Investing Billions - E428: Michael Green on Peter Thiel, SpaceX, and Inefficient Markets

Episode Date: September 11, 2026

What if passive investing is actually one of the biggest active forces shaping markets today? In this episode, I sit down with Michael Green, Founder and CIO at Tier1 Alpha Asset Management. Michael challenges the conventional view that stock prices primarily reflect fundamentals, arguing that the transaction itself moves prices and that the rise of passive investing has fundamentally changed who trades, why they trade, and how markets respond to capital flows.

So Michael, you're a portfolio manager at Tiel Macro, which is Peter Thiel's hedge fund. What did you learn working with Peter Thiel? What I would define as Peter's core characteristic is the willing to challenge conventional thinking, right? When you interview with Peter, the question he is famous for asking is, what is the one thing you believe to be true that nobody else believes, or the vast majority of other people believe to be false? Or the reverse. What is the one thing you believe to be false that everybody else believes to be true?

and that's really meant to effectively stimulate and isolate a deviation from the crowd, which is necessary for extraordinary or breakout performance. That thought process combined with a second Peter Thiel insight, which is you should never straw man your opponent's arguments. You should steal mann them. You should prepare yourself against the best argument that they can make, even if they can't make it themselves. That approach is very rigorous,

and I think Peter has exploited that to an extraordinary, extent within his portfolios and his investments. And it's very much aligned with the way I approach the world from the standpoint of you should always use the scientific method, adopt the null hypothesis, try to disprove your conjecture as compared to try to prove your conjecture. What do you believe that most smart people in the industry do know? This was actually the topic of the discussion that I had with Peter. And my argument at the time was that passive investing was not passive in any incarnation, that it was creating distortions by virtue of the fact that they transact. And so the definition of passive investing

in the academic literature is an entity or an individual who always holds every security in proportion to the market capitalization or its exposure within the market. Proversely, that means that there's no mechanism for them to get into that position or to get out of that position. And since we know that can't exist, it would require magic. And literally in Bill Sharp's 1991 paper, he describes it as they are able to trade in the liminal hours in which the markets are not open. Obviously, that's absurd, but as a thought exercise, it was useful for his purposes, which was basically demonstrating why index investing was better. He was an index consultant. He was pitching his own book. 2016, Lassie Peterson and AQR successfully challenged that with another

paper called sharpening the arithmetic of active management in which he looked at the behavior of passive managers. And he said, well, what about index reconstitution? That's a change. in the portfolio that requires them to transact, therefore they become active managers during that time period and the thought experiment of Sharps where they own the same aggregate securities and therefore passive and active are identical except for the fees associated with the product

was untrue. And that actually has grown into the single largest hedge fund strategy in equity space by allocation. It sits at the core of most multi-manager platforms forms or pod shop type books. Which is betting against the passive investor. Actually, what you're doing in that strategy is you're betting with the passive investor. So you are trying to anticipate, you're front running them.

You're trying to anticipate the trades that they will have to make when a new stock is included in the index by buying those or when a stock is ejected from the index and selling those. And so that long, short portfolio is trying to capture the impact of the eventual passive trade into the individual securities themselves. Where it becomes a facilitation exercises as compared to betting against them is perversely the rules of passive,

you are raising the probability of entering an index if you drive the price higher. Are you raising the probability of it exiting the index if you drive the price lower? And so it's actually a self-reinforcing trade. It's a characteristic I refer to as investment judo using the heft of the passive investing complex against itself in large flow characteristics where a new stock enters the index or one exits

that creates a large rebalancing flow that most of your listeners will be aware of. That's what index arbitrage is doing. And this is why you think many stocks are driven not by business fundamentals, but by net inflows. They're always driven by net inflows. Fundamentals themselves are simply a signal of information that causes somebody to transact, an active description. discretionary manager seeing a favorable earnings report from a company says, gosh, the prospects are better than I thought I should probably buy this stock that I was evaluating. Or if the earnings report is poor and they have an existing position, it failed to confirm my hypothesis around the fundamental behaviors, therefore I should sell. It's the actual act of transacting

that causes prices to change. Markets are not truly weighing mechanisms in the sense that you put them on a scale and you compare it against the DCF. They require discrepancy from your estimate of fair value that allows you to say, I think the expected return for this will outperform the market or underperform the market. It's the transaction that drives the prices. So it's always been flows. And this is why certain companies will for years

