The Dividend Cafe - Index Funds as Weapons of Mass Destruction

Episode Date: September 25, 2019

Topics discussed: Our investment committee creates this podcast for you to tackle a variety of issues pertinent to investors. The mass increase in the popularity of index funds is the latest topic, only we don’t do it with the dryness and academic focus many advisors may pour on this topic. Rather, we delve into the subject of index funds with a view towards what matters to investors, where risks may actually exist, and what we believe can be done about it. This is worth your time to listen to or view! Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe podcast to summarize kind of this week in the market, update you on Fed, trade war, all sorts of things. But right now, we're going to take another particular topic. You may recall the last time that we all got together where I was sitting here, we talked about this debate between passive and active investing, what it means at the Bonson Group, how we approach the subject. And we want to continue in that theme of taking different topics that we think are important for investors to understand and allow our investment committee to have kind of a live discussion around those different topics and see if it might be something that our listeners benefit from, a chance for us to

share our particular philosophies around different topics. Sometimes we'll have dissent amongst the five of us on a given issue, but we'll kind of podcast our way through different issues. And today we have a particular one that we're going to go through. And that issue, that topic, will be the role that index funds are now playing in the market. And there's going to be a whole lot of different angles, nuances we can approach. But first let me bring in the whole team here, our investment committee. I'll start with Brian Saitel sitting on my left. Brian, how was your weekend?

It was fantastic. Thank you. Yeah. Nice day of football watching yesterday with the family, so can't complain. Pretty good day of football. Julian, welcome. How are you doing? Good, thank you.

Very good. Did you watch a you watch football yesterday? No football for me. I watched the Rugby World Cup, but it's like in Japan, so it's like a terrible time, like midnight, 2 a.m., so I can't really watch it. I just watch the summary after. Yeah, I actually, at midnight to 2 a.m., was doing the same thing I would have been doing if I had been watching rugby and not sleeping, so it worked out just fine. Dea, welcome. How are you doing? Doing good. What did I do over the weekend?

Oh, I had- It's never a good sign if you don't remember. I had my last sailing lesson. It was supposed to be my last sailing lesson, but the instructor said I wasn't good enough and I have to take another sailing lesson. It's good to find that out in the classroom first, though. Truth telling.

So I'll get that. I'll be able to charter those waters in no time, but not until the next lesson. My only request is that you remain a better trader and analyst than a sailor. You don't want your investment team being real good at sailing. Well, that's why. It's because I was doing so much investing and analytics, I didn't have time for the sailing.

There you go. I'm joking. So clearly, clearly. I always encourage clients to check out my handicap because if they're ever worried about me spending too much time on the golf course, they'll quickly realize. But I've played with you before where I was a little worried,

like, oh, Daya's a little too good at golf. That's not a good sign. And then I played another time where I'm like, no, he's like appropriately like mid-level, you know. Daya's golf game is like a guy who's a good golfer who doesn't play that much anymore. Is that a fair way to put it? Yeah, that's perfect.

And my golf game is like a bad golfer who doesn't play that much. So it all works out. Me too. Robert, how are you doing? How was your weekend? Hey, it was good. I just thought a lot about index funds, actually. Did you really? Yeah. I've thought about it a lot for many, many years now, and we're going to kind of set

the table a little so clients know what we're talking about. The debate is actually not a repeat of what we just talked about a couple weeks ago, which is passive investing. But of course, index funds essentially are a way to go capture passive investing. And so you could either use what's called an ETF, an exchange traded fund, which is a stock that is a basket of stocks, a basket of securities meant to replicate a given index. And it trades like a stock on an exchange. You get more favorable tax treatment, you have intraday liquidity. There's different pros to it, generally low expense structure, things like that. And then of course there are index mutual funds, which have been around a very long time.

Vanguard was a huge kind of pioneer in this space, and they would really trade and function exactly like a regular mutual fund. You're going to get the pricing at the end of the day, and you're going to buy or sell at the closing day's price. It gets taxed the same way a mutual fund does. And so there's pros and cons to that as well. But what we're not meaning when we bring up the topic today of index investing is the pros and cons around being passive in a given asset class, which I think we really well covered and kind of talked in our strategic versus tactical discussion a couple weeks ago. What we more want to talk about is the possibility, Brian, I'll start with you, that the market itself and an investor's experience in the stock market is theoretically going to look a lot different because of the fact that there's so much more index ownership, that there is such a massive volume. It's $5 trillion, an okay number to use.

Something like that, yeah. That the index is going to do. Obviously, you can round up or down a little bit. Obviously, you can round up or down a little bit. But more or less, when you and I entered the business close to 20 years ago, we were looking at about a trillion in various passive strategies, the vast majority not in ETFs. Now you're sitting at $5 trillion. So you've had a 500% increase. And there's a school of thought out there that there is a big unknown as to, well, how much this volume going into index funds affects future market issues.

