Odd Lots - Why The Rise of Passive Investing Might Be Distorting The Market

Episode Date: February 10, 2020

Over the last decade or so, we've seen an incredible rise in so-called passive investing. While definitions differ over what this means, we've seen more and more money poured into index funds (which own every stock in a given basket). Meanwhile, money has been yanked away from money managers who attempt to select individual stocks. One school of thought argues that this is a positive, in part due to lower fees. But is there a dark side? On this week's episode, we speak to Mike Green of hedge fund Logica Capital, who argues that the trend is causing major market distortions that will eventually unwind with ugly consequences.See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon Music. 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 very big. It's a very big. It's a very much. 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, go 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. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Wazenthal. So Joe, I tweeted something recently and it provoked a large response on social media. It's weird how that happens, right? You tweeted something that provoked a response?

I find it very hard to believe. I know. It's outrageous. But I was talking about, have you heard of the fire movement? Yes, vaguely. Like, I am familiar with it. It has to do with people retiring early, right? Yeah, so it's fire as an F-I-R-E, and it stands for financial independence, retire early. And the basic idea is you can save a lot of money, and if you invest it wisely, you can retire at an early age, like in your 30s. And supposedly it can work out for even normal people or people on normal salaries.

We're not talking about really wealthy people. And the thing that I always find really interesting about it is when you go and read about how people are actually investing that money so that they can retire early, they're almost all talking about doing it, A, themselves, and B, through passive investments like ETS. Right, exactly right. So people think, okay, they live frugally. They work for several years. They live frugally.

But then they sort of have this confidence that historical returns that we've seen in stock and bond markets throughout the world will just always be there for them in the future. And so they just put a bunch of money in passive ETFs or, you know, passive-ish ETFs. And then they count on that existing for the rest of their lives. And then they do something, I don't know, they go on Reddit or tweet for the next from 35 until they're done. That's right. And the reason I find this, you know, it doesn't sound bad to me, to be honest, I would be fine. I would do that if I, if I had confidence. You can see the allure. For sure. But the reason I find it so interesting from a market perspective is to me, it hits upon like a number of very, very important themes, but really it hits upon this question of whether or not

the fire movement can exist without the bull market that we've seen for the last 10 years, right? it's very easy to say, dump all your money in something like, you know, a vanguard total stock market ETF and just watch it soar when that's the thing that's been happening for years and years and years and years. Well, I'll say two things. So one is it certainly raises the question about whether this subculture can continue to exist, but it also raises another question about people who aren't in that subculture, but in a way have de facto bought into it because this mantra that.

we've gotten from sort of the media and the fund management industry is, okay, most people aren't saying you should try to retire a 35 or 40, but this idea never try to time the market, never pick individual stocks, just have a broad diversified basket of ETFs that you maybe rebalance every once in a while has become so intense and extreme and everyone's being pushed to invest like that. So even if you aren't one of the fire people on Reddit, it still raises the question, of how much is everyone else who is not planning on per se retiring early, essentially bought into a less extreme version of the same story? Absolutely. And you'll see a lot of the investment advice that the fire people talk about is actually very, very similar to advice given to people generally

when it comes to their 401ks and stuff like that. Passive is supposed to be cheaper. It's supposed to be much better. But what if there's a downside to passive investing? We've spoken about, you know, active versus passive on the podcast before, but we haven't done that much on how passive investing might actually be changing the way the market functions. No, absolutely. And it's such an important question given, as we've been talking about, how many people have portfolios in which the only action they do is just add to the same basket of three or four ETFs every single month for their working lives. It's been fantastic since the crisis with an incredible rally in stocks and bonds simultaneously, but, you know, as they say, past performance, no guarantee of future returns.

