound upon them a little bit today with you, Hari, which is what I think everybody in markets should know that very few people fully appreciate, which is There are about $500 trillion of long global assets. Why do we need to know that? Because the size and leverage and amount of effect that these markets have is dramatic. Global equities are about. Public equities are about 150 trillion. Private equity, private businesses, everything else that would count in terms of business or equity or you know, equity, like think credit vehicles as well. Takes US to about 300 trillion. 200 trillion of this is, is more sovereign bonds, real estate. Right. Other things that clearly are highly affected as well by market outcomes. Okay. And when the market goes up 15% like it did in two months, month and a half, really, you know, you could argue it's somewhere between 45 trillion and $75 trillion of new collateral. It's created like that. Now let's, let's go back and compare that to like the power the Fed has or the treasury for that matter. What's the most, I mean, we think about the Fed as all powerful.
- [22:19]
C
Right.
- [22:19]
D
Like the Fed Putin was, you know, don't fight the Fed. How much, you know, during, during the, during COVID How much did the Fed actually liquidity. The Fed create what, maybe a few
- [22:33]
A
percent of it of that. So maybe a trillion or so.
- [22:37]
D
Yeah, maybe five at max, depending on how you look at it with fiscal and all the other things involved. Right. So the point here is the, it's a, it's a order of magnitude plus bigger than the Fed that we have to think about markets in that context. And I don't want to go down this path too soon and we'll come back around to it, but government officials are aware of this. The Fed is aware of this. Hyper aware of this. The treasury is aware of this. This is why we have hedge fund managers as the managers of these entities. Now, to live in this world where we think that markets themselves are not being managed is so naive. It goes against. It's like saying the government officials don't care about that source of liquidity that is 10 times bigger than the Fed. This is why they have to voice and try and move markets ahead of time. This is why they have to get ahead of things more and more as opposed to play reactively. They have to be proactive.
- [23:40]
A
These are great points, but the one question I would ask is if, as I believe, and you probably believe as well, that the market is a complex system, can you really control a complex system over any appreciable length of time?
- [23:55]
D
The answer of control is in the grays. Right. It's just like anything we talk about. It's not black and white. I mean, I guess there is a point of absolute control. What I would argue is absolutely not. There is no such thing as absolute control. And the more you absolutely control. This is that Sumo market. I talk about the tectonic plates. Markets can be controlled. And underneath the hood, the amount of pressure and you know, it's like a balloon. You can control the air, but at some point it pops. Right. And so what we've created, and I think this is what you're touching on, is a system that is increasingly controlled, which leads to higher pressure under the hood and nothing can be controlled forever.
- [24:41]
A
Yeah, this was kind of the thinking we had when we built the first model with Stefan, which is that a complex system cannot be described by any one model. You need a bunch of models, but let's build a few, even if they're toy like, let's see what the consequences are of these models and see if we can link them together and make something out of it. And so really I put on the complex systems hat when we started with this,
- [25:09]
D
you can talk about these systems in the short term. Right. And they're where we are now and where the rise of passive has led us to. But I think there's a much bigger story, which is for the last 40 years, supply side economics, taking interest rates from 20 to zero, forcing the leverage and the passive is a huge part of that. And honestly it's a, it's a reflexive recency bias effect because if markets go up for 40 years, because interest rates go down for 40 years, the amount of leverage and passive and structural governmental structures, everything leads into this momentum effect.
- [25:50]
A
Yeah.
- [25:50]
D
Which then just gets eventually too big to handle. And at the end they try and control and control and control as much as they can because the risks are too high. And that's where we are in the story. And eventually things have to reverse. And this is complex systems. Right. From a larger sense, but also what you're talking about on a small sense.
- [26:11]
A
Yeah, that's right. I mean the sort of Mach 2 of this analysis, which was spearheaded again by Mike, is that there's a. If you look under the hood, what you're seeing is the mega caps growing even bigger. Because whenever the flows go in, the names that receive a large dollar allocation but aren't that elastic, meaning that relatively speaking, equal percentage allocations to those names cause bigger price moves down or more notably up. What you get is greater and greater concentration in a few names over and above their importance in the economy. And that gives them access to leverage, which creates even more concentration of the largest names in the economy and can be damaging to the health of the overall system.
- [27:05]
D
It has a ironically supporting effect for those businesses in the short term.