Before we go into unpacking what could be a threat and not be a threat, just generally speaking, is there systemic risk in the popularity of index funds? Systemic risk? I don't think so personally, no. I mean, I think index funds are the constituents of which are usually weighted by market cap. The larger stocks that are out there, they're pretty liquid instruments. You can analyze them pretty well, so you know the fundamentals. So as far as a systemic risk where the whole market would kind of come off, you know, come apart because of some sort of downturn, because of just exchange-traded funds, I think it'd be a stretch to try to pull that one together. I think you could have maybe some larger stocks become overvalued just because half the flows

and equities at this point are going into index-type passive products, and so you're driving up those large stocks on the top end of the index a little bit. But still, you still have fundamentals that you can look at and say, well, some of those top four big tech companies that make up about 13% of the S&P 500, you still sort of know what they're earning and you can still analyze them. And there's still a whole lot of money chasing and setting prices for price discovery outside of an index fund too. But even backing up a minute, Julian, why would it not cut both ways? For for every buyer these stocks may be higher weighting within the index than they used to be and therefore more volume but there's got to be

buyers and sellers right well there's the i guess the flows and there's the trading it's two very different things i've done you know i have a lot of research here that I've done in the last few days just on the topic. And if you look at the trading, it's still 95% of the trading done on the market is from active managers. So even though the passive investing is now 40% of the market, it's money that's being invested for the long term, and that's not really traded. So let me, if you don't mind, make a clarification for listeners on what you're getting at. I think what you're saying is of the ownership, index funds, maybe let's call it 40% of ownership, but of trading volume, it's only 5%. Exactly. So the trading is still done mostly by active managers. So the price discovery is still done by active managers.

And these index funds, they are simply owning stocks in a proportion that all the active investors are owning. So I don't see necessarily a real issue when we add 40%. If we go to 90%, then it's different. But we are still very far away from that. Okay. Well, that's a really helpful distinction. And so what you would say is that the trading volume is so insignificant that there isn't systemic risk coming out of that just merely because of broad ownership index funds have in the market. That's right. And also the trading volume being historically much higher these days than it used to be.

It was like another data that I found like 50 years ago. You would have 3 million shares trading volume on the all of NYSE. And today you have 26 million shares in just Apple in one day. So like the liquidity is just amazing. And, you know, that's another factor that helps, you know, market efficiency. So I think market are more efficient today than they've probably ever been. I think markets are more efficient today than they've probably ever been. Daya, do you believe that the entire conversation of index funds and potential technical or mechanical complexity they bring into the market concerns some investors? Let's say you're an investor at the Bonson Group or one of the five of us here at this table, And we are buying stocks in our portfolio on an individual basis. And so that makes us two things. A, not invest in index funds,

but B, invested in the market that does have a lot of index fund representation. Do we have anything to be concerned about by the fact that index funds have taken on this heavier percentage of market ownership? The short answer is absolutely not. And if anything, I think we should welcome essentially what has been one of the great revolutions in finance, and that is the rise of passive investing. And I just want to make this clear as far as the listeners go. When we say passive investing, index investing, we're talking about any sort of investing that does not have the human element in it. Active management, on the other hand, does have the human element. There's actually somebody deciding whether or not a security is entering that basket or exiting that basket. Very much

what we do here at the Bonsai Group, you have people to get together. There's an investment committee. There's deliberating. People are looking at fundamental analysis. And maybe there's a little bit of discussion around what gets added. So that human element is that distinction that we're talking about. And as far as, do we have anything to worry about as far as the rise of passive investing and index investing, and we're using this anonymously. No, I don't think we have anything to worry about. I think it can make active managers look bad when there's a melt-up in the market and there's a limited amount of dispersion and good stocks and bad stocks are going up at the same rate because money is just

entering passive vehicles. So in that sense, it can make an active manager look bad because it's not giving them credit for picking the good names that they own versus the bad names. But on the other side of things, when there's a large sell-off and dispersion is limited and the baby's getting thrown out with the bathwater, so to speak, bad stocks and good stocks are getting sold off at the samewater, so to speak, bad stocks and good stocks are getting sold off at the same rate, it can present some opportunities for some bargains for an active manager, especially if your active manager is able to hold some cash on the sidelines.

So look, I think it presents the potential for a systemic kind of mispricing, which is a really good thing if you're an active manager. So I like, as far as the trends go, and passive index fund investing, that's a trend that I welcome. So, Robert, I am going to ask you this question because it looks like Julian has all these notes and he'll be able to cheat if I direct it to him. I'm going to try to catch you maybe off guard.

But you have, we're not going to go into any individual names or anything, but you have this so-called FANG acronym into any individual names or anything, but you have this so-called FANG acronym and a couple, there's even a couple of non-FANG names that might fit into this. But you may recall from a dividend cafe I wrote last year that, and I don't know exactly what these numbers check right now, but I don't believe it's varied much. There's something in the range of five companies that had a market capitalization equal to the bottom 250 companies. It was actually 243 in the S&P 500.

