The Breakdown - Violent Reflexivity: Why Market Movements Are More Aggressive Than Ever, Feat. Corey Hoffstein

Episode Date: September 24, 2020

Corey Hoffstein is the founder and Chief Investment Officer of Newfound Research LLC, a quantitative research and investment fund. He is also the host of the “Flirting with Models” podcast.  His most recent research is “Liquidity Cascades: The Coordinated Risk of Uncoordinated Market Participants.”  In it, he examines three popular narratives about what is driving radical swings in markets, including: The increased role of the Fed The rise of passive and index investing The growth of volatility-correlated strategies  He finds that, individually, none could explain the radical market shifts we’ve seen. However, when combined, they create a market incentive loop that is causing markets to move and react to exogenous shocks more quickly and aggressively than ever before.  Find our guest online: Twitter: @choffstein  Website: Newfound Research

I heard for a very long time over the last decade, oh, risk parity is causing these issues, or, oh, it's the trend followers. And again, in isolation, I don't think any of them are the problem, but when you look at this big, massive category together and consider the hundreds of billions of dollars that are in there that are suddenly all having to trade at the same time because they're all taking some sort of volatility contingent trade, all of them are ultimately demanding liquidity when there is none, causing severe pressures on the market, amplifying volatility, and very often in a way that is directional. So when markets sell off, most of these strategies are also trying to sell at the same time, pushing markets further, faster.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the Big Picture Power Shifts remaking our world. The breakdown is sponsored by Crypto.com, BitStamp, and nexo.io, and produced and distributed by CoinDes. What's going on, guys? It is Wednesday, September 23rd, and I am so excited to share this conversation today with Corey Hofstein. Corey is the co-founder and chief investment officer of Newfound Research, which is a quantitative investment in research firm. Corey and Newfound just put out a new paper a couple weeks ago called Liquidity Cascades, the coordinated risk of uncoordinated market participants.

And where it really comes from is a desire to understand that feeling that so many people have that something in the markets is off. The interesting thing that Corey does in this paper is dig into three different narratives, the narrative of Fed intervention, the narrative around the growth of passive and index investing, and the convex nature of hedging, i.e. the liquidity mismatch between market makers and other market participants, particularly around volatility correlated products. What Corey finds is that these narratives individually don't necessarily explain the whole system. But when you put them together, you start to see this incentive loop that could easily cascade, causing the sort of

radical violent sell-offs we saw earlier this year, and which may be, in this estimation, a more recurrent feature of markets going forward. I'm really excited to share this research in Corey's ideas. He's incredibly well-spoken and thoughtful about this, and I think you'll really enjoy it. Without any further ado, let's dive in. All right, I am back here with Corey Hofstein. Corey, thank you so much for joining the show today. Absolutely pleasure to be here. Thank you for having me. So I'm really excited to have you on the show. I've been following your work for a while, but then this most recent paper that you released on liquidity cascades, I thought, was such a interesting way to look at a lot of the different threads that people are pulling on right now to try to explain what we've been seeing in markets all year.

So I'm excited to dig into that. But first, for people who aren't familiar with your work, I know even this is a little bit divergent from what you normally do. So maybe before we get into the paper, let's start with kind of what you have. historically have spent your time on? Yeah, so by background, I'm a quant. I co-founded a firm called Newfoundor Research back in August of 2008, really as a quantitative research firm. And then over time, it's sort of evolved into a more traditional quantitative asset management firm, but really wholly rooted in a purely quantitative view of the world. Everything is statistically driven and really with no appetite for macro perspective. And so this paper, is really a big divergence from our traditional research.

We have for many years written a weekly research commentary that dives into the nuances of portfolio construction and quantitative equity signals and signals in different asset classes, really looking at the historical efficacy and whether they're pervasive across other asset classes. And so for us to tackle something like this, a lot of these macroeconomic narratives that were out there,

it was just a very unique departure. But after March 2020, really seemed like the right time for us to try to sink our teeth into it and try to meld our two approaches of how we think about the world. Yeah. So I wanted to just ask about that. Was it, you know, the genesis of this, how much was it you observing things that were kind of curious that you wanted to explore versus clients asking to you to explain things or some combination thereof? It was definitely a little bit of both. For years, I've had clients of mine. So, financial. advisors and institutions asking me the question, it feels like markets are different with no real tangible evidence as to why. And they would ask me to look into it. And I would say to them, look, of course, markets are different. Markets are always different. It's new players, new technology. Certainly the markets we have today are very different than they were 30 years ago. But I couldn't

necessarily put my finger on evidence that said it was meaningfully different in a way that should justify investing in a different manner. And so December 2018 rolls around and markets seem to behave a little bit oddly. But again, I can't put my finger on really what's going on as to why. And then March 2020 comes around. And in real time to me, what I was seeing was news about an exogenous market event and an economic risk that was driving the markets. But under the hood, all the evidence I was seeing was really about this endogenous liquidity issue that was happening in the market. And so people were making political arguments about whether there was moral hazard with the Fed coming in and different Fed action. And I was sitting there from the perspective that I was

seeing saying, well, they have to really step in and fix these liquidity issues. And there's something fundamentally wrong here. So after March 2020, I said, this is something, there's something I'm missing. There's a piece of this puzzle. I'm sure there's many pieces of the puzzle that every investor is missing, but there does seem to be a key piece here that has changed. What is it? And so for people who read the liquidity cascades piece, all I really tried to do was go out there and look at the existing narratives. So there's really nothing new truly that I bring to the table. These are narratives that have been proposed by many other people. My sole goal in doing this research was trying to go down each rabbit hole of many of these narrative threads. and figure out which ones I had higher conviction in, and then see if they fit together in some way. Yeah, and I think one of the things that the paper does really well is explain how these perhaps are part of a combined set of phenomenon or related set of phenomenon that are sort of self-reinforcing and, you know, kind of connect to one another more than the narratives perhaps give credit for. So we'll get into that, but I guess, you know, to start, let's talk about it.

I mean, you started to kind of explain it with the dating of this. But what is the phenomenon that these narratives are trying to explain? What are the three kind of main narratives that you chose to explore? And just for the sake of, I guess, contextualizing it in the larger conversation, which are the groups that you found tended to be most connected to one or another of those narratives? That's a lot of questions all at once. Yeah, I should have written them down. So I think your first question there was really around, was it the timing aspect of it?