This is true. All right. Well, I'm happy to say that we have the perfect person to talk about this today. Our guest is Mike Green. He's the chief strategist and portfolio manager over at Logica Capital Investors. Mike, thanks for being on. Thank you for having me. So I guess my first question is, how did you get interested in this particular area, examining the impact of passive investing on the broader market. Is it something that you're observing in your sort of day job? Well, the way I think of my day job is to really try to understand the market structure. I'm not a trader in the traditional sense, wasn't trained on a prop desk or anything else. And so, you know, I've always managed to make money by trying to figure out

actually what people are being forced to do. What is the incentive structure that's causing people to do what I think is fundamentally irrational rather than just saying, hey, they're crazy and stupid, and this will eventually stop, the opportunity to dig in and understand actually the incentive structures that have been created, the restraint or the requirements for people to engage in certain transactions, whether that's from a regulatory framework, whether that's from a institutional framework, basically built into their prospectus. Ultimately, that can create the opportunity to identify trades that you think are irrational and have the potential to break as that behavior is brought to its logical extreme. So that's how,

I stumbled on to this stuff. So what are, in your view, the big structural trends or the big structural impositions on individual investors or pension funds or any other entity that has a lot of money that are all causing people to sort of invest in the same way right now? What are the big, the key ideas here? So there's a couple of key things. The first is, is that the growth of passive investing has been well documented, right? And the narrative behind the outperformance is fundamentally built around the work of Bill Sharp, who is the father of the Sharp ratio, the CAPM formula, et cetera. His paper in 1991 called the arithmetic of active management is this analysis that we've all heard that says fundamentally passive investors by definition are only matching the active

investors in terms of their overall allocation, and so the difference is just going to be fees, which means that the active managers underperform. Everyone accepts this today, because we've seen the evidence. of the outperformance of passive, but very few people take the time to go back and actually look at the construction of the problem, the assumptions that existed under that. The assumptions are just absurd, right? So in the definition of what a passive investor is, according to Bill Sharp, is that passive investors hold all the securities in the market. How do they get in? That's magic. How do they get out? That's also magic. They never transact. The minute they transact, they

cease to be passive investors. And as we know, passive vehicles are dealing with billions and billions of dollars of inflows on a daily and weekly basis. They're in the market transacting. They are the single largest transactors by far. And as a result, they have to be influencing the market. They cannot be passive. So the fundamental premise on which this whole idea is built is flawed. The second thing that has happened, though, is because passive investing has grown so large and so powerful, the resources to engage in lobbying efforts to institutionalize passive within the framework has expanded dramatically. Most people have a cursory familiarity with things like 401K plans and IRAs. Vast majority of Americans have some exposure through their employer to these plans.

Those rules have changed over the years to the lobbying efforts of passive players like Vanguard and BlackRock to inculcate passive strategies into these vehicles under the premise that this is the best possible vehicle for the vast majority of Americans to invest in. And it's had the effect of creating this crowding that has further accelerated the performance of the benchmarks that these are ultimately tied to. Oh, man. Sorry, there's so much just in that first couple of minutes that I find really, really fascinating. Oh, why don't we go back to the first point, which is this idea that when we're evaluating

the performance of passive versus active, we're not actually taking into account. the way that passive can influence the market. So how are you seeing passive investing actually impact the market now? We're seeing it in a couple of different ways, right? One is that we're seeing a distinct performance advantage that is being created for those securities that are in indices that are being invested into by passive investors. This is a fairly well-studied phenomenon in terms of the dynamic of what's called index inclusion. So we have one-off events in which we can look at securities that have been put into an index or have been ejected from a widely traded index.

And we see that there is a distinct and permanent shift in the valuation, the price levels associated with those securities. This is a well-documented academic literature. What the literature has not studied is the dynamic of the continued inclusion, the continued flow of capital. And that becomes a harder problem because suddenly they're on par with all of the other constituents in the index and they're all experiencing it. So I, I, I, gave a speech several years ago in which I compared it to the David Foster Wallace, this is water, right? The medium in which we're actually participating is being skewed by the behavior of these passive flows. The best analogy to think about this, most people

have had exposure to the carnival game where you're shooting water at horses that are racing across, right? The best strategy to play that game is to wait until the table is relatively full, so it gets a large prize, and then you and a friend simultaneously go to the table, and you both shoot at the same horse, abandoning one of your horses, but the objective is to win. And by simultaneously exerting pressure on the water sensor, you're giving the perception that you are more accurate, causing that horse to outperform. That's what we're seeing with the benchmarks, as more and more people are shooting water at the stocks that are explicitly in these benchmarks, and in particular the larger stocks, right,

because of the momentum bias associated with this and some of the techniques under which many indices are constructed what's called sampling techniques where they're trying to, with the minimum number of transactions, replicate the behavior of the index, these securities are in turn those horses that are receiving additional participants or water flow at them leading to the perception that their performance is better. Because those are the benchmarks, that then leads you to conclude that all of the active managers are actually underperforming when the problem is just how we're measuring it. So there's this, I guess some people call it a virtuous cycle.