and sometimes decades trade at different multiples than other companies because of the demand for that company. A good example of that would be sin stocks, like a Philip Morris or Altriot today, right? Some people have investment mandates that prohibit them from owning tobacco stocks. all else equal that should lower the price of Altria relative to its competitors, reduce the speculative aspect associated with it,

and create conditions under which higher outperformance can be achieved for each unit of fundamental performance. That's why people were attracted to that. That's why the ESG framework emerged. People speculated that the idea that companies behaved in an environmentally social and governance manner that was favorable to investors and the broader population would ultimately lead to better fundamental results. A lot of those theories are ultimately nonsense. You're basically trying to play a variant of the Keynesian beauty contest and figure out what other people are going to want in the future. ESG was a giant bet that woke investing was going to spread wildly and suddenly people would

become far less capitalist and aggressive in their prosecution of profit. If anything, I think the current environment says that that that is. absolutely not the case. The woke trade is an interesting one in that it would have worked if institutions had codified specific rules to such an extent that there were more inflows than outflows. So it could have worked even if the fundamental businesses were weaker pre this mandate. It could have, it would have required a sustained inflow. And in fact, during the period in which ESG investing received significant inflows as people embrace this style of investing, it actually contributed to the outperformance. Again, the flows were suddenly directed into those stocks that

caused those stocks to outperform on a relative basis, and it became a self-validating component. The minute that Bloom was off the rose and the allocations had already been made, and very little additional capital was making its way in, and in fact, as people became aware that it wasn't meaningfully outperforming in part because funds were able to charge higher fees on this differentiated process, and that is a real challenge. Firms like BlackRock, for example, are constantly forced to balance very low income ETFs or index funds against higher fee alternatives, which is really where they're making their money. If you charge 90 basis points for enhanced indexing and three basis points for indexing,

you can see that there's not much profit margin in the index itself. It's really about the access that portfolio and that offering gives you to sell the higher value products. We're seeing that across the industry as every entity is now exploiting their access to customers because of their presence in other products by delivering higher fee products. Maybe the most famous example of the effect of inflows is SpaceX. We just passed a big unlock on the company. In full disclosure, I remain an investor in the company. I've been private investor for a while.

Double click on how inflows may have affected the SpaceX price. So there's a couple of things that are really critical in understanding SpaceX. It's just the evolution of a process that has been playing out for an extended period of time. There's a lot of people out there that will cite Medigliani Miller and say, dividends and buybacks are the same. And so people complaining about buybacks are just wrong. In their analysis, they haven't studied the formative literature and they're functional idiots. This falls into the internet meme of Midwit, basically shouting at everyone,

And the simplistic view and the sophisticated view are ultimately the same. That Medigliani-Miller expression is just wrong in an index world. Imagine a scenario in which a company pays a dividend, that dividend is received by an index fund, and that index fund then reinvest the proceeds. It's going to take that dividend from Apple, and it will only send 6% of it back into buying Apple stock. It'll send 94% of it to buying all the other stocks. in a market that we have discovered is far less elastic than the original theories presented. And this was the key findings of Xavier Gabe and Ralph Coagin in 2021 with their paper,

the inelastic market hypothesis that tested the idea of elasticity, meaning the response of price to changes in supply and demand in the market. The efficient market hypothesis presumes that markets are highly elastic. They can accommodate almost anything that is thrown at them in terms of activity. and the actual specification is that a dollar into the market, because every buyer has a seller, which is a mathematical truth, creates about one penny of additional market capitalization, basically the crossing of the bid-ask spread.

Gabay and Coagin's findings was that the average impact of a dollar into the market from 1992 to 2019 was $5. So 500 times more inelastic than was speculated in the theory on which we have based all the passive investing. That number itself is an average from 1992 to 2019. Valentin Haddad at UCLA with his paper, how competitive is the stock market, identifies that is actually a trend that is a function of passive share relative to active share.