You sort of what the underlying, the big kind of question, the big phenomenon that this is trying to explain. So the big underlying phenomenon was really this idea is why does it seem like markets are moving for lack of a better word faster? Why does it seem like we're getting these rapid selloffs followed by very snapback recoveries and entering what seems to be a very big. bi-modal environment as it relates to volatility? Why do we get years like 2017 where the market has substantially lower realized volatility than it's ever had before? And then how do you get that followed by sell-offs like December 2018 or March 2020? How do these really coexist? And I think that was the core question. The core phenomenon needs to be happening is this bimodal almost Jekyll and Hyde nature of the market. Is this truly being driven by people making fundamental

decisions, either about their economic viewpoint or cash flows of a business, or is there something else at play here that's driving this sort of behavior within the market? And so the three major sort of themes that I heard out there as I started exploring was the first was really about the impact of Federal Reserve policy, whether that was the actual. The actual, policy enacted or the narrative policy that they're putting out there. The second thesis that's out there, and this one, I think the strongest proponent of this is Mike Green at Logica discussing the impact of passive investing in the market. And this one was pretty interesting to me because the more I sort of dug into it, the more it seemed to play out at two levels, both sort of a macro and a micro

level, and we can get into that. And then the third was really around liquidity asymmetry. And a lot of the initial focus there was around the role of high frequency traders and electronic liquidity providers, this idea that they just pull the liquidity rug out from underneath the market, whenever the market needs it. But as I dug in more, there was a more subtle argument that was going on around the sort of asymmetric hedging needs of a lot of players in the market. There's all these sort of systematic volatility contingent strategies that exist that as soon as these high frequency traders pull their liquidation. These other players are stepping in at the same time demanding liquidity. And there's a big asymmetric mismatch there. And what was really interesting to me as I was going down the rabbit hole of research was people who fell into each camp were very, very certain with high conviction that it was that

particular story that was driving the market. And for me, I could never really get behind one particular story. All the evidence for all these stories seems to be circumstantial. But when you start to look at what the ultimate impact is, whether it's the Fed narrative, whether it's the impact of passive investing on the market or these hedging asymmetries that occur, they all ultimately funnel to the same latent risk. And so that's really where the genesis of the paper came from. It basically said, look, I'm not going to tell you which of these ideas I have higher

conviction in, but it doesn't really matter. Because even if you don't believe in the Fed aspect of this, but you believe in the passive aspect, the ultimate impact perhaps is the same. So I think it's really interesting. The way that you framed kind of you didn't have a ton of conviction around any of these individual narratives, although listening to your research, it feels almost like a different way to put it is that these narratives are sort of fundamentally incomplete without understanding the other pieces, that they can only explain so much.

I mean, is that kind of fair? I think that's very fair. I think for me, and maybe we can just use sort of the idea of the impact of the Fed, right? The very basic concept theory. Let's actually, I would love to go through these. So let's start with the Fed. It's a perfect, perfect starting point. So the Fed, right, when you start to talk to people about the impact of the Fed,

it's everything from, okay, they obviously are implementing these policies that are creating stabilization effects in the market, whether that's happening from a microstructure or truly providing liquidity in helping buy fixed income so that the credit markets can function, and that's actually having a knock-on effect to the economy, to, no, there's a Fed put, the plunge protection team, there's someone out there coming in and buying markets, right? It's sort of everything from probably pretty reasonable to a little bit of a conspiracy theory put on your tinfoil hat. But the ultimate idea that stuck for me was thinking about the impact of what happens when the Fed decreases target rates, what does that ultimately do for investors?

What does that mean investors need to do as a response function? And what was really interesting as you sort of think about the different players who are ultimate investors, there's a large contingency of players who have what I would call fixed dollar liabilities in the future, that there's a pension who has obligations in the future, an endowment that needs to withdraw a certain amount, or even individual investors who maybe have their target, you know, 4% withdrawal rate, but that turns into real dollars. And so what happens is when the Fed lowers the target rate and all of a sudden the return you can get on fixed income goes down, if you still have those future liabilities, if they don't also come

down, then what you need to do as an investor is start moving your way up the risk curve to try to earn a higher risk premium so you can hit the return target that'll allow you to meet those obligations. And so the ultimate impact, as I saw, was all of these players in the market are now being forced up the risk curve. The portfolio you could have used in 1995 to achieve a seven and a half percent return was about 100 percent fixed income. Today, it's closer to 80 to 90 percent equities based on most capital market assumptions. So when you think of how the investor portfolios had to shift over the last 20 years because of the market impact of Fed intervention and lowering that discount rate is ultimately pushing everyone up the risk curve, which ironically has a reflexive

effect because as everyone moves up the risk curve, it should in theory drive down those risk premiums forcing them almost further up the risk curve. And so why is that matter? Well, if everyone is having to take on more risk than they're truly comfortable with, either through explicit leverage or sort of just trying to hold on to an asset that maybe has more volatility than they're comfortable with, it means that there's going to be more people who are hitting both explicit and implicit risk limits. That when the market starts to sell off, they're going to have to cut risk, either because they're uncomfortable with sort of the volatility they're taking on or because they quite literally have margin limits and the sort of leverage they've adopted to hit those return targets.

And so it's going to lead to a de-leveraging cycle within the market because everyone's been pushed up the risk curve and out over their ski tips. So I think that this is a, I mean, this is a hugely important point and a really key setup. And part of what I got from kind of listening to you talk, but also kind of reading the report, is it almost is incidental whether you think that the effect of the Fed is from the actual implications of policy versus the way the narrative has pushed or has made people feel more comfortable, they both add up to movement farther out on the risk curve, right? And so it's kind of the, yeah.

Yeah, so that's a hugely important part here, right? Because there's an aspect of this, which is, well, there's a need, right? The investors have to walk up the risk curve. But just because you have to doesn't mean there aren't other ways in which you might be able to hit your liabilities. You might just be able to save more. So what ultimately gives investors the confidence to walk up the risk curve? I think that is sort of the Fed narrative.

There's both the action you can look at. And so there, there's a graph in the report that I took from a J.P. Morgan piece where they plotted a lot of the experimental monetary policy that was unveiled in the 2008 crisis, the speed at which that was unveiled versus the speed at which those same plans were unveiled in 2020. And while they were developed in real time from 2007 through 2009 during the credit crisis, a lot of the exact same strategies were put into place in a two or three week period in 2020. The Fed said, we're not just referee here. We are an active player in the market and we will come in and stabilize.