Some people might call it a vicious cycle. But what you're describing essentially is, okay, we look at all these fund managers. Maybe they're underperforming the S&P 500 over some period of time. But it's essentially because all the money is going into the S&P 500 as a whole. And then that accelerates because the fund managers, to be unperforming, that appears to vindicate the idea that, oh, yeah, of course, just go passive, active doesn't work, and the problem, or the disparity grows larger. So if this is true, it means that something, like, quite big and fundamental has actually

happened or changed in the market, which is that there used to be a point where things would get too expensive, and that's when investors would stop buying them, and eventually the price would sort of self-regulate itself and drop back a little bit. But now what you're saying is basically because we have so much money hitting the same target over and over, and we basically have flows chasing flows, that markets are no longer self-limiting, so to speak. Unfortunately, I think that's correct. I mean, there will ultimately be limits, but they're far beyond anything that we have currently experienced. So any reference to historical dynamics becomes inherently flawed because we did not have these participants in the past.

So it's a good thesis or it's a provocative thesis. And obviously you can point to the data that shows lots of fund managers underperforming the benchmarks that have been set by them. And maybe those benchmarks are arbitrary. But how do we know that's true? What are some other indicators, like how do we know it's not just fees that are causing them to underperform? Or how do we know it's not just that they're bad at their jobs and they're bad at picking stocks that are causing them to underperform? What other evidence is there that people, that they're actually still, I guess, doing a good job in spite of their underperformance? So the easiest way to actually tease something like this out is to look at the performance of benchmarks that are designed to model many of the

strategies of active managers, the generation of alpha, and have historically worked quite well in doing so, but charge no fees. So a simple example of that would be the buy right index from the CBOE, which is you own the S&P 500, so you are actually tied explicitly to the benchmark, and you sell an out-of-the-money option on a continuous basis, capturing the premium associated with that option, right? That has always historically delivered, quote-unquote, alpha, right? What you're actually doing is you're selling some of your top side exposure. You have full downside exposure. In exchange for that sale of the top side,

you are actually receiving a premium, right? That premium delivers return, regardless of the underlying return of the S&P 500, the underlying. And so that shows up as a alpha-producing strategy, right? We have seen this alpha decline in a nearly linear form over the past 25 years, right? It's not tied to interest rates. It's not tied to the implied versus realized,

which is the traditional component that people have focused on. We've seen these strategies that should offer a consistent return, deliver now negative alpha, which is highlighting part of the problem. We're using tools that presume the efficient market hypothesis is true, right, to measure performance. So the calculation of alpha is literally just the intercept in a y equals MX plus B equation, a linear equation. If you try to solve a linear equation,

if you try to use a linear equation to solve what has become a curved or distorted surface, right? Mechanically, that alpha shifts increasingly negative in the same fashion that we're seeing this happen across these types of strategies. So one of the guests that we had on the podcast, I think it was maybe like three or four years ago now, we talked to Michael Moveson, and he has a sort of a separate model or theory about how this is all going on. And he basically kind of likened it to the online poker boom in the early 2000s in which a bunch of bad players started playing poker. And that was a really good time for professional poker players, the sharks could eat the fish. And then when the fish realized that they suck at it, they stop playing.