- [27:14]
A
Absolutely.
- [27:15]
D
And a momentum effect for the earnings and growth of those business, which then reflexively creates better numbers beating earnings. You know, all you have to know is that 99 till 2000, that last year that tech earnings grew 30%.
- [27:38]
C
Yeah.
- [27:40]
D
Which is the highest growth they've ever had until they went bankrupt. And then 95% of them went bankrupt. That's about as black and white as you need to see. Reflexively, markets go up, everybody does. Well, not everybody. Those entities that are getting the capital do, do well. And that's what we're seeing the capex build out that comes from it. If you give somebody infinite capital, what do you think the anthropics and whatever the world are gonna do? They're gonna go spend it to build more growth. They have it. So go build out the capex. Guess what? 99, 000 we had a massive capex build out of the Internet.
- [28:13]
A
Yep.
- [28:14]
D
And the numbers get better and better and better and better. And everybody's like, see, see, look, we were right, but they weren't right. The numbers went up so that they were right and the number went down and they were wrong. It's not like the tech bubble burst like the, the earnings just stopped or the, you know, in the Internet boom. It's not like the, all of a sudden companies just started going bankrupt so that the bubble burst, the capital stopped flowing, so everybody went. So the capex stopped and the liquidation happened and the leverage came down and earnings imploded.
- [28:53]
A
And one of the notable things that you can see sort of empirically is that it used to be that there was a low volatility, maybe not premium, but low volatility baskets outperformed not only on a risk adjusted basis, but they were pretty comparable or better in absolute return terms. Now if you look at large caps, it's the higher volatility names within the large cap bucket that may be outperforming. And that has really changed the dynamics under the hood, indicative of the power of leverage and the power of stock prices that get bid up to allow access to credit.
- [29:33]
D
I try and talk about this all the time, but I think very few people truly understand this. Which is the way the voting machine and weighing machine almost always come in line is through discontinuity, through a break, through risk, through a deleveraging effect. And there is not some smooth mechanism with which the voting machine and the weighing machine converge. They converge when liquidity dries up. Because when liquidity drives up, fundamentals are all the nutters. This is that plane flying fuel analogy I've given for many, many years. And the reality is until that fuel stops, all that matters is the fuel is the liquidity is the position and, and then to a second order effect. Now to get to what you've been you wrote your paper about here, which I think is so critical, the primary driver of that fuel in the airplane that keeps the trajectory in line of where it's going is actually positioning itself.
- [30:46]
A
Absolutely. And I mean one criticism that we, that that I've gotten that maybe would be addressed sort of directed toward what you've said as well is that oh no, it's still a stock pickers market because dispersion, equity dispersion is still high. Look here the dispersion trade has been working pretty well. Now I have my theories about this. I would say that dispersion can be high even if everything moves up or down together on the same day simply based on the relative movements of the less elastic names. But I'd be curious to hear your take on that.
- [31:24]
D
Yeah, I mean I think most listeners here, and I know you Hari, know that the dispersion. I think it's pretty hard to refute this point. We've seen a complete break of how dispersion works now relative to how it used to work. And it lines up exactly with the beginning of this massive vault compression that was coming from vault selling products, structured products. Iron condors in 17 is kind of how it was and then you know, an xiv right. Is how is how it kind of started there. But ever since then V selling products, the non correlated nature of those and that people are driving to them and whether it's through ETFs or structured products or all kinds of other things have driven an index compression which is then pushing everything away underneath the hood. Right. Like that is the biggest driver, not even a question for me of what's driven dispersion. Now what wins in dispersion like that? You can say there's a magnet that's forcing compression at the index level which clearly if idiosyncratic risk still exists, drives things away from each other. So it's a kind of a reverse magnet on the single list which drives correlation breakdowns. But what wins and what doesn't, whether that's fundamentals that's driving that or not, that's a whole nother debate. And I'm, I feel very strongly that it's not fundamentals. There is a ton of dispersion. It is long short equity positioning which is also dramatically increased, doubled in the last two years. And so the positioning has actually gone up on long short equity which has driven, as we've seen during periods of illiquidity, dramatic pain both of the last two summers and buckle up here, it's May 11th. This summer is going to be the same. The biggest indicator of what performs in the summer and what doesn't isn't fundamentals. It's hedge fund positioning. It's long short equity hedge fund positioning. At the end of the day, we know certain things that we. One of the few things we actually know is actually that positioning is if people are long, max long, they can't buy anymore and they do have it's selling in weight and that they're max short, it's the opposite. And so the whole positioning of the market at any point where it's concentrated, leveraged, ultimately is subject to being forced to buy back or sell, sell out. More liquid markets are the worse that is. And that's been the biggest driver. My opinion.