And so what that does for a lot of investors is it says, okay, I accept I'm going to take more volatility, but I'm also now existing in a market where I. think the Fed is ultimately going to be the backer and the backstop to a market crisis. That's the environment I operate in. And so I'm a little bit more comfortable taking that risk. What was really interesting to me after publishing this piece was the feedback I got, not just from people on the individual ideas, but other people sharing further research. And there's a gentleman who passed me his paper that he had done for his graduate thesis

that was all about quite simply, not even the actually implemented. plans of the Fed, but simply how Fed narrative affects markets. So the Fed doesn't even have to do anything. They can just say they're going to do something. And it actually has a knock on cascading effect to the behavior of the market. So I think there's very real evidence that's emerging that it's not just about the policies that are put into place, but the threat of policies or the confidence that those policies will be there has the market sort of acting. in a way that they know there is a backstop. Yeah, I mean, I think this is absolutely essential.

So there's, you know, Jeff Snyder is someone who talks about this frequently, that the real power of the Fed is in the idea of their power, not the actual flood, you know, of capital that they put in, calls it the flood myth. But then you also have, and this is obviously something that your paper didn't, is too deep even for this kind of relatively deep paper, is the change in how the media cycle perpetuates, this narrative, right? One of the factors that I think was surprising to everyone, however they

chose to explain it, was the incredibly quick response of day traders to the Fed's reaction, right? You had these kind of Robin Hood crowds, the Wall Street Betts crowd, the Davy Day Trader crowd, who were all leading in some ways indicators for where eventually these kind of very nervous storied fund managers would get to. And I don't think it's as clean cut as sort of people had to follow on because of some volume shift or anything like that. But certainly it shows that we're in new territory when it comes to narrative amplification. We have the power of memes. And, you know, like Jay Powell is now a name that's kind of probably one of the most used names on Reddit, which is just a fascinating shift from even 2008.

Yeah, I mean, I think it's hard to sort of disentangle, right, what came first. It's sort of a chicken and egg effect. Did these day traders were they really tuned into the correct narrative, right? Or is it actually possible that these day traders, through their use of short-dated call options, were actually driving the market in some of these names. And I think there's a lot of evidence for that. And we can sort of go into that when we talk about the hedging pressures that occur mechanically in some of these markets. But you are certainly seeing the amplification.

I think that's a great word for it of narrative. And you're seeing central banks become more and more aware of it, that they can have these meetings and these public statements and say, no, we will do whatever it takes without actually having to do anything. And that sends a confidence message to the markets that the Fed will be there. There's an anonymous blogger named Jesse Livermore who has a blog called Philosophical Economics. I highly recommend people read it who just published what is an unbelievable treatise, sort of 90-page paper all about the idea of upside-down markets. And the idea was, why does bad news always seem to drive the market up? And his ultimate conclusion was because we know as a market,

bad news definitively means fiscal and monetary intervention. And so when we get bad news, we're expecting a response that will ultimately be positive for the market, at least on a nominal basis. And so you get this totally upside-down market situation where good news drives the market down and bad news drives the market up because we know there is going to be a corresponding response from the Fed or other political entities. Fascinating. Yeah. I mean, this could be an entire paper in itself. The graduate student who sent you his paper, clearly it is. But part of, again, what makes the paper that you put out so unique is that it combines these different elements. So let's move to the role of passive. And I guess

for listeners who aren't as familiar, this is something that's a growing topic of conversation. You pointed out Mike Green, who's been kind of beating this drum for a while. You have, just a couple weeks ago on Hidden Forces, Dimitri had on the guys who wrote The Rise of Carrie, and there's sort of a lot more of this conversation happening now. But first, could you just set up for us kind of the way that the role of passive investing at a very high level has changed in the markets over the last whatever period you think is relevant? Yeah, and I want to be really careful here and really precise with my language. So the way I'm going to describe this is that there are active strategies and an active strategy where there's an actual fund manager who's buying and selling individual

securities and when they receive a dollar, they can go in and buy whatever securities they want. True discretion. I'm then going to reference indexed strategies. Now the difference between indexed and active and indexed and passive is that an index strategy may actually make active bets, So this might be a systematic value strategy, but it's tied to an index. So these are like your smart beta ETFs. And they're only going to rebalance maybe twice a year. And in between that period, all the weights are just going to drift with the market. And then third, you have truly passive.

And with that, I'm going to reference things that are sort of market cap weighted or at least close enough. So the S&P 500 is not pure market cap weighted, but it is sort of close enough for this definition. What we have seen is a massive shift over the last 20 or 30 years, not only too passive in the adoption of passive, really going from less than 10% of the market to now numbers are showing over 50%, but with that, a huge adoption of indexed, indexed ETFs. So there's been a large flight out of active mutual funds into lower cost systematic indexed ETFs. And at least a lot of the narrative out there has been advisors trying to reduce costs for clients, still create the same active tilts in a more systematic manner.

So they're not relying so much on active manager discretion. The outcomes are more consistent, at least from their perspective, and they're doing it at a much lower cost. So huge, huge adoption of both passive and index, which are arguably, at least if you sort of buy into the Mike Green thesis, having impacts not. only from a macro cross-sectional security pricing aspect, but also on pure market microstructure, how trades are actually occurring is now very different than the way it occurred 20 or 30 years ago. And so I think those two ideas are the two biggest ones that emerge when we talk about the idea of the rise of passive and the impact it's having on the market.

So maybe let's dig into those a little bit. And again, this is, you know, we're kind of skipping stones over the surface. of this lake. So I don't want to kind of drag you too deep into it. But I just think it's very helpful definitionally. So, you know, kind of what are those shifts? What are those ripples? Maybe we'll start.