And then it's just sharks versus sharks. And the only thing is they are all good, but the house gets a rake and they all start to underperform. And that the only real phenomenon with the passive emergence is just, just that people who never should have been trying to invest in stocks in the first place aren't anymore and that the alpha that the fun the professionals generated was just a result of there being a lot of bad players in the market and now they're gone because they're all they're all buying SPY or whatever and it's not their fault but they just there's no bad there are fewer and fewer bad players that sounds like a plausible way a plausible story that is a little more benign than your

vision. Yeah, so I know Michael personally, I count him as a friend. Yeah. He's wrong. In really simple terms, he's framing the problem incorrectly. So we all like to think of Wall Street as gambling, and so it's easy to draw an analogy to something like poker. The difference is poker is what's called an ergodic system, the distribution of cards, the frequency in which you can pull the cards out, this particular suits, the hands that can be constructed are finite in their underlying construction. Statistically, that's not going to change over any period of time. Any sample that I draw as long as I'm drawing from a deck is going to have the same distribution and probability. That's what an ergodic system is. It's what the tools that we use when you talk about

Monte Carlo type simulations, they presume the exact opposite of what you said, past performance is not a guarantee of future success because we know that a blackjack table or a poker table or a game of craps roulette is going to have the exact same probability distribution at any point in time. That's not how markets work. Markets have an infinite and infinite number of combinations, and they also have a singular direction in terms of the arrow of time. We have no certainty as to what the forward distribution is. The Michael's premise is fundamentally wrong. 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, go 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. I wanted to ask you about another potential impact that your, if you're

correct, your thesis around the impact of passive investing on the market, another potential impact that could be playing out, and that's in the arena of volatility. So presumably, if you have flows chasing flows, then the market becomes much quieter, I suppose. I don't think that's true, actually, so I just want to be very clear on that, right? Certain types of behaviors of volatility become very different, right? So when you have a market that is, I would describe it as more accurately, continually providing liquidity, because you've removed the restrictions. You mentioned earlier the idea that valuation or a focus on valuation creates self-regulatory or self-limiting behavior. People eventually will stop buying and hold cash as an alternative to holding securities because

they find them unattractively valued and guaranteeing or virtually guaranteeing a negative return in forward expected space, right? When you remove that restriction and instead you place the investments with the world's simplest algorithms, right, which passive is. Passive is literally an algorithm that says, if you give me cash, then buy. If you ask for cash, then sell. You remove those limits, right? And simultaneously, as long as the money coming in is positive, right, the flows are

positive, you're providing liquidity to the market which dampens volatility to a certain extent. Now, there's a host of extenuating factors that have been created through what are called yield enhancement strategies, basically strategies that are built around selling volatility that further influence this dynamic. What we're actually seeing is daily volatility in terms of the point change is significantly less than weekly volatility, which is significantly less than monthly volatility, which is significantly less than annualized volatility. And that's the sort of behavior that you would expect to see if you're seeing this dampening on a localized basis, but the ability to inflate valuations over time. So I want to get to soon how this could

all go bad and belly up and all the grim stuff that I'm sure people are waiting for. But before we do that, I want to talk a little bit about what you identified up front as the sort of second key dynamic, which are these sort of other factors just sort of driving this trend overall. And you mentioned lobbying efforts and regulation. It also feels like, I don't want to say propaganda, but there's also been just a lot of media coverage about how nobody should ever time the market. Nobody should ever pick stocks. Nobody should ever just keep investing, riding it out, kind of the fire belief. Talk a little bit more about how this emerged, this sort of consensus around just if you have cash, put it in stocks, and if you need cash sell stocks.

Well, I mean, we've heard this repeatedly before, and it's part of what I think gives rise to a little bit of sanctimony from the active manager space of, oh, this is all craziness, this is a cycle, it will end. I think there's a deep underappreciation for how we've structurally changed the system in terms of those dynamics. And the regulatory framework is a great one. You know, we tend to take for granted the underlying structure of a market, the underlying dynamic, but vehicles like 401Ks and IRAs, which represent the vast majority of individual Americans, savings and actually can be thought of colloquially as the world's largest sovereign wealth fund, roughly $16 trillion in assets across the American public in 401Ks and IRAs. People tend to think of stock ownership is heavily concentrated amongst the extremely wealthy. The reality is that 401Ks and IRAs are actually mechanisms by which the vast majority