And if you update those numbers for the current levels of active versus passive share, my estimate is somewhere around $22 is created for every dollar in. For some of the largest stocks, the most inelastic stocks, those multipliers are now approaching 100. And so $1 into an Nvidia is raising Nvidia's market cap by $100. That's causing the market to become more concentrated. It's causing all sorts of perverse effects. When you think about the market in that framework and you think about something like SpaceX, what they're really trying to do is make investors aware that bid will be there to provide liquidity for them to exit.

it if they participate early. And so it's similar to a Greenspan put, right? We can call it the Vanguard put. Vanguard will show up to buy those shares, or investors who have referenced the NASDAQ 100 will show up to buy those shares regardless of valuation. Ultimately, that creates a time race that basically says, are we expanding index participation fast enough to offset the insider selling? And the mechanics of how they worked with NASDAQ to magnify the float so that they

there's actually roughly a three to one increase relative to the float dynamics, facilitates that exit. Anyone looking at this comes to the conclusion that this is going much higher. You as a private investor in SpaceX experienced this in the run-up to the announcement of the inclusion in the NASDAQ, as that became rumored, SpaceX roughly quintupled in price, very similar to the dynamics of when Tesla was included in the S&P in 2020. So you saw the same underlying phenomenon. The real key with SpaceX was twofold.

One, it was heavily marketed to retail investors under a buy-and-hold approach. You want to be part of Elon Musk's vision of men on Mars. That drew in retail who didn't know that they were the Patsy at the poker table. And they have actually proved remarkably resilient, locked up under exclusion components and platforms where they are limited from selling for an extended period of time, where they will be barred from future IPOs. Something like a 15 days hold period. It's actually 30 days at most and longer at some.

And so that actually created conditions under which the index demand which showed up the next couple of days and continues to expand as shares become available facilitated that exit for the insiders that want to sell into it. Everyone I talked to on the show is chasing the same thing, an edge.

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Start your free trial at Alpha-Sense.com. com slash how I invest. That's alpha dash sense.com how I invest. What was the mechanism that drove the price to over $3 trillion? Was it hedge funds running the passive traders? Same phenomenon we were describing an index inclusion, except now they're trading in an illiquid secondary market, right? So these are private share markets, far less liquid than the overall market itself, which is why it had such an incredible response. Did that also explain why then went down from $3 trillion to, I believe, $1.25 trillion?

People started to sell. And so there was more net selling. Those people being whoever held the shares, right? Shorts began to emerge, et cetera. There was an extraordinary bid for SpaceX on its initial launch because levered ETF variants had to buy twice as much exposure as they actually had access to.

But that also unfortunately creates a self-fulfilling prophecy. levered ETFs that have to rebalance on a daily basis, create an endogenous form of flow. If prices are going higher, they're forced to buy more to maintain their leverage ratios. If prices are falling, they have to sell more into that activity to maintain their leverage ratios. We walk through the mechanics of that if you want. It's like double a risk. Not only are you levered 2x, 3X where a 10% stock movement might really to a 20% gain or 20% loss if you're short, but also, all these levers together are creating this buying pressure that's creating this kind of very

parabolic outcome. That's what I refer to as endogenous leverage, right? Self-created flows. So let's just use the Soxel as an example. Imagine that there's only $100 invested in a triple levered semiconductor ETF. That means it has $300 worth of exposure because it has taken a three-to-one leverage ratio. If the underlying index rises by 10%, an unlevered position would appreciate to 1-10, the levered position appreciates to 330, that means that the equity in the levered position is now 130. In order to maintain a three to one ratio, you have to buy an additional 60, which is the endogenous flow that is created. And the reverse plays out on the other side. Levered ETSs have been around for a long time, and they actually provide a stabilizing

impact on the market in a weird way. Most professionals who will trade these recognize that high degree of leverage associated with volatility creates a harvestable component called the volatility drag. Volatility drag is a simple recognition that we live in a geometrically compounding world as compared to an arithmetically compounding world. Simple answer is 10% today up 10% down today. The next day in arithmetic terms, it's zero, right? But if I do that in a geometric series in which it's a sequential event in either direction, today I'm up 10%, so now I have 1.1. Tomorrow I lose 10% percent, 10% off of 1.1 takes me down to 0.99. That zero has transformed into a 1% loss. If I add leverage to that, it becomes a volatility drag to the power of my

leverage. And so if you go to 3x levered on that same scenario, you actually end up losing 8% on that event, those losses are large enough that the dominant strategy in levered ETFs has historically been to take short positions on both sides. That allows you to harvest that volatility, and it functions as a volatility suppression engine for the industry overall, because anybody who is trading implied volatility in one form or another has to recognize there's somebody else on the other side that benefits from that increase and realize volatility that you yourself are betting on. When narratives take control, when we see something like memory stocks or AI become kind of a no-brainer, there's an interesting phenomenon that you can track in the behavior of the holders of those types of products.

