Odd Lots - Did Passive Investing Fuel A Bubble In Ultra-Large Tech Stocks?

Episode Date: March 9, 2020

Questions continue to arise over the effect of passive investing, and whether or not it's somehow distorting the market. On this week's episode, we speak to Vincent Deluard, the Director of Global Macro for INTL FCStone Inc., who argues that the endless bid for ETFs have helped fuel a bubble in megacap stocks, which continue to outperform the market.See omnystudio.com/listener for privacy information.

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That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Hello and welcome to another episode of the Oddlot podcast. I'm Joe Wisenthal. And I'm Tracy Allaway. Tracy, do you remember our episode a few weeks ago with Mike Green? I do indeed. Fantastic episode. Yeah, this idea, and of course for those who don't recall it or those who maybe haven't listened to it, the topic was, what are these sort of distortions in the market that are being caused by the rise of passive investing. People are just throwing money month after month, paycheck after paycheck in the index funds. A lot of people think it's a really good trend, but there is more attention and more questions

being raised by what does it really like mean for markets and market structure when so much money isn't going towards individual security selection? Right. There's this assumption that passive investing is actually good in many ways because investors are paying lower fees, so over the long run, they make more money, but also in the sense that passive investing, because you're just putting money into these big benchmarks that are reflective of the market as it is, that you're not actually impacting the market at all. And only now are we starting to see some real criticism of that thesis and also some academic

research where people are saying that actually passive investing and benchmark index construction, can impact the market itself. Right. And of course, you know, passive investing, you mentioned the low fees. There is also a body of academic research on the side of passive investing, believers in efficient markets and so forth, who essentially say, look, the sum total of all active investors is just going to be the index itself. And you're unlikely to beat the market with your own stock selection. So why not just buy the market itself? And then you get the same return as everyone else, but at least you didn't pay the fees. Mike Green's argument when we talked to him was essentially it's creating all these distortions because the money just sort of goes to the index itself.

That drives the index higher. And anyone who's trying to buy individual stocks can't possibly compete with a strategy that's just put it all on the index. Right. And there's this sort of underlying theme that's running through all of this, which is what does passive investing actually imply about the functioning of the market? And I suppose the state of capitalism, right? Markets are supposed to be funneling money in an efficient way. And if passive investing is causing these sorts of distortions, where these overvalued companies just get more and more overvalued, I guess, then is capitalism really working? Exactly right. So today we're going to explore this topic further because it's clearly something that's of growing interest. And we're going to talk with someone else who's done research on this exact question, also making the argument that the rise of passive is creating weird, anomalous, bubble-type behaviors in some stocks that's clearly different than the old days. And so I think we're going to get more granular on what we're really seeing in the market that says something is weird about how the market is behaving specifically because of the rise of passive. Great. Let's go granular. All right.

We're going to go granular. We're going to be talking today with Vincent Deliard. He's the director of global macro for I-N-TL-F-C-Stone major broker-dealer. He recently came out with a report talking about the connection between passive investing and the sort of rise of these mega caps and the connection between the incredible performance of stocks like Apple and Microsoft and Alphabet and so on and what that has to do with passive investing. So Vincent, thank you very much for joining us. Thanks for having me.

Your pleasure. First of all, before we get into the question of the distortionary impacts of passive investing, what is, I mean, some people debate what that even means passive investing. And some people say, oh, it's a myth. passive investing isn't even a thing or whatever it is or that everyone is making some sort of active decision. But when we talk about this, how do you define the phenomenon that seems to define this sort of age in investing? Yeah, absolutely. I mean, I've been in my work, I've just defined it as investing in market cap weighted indices. And I do realize that people use them for

short-term trading, as a replacement to other vehicle, and that at the end of the day, there is a human behind it. But my focus, I think, and that's what the, I think that the missing link is for a lot of people, is to ask not so much where the money is going, but where is it coming from? And I think that's what creates a distortion. So in the research note that Joe mentioned, you subtitle it as dumb alpha, how to be an intelligent investor in a stupid age. age, which I find very amusing, but maybe a lot of index investors would find kind of insulting. Why do you think passive investing or index investing is dumb alpha? Walk us through your thought process here, because as you point out, actually, following the