of Americans are capable of saving relatively small sums. The median investor, once they hit retirement, has somewhere in the neighborhood of $250,000 in their 401k, and those funds need to. be spent, right, to fund retirement. So this is not a story of concentration of wealth. What it is a story is the mechanisms that are available for people to invest in their 401ks have increasingly been directed to passive assets. There's a passing familiarity with something that's called the Department of Labor fiduciary rule, right, which came into being in April of 2016. This actually changed the structure of 401K is quite significantly. Any corporation that offered a 401k

had to offer passive strategies, had to offer low-cost passive index alternatives to their employees, or they became liable to their employees for the excess fees that they were being charged to them in their 401K, and even more crazily, potentially becoming liable for the underperformance of the investments that they were offering. So corporations aren't in the business of guaranteeing a return relative to the S&P 500 or the Vanguard Total Market Index. they are in the business of trying to quickly and easily dispense benefits to their employees to keep them happy, right? And so this created a very accelerated shift into passive vehicles that began in 2016, became formalized in early 2017, and if we had not stopped the phase two implementation of the DOL fiduciary rule in 2018, this would have actually gotten far crazier.

The second thing that's changed is the mechanism that people invest, right? So 401Ks, again, were a product of the 1970s. They're created in 1978. Started the bull market in 1981. There was only about $75 to $100 billion invested in 401Ks. Today, that number is around $7 trillion. In 2003, we introduced products called Target Date Funds. I believe it was somewhere around 2005 that we began to change what's called

the qualified default investment alternative for people who go into 401Ks. One of the traditional problems that people had in going into 401Ks is that their employees, is that their employees felt uncomfortable making an allocation choice, and so they would default to the cash that was being put in there, and there was no actual investment of these proceeds. In 2005, that changed with a designation of a QDIA that was not cash. Effectively, the HR department decided on a base allocation, so if you went in, you didn't change anything. Typically, you would go into something like an S&P 500 or a total market index or potentially into an actively managed product.

as active lobbying for designation is appropriate for QDIA and the recent passage of the Secure Act further enforces this. Starting around 2012, a default, a QDIA default became a target date fund, right? Which means that your money is being put into a set proportion of equities and bonds based on your age. That is, in turn, investing almost exclusively through passive vehicles. There are a few exceptions to that, but the vast majority of target date funds are investing through passive vehicles, and so directing incremental flows into the market into those assets. And this has now become the dominant investment vehicle in the United States.

For money flowing into 401K, the number is close to 90% of incremental dollars are now going into target date funds. I know Joe wants to get to the bad stuff happening, but just before we do, I mean, you mentioned active managers there, and often one of the complaints we see from active managers is the reason they're underperforming is because the market is so distorted by the Federal Reserve or other central banks and massive amounts of liquidity that they can't possibly compete with, you know, the irrationality of everything.

Is there any space in your particular view of the markets for central bank liquidity distorting some of the flows? So there is, but not in the manner that many active managers complain about, right? And it takes two forms. One is the low level of interest rates that we've arrived at through central bank actions. And those interest rates are certainly in terms of risk-free rates. Those are a policy choice. The central bank chooses the level to set the front of the curve.

And everything else in the risk-free space has to be set as some function of that number. So it'll always be the anchor point. And there's true complaints about that. those low levels of interest rates relative to what they were even 15, 20 years ago, has created a condition in which there is a desperate search for yield because people have a shortage of financial assets that would allow them to meet their retirement or return objectives. That has given rise to a cottage industry that we call yield enhancement strategies.

In Asia, these are often referred to as what are called auto callables. In the United States, it could take the form of things like put writing or call writing strategies, overlay strategies. Very publicly, a firm called Harvest was a very active seller of yield enhancement strategies. UBS was sued about the underperformance of these strategies in 2018 going to 2019. And so I would argue the central banks are primarily responsible for the rise of those yield enhancement strategies. And those in particular are creating a lot of the vol dampening that you were referring to, Joe. Right. And listeners remember a couple of weeks ago, we talked to Ben Eifford about exactly that factor, the Asian retail buyers going back and buying all these sort of selling

volatility to generate yield. In this environment that you're describing in which there's this wall of money that comes in every paycheck or every month or whatever it is, is there a reason for anyone to do sort of like, you know, security selection, stock selection, what people, the old star mutual fund managers, or is trying that or trying to find a good stock selector, just kind of a loser way to play it at this point? Well, it depends on what your objective is, right? If your objective is to allocate capital, right, that's a very important role, right? The role of financial markets is actually to set the marginal price of capital so that companies