Starting in February, we began to see the holder base changed, and retail investors began using that 3x leverage, like a Leo Ashenbrenner, for example, to exploit their certainty that this was the trade. Now, it's a terrible strategy, because if you're not, running 3x levered on something exhibiting the type of volatility that semiconductors do, our rough math is that the break-even on that trade, if your dollar cost averaging in, it's about 150% annualized appreciation. It's an extraordinary hurdle to have to cross over any extended holding period, which is why all of these products carry SEC disclaimers saying these are not meant to be buy and hold products.

Nobody pays attention to that when they get excited about stuff. So it's not just that if you you have 2x leverage and it goes down 50%, you're completely wiped out. It's also that on a daily basis, the volatility is hurting your returns. Maybe you could bring it down to a layperson, like my mom who's a big fan of the podcast, or me who's a private investor, relatively uninformed public investor. What should I do with information about how much of the public markets is passive? How should I act on that? The quick answer is there's not much you can do, right? So this is what's referred to as a systemic risk. It's largely non-diversifiable. So it doesn't matter what you do.

is kind of the easy answer to it. You are going to be exposed to the ramifications of this regardless. And under that framework, unfortunately, like Lemmings, the right answer is you run off the cliff. That's been part of the challenge for me in explaining and articulating this for roughly a decade. I'm simultaneously saying these things will be the end of the market as we know it, and also they're the best investments as you can make on a short-term basis.

I can't tell you that next year is going to be bad. In fact, my work around passive suggests that the rise aggregate return relative to valuations is a feature of this transition. And so people who listen to me closely have heard me say, for the average investor, you should continue to invest passively. Now part of that was also a function of I had not yet cracked through the code of what exactly was happening in terms of how the indices were playing out and what were the parts that become predictive.

It turns out that the success that I had around Volmageddon with Peter Thiel, where we had pre-positioned and pre-announced our expectation that the XIV EETF would collapse to zero in a single trend in a single day as it did on February 5th, 2018, was that index an ETF complex referenced a single security? So the product and the underlying were the exact same thing. When you think about something like the S&P 500, any product like SPY or VOO or IVV from BlackRock. What's actually happening is that's a liquidity collection mechanism, like a fire hose that is then directing liquidity at a crowd.

And it's the behavior of the crowd that becomes interesting. The reason why you use fire hoses and crowd control is that they are non-lethal, right? They don't cause people to die for the most part, but they radically change the behavior of the crowd. And it turns out that all the interesting information is actually about focusing on the individuals within the crowd, the individual securities. And in gambler's fallacy, the success I had with the XIV trade somewhat blinded me to that insight until about nine months ago when I don't even remember exactly what the eureka moment was, but I suddenly recognized I was focusing on the wrong thing. And what did you start focusing on? We started focusing on understanding how the flows across many index products and many ETFs were affecting the individual securities. And to give you some idea the complexity of the problem, when we first began doing our individual securities, we focused on the largest individual stocks because obviously that's where the most information and transaction activity is available.

It took us about 45 minutes to analyze an individual stock. About two months ago, we got that down to about 45 seconds, and now we're about four and a half seconds, which radically increases the universe of securities that we're able to hold this information on, analyze it and deploy it. in a way that allows us to rebuild products that have similar exposures to large-cap U.S. equities, tracking error of roughly 1%, but deliver roughly 1% outperformance while taking no known additional risk. It doesn't test positive for any of the other factors that we've traditionally thought about. In fact, I'm working on an academic paper called King of the Factor Zoo.

It turns out that many of the factors like Momentum are really just the shadow being cast on the wall of Plato's cave. where the real information is actually in the flow characteristics. I was going to ask you about that trend following is that there's more volatility in the market and the flows are creating these more parabolic outcome. In many ways, that's the traditional momentum factor. So the momentum factor is presented by Cliff Asnes

in his thesis paper was effectively an information diffusion mechanism. I see a stock behaving anomalously that causes me to do research. That research in turn makes me comfortable with the price change. therefore I buy the stock add additional price impact that causes other people to do the work, et cetera, and so momentum diffused as an information gathering process through the market that was manifested in excess price performance.