indices, putting money in the most overvalued stocks, would have paid off in recent times. Absolutely. I mean, this was the driver for the title. You look at last year. I think the SNP 500 index outperform 85% of global stocks. So if you wanted to generate alpha, you have this traditional framework, right, where you have beta, which is just buying exposure to the index and then alpha I'm going to, you know, big stocks,

and because I'm smart and I'm going to big the market, what I was flip on its head last year. The way to generate alpha was to own the index. And pretty much anyone who did not own Apple or Microsoft in proportion to their weights in the index and it up underperforming, regardless of how skillful you were with your trading. I mean, I was recently talking to a friend who runs a hedge fund and had a good year,

but underperformed the index because Apple was reclassified. And just that simple fact of reclassifying Apple meant that a great year ended up being a bad year. And I think that's an experience that's very common for many investors last year. So you mentioned that the S&P 500 itself is essentially where the alpha is in that it beat the majority of stocks, 85% of the stocks underperformed. I was under the impression that historically most stocks did bad and that historically the vast majority of gains in any environment, whether it's passive or whatever, are often generated by a handful of stocks and that over time most stocks do underperform the index. How different is what you're seeing now with that level of

outperformance of the index versus say 20 years ago or 40 years ago or long before just sort of buying the SPY ETF was a major thing that investors did. Right. So what you're referring to, I think, is parieto's law. You know, you get 80% of your revenue from your top 20% customers or same thing with stock market returns. What's unique about last year or maybe not unique, but at least rare, is that the larger stock in the index massively outperformed. And you can go back. I mean, it's It's a very easy simulation to run. I mean, you can go back on the Dow, you know,

up to the beginning of the 20th century. And one of the easiest ways to have generated consistent alpha would just be avoid the larger stock in the index. I mean, that's the Icarus curse, if you want. You know, once Icarus runs too close to the sun, he falls down. Like usually stocks that become the largest in the world, either face increased competition, regulator's scrutiny, just hubris because, you know,

it's hard to grow, and usually they fall back. And of course, last year was the big exception with Apple up like probably on a total return basis close to 100%. And then Microsoft closely behind. So all you had to do last year to have a fantastic year is just on the largest two stocks in the world, which is usually not the way you make money. So can you walk us through the mechanics of what's actually happening here? Like why are these big overvalued stocks like Microsoft like Apple? why does money continue to flow into them? Right.

And I think that's that is the part where I think the, the criticism of passive is traditionally weak. And I think part of it comes from a bitter place of resentment. Like you have a lot of active managers that underperform. And every year they read the SNPA active versus passive reports that says, oh, 80% on the agenda perform. and that number rises over time. And it's a very painful thing.

So you have a lot of resentment and they say, well, it's because, you know, the index functions by the larger stocks. And that's not exactly true. I mean, it's very easy if you're Vanguard or BlackRock to respond. Well, no. If we market cap weight, we're not overweighing anything. We let the active segment of the market set price and we just bandwagon. we don't do price discovery.

So any sort of mispricing is not coming from us. And that's a powerful argument, one that I don't think we should take. The correct argument is more, okay, passive does not create distortion, but can we think about where the money coming into passive vehicle is coming from? And if this sector is structurally underway these mega caps, then shifting from them into market cap weight, will result in net buying of the mega cap stocks. So what do we see empirically in terms of the performance of across the S&P 500 or other indices?

So you and you made the point right in the beginning, which I think was key. It's not enough to say that the money is going into passive. It's that it's come, what it's coming out of. And so what you said in that last answer is essentially the money is coming out of active managers. The active managers were probably underweight, the very very. very largest companies. And so therefore, there is this rotation of people putting money into funds that are more heavily exposed to the largest companies. Do we see the reverse, though, where do we see not just the upward pull on the biggest companies, but do we see drags

on smaller companies, relative weakness of the lower end of the 500, so that's not just about the behavior of a few tech mega caps? Absolutely. I mean, you have, because generally it's, you know, you say an asset to buy another one. Yeah. It's not really new money. I mean, if anything, that's been one of the peculiarities of this cycle is how little new money has gone into the market. You know, the investors mostly staying on the sideline pretty much since the VIX Armageddon in January 2018, you've seen steady outflows from equity funds, more, more, more, more, more, more, some mutual funds and you have from ETS on that selling, which is very unusual as the market makes the top. So it's been indeed not new money, but shifting money.