can access that either in the form of debt markets or in the form of equity markets. We focused on the equity markets. I would actually argue the impact of passive on the debt and the rate and credit markets is increasingly pernicious because the models there are totally flawed. That is actually a very important role. Taking money from bad companies and giving it to good companies is a critical role in a capitalist system, effectively allowing those who are efficient and intelligent allocators of capital to give money to management teams that have good prospects in terms of generating future wealth. What we've created now is a distortion of that. It's a fun house mirror effect, right? Where we've presumed that everybody else is doing this for us, therefore it is a fool's

game to do it ourselves, right? And the rewards very clearly are accruing to those who are engaged in various ways of leveraging this phenomenon. You asked, you know, how can people beat the market? Well, we saw in 2017 a product XIV that was basically a hyper leveraged and leveraged, increasingly levered exposure of the S&P become the stock market darling. Right. The downside to leverage is what we saw in February 5th, 2018, which is in a single event that stock basically went to zero, right?

And so this is the conundrum, right? You can approach this from the standpoint of I want increasingly levered exposure to this, and that will allow me to outperform over a short period of time. And I presume that I have the skill to break away from the market when the greater fool theory is about to be exhausted. But if you're holding that recourse leverage, you could lose everything in the process. Let's talk about those yield enhancers or the overlay strategies because I suspect this is probably where things start to wobble a little bit. But how pervasive is the use of this kind of strategy to enhance yields? And who is most actively deploying it? So it's very hard to track.

There are lots and lots of institutional strategies that are not disclosed to the market that involve various forms of. yield enhancement. I know that most forms of private wealth management offer products that they call yield enhancement, which are various forms of selling puts on an investment-grade bond index to modestly enhance the yield, effectively saying I will take double downside exposure in exchange for a slightly higher coupon in current form. These are not well-tracked. Chris Cole and Ben Eifford, among others have made estimates. It is very clearly in the trillions of dollars that is involved in this type of behavior. But again, it's a natural byproduct of an environment in which yields have fallen dramatically in response to fears about securities prices. And that is the second area.

And I didn't talk about this where the central bank influence is quite significant. You know, you effectively have expanded the demand for financial assets dramatically because central banks target asset price stability in their behavior. So the way that they can do that is by cutting interest rates, which raises the price of a bond. When I cut interest rates, it raises the price of the bond. The benefit is not actually that this stimulates borrowing and investment in the economy, which is what the Fed is presuming is the channel that is occurring.

The idea being by cutting interest rates, I make more economic that marginal factory that could be built or that marginal home that could be built. instead what you're actually doing is in levered portfolios, you're expanding collateral. You're increasing the borrowing capacity to buy other financial assets. And so, again, it's a liquidity enhancement that is driving prices higher, driving interest rates lower, and increasing the need for these types of yield enhancement strategies, which in turn are fundamentally providing insurance to the market from individuals who don't know that they're providing insurance.

So obviously we've seen this passive trend. It's exploded as you laid out starting in the early 1980s. There's been a series of regulatory changes that also just sort of encouraged individuals and institutions to invest this way. What are the limits? Like where does it end? And in your view, the distortions that are being caused by it, how far could it go? So I think it's very hard to define that, right? There are limits in terms of the underlying behavior of what gets contributed. And so if you think about the dynamics of buying behavior, ultimately that faces limits in terms of the nominal quantity of dollars that are available to be incrementally deployed. So American savings into their 401ks will only change in proportion the quantity that can be invested by every individual, the amount that goes up every year, and the number of Americans that participate in 401Ks and are employed. It's super low levels of unemployment and very low levels of labor force growth

and relatively high levels of participation, although things like the Secure Act have tried to expand participation even further. I would argue we're beginning to approach the limits in terms of the quantity that can be contributed. There are similar limitations in terms of corporate share bybacks, which are ultimately bound by the earnings capability of corporations. They've taken an increasing fraction of their earnings and cash flow more than 100% because of the ability to borrow money,