My question is, do you believe that that is ahistorical? Is that a new phenomena? And I will confess before that I know the answer. I do think that it's different than in the past, but I think in the past there have been companies that have had similarly high weightings, but not to the degree and the concentration these days. Can I jump in and maybe take a counterpoint to what's been said here? So Julian said something really interesting, and Dave followed up too, about efficiency in the markets,

right? And when you talk about efficiency from maybe a bid-ask spread component, the volumes and the flows in the past have certainly been beneficial in that regard. But I find a great irony in these index funds and these passive investments because to some extent, you're blindly throwing capital at a lot of companies just because they happen to be a constituent of an index, right? And so that in and of itself kind of presents opportunities for active managers to go find those opportunities. So if you believe in efficient markets and you say, I won't fight the flow and I'll go into passive, you're actually doing the reverse of what you believe in. You're making markets to an extent less efficient and more beneficial for active managers down the road, right? You're investing off of a model, not off of fundamentals, essentially.

Yeah, that's right. You're putting money into a market cap weighted index, essentially. That's right. Price discovery can be skewed. Yeah. And also just a philosophical point, too I happen to think that to an extent, the concentration of voting power in a lot of these bigger firms, I'm not going to name any, it's maybe bad for capitalism. Okay. Well, let's do this. That is a very important topic. And that is really what people ought to be talking about. And we're going to come back to that because it's a great angle on it. So let's readdress that.

Yeah. Within the context of cap weighting, so let me first give a quick little tutorial for our listeners. If you look at the Dow Jones, it is rather bizarrely a summary of all the stocks in their index, or 30 of them, weighted according to the price of the stock. And so if you have a stock that is around $300 a share and it goes up 5%, it affects their index a lot more than if you have a stock that's $50 a share that goes up 5%. It actually affects it six times more because of math.

Now, you could argue, well, that seems horribly inefficient. Why would it matter what the price of these stocks is? And it would be really distortive to have that kind of alteration. Yet, the fact of the matter is, even though I agree with that criticism of price-weighted indices, over time, it's absolutely remarkable how much they end up correlating with cap-weighted indexes. And by cap-weighted, which is the way the S&P 500 is constructed, most of the Russell indexes and so forth, is that you take the market capitalization of the company, the value of the overall business.

And so let's say you had an index of two stocks, one was worth $900 billion and one was worth $100 billion, then the index would be nine parts the first stock and one part the second stock. So to the question I posed to Robert, we did have this where you have five companies, big tech, new tech, high cap companies, and it's Fang with a couple more. One Fang name is not in it. One non-Fang name is in it. You get the idea. Represent this huge portion.

So I was absolutely shocked to find out that, no, it is actually not the highest distortion of weighting. In 1999, we were far more focused within just five companies. That makes sense. And, in fact, the top 40 companies were two times the weighting of the S&P that the top 40 companies are now. So the differential between top five then and top five now was not quite as exaggerated, but the tech boom in valuations at the end of 1999 were-

Did that concentration persist for as long as this thing has? Do you recall? Well, it certainly didn't persist past March 2000. You talk about a month that will live in infamy. No, the NASDAQ giving back, it did not. It did not. And by the way, either did the FANG. During Q4, a lot of the market disruption,

you had an index that went down 14.4%. You had an average name in the index down 11%. You had FANG down 25%. So it did realign a little bit. And even this year, what's been a really good year for the market, FANG has dramatically underperformed. Yeah, I was just going to say that. And that's a great point. You have what you were talking about earlier as potential kind of market dislocation.

Money is coming into a model. It's going to an index based on a list of market cap-weighted names. Maybe that causes things to become overvalued. Maybe in the 90s, late 90s, maybe you could argue FANG. And then you get this, like you said, fourth quarter Q4 last year. You get kind of a reversion of the mean and you get price discovery. And that's why I think while you do get anomalies like that, I do think with a pretty liquid market, I think you get price discovery pretty well. But, Julian, isn't it true that intraday there could be enhanced volatility risk around one of those high cap weighted names, that they're more subject to a whipsaw in a big sudden bout of intraday volatility?

I guess intraday, yes, but I guess it's probably irrelevant to most investors. It's irrelevant to the five of us and all of the clients of the five of us, but if someone thinks they're going to go trade around it, they potentially have some sort of trading risk in theory. Yeah. That's right. I guess this whole debate, I guess, was restarted recently by Michael Burry, the guy who wrote The Big Short.

And so I wanted to see exactly what he wrote. So I just found a few quotes- Well, hold on. He guy who wrote The Big Short. And so I wanted to see exactly what he wrote. So I just found a few quotes. Well, hold on. He didn't write The Big Short. Michael Lewis wrote The Big Short, but Michael Burry was one of the characters in The Big Short. But Michael Burry is now the, I guess, I mean, they're talking about index funds being a new toxic studio.