And so the place where the money, to measure that effect, what I did is I looked at the top 200 largest mutual funds in the US with management fee of more than 1%. And I thought that would be a very good proxy for the asset losing segment of the market, obviously. and I looked at their top 20 holdings, and I looked whether they had any of them, I call it the Fang Plus, Fang Plus Microsoft,

and Tesla and so forth, like the big mega caps have been driving the rally. And what I found is that more than half of these mutual forms do not have the Fang Plus in their top 10 holdings. And the vast majority of them who own these stocks have them in a much smaller proportion than they weigh in the index.

So to me, that is. to me that is the source of this distortion. As these guys lose money and as that money flows into a market cap weighting index, the way in terms of net flow, it means net selling of what these guys own, which is primarily value oriented small cap stocks, into large growth. And to finally answer your question, you certainly see that enormous valuation discrepancy that has opened between growth and value. It's higher today than it was back at the peak of 2000.

If you look at the Fama French data, it goes back all the way to the 20s, the slope of the market, meaning how expensive your most decide is versus your cheapest decide has never been greater, which is consistent with what we've been seeing. What do you say to people who would argue that the price on something like an Apple or a Microsoft is justified by the amount of dividends or buybacks that they've been doing in the market? So if you can't get a massive growth in the share price,

maybe you can get growth through the dividend, for instance. So that would be one argument for buying these things, even at inflated levels. What do you say to that? Right. Well, first of all, I wouldn't exactly define the dividend yields as extremely high. I mean, you could probably have made that argument on December 24, 2018, when Apple was trading at a,

I don't know, like 11, 12p, something like that. After last year, it becomes a lot harder, especially, and again, as I explained, the money is coming from funds that have a value tilt to them. So if anything, they're probably selling stocks with a higher dividend yield to go into lower dividend yield. The buyback question is also quite interesting. And I think it adds to this kind of supply and demand imbalance. If you look at last year, it's no surprise at the best performing stock,

Apple and Microsoft, the two large cap tax with the largest buyback programs. So you have this rotation that result in kind of structural buying of these stocks. And then on top of that, you have a, I mean, I don't have the exact number, but I think for Apple, it was close to 5 to 6% of the market cap that it bought back last year. And I mean, I hate to sound to say it, but sometimes the market goes up because there's more buyers and sellers. What about, okay, so one of the things that you pointed out is that his, Historically speaking, you could generate alpha simply as easily as avoiding the biggest companies in the index.

And that, you know, there's just sort of like a natural, I guess, maybe the Icarus effect flying too close to the sun or some sort of natural dis-economies of scale where there's always so far you can go. What about the idea, though, that tech is unique. And the way it's unique is that the competitiveness of data-driven companies goes up as they get bigger. So if you're a Facebook and you have Instagram, you can serve a higher quality of ads with a billion users than a company that just has 100 million users because you have so much more data and your business runs better. And so what you could make the argument that these mega caps are better and more competitive and more in a position to grow organically, setting aside share price. than big companies in the past because there are returns to scale and that maybe you just can't compare

a really large tech company that has the advantage of all this data versus, I don't know, a big steel company from 50 years ago. Yeah, that is a very Y2K argument, which coincidentally, the last time we saw this phenomenon was, you know, remember when Cisco in the fourth quarter of 1999,

you know, I think, triple, quadrupled in just three months. And I think it ended up at a close to 600 billion market gap. And then that was the top of the market. But the argument was exactly the same. It was the network effect, right? I mean, as we enter in this dematerialized world, we no longer have the, you know, the low of diminishing return,

which fundamental principle of economics no longer applies because you're dealing with data instead of things. And the more people are on your network, the more valuable it becomes. Today, there is more of a big data AI tweak to the argument, but it's essentially the same one. I mean, I'll just point to the experience of 2000. You know, it didn't work out all that well for Cisco. And then for the companies for which I think there was indeed some sort of a natural monopoly like Microsoft.

Eventually, the regulators got caught on with it because if reality is the way you describe it, I think then we have almost a social and political process. problem that, you know, wealth just accrues to the one that have the most powerful platform and competition becomes impossible. Right, which is when you would expect regulatory pressure to come into play as well. And that's exactly what happened to Microsoft back in, you know, with a various types of probe in both Europe and the U.S. in the late 90s. Today's show is brought to you by Vanguard.