which ultimately still has to be serviced and so faces its own limits. But there are limits in terms of how much can be deployed in these types of strategies. On the other side of the equation, most endowments, most Americans through their 401ks need to take actually a percentage of their underlying portfolio. And so that is actually bound only by the price level of the financial assets themselves. And so there is a point at which the outflows

begin to outweigh the inflows, and this should reverse. Where that happens is anyone's guess. What does that reversal actually look like? I mean, you mentioned the VIX exchange traded notes earlier, and some of our listeners will remember the volpocalypse of, I guess it was early 2018 now, and the products ended up sort of impacting the volatility market itself. Is that something that you would expect to happen as these flows start to

reverse? Unfortunately, yes, right? Because the way that markets work is the prices are set by transactions, right? They're a little bit like Schrodinger's cat. They're neither alive nor dead until an actual transaction occurs. The presumption of continuity of those prices that Apple will trade at 225 and then 224.99 is simply an assumption. In the presence of massive flows in either direction, these prices can become discontinuous. We've seen it to the top side over the past four months, basically. The downside could be created when you have outflows similar to what we saw in December of 2018, which had the largest equity outflows in the history of the market. So what do you do in the meantime? If one is an investor, you look at this situation, it seems

unsustainable. The assumptions seem ridiculous. You don't want to play along with this idea of just riding the market or sort of thinking you'll be smart enough to get out a day before everyone else. What are other ways to make money in the meantime that are satisfactory to, if you're a fund, you have investors that want to see their quarterly returns. What makes sense here? Ultimately, everyone's bound by their own capability and their own interest in doing that. right. You may not want to participate this, but you need to be aware that your neighbor may be getting rich while you're not. Certainly my wife would highlight that underlying dynamic. When I see these types of structures, it can be very different, right? When you have an exposure

like the XIV, there were unique opportunities to purchase vehicles that allowed you to profit from that without significant day-to-day involvement. I don't think that's, I don't think that exists. and this framework. What we're doing at Logica is we are seeking ways to capitalize from obtaining non-recourse leverage in both directions, using the tools of finance to purchase products that need to be managed on a continuous basis, but give us exposure to that top side leverage as well as the exposure to the downside leverage in a February 5th, 2018 type of event. So it's, you know, this is a, it's a buyer beware market. If everybody decided to take, you know, my concerns to heart, then that would result in the flows turning

very negative and the markets would crash. Hopefully, nobody's paying attention and they continue to go up. Is it plausible that it deflates quietly, that the, rather than there being some sort of, you know, Tracy used the word of apocalypse earlier, in the end, like the XIV blow up, it was kind of minor and it didn't really have any sort of big spillover ramifications. Is it possible that rather than a volatility blow up, that it ends up being more just like, you know, a helium balloon, 10 days after a birthday party that sort of starts sagging down and it doesn't pop. Or do you think it will pop? Well, what I think has no bearing on what actually occurs, right? But you're here. But I'm here, so I get to pontificate. You know, my belief is that it will pop. When that happens,

I don't know. And as a result, you know, you're forced to engage strategies that allow you to both participate and protect yourself. I think those tools that are available, ironically, people misunderstand many of the tools that they are using. And so those are being provided to me at the lowest cost they have ever been provided in history. I'm actually quite excited about that. And speaking against my own interest here.

No, when you say, I mean, going back to connecting some of the dots here, are you talking, when you say tools that are available to you to protect yourself at the lowest price in history, are these more or less the sort of deep out of the money puts that Korean retail investors are selling to generate yield, depressing the cost of a, you know, a black tail risk insurance? Is that sort of conceptually what you're saying there? No. Okay.