- [34:00]
A
Well, I mean that raises the question how do you play that? How do you play these observations without giving away the shop? But in some broad strokes and I mean we could, we can talk about that quite a bit. I mean some things that I would argue would be that shorter term momentum is probably higher. So if the market's going up, it's likely to continue going up. The bigger names are likely to continue getting bigger. The call skew is probably likely to be underpriced because the index will become more concentrated and look more like a single name or a small number of single names. On the other side of the table, probably downside hedges are more important because A you're getting more bang for the buck being long and B, these breaks that you speak of can happen so suddenly that you're not going to be able to rebalance your way out of trouble. So that would be the kind of broad stroke view I would take. The one other comment I would make and I, I think shows sell better if we just disagree on everything. But let me just throw this one out there.
- [35:03]
D
No disagreement is where all the growth happens. I'm always looking for people who disagree.
- [35:07]
A
So I'm failing on two fronts. One is as soon as I introduce a formula or a quant symbol, I'm down. Secondly, I'm agreeing with pretty much everything you're saying, but how about trend following? This is almost a Neil's question. On single names, I know it's done. But if the single names are the ones that are attracting all the capital and are less elastic in some way, they should have pretty good momentum properties going up and also real downside possibilities. So you kind of want to have a floor on how much you can lose when you get In I know some CTAs do it, but I'm just curious as to whether that is a viable way to play the predominance of passive flows in the market today.
- [35:52]
C
The odd thing, and I'm not an expert in single name trend following, but the odd thing is that when you look at returns for managers and you go back say 25, 26 years and you look at the distribution of returns over the various sectors, people will think, well, equities have gone up so much in the last 25 years and certainly in the last 15 years that that surely must be your best performing sector. But it's not. And I think there's something to do with how equities move and the corrections that you get along the way, which can be very difficult to handle as a trend follow. These V, especially these V shaped recoveries we, we've seen, I don't know about single stock equities, whether that's the same you would get from that, but I don't think we can just say that just because you have a certain strong momentum. Oh, clearly, yeah. If you bought Nvidia and did nothing, yeah, you would have made a lot of money. But, but so I don't know about that. What I do notice is that those managers out there who do trade single stocks, I don't see that performance being better, obviously. I don't see the breakdown, but I don't see it as being better. But it could be, it could have a different distribution, of course. But equities as a sector is not necessarily a great sector for trend followers.
- [37:22]
A
Especially on the short basis.
- [37:25]
C
Exactly. Especially on the short side. And I think it has to do something with also how human behavior is, meaning tops tend to form, often taking more time than bottoms. We know, for example, a lot of these crises, they kind of turned on a dime and then they went straight up again. And that's very difficult for managers to deal with. But maybe just for me not to be the one talking here, since you're the guest here, Harry, I mean, I'd love to make sure we cover some of the topics from your paper that you want to cover and maybe what you've, you know, what you find most interesting and telling from the paper, such as, for example, how do you, I mean, how do you link between the size of passive and the say, you know, index level or something, you know, how do you, how do you, how have you gone about some of these more technical things? But. And then also maybe the whole QIS world and how that plays in. I Know, Jim also has some, some thoughts on that. But. But let's make sure we don't stray too much away from, from your paper since that's why we're here.