We can go backwards. We can start from kind of that micro perspective and then move up to the macro. In terms of the impact, you want to switch it around? Yeah, if you're all right, I'd love to switch it around because I think that might be easier. So I think the easiest way to think about this is the idea of the flight from active to passive, that there is a large proportion of people who are saying, I'm done with active, managers. I just want to go to the John Bogle, Bogleheads, three fund portfolio, go pure passive, low cost, and take my free ride on the market. And we have to think about, I think Mike Green's sort of

core logic. And again, I give him a huge amount of credit in being at the real vanguard, I would use that word ironically, real vanguard of this idea out there is that the market, as we normally think about it, his real thesis. is we need to think more about supply and demand and flow than thinking about all these risk premium isolation. So when you think of an active manager, when someone moves from active to passive, ultimately what they need to do is they need to unwind their active trades. And so the simplest way to think about it is if you have an active manager who's buying stocks that is benchmarked to the S&P 500, they ultimately have a set of overweights that they are,

relative to the S&P 500 and a set of stocks that they're dramatically underweight. And what we find when we look at a lot of the major styles, so value or small cap or quality, is that most of these styles are dramatically underweight the mega cap growth names right now. If you look at the top five to 10 stocks in the S&P 500 and it's making up over 30% of the market, it's really hard for a lot of these styles to be overweight those names. They're just intrinsically underweight. And so when someone wants to move from active to passive, they need to unwind this trade. And so what they're doing is they're ultimately selling down those smaller value names and having to buy back those mega cap growth names.

And so if we think of this as sort of a large shift that's occurring, either because it's people are throwing in the towel that they're tired of active managers and they're feeling like they want to go to a lower cost passive strategy or, Mike suggests that it's very demographics driven, that a lot of the active funds are held by an older generation who are in withdrawals where younger generations tend to be allocating to robo advisors like Betterment, where they're getting more passive. So you sort of get a demographic shift in money. You're ultimately getting this unwind of a trade that you're selling down these small value names. You're buying up these mega cap growth names. And that flow demand is ultimately going to continue to drive up the prices of those. those mega-cap growth names versus those small-cap value names, which is what you've seen over the last decade. Now, a lot of people are asking, well, why hasn't this happened? You know, passive has been

really taking off for the last 20, 30 years. Why is this not been something we saw for the last 20 or 30 years? Why is it something that's really only emerged and seemed to have accelerated in the last, you know, call it 10 years? And I think what the argument there would be is that you have to sort have reached that critical inflection point, that there needs to be sufficient change in demand and supply that once you get past sort of passive being 20, 30, 40 percent of the market, that marginal demand coming out of active and impassive becomes much and much more influential. Got it. Okay. So how does this play out in the context of these extreme moves? Because a lot of what you're exploring is when things start to turn quickly and how these factors combined,

you know, really, really add up to something, you know, greater than the sum of their parts in not necessarily the best way. So ultimately what we're doing is we're taking money out of the hands of managers who are making individual security selection decisions and pushing them into an approach that is just mechanistically buying. And when we think again about this from a flow perspective, if I put a dollar into a passive fund today and you put a dollar into a passive fund tomorrow, your dollar is going to be buying marginally more of those securities that outperform today and marginally less of those securities that underperformed today. So from a flow perspective, that trade as new money is coming in is a momentum trade. And momentum inherently is a very divergent

concept, things that go up, keep getting pushed up, things that go down, keep getting pushed down. And so it leads to extremes. When you compare that to, say, money flowing in and crowding a value strategy, that's a convergent approach where everything that goes up gets sold down when it's above fair value and everything that goes down, gets bought up by the manager. And so when you get crowding, you would actually expect a compression of relative prices between securities versus what you're going to see with a crowding and momentum strategies is a huge divergence. And then as soon as there's any sort of exogenous shock, you're going to see a large collapse because none of that is really supported by fundamental value that's there.

And so what you're seeing is a movement from money in convergent strategies into money in divergent strategies, potentially creating a large ripple in how the cross-sectional behavior of securities actually exists in the market. So, I mean, put simply with more money moving from convergent to divergent, you're going to see these sort of cascading events be amplified, happen faster. I mean, I guess one question is, do these, does this shift actually increase the likelihood of these types of events? Or is it more about how the markets respond to them? Well, I think it's, if you look at this piece in isolation, right? And we're not going to, and we don't talk, sort of touch on the microstructure.

I don't think you would say necessarily that this is going to cause large cascades in the absolute value of the index level necessarily. It might, right? If there's more money plowing into these mega cap names and driving them up and they're leading the market, you might see, again, the market drive up. And then as soon as there's an exogenous shock and people start withdrawing their money and you get the unwind of this divergent event, it could certainly cause things to crash down. But I would suggest in the short term, I think there's more impact on cross-sectional security pricing. Why, perhaps, the small cap and value continue to systematically underperform when it seems like from a relative valuation basis, it's so cheap. Why is there not more money piling into that strategy? And I think a lot of the argument that Mike Green proposes is ultimately it's this flow-based argument.

And so we're going to continue to see cross-sectional ripple effects. So early June, I think was a great example. People probably remember in the first couple days of June, the market jumped and then sold off. And from a total market level perspective, it really wasn't that big a deal. But cross-sectionally within the market, you saw a spread between value and momentum that exceeded 30 percentage points in a couple of days. It was an unbelievable unwind. And so if you think that there are going to be levered players out there who are trading long,

short equity and getting caught up in this. Well, from that perspective, all of a sudden, you might start to have hedge funds that are being forced to unwind all their positions, stretching out this performance, this volatility between securities that's being caused by a move from people participating in convergent strategies to more money participating in divergent strategies. What's going on, guys? I'm excited to share that one of this month's breakdown sponsors is crypto.com. Crypto.com offers one of the most cost-efficient ways to purchase crypto out there, as they've just waived the 3.5% credit card fee for all crypto purchases.

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it doesn't matter whether we're talking about active or passive. It's really more about the idea of going from active to indexed. An index can be passive or index can be smart beta. And here the whole core idea centers around what happens when you give a manager a dollar. So let's pretend for a moment that you are an index manager. So you run a smart beta ETF. and I'm a traditional value manager. Someone gives me a dollar.

I'm going to look at the securities in my portfolio and say, well, which ones do I think are undervalued? Or what's on my watch list? How can I put this money to work in the way that I think is going to maximize the impact of that dollar for the portfolio and buy what I think is most undervalue to get to my portfolio to where I want it to be from a total characteristic perspective? So I'm going into the market and I'm creating demand,

ideally for a specific set of securities or specific security. When someone gives you a dollar as an indexed manager, all you're doing is you're going out with absolutely zero regard for value and simply saying, I want to buy up a basket of securities that are ultimately the constituents of my index. And I actually want to do it as cheaply as possible from a market impact perspective. So you might argue you sort of know the price of every. but the value of nothing. Now, it's interesting to think about this from the perspective of, okay, let's say I am, again, a value manager and you're a value index, right?