Okay. I have a really simple question, which sort of goes back to the intro, the introductory discussion that Joe and I were having. should someone looking to retire relatively early invest their money in something like the Vanguard total stock fund? So it's funny when you mentioned the fire concept, right? Because you both are relatively young and far better looking than I am. But the, you know, fire pre-global financial crisis actually stood for finance, insurance, and real estate. And it was indicative of a bubble that was happening within a sector of the economy, right? I would argue the idea of a fire movement

in which people seek to remove their human capital from the labor force at an early age is indicative of a, is a clear indication of a bubble. That's an absurd use of a human being to retire at 35 to pursue their own objectives. You happen to have struck it phenomenally rich and, or you happen to be born into dilettante wealth, more power to you. It's a fantastic mechanism and for redistributing that wealth. Let's take the most valuable thing that any human being has, which is their capacity to contribute to an economy

and turn it to a life of leisure at that young age. Like, it's just, it's a stupid idea. Yeah, whenever I read those message boards, that is seem to be a huge issue is boredom. And so people retire, and then they just like, then they're all asking each other what they should do with their lives.

I always, sometimes I fantasize about retirement, and my wife says I would get bored, just tweeting all the time. And I think I would enjoy it, maybe she's right. Having taken a couple of sabbaticals over the course of my career, they can be periods of intense creativity, but you absolutely need to use that

in the prospect of, you know, leveraging that human capital and those insights that you've developed to return to an economy. I just think the entire premise is wrong. Well, Mike Green from Logica Capital Advisors, that was an absolutely fantastic conversation. Thank you so much for coming on all thoughts.

My pleasure. Thanks, Mike. That was awesome. Thank you. Joe, can I just say the notion of you retiring early so that you could tweet even more is very, very worrying to me for many reasons. Obviously, I would miss you on all thoughts, but also it would be so painful. Don't worry, Tracy. I have no prospect of doing that anytime soon. I have two kids under four. So there's no there's no path towards me retiring early to a life just tweeting more. So we'll continue the podcast for a while.

All right. The world thanks you. But I have to say, I found that conversation so, so interesting because as we alluded to in the intro, it sort of touches on a couple big themes. So one is the bull market and how high can valuations actually go. And the other one, of course, is the debate between active and passive management. And of course, we've had all these other episodes with people like Chris Cole, with people like Ben Eiffert, Zoltan Pozar, who's done some work on volatility overlay strategies. and to see all of that come together in one conversation is really unexpected and very pleasing.

Yeah, absolutely. And I really do think that, and I'm struck by, I hadn't, well, I'll say two things. I had not realized prior to this conversation with Mike, the full, like, degree of sort of regulatory changes that we've seen since arguably the start of this bull market in the early 1980s, essentially designed to just make sure de facto that there is this fresh cash being put to work every single month or every single pay period. And also, you know, I have to admit, like, as a member of the financial media, this idea that passive is better, that you're sort of a fool if you ever try to time the market, that you're a fool if you try to engage in your own security selection, like that message, that sort of ideological message, I mean, I largely have bought it. And I'm not saying I agree or disagree with it, but it's certainly one that I think many people in the

financial media practice have really internalized. Oh, yeah. Especially like if you remember the sort of irresponsibility of the late 90s and the way like media was just so like hyped up on individual tech stocks that people got burned on. There's been this major course correction since then it feels like to, you know, not move away from that style of talking about the market. Yeah. But you mentioned the regulation that is shaping some of this and the lobbying. And I find that really interesting. I find Mike's emphasis on incentives.

Very, very interesting. And again, it goes back to some of the discussions we've had about economic models that don't actually take into account the way the real world works. So, you know, if you're buying that ETF, as soon as you put money in, the ETF is deploying that money. That's just like what it does. That's what it's created and incentivized to do. And the idea that that would not,

that behavior wouldn't have an impact on the market. Like it, it seems quaint after that discussion. Two things I think we should schedule for future episodes is one. We should do really examine the fiduciary rule, because that is one of these things that, again, I think a lot of people in the media have just sort of taken as, yeah, that makes sense that advisors should have a fiduciary responsibility to investors to look out for

their best interest, but really sort of examine that story more fully. And we should also have Michael Mobison back on and sort of repress him. It's been a while since we've talked to him on some of these questions about passive versus active. So new territories to explore for us. Excellent. I agree with both those ideas. All right, this has been another episode of the All Thoughts podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at The Stallwork. And you should definitely follow our guest today on Twitter. Michael Green, he's at Prof Plum 99. Very high value follow. And be sure to follow our producer on Twitter, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast. Francesca Levy at Francesca today. And check out the whole family of Bloomberg podcasts under the handle at podcasts.

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