- [38:27]
A
Well, I get more excited listening to you guys than speaking, so I'd happily be a fly on the wall. Okay, well, I'll give you a little bit of history, which is that the CIR model for interest rates, the Cox Ingersoll Ross model for the spot race, was widely criticized because it allowed for negative rates or at least hitting the zero bound. I shouldn't say negative rates. Rates could go to zero in the model before they reflected back up. And people, when the model came out, which I think was in the 70s and subsequently argued that rates can never go to zero, so they kind of threw it out. We found that model quite interesting to revive because that zero bound property is actually quite interesting and it arises naturally from our model. Now, we would not argue that the S and P is going to go to zero in finite time. There are so many ways to prevent that from happening, both at the exchange level and at the government level. But we found that extreme feller condition, as it's called, pretty interesting. And I think the numbers we came up with with our parameterization were that at 91%, roughly passive share, the market could go to zero in finite time, strictly speaking, over any finite interval. But I won't state it too strongly that way. The more interesting case for us was that when the passive share gets to around 83%, volatility can increase uncontrollably at a cubic rate. A cubic rate means very quickly. And when we ran the simulations in the paper, we found lots of simulated paths going down very rapidly after about 12 years and many paths going close to zero. And so the range of outcomes was much wider. The median outcome was lower and the bad outcomes were much, much, much worse. They actually lost money. And again, this was not to say that this will happen, but that it's a natural consequence of a set of very humble assumptions that most people, at least quants, would agree with. And there was a lot of fight back there. Some people sort of were very angry at me because they said, well, the market will never get a zero. And my counter argument is use the model, argue against the points in the model, and if you can do that, fine, but at least we have a basis for debate.
- [41:06]
D
Yeah, I love that. And I think you agree that this is a toy model and it is meant as a vector or part of a much more complex system, as you know, and we should be exploring that as, as one important meaningful piece of a much more complex system.
- [41:34]
A
And I should add there that my friend Mika Kostenholtz has actually built a second order model that incorporates trend and mean reversion in the same model framework. And he actually gets lower values for criticality in his model.
- [41:53]
D
And I would actually part of why I started Big and now this is perfect Nils, that you brought back in the specific is how does this paper in my opinion relate to all the other things that we're talking about in terms of the big picture. And I think the problem is this as much as I agree with all of your findings in terms of that those things matter, systems naturally simple systems that are naturally more concentrated like this become more vulnerable to shock and more volatile. I think we'd also both agree that, that this is not just a two dimensional market of longs and shorts. Right. And if anything the dramatic increase in all the volatility products, all the hedge fund products, the leverage in long short, right. I mean long short equity has become $3 trillion in terms of leveraged long short and, and has an outsized effect when you start thinking about how active that is. Because the other thing that people don't really appreciate about markets I got to talk a lot about and I pat fly through and other people don't, we don't really compound again on is that on average $50 billion, 50 to 75 billion give or take is the incremental amount on a daily basis that moves this $500 trillion behemoth again 50 billion is what's on a day to day basis moving 500 trillion kind of mind breaking reality. And so these hedge funds and these entities that are trading quickly, the dealer flows all these things, they seem small on some relative basis, but most of the world again is this big tanker. And and so I think you know, when we look at this system and then we look at the size and scale of all the other things that are happening that are not just long the market passive or active, right. And then add in of course the most important part which is the Fed, the Treasury, the government, which incrementally much smaller than the collateral and everything of the big market. But from a ability to put their thumb on the scale and drive market outcomes is incredibly powerful.
- [44:25]
A
I think commodity investors have known this for a long time. So for example, in the electricity markets, if you flip your switch and there's no electricity, prices can skyrocket and there's no limit to what people will pay to keep their factory going in the absence of supply. And so prices have always moved at the margin. That's a very extreme case. And it's increasingly, as you pointed out, it's increasingly clear that that's happening in all markets.
- [44:59]
C
But can I ask both of you something? And so I'm going to be the uninformed ball guy asking two experts a question here. Okay. So some people might sit at home listening to this and say, well, hang on, what is it that's really changed that we talk about? Yeah, maybe the market can drop 50, 60% because if I'm not remembering incorrectly, the market did drop, you know, 85% in the NASDAQ in 2002. So the question is here, has anything really changed? It might be a different. There may be some other things going on today that didn't go. This is why I asked about the 2006 date. Right. Where the flow of passive maybe have started in some countries and certainly also came to our part of the world. But markets have had these periods before. And also just maybe one more thing. We had the whole shutdown of the world in 2020. The market dropped quickly, a lot. But there were stabilizers that came in so that it didn't go to 60% down. It stopped at like whatever it was 35% or whatever. So I'm just trying to understand if something has fundamentally changed in the last few years and maybe we can.
- [46:23]
A
Sure, yeah. I'm going to just focus on 2022.
- [46:27]
C
Okay.