Well, what's happening between index rebalances? Well, every time someone gives me a dollar, I'm doing the same thing. I'm going out and trying to buy that individual security that I think is undervalued. Between rebalance points, you are purely drifting with the market, right? So if you're the Russell 1000 value that rebalances only once a year, someone gives you a dollar in June, you're just going to put that dollar to work and buying the weights as they've drifted. And the person who buys the day after into that index is again going to ultimately be implementing a momentum trade. Because compared to the day before, it's all about the way those weights have drifted, which will now overweight the securities that have relatively outperformed and underweight the securities that are relatively underperformed. So between rebalances, all of these index products are ultimately implementing a momentum trade with respect to new flow.

So if you have all the money moving from active and moving into purely index strategies from a micro implementation perspective, again, we're moving very much away from convergent trades where I'm being very specific about the securities I want to buy into a divergent implementation. And so what I think is interesting here is a lot of the evidence that's starting to come out is suggesting that the move to ETFs and indexed basket trading is eliminating security efficiency. That when a market maker is only buying securities in a basket and we're eliminating the number of participants that can individually value in price of security, we're starting to create information linkages between securities. That securities are no longer trading, basically.

on their own relative value, but they're trading only on the idea that they're included in a certain basket. And so it's making the pricing structure of those securities less efficient. And we have to consider then what happens when we eliminate all these active managers who are adding friction to the order books of these individual securities and trading it now only to these market makers who are operating in baskets at the top of the order book. What happens if those market makers disappear? Or they get a completely asymmetric trade that they are now all becoming buyers or they're all becoming sellers because of market pressure. And there's now no one acting in the order book to try to value these individual securities.

Well, you can get these cascading effects because there's no more friction in the order book of these active managers willing to step in. So, I mean, this is really interesting. This is a weird way to put it. But in some ways, it's almost like the problem of the rise of passive and the rise of indexing isn't so much the rise of passive and the rise of indexing as much as the relative lack of active managers to act as a hedge when these distortions start to happen almost. Absolutely. And look, I think everyone recognizes that a fully passive market cannot work.

Someone has to step in and price securities. The real question becomes, well, how much do you really need? How many people have to be acting? And I think the core idea here, and this is a big switch for me was I would have told you a year ago, or two years ago, that without a doubt, a value ETF is active. I would have said it makes active bets. When you compare it to the S&P 500, there's clearly tracking error. It's clearly overweighing undervalued names and underweighting overvalued names. Clearly an active strategy. I think the light bulb that really went off for me in this research was thinking about the way it's implemented from that trading perspective, that when it rebalances, it will create demand pressure on the market to implement that active trade.

But once the rebalance happens, all the money that's in that ETF is now just supply that's been removed from the market. And all the new flow will implement that trade to a certain degree, right? It's creating those active bets, but those active bets are evolving over time in a way that's being driven by market momentum. And so when you think if we were to say, okay, what we're now going to do is eliminate all discretionary active managers and move now the definition of active is these index smart beta ETFs and pure passive. Well, now we really don't have anyone operating at the individual security level. It's purely operating at the basket level. And in between rebalances, all of those baskets are a pure momentum drift trade. Super interesting.

It's like a lot of accidental divergence strategy. accidental momentum strategy, seems to be kind of at the core of the switch. Exactly. Yeah, which would help explain why it's been able to get there. It's harder to see things. I mean, it's a classic kind of frogs boiling in the pot situation where it takes a while to understand what's going on, you know? Well, and I think, again, what's hard to pinpoint is what's actually causing this.

Why, for example, are people moving from active to passive? I have heard people say, well, look, this is, you know, I don't believe in active all the evidence suggests he can't overcome fees, we want to move to passive. I've had people say, I just have fee pressure from my client. I need to reduce costs. I'm moving from active to smart beta. That people say, look, I don't believe in the discretionary of active managers, but I believe in value as a style. I'm going to move to smart beta. And so what I think becomes very difficult to pinpoint, because all the evidence is so highly circumstantial, is how you think about your confidence in these individual anecdotes. Well, is it that people, you know, is it

Is it the flow from active to passive that people are reading the SPIVA report and that's driving it? Well, that might not be sufficient in and of itself. But when you start to consider all the reasons people might move from active to passive, right, even regulatory pressures of the threat of the DOL proposed DOL rule that came out in 2015, that ultimately said, you're going to have to defend your high cost mutual funds potentially. Well, that I know for a fact, speaking with advisors I work with caused a lot of them to move to lower cost indexed and passive funds. But that may in of itself not have been sufficient. But when you start to think of all of these things in conjunction, well, even if they're all contributing just one fifth

of the cause, in combination, it leads to a massive flow. And so to your point, what's very hard to pinpoint here is the reason. And I think that's why this has sort of been a very evasive topic for a lot of people is because I don't think there is one the reason. I think there's a lot of things happening coincidentally that's causing the same ultimate impact. Super, super interesting. Okay, so like I said, I think this particular discussion is something that's obviously rising. There's more people paying attention to it.

And it's clearly incredibly important. But there is a third leg of this stool in your argument. So let's move to that. As you said, it kind of started with high frequency trading, but it didn't really stay there. It's more about liquidity mismatches. Yeah. You know, what was interesting to me is when I went down this,

these different rabbit holes, high frequency trading was one that everyone would seem to be very convinced of was a problem. And as I started to go down that research path, I sort of very quickly went, I don't think this is the big problem people think it is. So the argument basically is, look, every time there's a market sell-off, we see a huge reduction in liquidity. You can look at any order book, and that's absolutely true. And the theory is basically that we don't have the proactive requirements for market makers to supply a certain amount of liquidity. And so when markets become dislocated, they protect their business by pulling some of that liquidity. And I certainly think there is an aspect of that, right? Market makers are not charities. They run a business. They need to protect

their risk. When risk limits start getting hit, they're going to withdraw liquidity. So I think that is just a fundamental aspect of making markets. But I don't think that's any different than it was 30 years ago in an open outcry pit. When things get weird, people step back. You saw the exact same thing in 1987. So I don't think that is a new aspect of markets. And I think what you see is that some of these market makers do want to provide more liquidity. What just happens is they tend to be capital constrained. A lot of these market makers operate on a huge amount of leverage and they've posted collateral via a lot of the securities they hold on their book. And so when the market starts to sell off, a lot of these market makers become collateral constrained. So I think it was around March 20th,