It turns out that all of the information stuff is bunk, and really all that matters is the flows. And so as you move more and more to what the academic literature refers to as sunshine traders, to trade not in a random noise fashion, but under a predate, framework where the source of their transactions and the size of their transactions are somewhat known in advance, i.e. contributions to 401 plans. That creates a predictable trader that can be exploited in that manner. What we're really seeing in today's momentum is what's called auto correlation. If the price of Apple rises today, it becomes a larger portion of the index, so the next dollar into the passive fund buys more Apple. If that was true, then we would

see momentum become a better trade as there's more passive participation in the market. Is that proven to be the case? That's absolutely proven to be the case. So let's say you're not an institutional investor and you can't invest into inflow products or trend following products. What do you do to just sit around and be prepared for the next crash? Again, that's been the frustration, right? The answer is, perversely, the growth of passive has what is actually an exponential feature on the market.

The larger passive gets, the less supply of shares that are actually available to meet that next dollar of inflow. There's no more informed traders left to say, this is a stupid price, I'll sell it to you here. They actually increasingly begin competing with themselves for liquidity, and that causes as long as the flows remain positive to get even more extreme in their components. go back and look at the forecasts from GMO of the expectations for a forward seven-year return period in 2019, and they would tell you that U.S. equities are supposed to massively underperform under a mean reversionary and valuation reversionary framework. Now, that type of positioning historically made sense because of the dominance of active discretionary managers who would see a surge in price relative to the underlying fundamentals and say this is clearly an opportunity for me to take a, liquidity and find something more interesting to invest in.

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I thought managing money meant paying bills and balancing a checkbook. But as you know, that's only a small piece of the financial puzzle. Managing your money takes more than just checking your bank account every once in a while, and great financial decisions come from having a complete picture and proactive management for your income expenses and investments. Take control of your finances with Monarch. It brings together all of your accounts, investments, saving goals, and spending into one place, making it much easier to understand where your money is going and whether you're actually on track to achieve your financial goals. What I like most about Monarch is that it doesn't just tell me what already happened and helps me plan ahead. The AI assistant lets me ask questions about my finances

in plain English and the AI weekly recap highlights spending changes or upcoming expenses before they become surprises. It's like having a financial advisor in your pocket. Write your own money story with Monarch. Use code invest at Monarch.com to get your first year of Monarch core half off at just $50. That's 50% off your first year at Monarch.com with code invest. Continue to take share, continue to dominate the aggregate flow picture. That actually changes that behavior and it becomes self-reinforcing.

leads to many of the components that we've seen, concentration in markets, the big get bigger. Now, we can attach fundamentals to that, and people try to, but the quality of those fundamentals has deteriorated markedly over the past few years. Many people will point to a correlation between free cash flow

and performance of the hypers. The last 24 months have been a clear indication that couldn't have been the driver because we have seen those cash flows deteriorate. Same phenomenon that played through with interest rates Going into 21, 22, everybody argued that the reason why momentum and growth had dominated was because interest rates were so low. And the discounted cash value of that NPV of future growth was much higher for companies that were growing rapidly under a low interest rate environment. This was actually a real-life test that I was able to participate in, which I articulated, no, that's not the phenomenon.

And in fact, even with high interest rates, will continue to see value underperform. and that has actually been validated by the events subsequent to 21-22. Now, look, I can't argue against every counterfactual. People will shout, oh, it's all about earnings, right? Well, my question to them is how is it all about earnings? How do earnings actually translate into transactions? Because we know that markets are actually defining the intersection of a transaction at every point in time.

And they'll say, well, people buy earnings. And that is true. But it is a shrinking pool of people who actually buy that earnings. And in fact, the growing flows, people who couldn't care less and never show up on an earnings report, et cetera, because they presume everybody else has done this work. It's an interesting thought experiment to think about what percentage of passive holders globally even know what an earnings is. I would suspect at least 50% don't even know what earnings means. Our own president seems to think it would be completely appropriate to remove earnings reports

and have companies only report twice a year, which, again, if you live in a passive world, who cares? One of your hottest stakes is that active investors, a lot of their factor models, do not produce alpha. Why is that? There's many reasons for that, but the primary one is actually the passive factor that I articulated. The impact of passive on the market largely subsumes most of the other factors. If you think about a passive factor where I'm buying in proportion to market capitalization, that means that more of my allocation will go to things that have gone up in market price. All else equals shares stay the same, price goes up, market cap rises.

if it outperforms the rest of the universe in that process, the next dollar I will allocate on a passive basis will put more money into that name. Now think about the value factor. Value factor is some fixed quantity, let's call it book value, or any number of multiple measures you want to use in a fundamental indexing type framework.