But then if you look at the, in more detail, the way he's writing, actually, the first thing he says, which is actually even more probably more interesting, he says central banks and Basel III

have more or less removed price discovery from the credit market. And meaning risk does not have an accurate pricing mechanism in interest rate anymore. So he's saying basically

central banks are removed. And they probably haven't removed, but they're clearly distorting the credit market. Well, okay, so we agree with that 1,000%. I've talked about it almost every week of my life for 10 years. The Fed has distorted risk in credit markets. What does that have to do with equity index funds?

Well, I guess because— How is Burry connecting those dogs? Well, because he's saying, and then you have the equity index fund doing the same to the equity market. But I think the point he's missing is that just the Fed is distorting the whole asset pricing,

pricing of everything, not just credit. It just, so I guess it's really the impact the Fed is having is on all assets, all assets,

all asset pricing, including equities and including index funds. But see, this is the thing that's so interesting to me. And Dave and Brian and I have had some conversations with some of the leading money managers in Wall Street about this face-to-face.

Is that, A, the thing we're talking about here with index funds, if there is a story, it strikes me that we're talking about it in the wrong asset class. That it's far more potentially lethal in fixed income credit than it is in equities. I agree. I mean, the prices are much more directly set by central bank policy than you could say an index fund or passive investment strategy

sets stock prices or valuations. Because stock prices and valuations, you can analyze, they trade freely, all those sorts of things. When you've got a central bank that takes rates down to zero, that sets rates. And that adjusts immediately credit markets. And so I think it's just more direct. And so there's much more of a distortion in that market, or a potential for one.

There's no price discovery. Italian bond yields are the same as the U.S. Yeah. There you go. When do bonds trade? They trade OTC for the most part. And if you have a liquid ETF tied to a bond index that's trading intraday, I think Gunlock actually brought it up a while ago.

I won't give him all the credit for it. I think other people talked first. But that could be a potential problem, I would say. And that comes full circle, actually. So we would go back to passive investing and indexes and ETFs in general. I would say your question, is it systemic risk on those types of things? I'd say no. But on fixed income or non-liquid assets, gold or muni bonds or things like that that really don't change hands very much

if you're trading an ETF intraday, millions of shares of volume, where's really the price discovery there? Could there be a dislocation in there? And I've always felt that way. It's never really played out that way, but it's always been a fear of mine. Yeah, I agree with that. I think if you look at the underlying basket of a lot of these bond ETFs, many of those bonds won't trade for weeks. So if there's ever a situation where, and there's two ways- Some of them have never traded since their primary issuance in the municipal sector. Build America bonds, you mean? Yeah. So you're talking about pretty illiquid underlying securities. And ETFs can trade on the secondary market where an example is a retail investor buying an ETF from another retail investor.

Or if there's an overabundance of selling, then they sell on the primary market and the underlying basket has to be redeemed. So essentially it introduces forced selling of those underlying securities in the marketplace, which can lead to significant mispricing. And if you own an ETF like that, there is risk there. But I think that what Julian said earlier was important. Is the risk anything more than one-day volatility risk? one-day volatility risk. Like I think we saw in February of 2018, in December of 2018, you had some really exaggerated selling pressure. It starts off fundamentally driven.

Markets don't trade down for no reason. So let's just assume it might have had, I don't know, something to do with Trump and a tweet and trade. Are we just pretend? Sure. Okay. So the market starts selling. You're down 500. You settle down 500 for a couple hours.

Then all of a sudden, final hour, you jump down 800. It's unprovable. It's unknowable. But it's reasonable to assume part of the additive selling pressure is ETFs having to square away the trading books near the end of the day. True or false? I think it's true. Yeah, I would say it's true. It does speak to, I don't know if this is what Michael Burry was talking about, but there could be an inherent flaw in that you're basically decreasing the cost of capital

to a lot of companies who don't deserve it to be where it's at, but through this passive and index fund, maybe that's who he was going with it. You know, when certain companies can raise junk bonds at four and 5% at will in the marketplace, that speaks to trouble to me. I think junk bond market, high-yield bonds,

I think that would be cost of capital. But as far as equities and things, I don't think that that would correlate the same way. But maybe your credit markets. You're popping PEs and therefore decreasing the cost of capital. But that's not creating more capital for the company. But I don't think that's the passive money that decided the P of these companies.

That's the Fed at 1.5%, and that's active managers who are doing the trading and decided that these stocks are growing at 20 times PE or the S&Ps were 70 times PE. And then the passive buy what's in the index.

There's a real non-sequitur around assuming that index buying is affecting the market multiple. We've had PEs higher than this for a sustained period of time, many, many times in market history when there was no such thing as ETFs. Very true. I mean, how did we get to a 29 times S&P in early 2000?