March 22nd this year, Virtue Financial, one of the largest market makers out there actually put a note out saying they were trying to raise a couple hundred million dollars so they could keep providing liquidity. It wasn't that they didn't want to provide liquidity. It was just that they were quite literally capital constraint. And so I think this idea that's out there of market makers are sort of a vampire are on the market and it's not all that great and they're pulling liquidity. I think the reality is what's more likely is that they seem to be very capital constrained in these market sell-offs. It's something that has always existed. People are going to protect their book. I don't think that's been a fundamental shift that's occurred over the last 30 years that's making markets

behave differently today. So I introduced that in my piece, but I sort of dismiss it very quickly. other than to say, yes, the liquidity disappears, but what's new today is this huge emergent of volatility contingent strategies that now demand liquidity at the exact same time. And this is something that maybe didn't exist 20 years ago. And here, I need to really give a round of applause to guys like Christopher Cole at Artemis or Veneer Bonsali at Longtail Capital and Ben Ifer. at QVR who have done a tremendous amount of work and sort of highlighting these different strategies and how they can have an impact on market liquidity when markets begin to sell off.

So maybe we could just do a quick primer on what those types of strategies are and how they interact with this sort of moment where I think the way that you put it is they further demand liquidity when there is none, basically. Yeah. So there is this whole sort of category of strategies that I will call volatility contingent. And I will keep that sort of a vague word, because some of them are explicitly tied to volatility. So what we've seen over the last decade, for example, is a huge adoption of institutions introducing covered call selling to try to generate yield and harvest that volatility risk premium. Some of them have adopted put underwriting type of strategies. So that's very explicitly trading volatility. You then have a large

rise in strategies that are volatility targeting or volatility capped. So things like risk parity, CTAs often operate with a volatility target, but a lot of the variable annuities that are out there also have some sort of volatility cap or volatility target. This was sort of a regulatory pressure that occurred after 2008 when a lot of these insurance companies recognized that uncapped, they had a huge amount of risk on their balance sheet from what was going on with these indices. And so a lot of them adopted volatility targeting strategies that will de-risk these variable annuities whenever volatility picks up in the market. You then have a whole host of structured products that have sort of, I don't know, a better word for it other than shadow volatility that's in there. A lot of these actually are from around the globe.

So a lot of auto-callable products in Asia and Europe that we often don't think about but are getting head. in a way that ties back to the US options market. And so all of a sudden can create huge demand and hedging pressure for S&P 500 options, which has sort of knock on hedging effects within our own market. And then even things like just trend following strategies. We've seen a big adoption of trend following strategies within the retail space. Things just like get me out of the market when it falls below its 200 day moving average may not be tied to volatility. but is volatility correlated in the sense that markets tend to fall off when volatility spikes.

And so what we find is a lot of volatility correlated strategies. And so for me, again, going back to changing beliefs, I heard for a very long time over the last decade, oh, risk parity is causing these issues or, oh, it's the trend followers. And again, in isolation, I don't think any of them are the problem. But when you look at this big, massive category together and consider the hundreds of billions of dollars that are in there that are suddenly all having to trade at the same time because they're all taking some sort of volatility contingent trade. All of them are ultimately demanding liquidity when there is none, causing severe pressures on the market, amplifying volatility,

and very often in a way that is directional. So when markets sell off, most of these strategies are also trying to sell at the same time, pushing markets further, faster. So, I mean, you basically have, it sounds like a lot of this story is people are kind of set up and leveraged in a way such that when one of these shocks happens, you have some meaningful percentage of them that are just, that the trade is absolutely going to be the same because there's no option. And that happens at the same time as the people who could be providing liquidity into the system are running the opposite a direction and it just kind of creates this total mismatch that leads to the sort of rapid moves that we've seen. Absolutely. And this sort of ties nicely back to the very beginning of the

discussion, which is, okay, why has there been this huge adoption of volatility contingent strategies? Well, if you're being forced up the risk curve, right, if you can no longer hold bonds, but you have to hold equities, wouldn't you prefer to hold equities in a way that you think can de-risk you? Maybe it won't get you out after first dollar, but can you, can you, can you buy equities with a put option? Can you buy equities with the trend following overlay that's going to get you out rather than just buying equities and moving up the risk curve? And so what you've sort of seen, in my opinion, is as people have been forced up the risk curve by Fed policy, by reducing those target rates, reducing the return they can get on fixed income, forcing them up the

risk curve, they've adopted a whole host of strategies that are ultimately taking the same trade. in different ways, but ultimately creating the same pressure on the market. And so when you get that exogenous shock, when things are, are seem fine and all these strategies sort of are creepingly increasing their leverage, and then you get a shock like the corona crisis that all of a sudden markets sell off and hit all these systematic and mechanical triggers for these products to de-risk, everyone flees for the exit at the same time and ultimately causes this massive cascade of selling into the market. that drives volatility way up and often puts pressure directionally in the market.

So I think this would be a good time to just almost recap this in the context of what was figure one in this document, the market incentive loop. I'll share the screen. I'll have our editors edited into the video, but just it's probably easier for you. So I'm going to share this just so we can go through it. And for those of you who are listening on audio, this will be up on YouTube as well. Can you see the figure? I'm with you.

Okay, cool. So what ultimately emerged from this piece for me, again, was there were all these different narratives and people in the camps of each narrative were very certain that it was their narrative that was ultimately causing this, for lack of a better word, weird behavior in the market. And what I saw was really more of this loop.

And when this loop started, I think is debatable. I talked to some people that think it really started in the late 90s. I think it was sort of accelerated in 2008. But ultimately, what you have is it sort of begins arguably with the Fed intervention and Fed policy that ultimately suppresses rates and Fed narrative. And what that does is it moves you sort of to this, what's called the Fed Eden, and calls it the recruitment channel, that by reducing those rates, it forces investors up the risk curve and Fed policy and narrative actually gives investors

the confidence to move up the risk curve. And so all of a sudden, all these investors are taking more risk. Now, one of the other trends we've seen over that period is as returns are harder to come by, people are more fee sensitive. You've seen this movement from active to passive, that people are a lot more performance conscious, a lot more fee conscious because those returns are a lot more important to them. you've seen a migration from within active to other active from a benchmarking perspective. You've seen it from active to indexed and you've also seen it from active to passive.