- [46:28]
A
So when a lot of things that used to work didn't work, 2022 had an equity market that went down maybe 22% if the S and P is a barometer. Rates went up 60, 40 portfolio got obliterated as allocators rebalanced between equities and bonds. They had to sell some equities. The mega caps had a sharp reversal in performance. Long volume, which would have almost invariably worked, didn't work in 2022 because volume was high going into the year 2022 was a signal to me of significant structural change. That putting my global macro hat on would be suggestive that if we do have an increase in rates or any sustained increase in inflation over and above the oil price shock, most. This is too strong a phrase. Many of the strategies that are currently being used by large institutional allocators will be turned on their heads. And so the only way to defend against that is, in my view is to have. I'm selling my book here. But to have inflation sensitive assets such as commodities, short strategies of various types of trend following type strategies and Perhaps not to lock into the greatest asset of the late 20th century and early 21st, namely bonds, treasury bonds as a ballast plus a return generator. There has to be other stuff to go into.
- [48:07]
D
But I think the important part is that the world is waking up to that. Everybody in 22 started seeing that. And what have we seen since 22 in four years we've seen gold, triple precious metals on average, more than triple. We have seen continuation of in waves of crypto's growth. Right. And importantly, things like fall products, structure products, ETFs have 5x from 500 billion to two and a half trillion dollars and growing faster and faster each year. And hedge funds which were at by the way, 2 trillion or so, 2 and a quarter trillion in assets for literally flatline for 10 years have gone to 4 and a half to 5 trillion in the last four years.
- [49:01]
A
But again, high concentration in names.
- [49:04]
D
Correct. And this is the part that I think is you completely are right. That's the part that's important. It's that people are trying to do at a very basic level. Again all of that, it went from 7 trillion to call it $22 trillion of assets in the context of 500 trillion long. Right. So it's still tiny percentage.
- [49:26]
A
Right.
- [49:26]
D
We're talking about, you know, what is that? That's you know, 5%. And so the question is, is that really truly non correlated enough? And how concentrated are those things? Very concentrated. The options positioning is not like rich and complex. It's very concentrated in certain types of strategies that at certain expirations, at certain places like the indexes or, or a couple of different names. Well they're, they're a lot of long short equity is also very leveraged and same type of names, very fundamental kind of driven.
- [50:03]
A
And there are a lot of interesting dynamics that make the situation worse. If you're sitting in a seat at a large multi strat, you have a downside exit or downside risk cut. So you have to chase stuff that's working. You can't go for the long term contrarian bet unless you have other things going on. And so you're at the mercy of realized volume as well as returns on a given day. The whole market is at the mercy of realized volume at some sense. And so if markets are going up and realized volume, with the exception of the early phases of the Iran war is low, people are just piling on the leverage. And so volume doesn't represent risk. In fact it's inversely related to risk.
- [50:55]
D
Yeah. And at the end of the day I think we have a situation where the people who are moving away from the passive kind of 60, 40, which is still quite a small percentage trying to diversify. Early adopters, what I would call them, are having pretty great returns relative to bonds at least I would say think about the gold performance, think about other things and that's driving more momentum there. And I think when we start talking about this passive flow piece, I think that's important because things work in passive reflexively. There's a momentum effect. Right. That keeps it working longer than maybe fundamentals would dictate for certain businesses drive. But because it's working, it also drives better outcomes. So it naturally drives us both. But there is a point at which certain non correlated assets, strategies, other things outperform.
- [51:58]
A
Absolutely.
- [51:59]
D
And, and as that happens, that builds momentum in a sense. Passive flows. I mean when we talk about passive flows, by the way, it's just recency bias. That's what it is, that's what drives. But the passive flows themselves drive good returns which drive better recency bias.
- [52:15]
A
Yeah, I mean the techie way to say it is there's a performance flow feedback loop, good performance, more dollars chase it.
- [52:25]
D
I think we both know if it doesn't work for some point or not, if certain parts of the market don't work, then that momentum machine will go into another part of the market and that's the real risk. Right. At some point something other than these flows, because these are not just the only things that matter and then something new becomes the passive flow. And what happens if non correlated becomes the new passive flow because worked while other things didn't or we're doing a big non correlated bucket but like let's just say inflation assets like you said.
- [53:00]
A
Yeah. I mean the obvious scenario where things could break down a bit is a spike in rates or a spike in inflation.
