Barry Ritholtz speaks to Mike Green, portfolio manager and chief strategist for Simplify Asset Management Inc. He previously served in the same roles for Logica Capital Advisers LLC. Prior to Logica, Michael managed macro strategies at Thiel Macro LLC; founded Ice Farm Advisors LP, a discretionary global macro hedge fund seeded by Soros Fund Management; and founded and managed the New York office of Canyon Capital Advisors, a $23 billion multi-strategy hedge fund. He is a CFA holder.
Bloomberg Audio Studios, Podcasts, radio news. This is Master's in Business with Barry rid Holts on Bloomberg Radio. Hey this weekend on the podcast, I have an extra special guest. Mike Green and I have been chopping it up on Twitter arguing over passive versus active, and I thought, well, why are we wasting this on Twitter as it circles the drain. Why don't we just have a conversation in the studio about his beef with passive, Why he thinks it's a structural threat to the market, and the advice that he gave to David Einhorn about it that helped lead Einhorn to start really kicking the benchmark's butt again for the past couple of years. I found this conversation to be both interesting and surprising. Some of the things Mike said about investing, like what would you tell your friends and family to put your money into. He says, it's hard to argue against the low cost and the performance of indexing, but that doesn't mean regulators should overlook the potential threat. I'm kind of unconvinced by the argument. There have been a series of arguments over the years against passive. What makes the discussion with Green so interesting is he's the guy that identified the structural problem leading to the destabilization of the VICS. If you recall back in twenty eighteen Val mcgeddon, he was on the right side of that trade, made hundreds of millions of dollars for his firm in identifying a structural problem that was about to blow up. Now, I don't believe the market structure is subject to the same risks as a single inverse trading instrument, but he makes a really compelling case for this is important. We have to pay attention to this, and we have to understand why this is potentially a risky asset with no further ado. My discussion with simplifies Mike Green.
Verry, thank you for having me.
So let's start out a little bit with your background before we get into your really interesting career Wharton at the University of Pennsylvania. You're also a CFA holder. What was the initial career plan?
Well, the initial career plan actually, so I grew up on a farm in northern California. My initial career plan was that I was going to go into science. I actually studied physics as a young man, and then recognized that I was not actually nearly talented enough in physics to do anything of note, and so transition, like many people did in my generation, into finance.
Similar similar story. I'm always fascinating when to hear people who were great in high school at mathematics or physics and then go to university and say, oh, I'm only pretty good at that. I'm in the same camp. Camp you. You've had a fairly entrepreneurial background, not just in finance over the past decade or two, but you founded or co founded value add Software in the nineteen nineties. Tell us a little bit about that experience.
Sure, so that was actually an outgrowth from my experience coming out of Wharton, And you mentioned the you know, the transition of people who tended to be skilled at math or physics into finance. We forget that there weren't personal computers on everybody's desk back then. We forget that most people didn't have the skill set around Excel et cetera.
We did.
Excel didn't even exist when I started. It was VisiCalc and lotus, right, and so in the nineteen nineties I developed the late nineteen eighties early nineteen nineties, I developed a skill set around valuation in particularly discount of cash flow or residual income type models. Along with a couple of peers out of the consulting industry, we built a company that was focused on valuation, initially actually targeting corporate strategic planning departments, so working with companies like PepsiCo or others that were looking to either divest business units or to make acquisitions and needed to have mechanism to think about the valuation of these. That's what value added Software was originally. It also was the path for me into the asset management space because coincidentally, Mitch Julis of Canyon Partners was researching on the Internet in the early days of the Internet for valuation engines and insights, stumbled across our stuff and reached out and said, hey, could you link this to the public equity databases like compustats so we could use it for valuing stocks. That actually is exactly what we ended up doing. We were one of the last to get what's called the value added license to the Compustat database, and so that then led to the sale of that business in the late nineteen nineties to Credit Swiss, And.
Then you end up actually at Kenyon Capital. Previously I had Dominic Neil as a guest. But you stood up. They're an LA outfit. You stood up the New York office and ran about five billion dollars for them. Tell us what it was like doing that a couple of years before the financial crisis blew up.
Well, it was very tight to the financial crisis, and so I'll tell you candidly that I I thought there was a very reasonable chance that I was going to be out on my so the technical term in the financial crisis. You mentioned dominicqu Miels is one of the fantastically talented people at Canyon Partners. She was based out in Los Angeles, and from kind of that nineteen ninety six introduction to Mitch and Josh, they repeatedly tried to get me to go to work for them in Los Angeles. And finally, I think it was two thousand and three or four, I ran into Mitch on the street on actually on fifty seventh, just around the corner from where we are right now, and he said, hey, you know, we're thinking about opening a New York office. Is it US or is it Los Angeles? And the answer was it was Los Angeles. I didn't want to be in Los Angeles. My wife doesn't like to drive. I actually came like within inches of accepting a Canyon Partner's offer back in nineteen ninety eight. And then I'm going from dinner at Mitch Julis's house to the airport. It's eleven o'clock at night on a Friday, but bumper to bumper traffic, and all I could think is, if I do this, I'm done. My wife is going to leave me in about two and a half minutes. And so we just made a meeting of the minds. When they decided to branch out to New York City, it provided the perfect opportunity to transition to Canyon Partners. Initially I joined to help them manage their equity portfolio. My background in the asset management space was originally going to small cap value, and Canyon Partners really gave me the platform that allowed me to branch that out into multiple different areas.
How do you more from small cap value into things like derivatives and FX.
So my actual background was originally in derivatives. My first job on Wall Street, when I was still at the Universit Pennsylvania, was trading crude oil futures to offset option positions for spear leads in Kellogg. So I had a background in derivatives. The opportunities to trade derivatives and be involved in the hedge fund space was something that really had not emerged, at least for me in New York until Canyon Partners provided that opportunity. But if you look at when I sold my software company in the late nineteen nineties, we had this huge disconnect where I'm a value investor, I'm somebody who's focused on evaluation and small caps and small cap value in particular, we're trading at this incredible discount, and so I actually went into small cap looking at it from the same standpoint that a macro investor might and say, this is an area that has real resources and opportunity, and the valuations are totally mispriced relative to what we're seeing in the broader market. I just got lucky, candidly that the dot com bubble broke about six months after I made that transition. If it had gone on for another two years, I might not be sitting here to talk to you today.
Right Hey, listen, smart as good luck is better, luck is better, definitely absolutely true. So after a successful run a Canyon, you stand up your own fund ice Farm Capital, you're seated by Soros Fund Management. So I met him once briefly. I think I was honest at his apartment of Park Avenue for some event. But tell us what it was like working with the people at Soros.
Well, So again the Soros guys, in particular Scott Bessett had actually rejoined Soros as the CIO. At that point, he was the lead analyst for a stand Ruck and Miller, and so he was returning to Soros. He basically tried to build a stable of outside managers that he thought were interesting and presented interesting ideas. Initially, same thing as canyon partner is basically meaning.
A non correlated multi strategy. Let's spread it across a lot of different ideas, disciplines, approaches, and hopefully some of them are working most of the time.