Inevitably, in the denominator is market value. And so in one, market value is the numerator, and the other market value is the denominator. that mechanically means they must have negative signs with each other. And so the value factor, which I would argue is misunderstood for a variety of reasons as well, but is fundamentally negatively correlated to the passive factor. And so as you try to introduce historically performing components that were built for a active manager-dominated world, and just to put context on this, in 1995, active managers

would have represented about 85% of the daily trading activity. Today, our estimate is they represent about 7%. And that is dominated by the trading activity around index methodology and index inclusion, the creation redemption process, index arbitrage, et cetera. We've also simultaneously facilitated extraordinary growth in the noise traders, the quote unquote, uninformed traders of by introducing zero fee trading,

by introducing free access to options across any platform regardless of your investment expertise. Right? That behaves much more like gambling than anything else and perversely gives rise to extraordinary growth of the noise traders. How does that affect the active traders? Well, the noise traders are largely random in their implications and theoretically they're a source to be harvested by informed traders. Grossman-Siglis speculates that there's only two types of traders, informed traders and uninformed traders. First, there's no mechanism or facilitator between the two of them to actually effectuate a trade, quote-unquote, market makers.

So you have informed traders and uninformed traders that are trading in a largely frictionless world in which the only differential is the bid-ask spread. And under the Grossman-Siglitz articulation, that means that the information that is sought by the active discretionary informed trader is valuable and can be used to earn excess returns as a corrector mechanism to, the wildness of the crowds. It turns out that there are both not just informed and uninformed traders. There are different types of informed traders, and there are different types of uninformed traders. The first uninformed trader is the simple noise trader, the person who decides to buy because the Packers won the Super Bowl, right? They didn't disclose their intent.

They don't have a published methodology. They're just feeling good about life because their favorite football team won, and therefore they choose to buy because, gosh, they feel lucky. They won a bet and they've got some surplus cash to put to work in the market. That's the true noise trader. You can basically think about it like Robin Hood. The second type of uninformed trader is what's referred to in the literature as a sunshine trader. It's somebody who trades for predictable reasons. The sun is shining. Now, if I have good weather forecasting skills, I can understand that the sun will be shining tomorrow, which means that the passive or sunshine trader will be buying into the market.

Really, that's just about employment more than anything else. On the informed trader side, there's actually two roles that you can take. You can be an informed trader who functions as a corrector, or you can be an informed trader who functions as a facilitator. It's called them drug dealers, right? They take the passions of the crowd and they say it is far more profitable for me to facilitate their insanity, effectively front-round. running their trade. Now, in order to do that, you need to have transparency in terms of what

they're doing, effectively be able to see the crowd better than any individual in the crowd can see themselves. That makes the most valuable piece of information, their order flow. Is this why Citadel was buying the order flow from Robin Hood? Was? Is, you mean? Yes, of course. That's exactly what it is. So they have transparency. It's also why Jane Street, which is another market maker or facilitator in the informed trader space. And, and has actively sought out authorized participant and lead market maker positions in ETSs because they also get to see the flow before anybody else.

That positions them as a particular type of informed trader, a facilitator who really serves to fan the flames of the crowd. And the failure that people have, I mentioned earlier, there was a paper released earlier this year from Hannah Unterberg that looks at the aggregate active share of the traditional discretionary managers and concludes that it's become negative. That's looking at the asset management space. But that ignores the informed traders who are really the market makers who've chosen the facilitation route and use that to seek extraordinary profit, witness the profits we've

seen at Citadel and Jane Street and other market-making firms. They effectively have become the croupiers at the casino. They're encouraging people to- They're not included in the study. They're not included in the study. Hedge funds that are making- Correct. So what we've seen is the active manager alpha has been encouraging-

increasingly concentrated in the market makers who with this shift to decimalization and the shift away from specialists who had a tri-party agreement in which they agreed that they were not going to front run either the buyer or the seller in their specialist book. And they also had an agreement with the company who they received the monopoly in that book from that they were not going to engage in behaviors that would reduce the liquidity and effectiveness of the market-making operations in the search of extraordinary profit. that placed a cap on their profitability. Now, I want to be very clear, I'm not bemoaning the idea that we should return to specialists

because they were flawed human beings as well. The late 1990s saw many scandals in which it emerged. The specialists were abusing that privilege and trading ahead of their customers, right, front running on their own. So it was the sales and trading desks and investments. No, it was more of the Spearleys and Kellogg's and others who actually held control of those order books and got to see transparency on all of the order flow. And so the regulatory solution to that was to break up those monopolies. We shifted to best execution across multiple exchanges,

so New York Stock Exchange no longer had a monopoly, and the trading was available to everybody else. And we reduced spreads with decimalization to the point that it physically impaired the profitability of traditional market makers and required a new generation of market makers to emerge, what we used to call high-frequency trading firms who fought the latency wars to effectively win the oligopolis that were abandoned by the specialists and that regulatory change. And now the system is settled down, and we are beginning to see what I would broadly describe as abusive behavior by the market makers who are no longer bound by those tri-party agreements.