And a lot of these are creating cross-sectional ripples within the market of security pricing in a way that seems to be untethered from fundamental value. And you also see it from a market microstructure perspective where no longer do we have a market that's truly operating in a way that investors are buying individual security. based upon value, but now everything is done as a basket trade, that you buy your turnkey portfolio that's built of a set of ETFs. Those ETFs are all built off a basket of securities, whether indexed or truly passive, and all of those flows are ultimately implemented in a manner that's creating a divergent trade with really no consideration for what value is. None of this really matters

until there's some sort of exogenous shock, right? This can all sort of operate in peace, But once there's an exogenous shock, what we find is that a lot of the liquidity providers in the market, which seems to be a more and more concentrated set of parties, is being forced to pull their liquidity, both to protect their business, but also because they seem to be capital constrained. At the same time, in walking up the risk curve, a lot of investors also introduced volatility contingent strategies. These are things like selling covered calls to try to earn some return premium. These are things like target volatility indexed annuities, risk parity trend following. All of these strategies tend to try to de-risk at the exact same time when volatility goes up. And in doing so, puts further pressure on the market going down and further pressure on driving volatility up.

And in a very pro-cyclical way, it sort of becomes an arms race as to who can get out of the trade faster, and it has knock-on effects to other strategies. And this sort of spirals out of control, much like we saw in March, until the Fed steps in or certain of those strategies have sufficiently de-risk, like we sort of saw in late March, a lot of these strategies were either already de-risk, so there was no more selling pressure, or a lot of the options started to roll off in late March in a way that sort of burned off a lot of the hedging pressures from the dealer community. you have the Fed simultaneously step in and all of a sudden order is restored. Now, I think what's really interesting is the question of what stops this loop?

Was it was enough risk burned out of the system in March? And I think there's a lot of sort of macroeconomic debate you can get around what ultimately stops this loop. I think what's really interesting is to consider almost the alternative. Is this loop going to now accelerate? In my conversations with a lot of investors, the large concern has now turned to the the role of fixed income. Not so much this idea of a death of a 6040, but just the very realistic recognition that when you have 40% of your portfolio in an asset class that's returning less than 1%, and you're a financial advisor charging 1%, that becomes a really difficult

conversation to have. And so a lot of advisors that I'm talking to are now beginning to look at strategies that are volatility contingent in nature. They're looking at a lot of these buffered ETFs that have come to market, where you're selling a call and buying puts on the downside to try to lock in a defined outcome. Or they're talking about moving up the risk curve and buying lower quality fixed income. All of these things, in my opinion, are part of the same larger trade that is going to continue to put more and more pressure on the system because you're going to create more and de-risking and de-levering occurring at the same time. Yeah, I mean, I guess that was my next question is, does the recognition of this incentive loop lead people to take on trades that would

break the loop or take on trades that have the impact of, you know, accelerating it in some ways or increasing it or making it even kind of more powerful? Awareness is a really interesting thing because it brings about reflexivity, right? So if you're aware of this loop, the question is, all right, how do you profit from it? And I think the really difficult aspect, there is a question of where does your confidence lie? Do you believe the Fed will always be there and always backstop you? Well, if so, if you have a sufficient horizon, you just might want to take on as much leverage as you safely can buy some global equities and close your eyes, right? Because if you think the Fed's always going to be there to backstop you and you're just going to ultimately have

more and more people demanding higher risk assets pushing those prices up absent of any sort of valuation analysis because they're forced into the trade, that's going to work out in your favor. But if you are concerned that the Fed is ultimately not going to be able to, you know, prevent true economic gravity from taking hold at some point, well, that trade can really work against you. So I think it's really a question of where your confidence lies in this loop, right? You can sort of believe in the loop as a whole and say, well, you want to know what? I think the loop as a whole works, but I really believe this piece about,

The mismatch of liquidity is the big aspect here, that all these people are being forced to deliver at the same time. If that's the case, how can I be a liquidity provider, right? Is it simply as simple as I'm just going to spend more money on put options because I think the market is mispricing the amount of rapid and sudden selloffs that are going to occur? And I want to be someone who has capital available at that time to buy. Or is it simply, I think these rebounds are going to continue to happen. and so what I ultimately want to do is be implementing mean reversion trades.

So I think the answer is ultimately in how you want to play this is highly contingent on which aspect of the loop you have the most confidence in and how it plays ultimately into your overall investment plan. Interesting. What has the response been since you put this out? It's been a little over a couple weeks now, right? Yeah, I think we're going on our second week. And I really, as I said, this is a very uncomfortable piece for me to publish.

was very different than what I had published in the past. So I had sort of put it out there to 20 or 30 people that I felt very confident in getting their response. And I think what's really interesting is a lot of the response has been this is giving sort of a comprehensive view to the feeling that a lot of people were having. Just this feeling that something fundamentally is wrong in the markets. And so they're sort of attaching to this narrative and saying it's, I don't I don't have to ascribe to Mike Green's philosophy. I don't have to ascribe to this philosophy from Christopher Cole about these volatility contingent strategies.

I can look at it as all sort of the big same thing, the big same effect. And so I don't have to have confidence in any one of these things. I can just sort of say the whole system is fundamentally now designed for these sort of rapid ramp ups and rapid sell-offs. So overwhelmingly, it's been a lot more positive than I would have expected because I think there was already that feeling in the market that something was wrong. I will say probably some of the most interesting feedback has been when you get an expert in a particular narrative, they either feel like their narrative is being undersold, right?

People who really believe in the Fed strategy are going, well, you're not given enough credibility. These other ones aren't that important. Or I will certainly say there's been a lot of people who are part of the ETF community who say, no, you're totally misrepresenting it. Your discussion about these index products is overblown. So, you know, again, I think what you're always going to find with all of this research is that there are people, who are going to believe in the individual components, but I think what was really important to me here was saying, I'm not going to tell you what I necessarily do and do not have conviction. And that's not

even the important part, because even if you remove one of these pieces, the whole loop still exists, right? And it's not that one of these pieces is necessarily the driving element. It's that they exist in conjunction. And so it's not just circumstantial evidence for one of these ideas. It's all the circumstantial evidence combined that ultimately points to the same latent risk factor, that people are being forced up the risk curve and everyone's being forced to de-risk at the same time, pulling liquidity from the market when people really are seeking it. That's ultimately causing this very weird behavior. Yeah.