One hundred percent. That's exactly the idea. And so Scott actually approached me about joining Soros, and I turned him down with the observation I've already got a great job. He immediately picked up on that that the word job probably came across tapping into my entrepreneurial background, and he said, well, if you don't want to change jobs, would you be interested in running your own firm, We'll see you. That's what led to Ice Farm Capital. The name, actually, I funnily enough, comes from a vacation property that I used to own. We sold it when we moved to California to follow in the rest of the career. But I owned a nineteenth century ice harvesting operation, which sound insane until you actually stop and think about all the characteristics of what the world would have looked like in nineteen hundred. Ice was very much a business like cable television. Back then, you actually didn't own your ice box. You leased your ice box from the ice company. The iceman cometh right. The iceman was somebody who would deliver the ice on a regular basis, alongside cheese and various other components. And believe it or not, that was the seventh largest business in the United States in nineteen hundred and by nineteen thirty five, with the invention of air conditioning and modern refrigeration techniques, primarily by carrier, the entire industry is gone and everything files for bankruptcy. And so we actually picked up a vacation property that's just outside of exciting vacation destination just outside of Scranton, Pennsylvania, that was in the Pocono Foothills. It was effectively a property that is between two three thousand foot mountains and so in the northeast it constantly stays cool. It was fed by five artesian springs, and so this is the fantastic, most perfect place to grow ice and see ice farm. And we had like railroad tracks that went to New York and Philadelphia, et they're all abandon long since abandoned, but that was the genesis of the name. We're always looking for a name. Toron the te launcha farm.
No, that's great, and there's if you look at every Greek mythological creature or god, like, all the names have been taken. It's pretty it's pretty hilarious. So let's talk about the next gig. You have Teal Macro. You're managing the personal capital of Peter Teal, which I found fascinating because people have a tendency to read into the politics of the investors. The New York Post famously does this all the time. But you know, the politics is capital is capital, whether it's coming from source management or Teal tell Us a little bit about what it was like working with Peter Teel Well.
So those are pretty much the two extremes, right, one certainly perceived as you know, right wing in one way, and the others perceived is very much left wing. I don't care about the politics component. I care a lot about politics per se, but I very strongly believe that we're able to have our own opinions. There is a degree of discussion around those types of components in any setting, right, and so it is important that at least you're able to entertain that. Peter is unbelievably brilliant, right. He is one of these people who I think has a very intuitive grasp of order in the universe and tries to take positions that exploit those underlying dynamics. His you know, familiarity with Rene Gerrard and the dynamic of mimicry and people's desire to imitate what other people have or to try to obtain what other people value. I think it's kind of his underpinning philosophy and has proved to be really really powerful in terms of identifying where the puck is going. You know, Peter built a phenomenal pool of capital that it was a real privilege to have the opportunity to work with him on.
And he was an early investor. People sometimes forget he was early in Facebook, he was early in I think was Uber. I mean, he was in the right place at the right time more often than we were talking about Lucky at a certain point. It's like, hey, you know once or twice as a coincidence, but at a certain point there's a certain set of insights and skills there.
Yeah, I don't think Luck plays nearly as much of a role as people would like to think because it relates to Peter. I do think that a lot of the dynamics that we saw coming out of Silicon Valley, Peter was one of the first people to say, hey, wait, let's try to treat this like a business as compared to purely a scientific experiment. And so he was part of that early crop of venture capitalists in that late nineteen nineties time period. Then I think started to think about it less on the pure technology front and more on exactly as I was referring to with rhine Asia, are the aspirational dynamics, Like what do people really want? Right? Very few people want to quote unquote get onto a smartphone. They want to be able to connect with their friends, they want to be able to do math, they want to be able to get their email, they want to be able to do their work away from the office, et cetera. That awareness that that world was transitioning to the online space, I think is really what Peter's key observation was, And now it's interesting to watch him as he recognizes I think in a lot of ways that people want other things in life, not necessarily just technology.
There's a whole long conversation about the evils of how we use tech. But before I leave the teal macro, I got to ask you about the famous vommageddon trade in twenty eighteen. You had identified in advance that there were some structural problems with XIV, and on behalf of that funds you made a bet that, hey, this thing is going to blow up. Tell us a little bit about that trade.
Sure, so, XIV, which has been reintroduced in various forums, was just an inverse of the VIX index.
Meaning when market volatility went down, that should go up.
It should go up. The irony, of course, is that like most of these trades that's out there, it's not quite what people thought it was right. So the actual source of profitability in that trade is not the level of the VIX, but the shape of the vul's surface.
Right, just describe define what you mean by that.
So the structure of the vall's surface is generally upward sloping, meaning that people are more uncertain and priced greater uncertainty about events far off into the future as compared to events that are relatively nearby right now. When that inverts, when the VIC spikes on a risk off event, that actually means that you're suddenly if you're inverse, right, so you're shorting this dynamic. You're shorting stuff that is low priced is rolling up to high price. Right. That's really bad on the flip side of that equation. In a normal what's called a contango construction in the VIX, if you are shorting six month volatility or two month volatility and buying it back as one month volatility, you're typically selling it around fifteen and buying it back around twelve. That's a crazy return when you think about it that that's happening every single month. You're basically generating twenty close to twenty five percent right in that trade on a monthly basis. When you run that full strength, it gives the dynamics of something like the XIV, which rose six hundred percent in twenty seventeen. Right now, my observation was twofold one was that because of the growth of this strategy, it had actually gotten so large that it was consuming all of the liquidity in the UX futures, the vic's futures. On normal trading days it was about seventy percent of the daily volume. Was simply the rebalancing of these things.
Wow, that's huge.
So the passive component of that, which will feed into a discussion we'll have later on, had just become so large that it relied on liquidity that was not necessarily going to be there.
Right, very similar to the financial crisis, where people had long term debts but it was so much cheaper to finance that with short term paper. Hey, we'll just roll it over.
Every thirty days one hundred percent. That's exactly the same underlying dynamic. And by the way, the model for the trade that I built was actually going back and reading Paul Tudor Jones analysis leading into the crash in nineteen eighty seven folio insurance components. Right, it was the exact same trade. So like down to the point the portfolio insurance was consuming somewhere around thirty to forty percent of the volume on the S and P five hundred on a normal basis. Paul's observation, Paul Tuder Jones' observation was that in an event that actually exacerbated volatility, the trading quantity that they would need was far greater than the market could supply. I had the exact same insight, exact same view, and simply pointed out that, like, look, there's a misunderstanding of an inverse product. You think, like a normal stock, it's getting safer and safer and safer as it goes higher in price. But that's the exact opposite. And so what you were actually building was a bimodal distribution, meaning two homps to the distribution where there was a smaller and smaller probability that everything was okay, and a bigger and bigger probability that all I think technical term is all hell was about to break loose.
Right.
We basically came to the conclusion there was roughly a ninety five percent chance it was going to go to zero. Over a two year period. We ended up buying. This is one of the wonderful things about financial markets and degrees of completeness. There were options available with a two year time horizon that allowed us to.
An amazing leverage. So how much how much were you putting at risk at that moment that Hey, this this analysis is correct and the timing this should happen within two years.