- [53:08]
D
Absolutely. This is actually, this is. You want something actionable. Everything that you're telling me and everything we're talking about has led me to one conclusion, which is these markets from a government perspective cannot go down too much for too long. It has two big economic consequences. And so the only way out is some type of bigger and bigger and bigger as we've seen reaction from government. And at some point the only way out is monetization of valuation, not just debt, but valuation of leverage, of everything. Right. This nominal illusion world is the only way out politically and even that's not, it's the least of all evils. I think by the way, they said it out loud with Hank Paulson just three weeks ago. But I guess the big point here is the passive machine is not only affecting the distribution of outcomes on its own and driving more volatile outcomes, it is reflexively affecting the system. And the system has become so levered to it that to not look at the players at the table to say we're playing a game of poker. The odds say X, Y and Z, which I think is what the paper is probably mostly saying. Right. Which I agree with. That's numbers is there are people playing this game at the table and there's a one. There are several big entities with big stacks who know the same things that, that you know. Right. Who are putting their finger on the scale every day and have every incentive and it's all about reading that player and knowing their incentives who to drive an outcome where that doesn't fail.
- [55:05]
A
So there's no reset. There's no reset unless there has to be.
- [55:09]
D
Inflation is a reset in a sense. But my guess is that's the most palatable reset. And I think if there's a release valve, that's it.
- [55:18]
C
So what might the trigger be? Have any of you any thoughts about what might the trigger be? Other than we get to from whatever 55 or whatever percentage of passive we have now to 75 or 65. But at some point we need the trigger.
- [55:34]
A
We do need a trigger, even in the model that's in the paper. The paper model assumes that if there's a random shock it will feed forward into more volatility in a hard to control way. I think rates is basically what Jem and I discussed. Higher rates force rebalancing out of equities for balanced portfolios. Higher rates put pressure on the economy. They increase the cost of financing. They could break. The private credit bubble is a strong word, but the private credit overhang and that would almost certainly have an impact on other markets. I can see an exaggerated 2022 type scenario playing out. I agree.
- [56:25]
D
And I think the entities, again Fed treasury know that again, you don't trot Hank Paulson out to do a trial balloon on. We have a crisis coming in the long end of the curve and we must defend the treasury market proactively, which is essentially what he said. There's zero chance in my mind that Hank Paulson goes to Bloomberg and has a big speech about preparing for the treasury market crisis without treasury involved in that. That, that conversation.
- [56:58]
A
I feel worried about all this though, because I don't like an economy putting my free market cap on. I don't like an economy that is reliant on a small number of people to act as the watchdogs for a system that is bloated and fragile. No offense to any individual in the chair and I totally agree with you that they're very well qualified to deal with this. But still it's dependence on a small number of people to support a global financial system that impinges upon everything in society.
- [57:35]
D
I 100% agree. And importantly they don't have all the same level of control and theory that they may have had five years ago and that the world is a bit more fractured. Right. And who has how much control matters in those decisions as well. I don't like it either, Hari, but it's not about whether I like it or not. It's about incentives. And for me the incentives are there where like there is no other. What are we is the result to just do nothing and let markets rebalance? I think that's a good idea to like, you know, this town needs an enema. Let's have a catharsis and that'll fix all kinds of problems and then we can more quickly move through a more. A better allocator of capital, better system.
- [58:29]
A
I'm touring about. I'm torn about that because I agree with you in principle. But I don't know what the aftershocks would be in that scenario. The other thing is that from the standpoint of an investor which both of us are at some point you just have to say this is an event, this is the way the world is, this is the way it works and we have to deal with it as investors.
- [58:52]
D
Correct.
- [58:53]
A
We can't say it's wrong. So we're going to fight it with whatever dollars we have.