I mean, I think what was so interesting about it to me and appealing about it to me is a lot of, you could follow the flow of this loop from a kind of common sense perspective while reserving your debates for, to your point, the specifics of which, you know, kind of factor is overweight or underweight relative to explanation. But, you know, it's hard to argue that people have been moved farther out onto the risk curve. And you could debate all day whether that's because of actual policy or perception of policy, but the functional reality is the same, right? The, you know, kind of the difference in what you'd have to do from a kind of a risk perspective in 95 versus now, I think really sums that up. And so then if you have a mechanism by which that

gets amplified through kind of crowding around these divergent trades. Well, that probably exists too. Maybe we can debate, again, exactly the extent of it, exactly the kind of the problem, whether we should be more concerned or less concerned. But it's still, it's an observable reality. And I think it's hard to have conversations. I mean, a lot of this comes down to for me, and I think for you, too, the fundamentals of a market are about hedges taking the pain of certain strategies out and leveraging them to get

some amount ultimately of stability. And if everything is kind of going the same direction because of these forces, that power, those guardrails, those buffers are threatened, right? Yeah, I think for me, to summarize really the whole piece was trying to look through a lens of the markets that's ultimately about supply and demand. If I were to really try to put it into one core idea, it's, I'm not talking about the market is, is it overvalued, is it undervalued? Is Fed policy right or wrong? Quite purely, I think all of these ideas come back to the core concept of what impact

do they have on market supply and market demand and when is there a meaningful mismatch? Either a mismatch that is building over time slowly and is bound to explode or a mismatch that occur sort of instantaneously because of these different pressures. And I think for me, what I found is, again, it doesn't matter which of these narratives you look at, which one you have more confidence in, which one you have less confidence in. It's all creating the same supply demand mismatch that ultimately seems to be playing out when you get some sort of exogenous shock like we saw this march. What are you now watching going into the fall, going into election season,

going into potential COVID flare-ups, more lockdowns, you know, kind of within this framework, you know, what are you paying attention to? Yeah, so again, my personal view has never really been one where I have a huge appetite for macro. And that's not because I don't think it can be hugely important. It's just not how I personally feel comfortable in interpreting markets. What we've really been spending a lot of time on is trying to build out models that can try to identify these liquidity points.

So for example, looking at option dealers and saying, how are they currently positioned? How are they going to have to hedge if the market moves up or down? And if suddenly the market moves down 5%, and they're all of a sudden going to have to hedge in a very large manner that's going to be liquidity demanding, well, that's important for us to know. Similarly, what's happening halfway around the globe in Asia with the type of structured products that are in demand. From a macro sort of trend perspective, what we're trying to look at is where a lot of investor flows going. Are we seeing people moving away from covered call strategies, which would be, I think, very important in terms of unwinding some of this liquidity demand. Are we seeing investors in Asia moving away from these structured products? So those are sort of the more slow moving trends we're looking towards.

But sort of in the short term, it is more around can we identify these liquidity hotspots? and the potential risk that they will introduce to a portfolio and not necessarily front run those hotspots, but try to make ourselves aware of where they are so that if the market starts to unwind around them, we have a better perception of what's actually occurring rather than whatever sort of macro narrative there is out there. I guess that makes sense, right? If you kind of look at this loop as the functioning of the system that's going, that any sort of macro shock, any macro event is going to get.

fed into looking at the parts of the system, the actual parts of the plumbing that are likely to be the kind of pivotal points makes a lot of sense. And I think that's a really important point, right? Because I don't want to dismiss the ultimate impact of the macro. I think what I'm talking about here is sort of the way in which the market can become this tightly wound loop and everything can be hyper levered and everyone can sort of crowd to one side of the boat. And it can remain very stable in that manner. I would argue 2017, for example, saw a continued increase of leverage among people who were doing target volatility strategies. And it worked out very well for them. You can have a lot of stability for a long time in a very self-reinforcing way. But once you get that macroeconomic shock,

you can get a very violent unwind. So it's not that we can't be aware of the macroeconomic shocks. I just personally don't feel like I have any particular edge in figuring out which of those macroeconomic shocks is going to cause the unwind. So for me, what I'm ultimately trying to do is figure out how tightly wound up we are in the loop and how likely a macroeconomic shock will cause a violent unwind. Well, Corey, this is really, really fascinating conversation. I love this work. For people who want to follow along with what you're thinking about, what you're putting out,

where can they find you? Yeah, so if they want to access the paper, they can go to our website, thinknewfound.com. If you want to track me and sort of the things I'm thinking about with the rest of my team, I am on Twitter at C. Hofstein, that's probably where you'll see most of the release of our new information. Awesome. All right, Corey, well, thanks so much for spending some time today, and we'll check back in soon. Absolutely pleasure. Thank you so much for having me. In 2005, David Foster Wallace gave what became an extremely famous commencement speech at Kenyon College. And he started it with an anecdote. There's these

two little fish swimming along, having fun, when an older fish swims by and says, Morning, boys, the water's beautiful today, huh? The two little fish look at each other and say, what the hell is water? The central crux of that aphorism and the speech that followed it is that the context that we find ourselves in day in, day out, is in many ways the hardest to disentangle ourselves from to actually observe and understand rationally. In other words, the reality that we live in becomes almost impossible to analyze objectively because of our familiarity with it. After we ended the conversation, Corey and I were talking a little bit more, and he was talking about one of the funniest, most interesting critiques he's got on this paper,

which is someone from Reddit saying, this is so obvious. And what Corey said to me is that he kind of agreed that when you separate yourself sufficiently from the narrative, the way that these systems interplay with one another begins to feel pretty kind of clear and obvious. The problem is just that we live in it so much every day. We live inside the context of being pushed out further on the risk curve. We live around advertisements for betterment and wealth front and reduced fees as just the norm, right? All of these things have become so much the reality of market participants, that trying to see it as a system separate from ourselves and then analyzing it becomes really difficult.

There is, of course, another famous aphorism that refers to this phenomenon, which is the frog being boiled in the pot for so long that it doesn't realize it's being boiled until it's too late. Hopefully, by having research like Corys that puts a spotlight on how these systems work, we can avoid the fate of the frog, we can recognize the water around us before it's too late to get out, or at least turn the temperature down in some way. With that, I think I'm done trying to make lots of a aphorisms make sense in the context of a financial podcast for today. I appreciate you listening, and until tomorrow, be safe and take care of each other. Peace.