So we were actually ultimately limited by the liquidity in the space, but it was large enough that we were able to put a sizeable amount of amount and make a meaningful.
Long So you made this trade on behalf of Teal macro put any of your own capital into it also.
Well, that's one of the funny things that everybody discovers is you go through this industry, is that when your compensation is tied to the outcome of the trade, you can absolutely express components of it. But the reality is is that we're all massively underinvested in things like equities, et cetera.
Because so much of your income is that you know, I've had that exact conversation, Hey, why don't you own more common stocks? You talk about passive investing this and that, I don't know, how about ninety five percent of my net worth is up in market related investments.
You're in the same leg one hundred percent, and it's hard for people to understand that. So it's great to have the opportunity to actually share that. I mean, our industry tends to be among the most conservative investors out there, precisely because we look at it and we're like, wait a second, if this risk goes wrong, not only do I lose my assets, but I lose my job.
Right, it's double concent trade risk. There were lots of rumors about that trade at the time. Some people said it was fifty million, one hundred million, two hundred million. I don't know what you're allowed to talk about, but it's safe to say this was a big eight or nine figure trend profit, right, this was a giant win.
Yeah, the notional amount of the trade was about a quarter billion dollars and we did well.
I'm going to guess you don't have to sit. You don't have to admit or deny the following. But if the if that was your notational one hundred isn't a ridiculous profit margin. That's Barry saying it. That's not Mike. So any compliance people listening, I'm just spit bowling here. A couple of months ago, I had David Einhorn on and he made some news basically saying passive has broken the markets, and kind of snuck by after he dropped that bomb. Was he credited you with helping him understand how passive has changed market structures and forcing him to become as a value investor, more of a let's call it a deep value investor, and his performance has since rebounded. So, given that Einhorn has credited you with this insight, tell us how you came about to this belief.
Sure, so the XIV trade was actually part of a broader research into the dynamics of passive And if I'm going to run through that language and help explain it, the single biggest contributor to that research was actually a twenty sixteen paper by Los A. Peterson at AQR Brilliant individual. He wrote a paper called sharpening the Arithmetic of Active Management. Right. That paper refers back to the foundational literature of Bill Sharp, who wrote the famous paper in nineteen ninety one the Arithmetic of active management, which is the source of any statement that you hear which is active simply owns the same stocks as passive because it charges less. Therefore, passive will outperform over time. Right, The argument is very straightforward. There's an assumption of completeness and markets. What Lasse pointed out in his paper was that passive had to transact during periods in which there was index rebalancing, and so in that period they ceased to be passive investors. They became active investors, and that became an opportunity for outperformance. Now, the reason that that became interesting to me was I recognized one additional feature that Lasse had not highlighted, which is that passive investors are always transacting because of the dynamics of flow. So you get your paycheck, you put six percent aside that flows into various Vanguard funds. There transacting on a daily basis, And just to put it in perspective, over the past couple of years, Vanguard has averaged somewhere in the neighborhood of three hundred billion dollars worth of inflows every single year. That's the equivalent of a large hedge fund every single day having to deploy its capital into the market. And so when you think about this dynamic of is passive actually passive, it's really important to understand that the definition of passive as it stated, and this is true for the XIV, it's true for the S and P five hundred, in any form of index fund the definition of passive is somebody who never transacts. If they transact every single day, then they're actually a different animal.
So let me push back on that definition a little bit, because I don't want us because you and I are going to disagree about some things, but I want us to have some fundamental agreement. My definition of passive is rather than trying to time the market or pick specific stocks, or have a concentrated portfolio, meaning a high active share so you don't look like the index, you're just going to default to a broad index, whether it's the S and P five hundred or the Vanguard Total Market, which I think is eight hundred, and then there's an even larger one that's a few thousand, and I'm going to own the whole market. And what that will allow me to do is have minimal trading costs, minimal tax costs, and avoid all the behavioral problems that comes with active management. And so I'm going to own this in a four oh one k. It'll be a mutual funds in a taxable account, it'll be an ETF and I'll let that run. So I don't think you're that disagreeing with that definition or how far off is my definition from yours.
Well, the only difference in our definitions is actually the process of how you get to hold it. Right, So the natural conclusion that you're making is actually consistent with Sharp's paper, which is the idea that passive investors hold every security. The problem is how do you get in to hold those securities and how do you get out when the time comes to sell them.
No, you're not disagreeing at all. You set up your four o one K, or you set up your investment plan, and whether you're making a purchase and putting it away or dollar cost averaging in your four oh one K or in any other My partner Josh calls this the relentless bid. The constant flow of money into four oh one k or iras have operated as a little bit of a floor on the market. You know, the dot com financial crisis and pandemic crash is notwithstanding. Most of the time there you can count on positive inflows to equities.
Well, yes, right, I think that's correct. And I do think you used a term that I think is really interesting, the relentless bid.
Yeah.
Absolutely, And so when you start thinking about each of those individual components that you're talking about, first of all, just it's really important to understand that all the literature that exists around active versus passive, and the idea that passive doesn't meaningfully change markets actually presumes that it's simply a hold that there is no transaction activity.
It goes I mean other than I mean, obviously, it's not like, Okay, everybody in nineteen ninety nine buy stocks and then no one buys stocks for the next thirty years. There's a continual the economy continues to grow, people earn wages, whether it's a retirement account or a tax deferred account or just an investment account. The average mom and pop investor throws money into the market on a regular basis and takes money out of the market when it's needed for other purposes.
So the fascinating thing about that is, first, I completely agree, right, and I think that's actually part of the language that gets confused and lost on this. And so again, anytime you're transacting, you're not passive. When you decide to buy with your weekly contributions. You're not passive. What you're actually doing is you're transacting in a systematic fashion. So you are a systematic algorithmic investor that has a very simple rule, what do I buy? I buy everything? What price? Should I buy it? At? Whatever price the market is offering me that's presumed to be the right price right now. Anytime you buy, you've traded portfolios that are several hundred million to billion dollars in size. Anytime you attempt a transaction like that, you're going to influence the prices. And that's really what distinguishes the difference. That's what David is highlighting. As more and more investors transition to this systematic algorithmic investment that simply says did you give me cash? If so, then buy? Did you ask for cash? If so, then sell?
That starts to.
Change the market behavior in a measurable and meaningful fashion. It actually causes two things to happen. One is it creates a momentum bid because what do I choose to buy? I choose to buy whatever the market is pricing it at. So things that went up since I had my last purchase, I buy more of as a proportion of my assets, I buy less of things that went down. The second thing that it ultimately does is it creates conditions under which a transition from cash rich portfolios that are ultimately option like in their characteristics. So I, as a discretionary portfolio manager, if you hand me cash, I can look at the market and say, you know what, thank you for the cash. I'm going to hold it in my portfolio. I'm going to use this as an opportunity for me to reduce my exposure to the market. Or I could choose to use it to buy something without having to sell something.
Given that, what are the risks to the US economy and to the markets from too much passive investments flowing in to equities?