To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. One of the really interesting things in your report is you talk a little bit about demographics and different approaches to investing between baby boomers and millennials who are, you know,

really just starting to accrue wealth in the stock market. Can you talk about how that plays into your thesis about, you know, money flowing into certain things, but also money coming out of certain things. Right. I mean, overwhelmingly, you know, baby boomers are in, you know, they came of age, you know, really started saving in the 90s at the time when you had the Peter Lynch, the big, you know, mutual fund managers and they were happy to pay, you know, 1% management fee to invest with an exceptional type. At the time, active managers actually did perform quite well. And anyway, returns were higher so people were not less cost sensitive. As I'm sure everybody knows here, the median baby boomer

is somewhere around 64, 65. As you head into retirement, you reduce your allocation to risky asset, increased that of bonds, which in many ways explains the flow paradox that I was highlighting before, where we see the market making new high, but money coming out of mutual funds. So, boomers are selling their holdings, which are primarily made of high fee, value tilted, small-cap-tilted mutual funds. And to the extent that millennials are building wealth, which, you know, as you all know, is not as fast as everyone would wish. That money is primarily invested. Yeah, you know, Robo Advisor or even directly in low-cost CTF. And it's a very, it's very hard to see this trend change in 2020, 2021.

As much as like someone who believes in market-based allocation of capital and the value of price discovery, it's very hard to see this change in the near or even medium term. I want to go back real quickly to the question of comparing mega caps today versus back of the day when it was a big steel company. So as of the day we're recording this, just for people's knowledge, we're recording this a few weeks before it comes out. But the day before we recorded this, we got earnings from one of those mega-caps, Alphabet, the core advertising business up 17%, the cloud business up 50%. I mean, whatever was the biggest company in 1960 or whatever, I don't know what it was, but probably some big industrial, right? Like, they were great.

growing like this, were they? Well, I mean, you had that. I mean, this is just incredible, like, I just want to push me. I mean, these are like incredible numbers that someone would say, okay, for getting passive, forgetting all of this, like, it's just, it's a, they are incredible juggernauts that make more and more money every year.

It's funny you should bring up the 60s and 70s because you actually had something very similar, which is the nifty 50s, right? And so at the time it was your IBM, your Coca-Cola, American, and McDonald's, and I don't have, off the top of my head, doubt on how fast they grew, but it also seemed like, you know,

they had these kind of new methods of management that had been, you know, invented after the war. They were the first multinational. They had, you know, at some, you know, Europe was recovering Asia. It seemed that they also had endless growth. And the argument that was made at the time, you know, they were one decision stock. Don't worry about the valuation, they'll grow into it.

Right. Which is exactly what we hear today. about you know Google and and the other the other mega cap the one thing I would point though on on the the earning side is well actually two things uh one watch for uh margins and and and and cogs uh actually no salary costs i mean that's that's an area that's been really uh painfully growing much faster than on earnings your revenues and people kind of focus oh you know 20 30 percent, you know, top line revenue. Look at how much salary expenses are growing, especially stock-based compensation. And I think that's a huge advantage that these companies have over traditional companies. You know, you look at a typical salary package at Google or Facebook or Amazon.

First of all, it's very, very high. I mean, I was reading a piece that I think it was in Bloomberg interns that Facebook started at $8,000 a month. Entry-level jobs are probably more around 200. And then mid-level, you're looking at $450,500, but half of that is paid in stock. So you don't really feel the pinch, right? Because if you pay your employees in stock or half of your comp in stock, hey, you still end up with a cash at the end so you can do a buyback, you can, you know, invest in the next big startup, you can. And I guess if employees assume that the stock is going to keep going up 20 to 50% a year, then that's implicitly worth more than cash, even if it's the same And to some extent, it also adds to my supply and demand argument before.

And that's another peculiarity about a lot of these tech stocks is that the flow is actually smaller in the market cap because, well, in many cases, you have a founder that has a significant stake. I mean, you can think of Amazon with Bezos and McKinsey. And then you have employees who've also been given stocks over the year and sometimes been quite reluctant to sell. So if you have a base of investor that's not willing to sell the stock and you have index funds are trying to buy in proportion to the market gap that kind of add to that squeeze

that we're describing earlier. So there's this sort of virtuous cycle at play. It sounds like where as long as your share price is going up and it probably is if you're one of these big successful companies like Apple, you can reduce your expenses by paying your employees with stock. And the assumption is it will keep going up. And you can also embark on big buyback or dividend programs because your shares are going up and your cost of funding in the debt market is probably pretty low as well. And all of that just combines again to flatter your bottom line and maybe increase the share price again. When does the cycle actually stop? Not just that virtuous cycle of flattering share prices, encouraging better share prices, but also the cycle of passive money

flowing into overvalued stuff. To say the truth, the passive rotation, I don't know. I don't know whether it will. I mean, there's always this hope, like every year amount of active managers. It's like, oh, well, you know, typical investment outlook from an active manager.