They are free to take advantage of any type of discrepancy that occurs. And against that, they argue they're providing a service of facilitation that they then use to explain the extraordinary profits. But really, if you properly specify Grossman Stiglis, and I've done this as part of another academic paper I'm working on with Harry Christian and Stefan Stern, who were my co-authors in the March paper called a model of passive that breaks the market to demonstrate some of these things. It turns out that the optimal strategy becomes the facilitators targeting the informed traders because the informed traders, the traditional correctors are the ones who theoretically actually know something. And so the optimal strategy becomes to partner with the noise traders and partner with the Sunshine Traders. And as we highlighted payment for order flow as a mechanism of, here I'll give you free trades in exchange for your information. Think of the Google mantra. If you're not paying for the product, you are the product.

So the growth of Robin Hood and the zero commission platforms was largely facilitated by that payment for order flow. The second phenomenon on the Sunshine traders, as they get larger and larger in the market, what they're really seeking is liquidity provision. And you can just Google Vanguard partners with market makers to facilitate liquidity. They're effectively opening up their kimono and giving their order book to the market makers so that the market makers can facilitate their trades. So now think about it. We've got four players in the game, two uninfluenced.

traders who are both giving their information to a group of informed traders called the facilitators. The facilitator's optimal strategy is to begin hunting the discretionary traditional active manager. And that's exactly what you see. Who bailed out Leo Ashenbruner? Citadel. Bringing this back to venture capital, there's this concept of power law, which a few companies lead to these huge outperformers. I'm wondering, has these biggest winners go public?

and they're now being fast-tracked into indices like the NASDAQ. I wonder whether that increases the returns of the best companies in the venture capital. Well, it is actually prevented returns for many large companies, right? It was very difficult for venture capital companies to come public for an extended period of time. We had a dearth of IPOs, and part of the reason for that is that a traditional IPO requires active managers who are capable of diverging from their benchmark to buy this new conceptual vehicle that they've bought into fundamentally

under the expectation that will ultimately outperform in the market. As that manager community experiences outflows, they have less and less capacity to take those sorts of discretionary bets. That means it's harder to get IPOs out. The IPO waves that we've seen, the SPAC IPO phenomenon of 2020 and 2021, and the recent listing of,

SpaceX, for example, are largely forms of index arbitrage. Spacks took advantage of a wrinkle in what's called the total market indices or the CRSP indices in which SPACs were excluded from index inclusion when they were finance companies, effectively pools of cash searching for an acquisition. There was a wrinkle called Fast Track, which is, again, the language that you're now using to describe this next generation of IPOs, in which if a SPAC made an operating acquisition and the size of that operating acquisition exceeded the 85th percentile threshold of the total market index. As of 2020, that was about a billion and a half dollars.

Then the indexes could be forced to buy in as few as five days. Now, in a SPAC, insiders who are the sole source of liquidity are restricted for selling for a minimum of 20 days. So if the world's largest buyers show up to buy stocks that the only sellers can't sell, The solution set is price rises dramatically. And people misinterpreted this. If you remember, the language was, well, Spax offer the opportunity to share prospective statements that can't be shared under traditional S1.

Listen, there's something wrong with your head if you think the reason that Adam Newman couldn't get we work public on an S1 roadshow is because he couldn't make promotional enough statements. And the simple reality is it was an index arbitrage methodology. In September of 22, a Center for the Research on Security Prices quietly changed their methodology to eliminate fast-track capability for SPACs, and we've never seen the phenomenon reemerge. Now we're seeing that same phenomenon in fast-track IPO status and an inflated float component where we are trying to create a mismatch between the liquidity sought by the corporation or the insiders and the liquidity that is provided in the market, it's back again.