So the key risk ultimately lies in that very simple language, Right, did you give me cash? Ift? So then buy? Did you ask for cash? Iifts? So then sell? And I just want to pause for a second and go through a little bit of financial history here, because I think it's really important for people to understand this. Things that we think of as having always been there, things like four to oh one ks and iras are actually very recent inventions, and there have been dramatic changes around on their implementation within your investment career and my investment career, which are roughly similar in duration.
It actually predates US, but had not become popular like it had existed for about twenty years before people start to figure out, wait, I could put this money away and have a grow tax free. It really took a few decades before the market kind of came to grips with that.
Yeah, I mean so just very quickly. Iras were actually created in nineteen seventy two to facilitate a key risk that nobody had ever imagined before, which is, if you were a union employee who was fired in the nineteen seventy one recession and you received a lump sum settlement of your pension, you suddenly that was treated as earned income in that year, you were subject to the seventy five percent marginal attacks ray. It was absolutely insane and devastating to many individuals, and so the IRA was created to facilitate the rollover of those on a tax deferred basis, so you could maintain those assets even if you lost your job. Right. The second tool that was introduced was the four one K, which refers to a specific provision of the tax code that created the defined contribution. Right, if you launch yourself all the way back to nineteen eighty one and the start of the Bowl market in nineteen eighty two, the start of the Bowl market in US equities following the election of Reagan. The total assets in those two were about one hundred billion dollars in each. Right, today, iras I believe are around seventeen trillion and four oh one k's are somewhere in the neighborhood of eight to nine trillion. Right, these are the single largest pools of assets on the planet. Is the American retirement system. There is a subsequent change in two thousand and six called the Pension Protection Act that one tried to push more and more people into four oh one k's, right by making it what's called an opt out framework as compared to an opt in right.
You can blame Dick Taylor and Nudge for that.
One hundred percent the Nudge dynamics and trying to create the ownership economy, and those have been on net quite positive components to them, but they have meaningfully changed the structure of how flows enter the market.
Cause to the QFIDS right.
So QDIA is is what QDI is so the qualified default investment alternative. If you're going to default somebody into participating, you no longer leave it up to them to say, hey, what do you want to buy? You actually have to select something that you're going to put them into. And so the Pension Protection Act also introduced this idea of qualified default investment alternatives that provided a liability protected mechanism for HR managers or CFOs to declare, this is where we're going to default people into. Initially those were balanced funds, so this is part of the key growth of PIMCO, which had skill set in both in both equities and fixed income. So the growth of balanced funds was a really really key characteristic of that two thousand and six to twenty twelve market. And then in twenty twelve they changed the QDIA to what's called a target date fund, which is what about eighty five percent of Americans now default into in their retirement assets.
Right. What the way it used to be is you would start out a company, even if they had a match, you had to go out and do the paperwork. You had to go out and choose a fund, even if they said as joining a company, you automatically get a four oh one K. Cash would just pile up in there if you didn't give some form of diffraction. So essentially what was designed to say, Hey, you got to get off your button, do something. We're gonna make it. We're gonna make sure you're investing in something. It's up to you to go in and change it to what you want. It's kind of shocking and in some ways just reminding us of the strength of behavioral finance that people are so lazy, just like would you put me in okay, great, and they don't even think twice about it one.
Hundred percent, And that actually is exactly what we see. So it's also a very bifurcated experience where those who were older and who already defaulted into four oh one K plans and made the choice to go into those one K plans, they typically would choose from a universe of active managers. Right. That's the world that largely existed prior to two thousand and six. The passive share at that point was still quite low when I entered the industry, when I first started, you know, cutting my teeth on this stuff. It's hard for people to remember, but passive was still roughly one percent market share in nineteen ninety two.
Vanguard formed in nineteen seventy four. They didn't get to a trillion dollars till pretty much after the financial crisis. I have a thesis that have said, you know, from the nineties implosion and then are just a raft of scandals, the accounting scandal, the Anaal scandal, the IPO spinning scandal, the just go down the whole list, and then burning made off and then the financial crisis. My general sense has been lots of mom and pop investors have said, we just don't want to get involved in that mess. Just let me buy the market and forget about it. And for those folks, it's worked out. And those folks are very often my clients. So let me pose this question to you. If you're having a discussion with a fiduciary who runs a few billion dollars in client assets, convince me to shift those accounts away from either broad indexes or passive generally to something more active. Why should I move their accounts elsewhere?
Quick answer is you shouldn't. And that's actually a part of the problem is that the individual choice should be to bypassive right the problem is is when all of the individuals bypassive, we actually change the structure of the market and so it no longer represents what it historically did.
And by the way, let me interrupt you and just say, we obviously have huge swaths of fixed income and muni bonds as part of that portfolio, and we also own a variety of non passive holdings, some with a value tilt, some with a momentum tilt, some international. So it's not like, all right, we're going to try a fee and just load up on the S and P five hundred. It's obviously a lot more significant than that. But given what you're saying that fiduciary should be looking for low cost at least in a COREN satellite setup, how do you go about reducing the risks to what you see as market structure problems caused by a simple default to passive.
So this is actually the core of the issue, and it's part of the reason why I spend so much time talking about it, and it's part of what I made David aware of in that conversation. To go back to it is there's very little the individual or the individual ria can do to change this. This is a regulatory framework, and it is controlled by the vanguards and black rocks who are spending far more on lobbying than the rest of the industry combined. So part of what's really happening is the political choice to push you into these vehicles. The political choice to make it the only acceptable alternative under the rubric of offering safe, low cost investments to people is understandable. We all want that desire. Certainly, that's your desire as well.
I mean, is it an overwhelming amount of academic literature that says, you know, some active managers managed to outperform, but by the time you get to ten years and take in taxes and costs and fees, you would have been better off impassive. The more people who find their way into passive vehicles, doesn't that create more opportunities for people like David Einhorn. Isn't the greater the percentage of passive ownership, the more inefficiencies there are, And therefore shouldn't we see active sort of reassert itself, perhaps at a lower fee than the past. But aren't there more and more opportunities for people who have a skill set to identify inefficiencies Wherever they pop up.
So I'm really glad you asked me that question, because this is the traditional model and the way that people think about it, and it's exactly what I focused on with David Right. The immediate reaction to the idea of the growth of this non thoughtful entity passive right makes it seem like those who are thoughtful should have an advantage. The problem is is in the theories that lead you to that articulation. So what you're referring to is broadly called the Grossman Stiglitz paradox, the dynamic that the more people choose not to put an effort into the market and divining prices, the greater the incentive and the opportunity set is for those who are choosing to put that into the market. It's what they call the impossibility of perfectly efficient markets. The problem again goes into the details of the assumption of the model. So really what Grossman Stiglitz is all about is the wisdom of crowds. You're familiar with the micromobison examples of these, or the articulation that we're all familiar with. You go to the county fair, the giant jar of jellybeans, and you're supposed to guess how many jelly beans there are in there? Right, any individual has a very low probability of success. But when we aggregate all the guesses and we take the mean of that, it tends to be pretty darn close to that answer. And that's composed of absolute nerds like me who are like, well, what's the diameter and how big as a jelly bean and all that sort of stuff, right, and people who are making just total wild guesses. Right. The problem is that model the wisdom of crowds actually requires everybody to have what's called equal endowment or the same number of votes. And that's actually what Grossmuns Stiglitz relies on as well, is the idea that the wisdom of crowds is caused by the dynamic of each individual making those choices and the market in its totality being able to guide towards that and so that incentive where prices get pushed off. If I'm the same size and I have the same number of votes as everybody else, I can guide the market back to that. That's the opportunity set.