There wasn't even such thing as an ETF or the spider SPY was just starting off. I think it strikes me, I will say this, actually, who was the guy who played Michael Burry in the movie? I think it was Christian Bale. Christian Bale. It was a great performance. The books were interesting. I've heard Michael Burry speak on a number of occasions. I like him from everything I've seen.

But listen, I have a big problem when people, there's a couple of things that are warning signals to me. Something like, oh, this is the new CDO. Whenever someone says, this is the new cdo yeah whenever someone says this is the new lehman okay i was on cnbc the day that brexit passed and the financial times editor saying i think brexit represents the new lehman and i thought well i don't know i sure i remember lehman a lot differently than you do apparently it was um so my uh my i promise you the restaurants were a lot more crowded in new york the after Brexit than they were the day after Lehman. Very true. The reality is that the dramatizing of it is sort of a turnoff.

And yet you don't want to miss a point that could be a good point just because you think someone is sensationalizing something. Well said. But my theory on it is that we're on the right track here. If there's a story to talk about, he's talking about the wrong one. It's sort of like your building's on fire because there's arsonists that are building a fire, and then you write a story on how the sprinklers in the back exit number 14 aren't working

and you're worried about systemic risk on the sprinkler. It's like, well, yeah, but also there's this other thing. And I don't believe that we have a fire. I just use that as a kind of reasonable analogy. My point being, the central bank issue is 10 times the story, 100 times the story this is. Julian, what else did you unpack from this that you thought is noteworthy? No, that's why I wanted to address that point, because I guess, everybody focusing on the passive indexing, but he was mentioning as well the central banks,

and I think to me it's a much bigger issue, you know, the fact that they remove, I mean, basically, they're forcing you to invest and they're removing price discovery, and that's, I think to me, that's much more worrying, the fact that whether or not now we add 40% of passive investing instead of like, yeah, it was much less than that 10 years ago. It changed the market structure, but I guess valuation haven't been impacted. And I think the market looks like it's been efficient.

And so I don't see really a problem there. Well, let's do our listeners a huge favor here. The five of us, I think, are pretty sober-minded guys. We have a philosophy we believe in about the market. Dave, I hope it was okay I said sober-minded after your weekend. You were having trouble remembering it. I was just sailing. To me, I think listeners really deserve to hear what we're about to share.

There is a phenomena that takes place that I am convinced is toxic for regular investors, where people that don't necessarily have a hyper-sophisticated level of depth in a given subject are provided just enough vocabulary to sort of create a kind of brain signal response that is fearful. Like, okay, this doesn't sound good, yet there's no real connecting of dots. No one explains why this A, which involves B, is going to lead to C, and C is supposed to be a horrible thing. It's not even necessary for the person making the argument, whether it's media or a fear-mongering market actor.

They don't even need to connect dots because they know it's unnecessary. As long as you just create the appearance of something that sounds bad, there are people that will sort of run with it. There's entire websites that sort of run around this stuff. They can put up a chart, and

there's one, I don't actually want to say the name, I don't think we're not allowed to do, but I'm just not going to. But there's one, you'll share a lot of the content from them. And I've been reading them for years. The proprietor of the site refuses to use his own name. Cutesy hides behind a movie character name. But they'll sometimes put up a big chart and the chart is accurate.

It's correct. They'll go, oh, you know, see, CDS spreads blow out to this level. Oh, OK. You know, CDS spreads blow out to this level. Oh, okay. But there's absolutely no logic behind why the thing they're sharing with the size headline and everything is supposed to mean something bad. And I think listeners need to know they're being played. This is not unintentional.

They are purposely knowing people don't understand the mechanics. High-frequency trading. Do you think, Brian, that the reporting about the world of high-frequency trading has been intellectually honest? No. I do not. I mean, is that a good example? Yeah, it is a good example. It's something that most people don't fully understand.

And you can have statistics and charts to prove almost any point given a particular period of time and or what you're doing. And you can get a sensationalistic headline and or it drives clicks on whatever you're doing, and it's selling. And honestly, it's the same thing sometimes that some of the media companies do as well on TV. I mean, with all the graphics now, with markets down 500, you've got a flaming, burning sign of the S&P 500. It's kind of the same idea. But that's a cartoon. It's a cartoon. It's literally a cartoon.

I think that this commentary around all this stuff, and the machines are about to be the example I'm going to really elaborate on. It's cartoonish coverage. There is this narrative. I see it with intelligent people, grown adults. And they'll be like, oh, man, you see what the machines did to us today. I go, so the market was down. And they go, the machines are taking over and this and that. And they have this view that the market should have been down 220 points, but it was down 700 because this computer got involved. And I'll try to point out, well, there could be some inefficiencies.