- [58:57]
D
Of course. Yes. Yeah. We have to trade the market in front of us. And so. So my best guess is that the way out here and I think I pretty strong conviction of this eventually it's going to take time is through kind of an inflationary monetization of the debt and the way that plays out is a multi year controlling of a long end of the curve in the US which creates negative real rates and drives more inflation which eventually becomes untenable and forces a reaction to let go of trying to control the long end of the curve. There is an active process currently of controlling that back end of the curve. It has been the focus of this administration from the day they started. Just look at when they react to what and how they turn. It's always when the, when. When the. The 10 year goes above 4.4 and starts threatening 4.5 why? Because the equity, you know, the equity Yield is around 4. Right. There's just not a, you can't have the 10 year go to 5 and not have market, you know, market pain at some point. So that's a problem if inflation keeps going higher. So you said, Niels, you asked what's the event? The event is a, is a, is an oil shock, is a move in Iran that forces higher inflation, a breakdown inflationary pressures, which we've been talking about for five years, Niels, which we were way ahead of that. We are now seeing a second wave that drives a battle between, that puts the Fed in a greater box and ultimately forces a situation where negative real rates drive a, a debt, you know, a inflation move.
- [60:53]
A
Yeah, well, that's very interesting because a lot of people would have said, well, Japan's already successfully conducted that experiment many years ago, backstopped by the US which
- [61:02]
D
had ultimate power at the time and in a very different demographic circumstances.
- [61:07]
A
Exactly. Post Berlin Wall, we were in kind of a structurally deflationary environment. Change that. See how it works. It's, it's going to be tough.
- [61:19]
D
I talked about this with Volker. You know, people talk about Volker being the hero. Volker did the same thing that William McChesney Martin did, you know, 15 years earlier. William. Nobody talks about William McChesney Martin. The difference was William McChesney Martin was at the wrong place at the wrong time and things had run its course in terms of politics, in terms of the rebalance in the system that, that Volcker, what Volcker was trying to do worked. Same is true for Japan. Japan worked because of the situation, the circumstances of the time. I think to simply take that, oh, it worked before, so it'll work this way for us Now, I think Mrs. What's happening structurally in the world. Right. The structural populist impulses, the inflationary outcomes. It also takes a different system in the US relative to Japan at that time. So, but they're going to try and they, and, and they think that that is a data point that makes them believe that, well, we can probably do this and they really don't have a choice. Candidly. Anyway,
- [62:30]
C
I have a couple of questions that I want to ask before we wrap up. And one is, I mean this is paper is obviously focused on the U.S. but do we see the same structural problem elsewhere in other markets that you've noticed?
- [62:44]
A
Less so directly. So I gave a speech recently at an Indian conference and they pushed back and said, well, in India, passive is probably only high teens to 20% of the market. And I said, well, there are two ways to think about it. One is that locally it's less of a problem. The other is that the US market is the market that drives all risk assets. So it depends on your perspective there.
- [63:09]
C
Yeah. Okay. The last question I had, we'll see where Jim wants to go. But it's just what kind of pushback have you had from. I mean, this might not be very popular in the headquarters of some of these multi trillion dollar index houses. What kind of pushback have you had?
- [63:27]
A
One is the notion that this is anti American in some way for me to say that the stock market can collapse. And that's by no means my goal. My goal is just to give an objective assessment of the positioning risk in the US market. I'm far from the sort of person who would take a politically motivated stand on this. So I might do things for business reasons, but I'd never do them for something like that. The view of the large entity such as who you would know, has been to ignore this. Frankly, why stir any problem by attempting to attack what we wrote? It would just bring more attention to it. So I think they've largely tried to ignore it. Now there are two possible reasons. One is that it's not a big enough thing. But I think it is probably at some level a good enough critique of passive share that it should warrant some attention. But it doesn't incentivize them to draw any attention to it. Because whether we're ultimately right or wrong, I think what we've come up with is a defensible argument that things could become very unstable in the near future. And who would want to sacrifice their revenue stream by taking even someone as soft spoken as people have said as me on for this?