Why wouldn't that work in equity markets where people with more votes more dollars have a greater incentive to get the number of jelly beans correct.
So that's actually exactly what isn't the case. So what's actually happening is we're giving more, We're in more of a vote to somebody who doesn't care right. As a result, Vanguard and Blackrock, because of their daily transactions, the size of those transactions has gotten to the point, even though they're not actively trading on a day to day basis, that relentless bid that your partner refers to is actually changing the structure of the market. It's changing that price behavior. It's the same thing as if we went to the county fair and they said everybody guesses, and then the mayor gets to guess ten thousand times whose vote's going to count.
So I did a lot of prep work for this. You and I have had disagreements on Twitter about passive versus active. I think our disagreements are less than I previously realized. I think we both understand the advantages of low cost indexing. But let's talk about some of the recent data that's come out. I know you're a big fan of a lot of research that's out there. Last week, Eric Balchunis, who is the etf. Wizard at Bloomberg Intelligence put out a report Passive investing worries appear overblown as active as in control, and his key takeaway was when you looked at the S and P five hundred stocks and you broke them into quintiles with the most or the least passive ownership, the least owned quintile beat all the rest over one three and five years. So if that's the case, doesn't that prove the active managers are still doing okay and the struck market structure is behaving as it should.
So it'd be nice if that was the case. Unfortunately, the analysis was deeply flawed. I pointed this out in responses to Eric. Would you discover if you actually dig into that analysis? This is that the least passively owned stocks are the Apples, Microsoft, in videos, et cetera, the world the largest company, meaning the.
Active managers are buying those big magnificent seven socks.
Except that or not. And so the reason why that disconnect comes.
Is because you hold on, I have to stop you there, Sure, every concentrated portfolio I've looked at, every active manager, you have to really go down the list to get to people who don't have some combination of Nvidia, Microsoft, Netflix, go, you know, go down the list of the top ten. They all seem to own United Health. Now, if they're not closet indexers, if they don't own three hundred stocks, maybe they stop after ten or twenty. But those big big cap dare I call them nifty to fifty stocks, they seem to be the favorites of the active managers. Make the other case.
So it actually turns out that the active managers, and this is almost exactly why we see some of the dynamics that we talk about active managers skew towards smaller stocks. Simply by definition, right, the Russell two thousand has two thousand out of the roughly thirty five hundred stocks available publicly traded, it's about four percent of the toll market cap. So somebody has to actually go out and own that. We know it's not Vanguard, we know it's not Black Rock. They're not owning it in any different proportion or any meaningfully different proportion to what they're owning everything else. Through a total market type index. There are some wrinkles around that, but in rough terms, that's the case. You are absolutely correct that there is representation of Apple or Microsoft. But that actually hits on a slightly different component, which is if you are going to compete with the S and P five hundred. Paradoxically, you do have to own those names. You don't have to own Delta Airlines nobody cares, right, but you do have to have exposure to the Apples, microsofts etstead of their world. But almost no active manager can carry them in the size that a passive vehicle can because of concentration limits.
Why how much is Tesla in the S and P five hundred, or Netflix or Nvidia? None of them are more than ten percent. Didn't the SMP and the Nasdaq one hundred change those rules like ten fifteen years ago?
So ten to fifteen years ago they changed to you market from market cap weighted to float adjusted weights. I think that's what you're referring to. But actually, interestingly enough, this is part of the dynamic and where regulation plays a role. Entities like the S and P five hundred Growth Fund are far more concentrated than is legally allowed by the forty Act by which they're governed. They are too concentrated relative to that they've been given dispensation by regulators because they're index investors. And this is where the analysis that Eric was highlighting is flawed, because what's actually happening when you see the high levels of index ownership for an individual name, what's happening is that you're picking up a sector fund for example. This is very notorious in rets. It's also very clear in things like a technology index, the XLK for example, or the xl in the energy space XLE is I believe forty percent Exonomobile, forty percent Chevron, right, nobody can actually run an active portfolio that looks anything remotely are that's pretty crazy?
Yeah? That that that that's absolutely ridiculous.
Just very quickly. That is actually what Eric is picking up. And I would argue that those are not actually what we're talking about when we talk about passive precisely the definition you and I were talking about. If you're a passive or systematic index investor, you're not saying, well, I'm going to overweight energy, I'm going to allocate to an individual indust industry and sort of turn around and then say that those stocks that are most passively owned don't exhibit this type of behavior. Is to confuse those two dynamics.
So also with an Eric's research piece was something that said, hey, we went back and looked at draw downs of ten percent or more of the components in the S and P five hundred. The stocks with the highest passive ownership didn't weren't subject to greater volatility or larger draw downs than any of the rest of the ownership, which is a big part of the argument that hey, the structure is damaged and when it finally breaks, these passively owned vehicles are going to be a disaster.
So there's two separate components. So one is that again, the issue is how you're defining the passively held. So if by definition I've already gravitated to saying the least passively held are the Microsoft Apples, etc. The world, I'm going to come to that conclusion. But the unfortunate answer.
Well, what about the most passively held?
Those actually, ironically are the most passively held. And the reason that they're actually the most passively held is precisely this issue of concentration risk. Most active managers can't hold those names in the size that's required. If I'm a small cap manager or I'm a diversified fund manager, I typically have to run with one hundred names in my portfolio. One hundred names in my portfolio to be equal weight to Apple, for example, in the index, it have to far outweigh everything else in my portfolio I offer as an active manager, typically very little value added to the insights on something like Apple, and so the institutional space or most asset selectors, asset allocators are going to look for managers that are trying to add value. Otherwise, why not just bypassive? Why not go with a low cost solution.
So that kind of raises the question about what is the solution to this. I brought up Balchunis, but I recall, oh, maybe it's ten years ago. He wrote a column that he eventually turned into a book called the Vanguard Effect, and he figured out that over the course of the previous twenty thirty years, Vanguard has taken about a trillion dollars in fees out of the market. Now, it didn't all go to Vanguard. They got took about one hundred billion dollars in fees, but it forced everybody else to compress their fees, to lower their fees in order to be competitive, and ultimately saved. Ultimately saved investors are trillion dollars. So the question is, how do we not go back to the bad old days of expensive, underperforming active managers given the the alternative that we've created. And keep in mind, Vanguard and Blackrock didn't you know, they weren't born whole cloth into a vacuum. They came about following a lot of academic research and a lot of pricing underperforming active managers in the seventies, eighties, nineties. So how do we not go back to those days and yet still have an opportunity to fix the market structure?