Well, last year was bad, but it was because of this unique Brexit, the Fed hiking rate, the Fed cutting rates, correlations being high, correlations being low but next year because there's going to be that other than that I'm uniquely positioned to take advantage of it will be different and and I mean we've seen it for 20 years so I I don't know I mean maybe you'd have to maybe have a black swan-like event like like like some sort of like you know massive panic and then the ETF starts selling and and then but I really can't imagine

the market going back to structure that it is at 20 years ago what What I will, I will rebound on what you said about the virtuous cycle because I have done a bit of work on that. I looked at the, about 200 companies that are incorporated in the San Francisco Bay Area plus Silicon Valley. And then I created an index of these companies and I looked at their weighted average cost of equity, the cost of debt, their effective tax rate and how much of their compensation was going in the form of stock. And what I found was, you know, the cost of equity, effective cost of equity was very, very low because most of them don't pay dividends. Most of them don't have buybacks. So if they do have buybacks, it's to offset dilution, so on net it's very low.

The cost of debt is extraordinarily low because either they have very little debt or that debt is really pushed far away. So they don't really need to service it at any point. The cost of employees is low. I mean, it's high in absolute number, but it's very low if you look at what is actually paid in cash. the taxes, of course, are not existent. And then most of them, actually a majority of them, don't have earnings. So then if you start thinking about it that way, I think, okay, well, you know, if you were to run a business and you don't have to turn earnings, you don't have to pay dividends,

you don't have to pay taxes, you don't pay interest on your debt, or at least you can postpone it. And even better, you can pay, you only pay half of your employee salaries. Yeah, I think it could be the competition, too. I want to get into a little bit more soon about how you think Investure should be positioned to sort of prepare for the end of this or take advantage of this. But before we do that, I'm curious, in your work, have you looked at non-S&P 500 indices to see if there's the same effect as a result of market cap waiting? Like, if you look at, say, people putting money into IWM, which tracks the Russell 2000,

do you see a similar distortionary effect there where the larger companies within the small cap sector benefit disproportionately from some people, from the existence of these vehicles? Right. What I've done is, you know how the SNP 500 index is not a truly market cap rate index? I mean, it has a bunch of other requirements. The SNP 500 is not the largest 500 companies in the world. Right, right, right.

I think Tesla's not. Exactly, because they have some requirement about earnings, I believe, and liquidity, which I'm sure. I guess it should. That's another reason to buy Tesla. Here you go. That was a joke. But yes, I was looking at companies that were,

um, uh, should have qualified based on their market cap. This is the other question I was going to ask. Like S&P 500 S companies that weren't in the SMP 500. Exactly. And it's about like 30 to 40 companies that qualify in the market cap segment. But for whatever reason, they don't,

they don't match the other rules that by the S&P comedy. And yeah, indeed they haven't performed massively because they're not attracting the same flow. I mean, if you're not in the S&P 500, you don't get the SPI VO, flow. Right.

So you're structurally less underbar. What are some of those other names? I mean, Tesla is the weird one, but what are some other companies that, if you remember them off the top of your head, that are like, should be almost fit the S&P 500, but they're not quite in there. Right. I think there's a, I forgot it's named. The big casino companies in there.

And I think it's an anomaly where the founder owns, that that's often the case. The founder owns a bunch of the flow. then the full requirement is not met. Okay, I'm going to do Joe's question then. It's the age of dumb alpha, and you think that the flows into passive probably aren't ending anytime soon. So what should investors actually do?

Should we just be following the herd? I mean, you know, this is how like trillions of wealth were lost, right? I think it's stupid, but everybody's doing it, so I'm going to do it anyway, right? I mean, this is how you get the, you know, you pay a lot of money for tulips or the, you know, the Dutch, the South Sea company. Yeah. So it feels horrible to say that. I think eventually, I don't know when, I don't know how, but markets have a way of fixing things that are unsustainable.