And this time around, unlike the smaller or mid-sized company is a billion and a half dollars market cap is certainly sizable under any reasonable human scale. But very small relative to trillion-dollar IPOs like we saw with SpaceX, those smaller companies really don't have the capacity to get public under these rule changes. And it's a perverse component in our society that we continue to favor the big getting bigger. Why can't they just go public and not have this inclusion? Why does it keep smaller companies from going public at all? If you're going to get public and you're going to take in new capital, you have to find somebody who's willing to buy those shares. And that's why I highlight that a traditional S-1 roadshow

requires active managers who are capable of diverging from the holdings of the benchmark because the benchmark's not going to include that IPO, right, or at least historically would not include that IPO. As a result, it was completely dependent on the pools of capital from the active manager community, which were under assault from the growth of passive and regulatory changes that have cut off the inflows to active management. Less discretionary capital leads to just higher bar for which companies they want to. Why would you want to take a significant risk as an active manager who's largely

incapable of selling your services to the public? Your best strategy is just to be as quiet and as close to the benchmark as possible, so nobody notices you. Is this a bubble of sorts that could be possible? popped at some point. Yeah, ultimately it is flow dependent and it is critical to understand that inflows are always going to be some function of income levels and I can only buy what I earn. Now I can magnify 401Ks, et cetera, right? So 401K is typically you will have withholdings of between 1 and 5% of your paycheck that flows on a tax advantage basis into whatever products you've

selected for your retirement. Those are increasingly auto selected under the frameworks of the Pension Protection Act, they flow into what's called a QDIA or qualified default investment alternative. That is almost exclusively now target date funds. I don't know if you've looked at your employee's 401k plan, but my hunch is just that it is filled with various products labeled things like the 2065 retirement fund that will allocate assets on the basis of an expected retirement date of 2065. There's no thought process going into it. There is no particular articulation is this investor suited to these risks, are these securities the right securities to own, or even are these good securities to own, they simply presume that the market is the right thing to

own. And so where it seeks equity exposure, it's buying the S&P 500, or it's buying a total market index, rather than trying to select individual securities. So if it's based on net inflows, and let's say next year, nobody puts in more capital and some people retire, there's going be net outflows. Is that levered on the way down? So our models suggest that it is levered on the way down. Effectively, you take the escalator up and the elevator down is the old added. Why is that? The simple answer is because there is continuous liquidity provision on the way up, and a value manager looking at their highly appreciated securities, but finding nothing cheap to buy will hold on to that security. Until this passive investor bubble is popped, is value ineffective?

I think it's very hard to argue that value will work for the very simple reason. I encourage people who have access to a Bloomberg. Go into Bloomberg, type in APL, Apple, Equity, D-D-M. There is a dividend discount model, which at one point people used enough that they would incorporate the feature within Bloomberg. It was a very quick valuation check that you could run. The vast majority of stocks in the S&P 500, particularly in the largest stocks, if you run them through those dividend discount, models would suggest that they are trading at valuations that are much, much, much higher than they deserve. In the case of some of these stocks that are amongst the 10 to 25 largest, if you do that

DDM exercise, you will discover that the actual value on a dividend discount model is 1.15th of what they're actually trading at. In other words, they could fall somewhere in the neighborhood of 95% before they became fairly valued. I don't think it's going to be that straightforward because people have frames of reference that are coordinated to the prior behavior. By definition, any manager that has stayed invested in this time period has by and large loss their anchor

to traditional value. So I want to emphasize that I cite that DDM just to give you an extreme insight in terms of how overvalued we may actually be. But on that way down, you're going to have any number of people that say, oh, it's off 50%, therefore it's a buying opportunity, or it's off 75%, therefore it's a buying opportunity. These are individuals who have forgotten the mantra that emerged in 2008.

What's the difference between a market that's down 80% and a market that's down 90%? The Fed? No. The market that's down 90% is another 50% less to fall from the 80% decline. Right? So you look at it in hindsight and you say, well, I'm going to be a buyer there. All right, I'm going to get this. I'm going to be the player that steps in front of this train

because you have transparency on what happened next. When you're actually living through that period, your financing is being withdrawn. Your investors are redeeming. You are down 80%. You've completely lost your confidence in yourself. Everything becomes harder to execute that buy. And as a result, what we tend to see in that.

And again, there's fantastic academic papers that have emerged just in the last few years on this topic. you actually are seeing a liquidity destruction that means nobody has the cash to buy anything. And that means those things can get far worse than you would expect if you're simply looking back at history and expressing confidence because you've got an ever-rising line for the S&P that says, well, I'm going to be a buyer there. Well, Michael, thanks so much for jumping on. A real pleasure. Thank you for having me, David.