Yeah? I know. So there's a whole bunch of different components to what you hit on. The first is this idea of cost savings associated with Vanguard. First of all, I absolutely agree with Eric's analysis that the low cost introduction, the introduction of the mutual structure was absolutely part of the success of Vanguard, and the push towards lower fees has been absolutely critical. But remember the vast majority of the time that Vanguard was actually running, fifty basis points would have been considered really cheap fees, right, that's right, right, And initially introduced, I believe the fees on the Vanguard funds were about seventy five basis points zero point seventy five percent as compared to most active managers who are between one and a half and two percent, right, So that pulling down was absolutely critical. Today you're at a point where the three basis point candidately, it just doesn't mean it's free, it's factally free. It's effectively free. And one of the reasons that it's able to be effectively free is because they are hidden subsidies within the industry, which ironically are affecting things like the CPI numbers that we see where securities lending is actually what's paying for Vanguard, right, meaning.
People want to short stocks, they borrow it, they borrow paying a feele. You go to black Rock and Vanguard, Absolutely, those are the two that you go to. That's that's you know, it's real money when you're running trillions of dollars, but when you're three or four basis points or five basis points and don't forget, Vanguard is about thirty percent active funds. Black Rock is a little more forty something percent active funds. So they have an abandon that space. And when you look outside of their core or you know, S and P five hundred or for Vanguard, it's VTI or Voo, or you have a run of total markets or total global markets. US are global. There are some higher fee products ten twenty thirty basis points, but it's the scale, trillions and trillions of dollars that have allowed them to take a fund like that down to three basis points or four basis points.
So that's actually exactly the point that I would emphasize, which is that we have allowed the industry to change so dramatically from that thought experiment of Grossmann Stiglus, in which everybody was roughly the same size. Marril was bigger, but it was a whole bunch of individual brokers who were able to do whatever they individually wanted to. Right now, what you've effectively done is you've created an industry that, like so many other industries, has become remarkably concentrated. And so one of the iron news is when Eric is talking about passive share, the way that that calculation is done is simply by adding up Vanguard, Black Rock, et cetera. Right now, that actually was the focus of a research piece that I actually inspired. I challenged to Harvard professors, actually a Harvard professor and a PhD candidate. Alex Chinko was the PhD candidate. Marco Salmon was the Harvard professor. I was the adjudicant on a paper that they'd written where they did an analysis on the impact of passive. I very much agreed with the work that they had done this public record, but they had done their scaling of the impact by looking at it and saying the share of passive is fifteen percent roughly what Eric was working off of.
Right. In other words, when you look at ETFs mutual funds, passive is about fifty percent of mutual funds. Now it's over fifty percent, but the non funds, the direct ownership is primarily active. You're saying that is somewhat overstated.
It is very much overstated. So it actually turns out the statistics that people are using for that is very quickly. The mutual fund or forty act industry is about thirty five percent of the equity market in total. A little bit more than half of that, as you're pointing out, is passive in its structure, and so we can multip plates round up to right. That's the quick answer in terms of how much is passive. But remember passive actually got started even before Bogel, it got started in the institutional space as well as Fargo that was first in the passive space. And so it actually turns out that away from the retail space, passive is even larger in the institutional space, and that's the area under the iceberg that you're missing, right. So Marco Salmon and Alex Chinko's work focused on exactly that they went and they did. They did an actual experiment where they tracked what fraction of shares had to trade in response to an index rebalancing, and the answer is around forty percent.
Right now, I've seen some pushback to that that says there's a lot of end to day trading, there's a lot of people who are either front running or piggybacking those trades, and you can credit all of that forty percent rebalance number to passive and so that's how they end up with. Fidelity had to study. I want to say it was twenty twenty seven or twenty eight percent. Somebody else had another study that twenty three percent. But let's give you thirty percent. So if it's thirty percent going to forty percent, going to fifty percent, when fifty percent of the market is purely passive. Doesn't that mean that folks like David Einhorn are just going to clean up? Doesn't it create? Isn't it homeostatic and going back and forth?
So if it were a stable situation, absolutely the case. The problem is is that when you talk about going from thirty percent to thirty five percent to forty percent, what you actually have is the scenario that we have in markets today. We're more than one hundred percent of the flows, which is actually what determines the majority of transaction activity is passive in its construction. Right Again, the active space is losing assets, it's seeing net redemptions. The passive space is actually receiving more than one hundred percent of the inflows. And if you go back and you think about the dynamics of Andrew Lowe stating ninety percent or John Bogel himself highlighting the between eighty and ninety percent, markets begin to break down, it's important to recognize that ninety percent of the trading activity no longer has a fundamental component to it. That's actually research that was done by JP Morgan as of twenty seventeen, and all the components that you're talking about the arbitrage, the normalization, et cetera. All of those are done in the facilitation of that end of day market on closing balance is tied to the mutual fund, ETF orders, et cetera.
So what do you think about not traditional passive, but some of the concentrated portfolios. I had andrews Lemons of Morgan Stanley on not too long ago. He runs a twenty or a thirty name portfolio that has done pretty well. We continue to see people like Bill Miller slag the active side of the industry, calling them mostly closet indexers, and said, if you want to beat the market, you have to look different from the market. You have all sorts of things like smart beta and thematic investing, and I know simplify as an India based ETF. There's a lot of choices for people who want to run let's call it a core and satellite type of portfolio, where hey, our core is going to be look very similar to the market, but we're going to put our own stink on it because we want to have exposure to Japan, exposure to India, exposure to momentum, blah blah blah. Isn't that the sort of the direction things seem to be heading.
In, not at all. So yeah, so there's a lot of highlight around the growth of active ets. For example, they're about twenty five percent.
Become used right now, and they are capturing some flow.
They are capturing some flow, but they haven't become huge.
Let's actually be really become bigger. So I'm overstating it. They're much bigger today than they were five years.
Ago, with the offset being that the mutual fund and hedge fund spaces are much smaller. Fair, right, So what you've actually had is a net decrease in the quantity of active but it's instructive. Everybody points out like, oh look how robust the space is and how wonderful it is. Right. The simple reality is is that nobody can actually afford to acknowledge many of the concerns that I'm highlighting. It's really very straightforward. There is no such thing as passive investing. Everybody is an active investor.
Well, they're an active trader when they're deploying the capital, but they're not actively selecting stocks. They're relying on an index.
Which actually is a decision process as an of course.
Right, right, I did a column a couple of years ago, how passive? How active is you're passive? Where Hey, even the S and P five hundred, someone decided it's going to be market cap weighted. Someone decided what the rules are, and there's regularly additions and deletions that seem to be You remember when Tesla was added, that seemed to be an editorial decision, not a systematic algorithm deciding.
Well, it actually technically was a very systematic decision, right, And so we actually Tesla was a fascinating example on this because we actually had received a lot of speculation and around it. The rules for inclusion in the S and P. Five hundred are pretty straightforward. You need to be all of sufficient size and you need to have at least five consecutive quarters of profitability. So once Tesla began actually reporting profits and then moving towards that fifth quarter, it became very clear that on a pure size basis, they were going to be the next player to be included, and the size that they were going to be included in was going to require an insane amount of passive buying.
There was a ton of front running, also a ton of active running.
The exact same thing just happened with SMCI, for example.
Well, they're a lot smaller.
It doesn't really matter, though, So I'm glad.