I mean, things that unsustainable cannot last forever. So, you know, I think over the long term, if what we're describing is indeed happening, what this is. means is that the expected return on on these you know over owned stock is going to fall and the expected return on the kind of small-cap value that are under owned by the index crowd should be higher. And as a result the return to investors should be higher. So in general the idea would be to look for you know kind of opportunities outside of the index. At the same time I would caution that by saying you know you

You should be happy with basically dividend yield traditional, you know, Ben Graham style analysis and not worry about underperforming the index by 30%. Well, I was going to say it seems like in this environment and it's kind of like insult to injury because we're just we're talking about all the money coming out of active and the pool of mutual funds that have greater than 1% fees and so forth. But it seems like in an environment like this, you really. don't want to have the job of having to write a letter at the end of a quarter. So that like if you're like a sort of normal individual investor, you can diversify, you can say, look, maybe I didn't,

I wasn't overweight Apple and Amazon last year and I underperformed the S&P 500 a little bit in my personal account. But it's fine because it was a great year and a bunch of stuff went up. But, you know, the individual doesn't have to write a letter to some other limited partners saying, explaining why they underperformed or coming up with some excuse. So it kind of feels like that is a, I really wouldn't, like, that is not a very desirable job in this environment to have to pick stocks and explain, you know, and either be in this situation where you have to really lean into the mega caps and risk blowing up when it all turns around or avoid the mega caps and underperform on the way up.

Yeah, no, I mean, indeed, it's been a pretty terrible environment for active manager, research channelists and it's I mean there's probably things you can do to mitigate this I mean in the report I was mentioning again it's it's a somewhat of an expensive strategy but maybe one way to play this is to kind of have your your traditional value oriented you know stick by the book and hope that eventually things fall into place and I own good company that I understand and I do my DCF work and all like good stuff that's been completely useless for 10 years. And at the same time, to hedge against the risk of this kind of blow off top,

buy call options on the big names. I mean, one worry that I have is that this rotation would actually accelerate, partly as people open up their year-end statement in 2019. I think, you know, a lot of the money that's invested in these high-fee mutual fund this kind of sticky money that has been then forever, you know, great years in the 90s, people don't really know how much they're paying, but then like if they realized, I mean, 2019 was so brutal. I mean, because basically if you didn't have Apple or Microsoft,

I mean, you're gonna be up like, you know, 5%, you know, when the market is up 35. That kind of delta could be the kind of thing that, you know, I'm giving up. And I worry that, and you could certainly see that in the first weeks of the year when basically you had, I think Google was up like 10% up, of course, with Tesla was even out of this world. But it could have been just people opening the environment and say, okay, I dumb this guy,

let me go in the index and that rotation actually accelerating in some sort of a feedback loop. Right. Trace you're talking about the virtuous cycle, but this is the vicious cycle. Yes. For active. So I alluded to this in the intro, which is basically that there is a strain of thought that if passive investing is misallocating capital in some way, then it poses a giant question mark over the economy and the way capitalism works in general. What's your view of that

particular argument? Is there a particular area where you see passive investing, misallocating capital and impacting the economy in a negative way? Well, I think you see it anecdotally in, you know, some ETF related distortions. I think there was one like last week. It was a high dividend deal stock that was owned by a high dividend ETF. I forgot the ticker right now. But and then the, the stock kept getting cheaper or the dividend increased. And then it no longer met the market cap requirement of the ETF. So the phone had to dump it and that resulted in a kind of a really large down day for

a stock that was actually doing well. And you can find many of these distortion. You see it also in the gold miner ETF, for example, the junior gold miner ETAF owning the senior gold minor ETAF because there's not enough shares to buy. So, you know, and you know, these are anecdotes, but it tells you that this, this starts to matter. In general, you know, the question is what is the tipping point for the passive share? I mean, you can almost think as a almost like a laugher curve, you know, like if you tax people up to a certain point, then your revenue start decreasing.

Yeah. As the passive share rise, then economic efficiency starts to be, to be. suffering. The first data point you need for that is okay what is the actual passive share. And it's a hard one to answer going back to your first question like what is passive. If you just go by you know adding Vanguard, Black Rock and State Street, I think it's about 20% of the market for the average stock. Basically the third large, the three larger shareholders for most stocks are in that order of Vanguard, Black Rock, State Street. It's probably even a little higher because you have a lot, these companies also offer index replication.