There's trade errors. People forget flash crash was literally like a mistake. There could be fraud. There's things that could happen. But this idea that we're all sitting around kind of just mercilessly subject to computers that are doing us harm is the dumbest damn thing I've ever heard. And I'm tired of investors being scared by people who do know better and don't care. Dale, what say you? Yeah, I think all those headlines and sensationalizing is doing exactly what it's

intended to do, as you guys perfectly summed up, is that's to draw eyeballs. I mean, most of these people are, I assume they're doing it for some sort of eyeballs draw in profit, and it's doing exactly that. As far as investors, look, I think the market is, what you see, what the Dow does, what the S&P does, is essentially the culmination of millions of different market participants all pursuing their own self-interest and to try to make sense of exactly what, why something went up 600 points or 500 points. Sure, there may be some broad theme that's going on,

but I think it's a bit crazy to assume, to know that it's because of some machine. It's just rank oversimplification that I think is really dangerous. Dave, did you read my book, Crisis of Responsibility? I did. Do you remember my second chapter where I talked about the kind of boogeyman

that we create in society, and people will say Wall Street, but it's really broad and general. Others on the right might say government or the Fed. There's different kind of targets of our ire but the higher level the better because the more specificity the more you have to defend your position the less specificity the more you can get away with just saying general and and pretty unhelpful things i think that that point i was making in the book which was more of a cultural

commentary applies to this the why blame it on a computer? Because you don't have to. It's a great scapegoat. Oh, computer. Well, I don't understand everything about computers. They just happen to be providing all of the liquidity for the market. And to your point with the volumes, how they've gone up over the years, I mean, that's what they've done. They've increased liquidity. Is that a bad thing?

I don't think it is. When you and I first started, I mean, you were a little bit after me. But early on, you were probably in your third or fourth year, and I was in my fourth or fifth year. Warren Buffett had a famous line called Weapons of Mass Destruction. And he was not referring to Iraq, Saddam Hussein, 9-11. He was referring to what financial instrument? Was it a derivative? Derivatives.

Yeah. Okay. Who's the largest holder of derivatives? Yeah, right. Exactly. It was Buff was buffett right but here's my point why did that have a 100 chance of succeeding it was a fortune magazine article it had buffett you know god forbid anyone ever questioned what the oracle of omaha says about anything well no one knew what the hell the derivative no one knew what it was no one knew what it was and just said oh there's trillions of dollars it sounds terrible and here's the worst part.

Then people took a victory lap and no way. They go, see, those derivatives did kill us. I go, yeah, it might have been what they were invested in. But I think that that's an example of this fear mongering that I think is really unhelpful. Yeah, very much so. Why do all the hard root level work to really try to understand something where you can just take a headline like that and run with it and assume that the world is exactly that? So, yeah, I totally agree.

A lot of fear mongering, just running with headlines that people shouldn't be running with. I was going to say, is any of them the biggest risk of passive investing? I think for the investor, it's like not knowing what you own. So you really want to make sure you take the time of understanding what you own, because I guess the difference is like you invest with us, you know, study stocks, you know the way, holding your hand. And if you buy the S&P 500- But let me take the other side of it, even though I agree with you 100%. So I got to

do something right now I don't do often, which is pretend I don't believe, I believe something different. The counter argument is that's a plus for index funds. Oh, the good thing is you don't know what you own. You're less susceptible to human error. Sure. And that human decision making is a negative alpha contributor. And therefore, by not knowing and being hands off, that you have a better chance of a superior investment result.

That would be their argument. Well, I'd say like it's's probably, you're not going to worry as long as, you know, you make money every year, the market goes up, but the moment you're going to have like a recession or crisis and you're going to be down 20%

on your statement and you're going to see one line and you don't know what you own, you're going to be worried and what are you going to turn to to understand whether you want to hold it or feel comfortable sleeping well at night not knowing what you own.

So I think, I mean, if you own the S&P 500, there's nothing wrong about it, but you really need to know what you own. I totally agree. And there's a distinction between a vehicle that's constructed passively and the way that vehicle is being implemented in your investment strategy. You can be pursuing a hyper-aggressive active strategy, but be invested in solely index funds. By jumping out of it, either you're jumping in one sector ETF and you have some sector

rotation strategy, or you're trying to time the S&P. So there's a distinction between investing in a passive vehicle and a passive investing strategy. And I would jump in and just say, at the end of the day, how does an index solve someone's what they're trying to accomplish? I mean, it's an index. It's an okay investment vehicle. It's beta. And I have no problem with any of it. But for most people that are investing money for a certain reason, probably to save money for retirement or produce an income that they can depend and live off of, is the index something that's really going to scratch that itch? Is it