You brought up Tesla. We're recording this on the first day of May of two months ago. Tesla, originally part of the Magnificent seven, down sixty five percent from its recent highs. Doesn't seem like active flows or passive flows were helping Tesla. And then over the last month, you know, they cut a deal in China, they kind of explained away some issues with the self driving problems. They cut prices, and suddenly they're back to only down fifty percent, which is a big move when you're down sixty five percent. Doesn't that belie the whole argument that passive is destroying price discovery. Obviously, a bunch of active managers figured out Tesla was way too richly priced back in twenty one, and after it got whacked by two thirds, someone else turned around and said, all right, this has gone too far. This is not a worthless company heading to bankruptcy. We want to own it. Isn't there plenty of price discovery going on?
So, unfortunately, I think the answer to that is no, Right, there's always going to be a subjective component to that I would highlight. When you look at something like Tesla, there's a couple of things that are really interesting. One is who is the largest seller of Tesla besides Elon? No, that's exactly the right. Oh okay, so well, I did Tesla go down over that time period in which he was acquiring Twitter because he had to sell a ton of Tesla shares.
There are a lot of other reasons, Like I will make a fundamental case for you, the yeah, Elon sold some, he didn't sell enough to whack it two thirds. Their cars are kind of along in the tooth that they haven't really introduced an upgraded Even the X and Y look very much like the models, and I'm sorry, the Model three and the Model Y look like the S and the X. China has become an ongoing problem. Five years ago, they were a decade ahead of everybody in the software. Now they're I don't know, three, four or five years ahead of everybody. And there's a boat ton of competition. It's not just for GM, BMW, Mercedes, Audi, Volkswagon, Volvo, Renault go down the list. You could buy an Evy, Rolls, Royce and Maserati if you want. Everybody is piled into the space. So fundamentally, you can make a case Elon sold a bunch of stock, but suddenly it's a more challenging environment and the stock had become overpriced. That's the argument I would make that that that Tesla had become overvalued, and it seems like the market picked up on a lot of it, especially what did a peak at at one point two one point three trillion. That kind of suggested we're going to own the EV space for the next decade.
It wasn't even just own the EV space. So first of all, I actually agree with you, and I think most fundamental managers would agree with you that Tesla was overvalued. But the simple reality is overvaluation doesn't actually affect anything. What affects things is people actually executing trades. Right.
The only so how much did Elon sell? I mean it, it didn't seem like he sold what did he overpaid for Twitter?
Right?
And he didn't pay for that wasn't all Tesla stock it was I think he had to pay ten or twenty percent of it. It's called ten billion out of one point two trillion. Shouldn't have crushed the stock.
So let's use Bitcoin as an example for a second, how much money has flowed into the Bitcoin ETFs.
I don't know, sixty billion dollars over the past decade.
Well, not over over the past decade, but in particular since the introduction in January.
Oh god, you look at the blackrock ETF It was at five billion dollars in a month, and it's probably close to ten billion dollars now.
Right, So this's been about forty billion dollars worth of inflows against a bitcoin valuation or a market cap of bitcoin going into it of about four hundred billion dollars and it costs US sixty five percent appreciation, So forty billion dollars non linear? Yeah, that's fair. Same thing's true on Tesla, right, Everything happens at the margin. By the way, why did Amazon sell off so firmly over the past couple of years.
Sous Bezos departed and the company is a shell of the delightful retailer it once was.
Wouldn't that be awesome if it was true? Accept It really boils down to Mackenzie Scott selling her shares.
There's a lot of that. So let me shift gears on you. Since we're talking about structure, I want to change things up and for a one more thing at you about structure, because I'm enjoying this conversation. So a couple of years ago we started working with the folks at O'Shaughnessey Asset Management, who rolled out a product called Canvas, which was a direct indexing product. Directly indexing has been around for decades. It to me, it's never been particularly impressive. And O'Shaughnessy had a couple of things going for them that nobody else did. They over their course of twenty thirty years, created their own incredibly clean database that they had built out that was you know, you have to look at CRISP maybe as the or compustat in the old days is and the only thing that's close. But it was really very specific to them. And second, you know the team at O'shaughnessee and I've had all these folks on between Patrick O'Shaughnessy and Jim who famously wrote the book What Works on Wall Street are really a first quant book for the public. They created a form of direct indexing that as someone who's been a skeptic, Dave Nottig and I have disagreed about this for years when we first saw this, and I want to say twenty nineteen, it's like, oh, I get it. You can do so much more now. And of the four point whatever billion dollars we run, over a billion is on the Canvas platform now owned by Franklin Templeton. And what we have discovered is if you have any sort of this is a long way to go, but I'll get there. If you have any sort of potential capital gains, you've inherited a portfolio, you've sold to business, you have a bunch of founder's stock, you have a bunch of IPO stock, and you want to diversify out of that core portfolio. But the capital game are going to be fairly weighty. You could use direct indexing to tax loss, harvest and order of magnitude better results than if you own half a dozen ETFs or mutual funds. Just and first quarter of twenty twenty, anytime you have a thirty plus percent decrease that fits nicely in the range of the calendar quarter. You know, instead of being seventy five eighty basis points, it's three hundred O'Shaughnessy has case studies four hundred, five hundred based points. Giant game changer. Long ask question, short conclusion is do things like direct indexing, which have always been a small part of the market, but seem to be catching a bid now? Might this interfere with that relentless bid of passive? Can something like this change the game for what you see as a structural problem in passive?
So it is a very long question with a lot of different components to it. First, direct and next thing is almost by definition always going to be relatively small. It's a tax arbitrage strategy. It requires people to start with a lot and then try to maintain most of it right, And so the return differentials that you're quoting there are obviously a tax advantaged return differential. It's not the absolute levels of performance.
That's right, understand. Let me let me clarify. I'm referring to the tax al for returns yep over and above what you get from the market, and it's not aimed at market performance in its own way. It is a form of I don't want to call it passive because it's not, but it apes passive investments or whatever funds you want to put.
What it's doing is it's seeking diversification, right, So it really doesn't. What you're doing is you're taking heavily appreciated individual positions and you're then diversifying it into a market. Expos's exactly right. The ability to arbitrage your individual tax positions falls way outside the dynamics of market efficiency. Right, every individual is going to have their own components. We could get into tons of conversations around exactly that issue, and that actually almost perfectly fits with what the critical point that I would make is. It's not so much that passive itself is a terrible thing. It's actually the idea of a systematically algorithmic investment in which the simple determining algorithm is did you give me cash? If so, then buy? Did you ask for cash? If so, then sell? That actually can diversify a market, It creates a different mechanism, and it can actually lower volatility. And candidly, I think we saw that up to a certain point of market share, around twenty five percent market share. It actually turns out perversely that passive is beneficial to the market. It's once you go past that point that it starts contributing to higher volatility, much higher correlations, and the risk of severe left tail events, which brings us full circle back to the XIV type dynamic.
So then let me ask you one final question before we jump to our favorite questions. Who has the burden for dealing with the challenges of passive attracting so much in assets? Shouldn't it be on the active managers to reduce their costs, put up better performance numbers over longer periods of time, and take advantage of all of these inefficiencies passive creates. Isn't this a system that should heal itself if active managers start to perform, lower their fees and attract more capital.