They're not explicitly index funds, but they replicate the index for institutional clients. So you don't see that money into the traded vehicle, but it is like, so my understanding is we close to 40% in terms of the ownership of the US equity market. And probably when it comes to trading and flows, which I think matters most because that's where price discovery is set, right?

Price is discovered by people trading. with one another. So even though the ownership share is just 40%, if, you know, 90% of the trading at the end of the day is driven by passive vehicles, you get to this potential problem that the price discovery mechanisms do not work. Well, on that cheery note of price discovery mechanism ceasing to work, Vincent Delilah, thank you very much for joining us. It was great. Thank you so much for having me. Thanks, Vincent. That was really good. Tracy, I really feel like this is just going to be a bigger and bigger topic.

One thing that has come up recently that we haven't even talked about since we've explored the effect of index funds and passive investing is all like the antitrust angle. And of course, that's becoming a bigger and bigger deal. This idea, as Vincent pointed out, like, okay, if every company is owned by that same basket of like three investors, there's more and more scrutiny just on the question of like, what does it even mean for the companies to compete with each other anymore? Yeah, I think we need to get Matt Levine on again to talk about that particular angle. I know that's one of his big, that's one of his recurring themes in his newsletter.

Yeah, exactly. But one of the things that really interests me from that conversation is the notion of how all of this is actually influencing the wider economy. And I keep thinking about deflation and, you know, the mystery of missing inflation of the past 10 years or so. And you can kind of see if markets are funneling money in an inefficient way or doing it in a way that means that the biggest players just keep getting bigger and those players have more and more pricing power on the market, more ability to dictate wages, that that might be one reason why, for instance, wages are staying so low. Yeah, absolutely. There's all kinds of sort of interesting ramifications hearing Vincent describe that feedback loop, the incredible, natural competitive advantages of the 200 companies or so headquartered in Silicon Valley or the Bay Area, tons of different avenues to explore about just the incredible amount of money that's accruing to a fairly small group of players.

There's one other thing that I really like about Vincent's research and the way he's approaching this topic, which is that he's looking at investor behavior and he's looking at it on a relative basis. So, of course, it's not enough to have, you know, 5% returns in a given year if someone else is up 10%, right? Which I think is reflective of how most people actually think and view their portfolios. And certainly, you saw Donald Trump do this not too long ago, where he was talking about the stock market's up and your portfolio is only 50% up.

What have you been doing wrong? And I think that's also a point that sort of missed. in a lot of the analysis here. Yeah, no, I love that point about the sort of sticker shock at the beginning of the year because all anyone heard in 2019 is such an amazing year for the stock market, one of the most incredible ones on record. But there are a lot of investors who I don't think had such a great year. And essentially, like, either, okay, if you own the SPY, you matched it, but, you know,

if you, like, had any sort of normal diversified portfolio of equities, unless you happen to be like a really long Apple and Microsoft, you're looking at your portfolio or you're looking at your manager and what's wrong? And it could be the type of year where if, you know, as that dispersion between the biggest and the rest grows so big, as he points out, that could be a catalyst for even more acceleration from active to passive. So, you know, kind of like we were saying, it's a, it's a tough time obviously in active management. Sympathy for the fund managers, that's for sure. Yeah. I need to write another song about it. I should write a song about that. Do it.

I'll write a song for our next live episode. Wait, is it going to be a Rolling Stones cover? No, I got to write a new, I got to write a new one. I got to create something totally original. Okay, fine. Okay, well, we look forward to that. This has been another episode of the Odd Lots Podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway.

And I'm Jill Weizenthal. You can follow me on Twitter at The Stallwork. And be sure to follow Vincent on Twitter. He's at Vincent Deloard. Great follow there. Be sure to follow our producer on Twitter, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy. She's at Francesca Today.

And for the whole family of Bloomberg podcasts, you can find them all under the handle at podcasts. Thanks for listening. I'm June Grasso, inviting you to join me for the Bloomberg Law Podcast. Every weekday, we help you make sense. of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets, from corporate law to constitutional law and from state courts to the Supreme Court. At Bloomberg law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars, and policy

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