going to check that box? Is it really going to accomplish that goal? And I would say that it usually does not. And so we want to be intentional and own things that are attributable to an actual result we're trying to achieve, not just to mimic something else, which is a market cap weighted index. So Robert, is the sensation around index funds post 2008 driven by the fact that our friends at Strategas call financial repression, that the Fed, with three rounds of QE and with ZERP, effectively made it very easy for passive investing to outperform active. That's kind of been a golden period for passive investing. I always think back to the, what was it, the Warren Buffett bet against that hedge fund manager, which asset class would outperform. I think it's done a lot to increase the allure of passive investments, but

in a long-term, you know, Fed easing world and Fed easy world, I don't know that that's going to change in the near future. I think the dislocations will become more evident, you know, some of the things we've talked about today. But I think, you know, people won't realize the flaws in passive and index investing until it's kind of too late, until they see their statements down 20 plus percent, and they don't know what they own. I think those will be the problem periods, quite frankly. Brian, do you believe that our concern about passive vehicles, let's call it ETFs in particular, let's call it ETFs in particular, that were right to want to avoid buying high-yield bonds through ETF or municipal bonds through an ETF in terms of their ability in a market disruption to function smoothly.

So I do agree with that. I mean, we want to own, just like we would own individual equities, individual stocks, we would want to own individual bonds and or specific sectors and be intentional about what we own. When you own an ETF of a bond index of some kind, I don't want to say it's make-believe, but there's a lack of price discovery there if the underlying assets within the index are not trading hands. You don't really know what the price is. I think they're so far so good. They have not blown up they're marked to a matrix of equal durations and coupons yeah which which is okay i think in most markets it'll be fine so third avenue was an open-end mutual fund yeah of high of even more illiquid assets and it blew up yeah is that just a difference of degree or is it a difference of kind? And just so I avoid putting you in a tough position, I will say, I will show the ball.

I believe it was a difference of degree, that that's essentially what could happen but hasn't yet happened with some even more traditional fixed income assets. Yeah, I would agree with that. I mean, I think the Third Avenue thing was pretty specific to what they were doing inside of that fund. But the same thing could happen in the ETF market. The one thing I would say is that we went through an 08. And if there's a good stress test for anything, I think, in the financial markets to see what happens when it all goes the wrong way, that's a pretty good environment. And those funds did function through there.

There was dislocations for sure. You had flash crash dislocations for sure. You had flash crash, dislocations. High yield, we won't go into tickers, but the leading high yield ETFs had one-fifth the assets under management in the weight that they have now. Yep. It's a great point. I mean, we don't own them for those reasons. I mean, I don't want to be a doomsayer either, and we're not trying to sell advertising here, so I'm just trying to speak the truth with it. But just think intuitively about what they are. It's something that trades every day, millions millions of shares and the stuff that's inside

of it doesn't trade for weeks so there you go there's a little disconnect there so so uh julian we um have talked about this in the past in dividend cafe and we've had client events around this um the fact of matter is that the way etfs gets settled every day you know i was saying how a lot of just people out there don't know how computers work and high frequency works and this and that. How many people do you think understand how the pricing gets set in their ETF and how the market makers, the securities involved, settle up? Would you guess it's a pretty low percentage of people understand it?

Yeah, probably I would think so because most people don't understand all the dynamics, all the things that happen behind the background, your back office and all the training. So we are, I would like to say, investment professionals. We do this for a living. We trade in millions of shares of securities, usually on a daily basis. We're responsible for the stewardship of effectively a couple billion dollars of assets. We don't even know exactly how the pricing gets done on some of those bond ETFs at the end of the day because it isn't shared publicly. There's a complete lack of transparency.

So to your point earlier about knowing what you own, I would add there's a great point, a great benefit that you brought up in people knowing what they own, but there's also a great benefit in knowing how it got to be there, how it functions. There is no ability for someone to fully understand it. Now, you can take it on faith. Most of the time that probably works out. But I think that there is a significant enough amount of money that people are having to take on faith in some of these more of money that people are having to take on faith in some of these more idiosyncratic asset classes. S&P 500, big cap companies, FANG, I don't really care. I don't think there's systemic risk mechanically in the indexing of that product. But on this bond side, I think it's a big deal.

Yeah, I would agree. Robert, you brought up a point. I'm going to let you comment first, then I'm going to see if anyone disagrees. A threat to capitalism because of the large ownership that some of the big ETF makers might have. Talk about that. Yeah, so when people think about ownership of, let's just say stocks, right? You're entitled to some of the residual earnings, right?

But you also get to vote on certain corporate matters as an individual or, you know, a trust holder of those shares. When you hold shares, perhaps indirectly, through an ETF, you know, trust holder of those shares. When you hold shares, perhaps indirectly through an ETF, you know, some of the big names we all know, you essentially delegate a lot of your voting power via proxies to those big names, right? And as the growth in, you know, delegation of votes has increased over time, you really- You delegate it to the ETF provider. That's right. That's right. Generally speaking, there's going to be a box you check on, you know, something or you sign it away, so to speak. But you're essentially giving or providing voting power to a couple big entities in the marketplace. And the decisions that those entities make, certainly they're going to be sometimes and hopefully largely around increasing profitability, increasing returns for the holders of their securities. But sometimes they're driven by other factors as well.