So the answer is very quickly no. And unfortunately this brings us back to the question you had asked of, doesn't it get easier? And ironically what ends up happening mathematically? What occurs That constant bid that you're describing perversely changes the return profile of the market and it actually turns it into a This is difficult for people to see over radio, but I'm drawing a convex upward sloping curve right. It pushes valuations higher over time. Now, perversely, what we call alpha in the industry, which is typically how we evaluate individual managers, it turns out, is actually over time, just the intercept on a Y equals mx plus p and linear equation. Right, So I know this is hard for people, just like mentally, imagine your back in high school. It's your freshman year and you're doing a Y equals mx plus bograph and algebra. Right, what happens? That's the same thing as saying the portfolio return equals the market return x times of beta plus alpha. The residual in that the intercept in that if I curve that surface and I try to use a linear equation to solve it, it actually mechanically pushes the alpha's negative. The intercepts get pushed negative.
Right.
You can run this experiment with yourself. Just draw a positively curved line and then draw a series of straight lines that bisect it or intersect it. Understand how hard this is?
Over No, by the way I see the curve, I see the intersect. Okay, where I would just push back on the algebras simply and he seated one of your early accounts. Soros's concept of reflexivity should say that the bigger passive gets it creates the more opportunities for active and therefore.
It does in exactly the way that the XIV did, and that's why I chose the XIV for that trade, because it had already gotten to the levels of passive that I could very clearly see it happening almost immediately.
So last question before I we do a speed round of my favorite five questions, what's the trade that will capitalize on the damage that passive is doing to market structure.
So the quick answer is, unfortunately, if I'm right, you'll have an XIV type event for the S and P five hundred. I realize, how ridiculous. So you want to.
Buy out of the money puts on the SPX going out as far as the leaps.
Somebody will eventually win on that. But it is very stochastic in its framework.
Meaning you don't know if this is next year, five years from now. You look at it as an eventuality. I look at it as a tail risk that the market itself hopefully corrects.
And I would absolutely agree with you if that, if it could correct it, the problem is, and I'll share this with your audience, right. I presented this type of work to the FED. I've presented it to the IMF Financial Stability Group every single time, going in and saying please tell me why I'm wrong, And unfortunately the answer is you're right right. They actually acknowledge that. My reaction to that was fantastic. How can I help? What can we do? And their answer is there's nothing we can do. That's both the Vanguard and Blackrock control the regulatory apparatus. If we raise an alarm prior to the event happening, all that happens is we get fired.
Huh. So let me ask you one or two other questions then related to those entities. So you said some of the models that BLS and NBR use are flawed. I'm a big fan of George Box's statement all models are wrong, but some are useful. NBER should declare a recession in first quarter twenty twenty three. I'm kind of paraphrasing something you said. Tell us why you think last year should have been declared a recession or NBR might declare to recession.
I think in hindsight we might ultimately declare because we did see a combination of an increase in unemployment, we saw a decrease in industrial production, and we saw broad deterioration in terms of the economy. Things like leading economic indicators, etc. Are all consistent with historical recessions. Now, whether we choose to acknowledge that really boils down to the depth at which it occurred. And so the NBR looks at three separate components. They talk about how broad it is, how long it's occurring, and how deep the draw down is, And so the debate can be around how deep the draw down was at that point. I think the bigger issue that most people are struggling with is actually around things like the employment numbers, where there's been a very substantive change in how we calculate that data. What's called the birth death adjustment model, which was designed to reduce the need for periodic reassessments of what the levels of employment were in the economy tied to new business formation. There was an attempt to do that in a statistical framework, and unfortunately that statistical framework is now broken down now.
I remember the two thousands BLS was showing some quarters where one hundred percent of the job creation for the month was due to birth death adjustments, and a lot of people called them out on it, and they subsequently made adjustments to their model. I've seen in certain reports, in certain commentary, Hey, you look at the past twelve months, it's all been adjustments. I'm not seeing that in the data. I'm seeing a lot of new job creation. Yeah, if you look at the household survey, it's slipped and there's a lot of new part time jobs. But the new work from home remote hybrid model lets a lot of people work part time and still do childcare. Whatever. Tell me what's wrong with the BLS model.
Well, so the biggest issue with the BLS model is actually the conversion of those new businesses to jobs. Right, So, in particular, if you take a job in let's just say food service, right, or you create a job for yourself in food service by forming an independent company so that you can deduct some of your expenses for tax purposes for your job as a door dash driver. Right. Ironically, that falls into a category food service that's treated as high propensity to create additional jobs. And so this's a statistical model that then turns around and says, well, you started this DoorDash business called mike LLC, what's the prospect that that's going to create new jobs? Because of its sac code, it's actually treated as a high perpen city job formation, and it's assigned additional jobs in the establishment payroll.
What about all the Uber drivers and Lyft drivers out there.
So I actually think this is actually a fascinating dynamic.
Because what you said we used to call those people unemployed.
We did actually used to call those people unemployed. And so again, these are revisions that have happened within the data sets, and it's all very similar to this type of discussion that we're having, where it's in the details that ultimately matter. In two thousand and eight, we didn't have Uber, right, It's important to recognize that. So if you wanted to go drive New York City taxi, that was an entirely different job. You didn't even have Uber in twenty ten. What you really had was the Uber X introduced in competition. Would Lyft in twenty twelve. This or way out of the recession at this point. That changes the dynamics. But you used to be able to be unemployed and go get a cash paying job. I could go bartend at your bar, for example. You'd be like, Hey, I'm an LPIOD. I'll pay you under the table, right, Okay, you pocket some of your receipts, you sell some beer for cash, you pay me with it. Nobody knows anything from the government standpoint, those rules actually began to change quite significantly. In twenty twelve, we introduced what's called the ten ninety nine I think it's kay that changed the reporting crew requirements around that type of business. It made it much easier and much more electronic. And then in twenty twenty one we actually substantively changed the rules. We went from being able to treat up to twenty thousand dollars in income as independent and not requiring filing taxes to six hundred dollars. Well, when you go from twenty thousand to six hundred, you catch a whole bunch of new businesses and that's really what's showing up in the employment numbers.
Huh, really fascinating stuff. Thank you, Mike for being so generous with your time. We have been speaking with Mike Green. He is the chief strategist at Simplify Asset Management, helping to oversee twenty eight funds with over four billion dollars in assets. If you enjoy this conversation, check out any of the five hundred we've had over the past ten years. You can find those at iTunes, Spotify, YouTube, wherever you find your favorite podcast. Speaking of podcasts, check out my new podcast, At the Money, short conversations with experts about your money, earning it, spending it, and most of all, investing it. Find that wherever you find your favorite podcasts or here in the Masters and Business feed, I would be remiss if I did not thank the crackstaff that helps put these conversations together each week. Sarah Livesey is my audio engineer. Attico Vaalbroun is my project manager. Anna Luke is my producer. Sage Bauman is the head of podcasts here at Bloomberg. Sean Russo is my head of research. I'm Barry Rittons. You've been listening to Masters in Business on Bloomberg Radio.