- [65:00]
D
Yeah, I mean, what is the potential reaction? At the end of the day, it's to stop people putting money into their 401s, to stop having people stop putting money into the equity market. At the end of the day, the administration part of what's driven the last 20 years, actually probably the biggest driver of the last 20 years is massive capital allocation. And the reason we're having this AI boom is interest rates went to zero, is that passive flow continued to support those growth, you know, those growth companies. The momentum machine is the greatest tool that America has to achieve these outcomes. It is not a coincidence, by the way. Zero chance it's a coincidence. We're having this populist wave at the same time the machines have come to eat human jobs. The populist wave is a Function of interest rates going to zero and inequality going infinitely higher because money's being allocated to capital. And the more that we dive into that, the technological boom that's come out of it then is reflexively continuing to eat human output. So we are reaching a point where the passive momentum effects in the system that lead to more and more and more and more and the concentration of wealth and the power that it benefits to your point exactly, you know, that don't want to hurt their income. Everybody's clinging to it while the system itself and the people within it are, are doing everything they can to keep fighting and push for a different outcome. And it happens that the capital owners are not the same people as the people getting hurt. And this is the important part. Demographically, those capital owners are dying and the people who got hurt the most by this generationally are coming to power. And that's what breaks this, and that's what's breaking the global coordination. It's the protectionism to protect those people. The political will. It's a political reality that breaks this whole cycle. And my opinion is when that happens, this pass and flow part, which is the biggest, the tip of the spear
- [67:31]
A
on it absolutely bricks as well.
- [67:34]
D
But it is a function of demographics. It doesn't live. I guess my biggest pushback is, and I know you know this, so it's not really even pushback, is that this toy model doesn't live in a toy world. It lives in a world with a, with people and political dynamics, a governmental system that is incentivized and those that empower, that are incentivized to keep things going as long and as much as they can. And when you solve for that, the least painful outcome is inflation, even though that is incredibly painful for the poor as well.
- [68:08]
A
I strongly agree with that. The one thing I would say is that while I would freely admit that our model is a toy model, one could argue that Black Scholes is a toy model. All models are toy models.
- [68:18]
D
Absolutely. Very valuable. Nonetheless, I didn't mean to make a sense of.
- [68:21]
A
No, no, no, I wouldn't disagree with that. The other thing I'd like to point out, for kind of a philosophical perspective, which hopefully will wrap a few things up, is that that subtle violation of Goodhart's Law has driven a lot of this. When volatility ceased to be something you measured but became something you targeted. I hope I haven't paraphrased it poorly. So volume targeting means low volume, more risk, better performance. Lower volume, more risk, better performance. And the thing keeps perpetuating itself until it stops and before you know it, it's leaked into all aspects of the economy. And that's, I think that's the main reason why you and I, especially you have been banging on about positioning risk for so long, because that basic violation of Goodhart's law has been a cause for many of the problems that we find today in financial markets.
- [69:20]
C
That's a good place to wrap up. Maybe. There's one thing I should ask Harry and that is there are so many ways we could have taken on your paper. Is there anything you want to mention before we wrap up completely that we missed because it was pretty wide ranging and maybe not as structured.
- [69:42]
A
The main takeaways I would give are that as the passive engine continues to roll, so to speak, being long is probably quite attractive. Being long equities and accepting that this may persist for a long time, but also hedging and looking at inflation sensitive inflation protection as well as crash protection, I think is very attractive. Barring that, I think buying upside tail risk is quite a good thing to think about because that's a way where you don't have to take on additional risk in your long portfolio and you can still potentially participate from an underpriced index call skew if markets do rip higher based on all of the reflexive arguments we've given today. So stay long, perhaps buy upside convexity if you don't want to increase your longs, buy protection and find a way to get long inflation sensitive assets.
- [70:47]
C
And of course, none of that is financial advice. I should just add.
- [70:50]
A
Oh, by no means, by no means.
- [70:53]
C
But having said that, just one final, final thing I thought of was you mentioned this was one of two papers. Do you want to say anything about what's coming?
- [71:03]
A
Well, the first paper was designed to just model fragility in the S and P as a stock index that was written jointly with Mike and Stefan. Second one is really Mike's domain. So I won't, I'll let Mike speak about this at another time, but I'll just summarize. It's basically arguing in favor of outperformance of higher volatility stocks in the large cap sector, the mega caps, until the system breaks. So stay long or go long, the large caps, but buy some protection underneath.
- [71:36]
D
Cool.
- [71:36]
C
Great. Well, I mean both Jim and Harry, this was really tremendous and wonderful conversation. Thanks to both of you for doing this today. By the way, just to make sure that you go and follow and subscribe to Harris and Jim's work because as you can tell from today's conversation. We are living in a truly flow driven world now and perhaps it is not being covered so much in mainstream media, so you definitely need to go and follow Both of these gentlemen from Harry, Jim and me, thanks ever so much for listening. We look forward to being back with you as we continue our conversations. And in the meantime, as usual, take care of yourself and take care of each other.
- [72:15]
B
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