I mean, we hear about, and this is, you know, depending on your perspective, good or bad, but you hear about divestiture from certain types of assets, whether it's petroleum, oil, and gas, things like that. When you're making and placing votes on the basis of perhaps your own philosophical priorities, and it's not intended to be to the benefit of the underlying holders of your ETF or whatever product, that can be bad for the holders of the underlying holders of your ETF or whatever product, that can be bad for the holders of those products. And you could also be delegating philosophical votes to people that you don't agree with necessarily, or you could vehemently disagree with them.

No, but isn't that true if you have an active money manager? It would be, right? Yeah. So are you critical of the whole concept of proxy voting, Yeah. So are you critical of the whole concept of proxy voting, or are you critical of, in this case, that the person with the proxy has a different objective than what's best for underlying shareholders? I'm certainly not critical of proxy voting because I think there's an efficiency component to it. And most people don't even know that that is a concept that exists, right? So I think bringing awareness to it would be my intent.

So I think bringing awareness to it would be my intent. But also I think there are a lot of folks out there who would, if they knew about this, would disagree strongly with the votes that are being placed at corporate board levels across industries. Around social issues as opposed to – It can be social. A big one these days is environmental, of course, as well. But how does that affect your long-term returns down the road? Yeah. So I'm in 100% agreement with Robert here. I'm going to go to you and have a couple other questions for the guys before we wrap up on this.

However, I would argue that within capitalistic structure, we have the antidote to the concern that Robert has, which is competition from other ETFs. Competition from other ETFs. And remember, their market cap weighted, too. So the pools of those big companies are very large. But I would say this. I would agree with you, Robert. I do think that that's an interesting point.

I don't think people talk about it a whole lot. I mean, at least I haven't seen it a lot and it's very interesting. When they talk about it, they're talking for it. They're talking about, it's Andrew Osorkin writing an op-ed saying how a particular ETF maker

can go force companies to quit selling ammunition or something like that. Yeah, so a power for change in a positive way. Yeah, they're not talking about the concern of it. They're talking about the opportunity of using- It cuts both ways. It does. Yeah, yeah, yeah.

So Julian, do you see this as something that will grow as a issue, or do you think that we're overthinking it? The voting issue? And the idea that it could end up having a disproportionate impact in the boardroom, shareholder voting. It could alter the dynamics of what shareholder votes are intended to do. Well, I don't have enough data on that. First time I hear, I thought coming in today that it was neutral. Whether it's an active manager or passive manager, they still have fiduciary duty to their holders. And I didn't think it would make a difference. Whether it's an active manager or passive manager, they still have fiduciary duty to their holders and

I didn't think it would make a difference. Maybe it does. I think having in general, I guess what you want is shareholder voting because a lot of the boards really, there's not a lot of challenge from shareholders at the end of the day to what the board decides. So whether it's active or passive, what you want is

people vote and I think that's most important, that they don't necessarily approve all the resolutions that are proposed. And it looks like these days where investors are a bit more responsible with their votes. And if you have more concentration, that could be a good thing, that these big firms, they have more influence on what corporates do and can do. So, Dea, what's a bigger threat to free market

capitalism, this subject of ETF representation and shareholder votes, or Senator Elizabeth Warren? I would go with the latter. Those that are laughing, by the way, appear to not be taking the threat as seriously as perhaps

the chief investment officer of the Bonsai Group is. It's the latter. Yeah, I would definitely go with the latter. As far as the ETF- Does it feel like I was leading the witness there a little? As far as the voting as ETFs go, I do. I think it is a risk.

There's degrees of separation between the end investor that actually owns the shares and the management, I think that creates a bit of an issue there. But, Dave, hold on. Isn't there a difference, an issue of degree? Like most individual investors, then they put up a slate of names for the board of directors and ask you to vote. Most are very accustomed to saying, hey, I want to proxy my vote to the money manager because you guys are doing research on Bill Smith and his pedigree

on this board. And I don't know Todd Johnson. So they're trusting that. So that part we'd be okay with. But then it's when the proxy starts, as Robert brought up, implementing a kind of social agenda that might not be in the economic best interest of the shareholder. Right. Not all proxy voting is created equal. I'm sure that obviously our clients are aligned in more ways than just us trying to being responsible for their financial goals. It's more morals and ethics and all that stuff. So I'm sure we see the world similarly as a lot of our clients. But as far as the proxy voting, and I don't know to the extent that, and we can say the

names of some of the largest passive providers out there, which is Vanguard, BlackRock, State Street, to the extent what their social agenda is, I can't really say. I assume that most of the time they're voting alongside management. I haven't seen the data. I'm not exactly sure. So I think it creates the potential for some risks down the road. But right now, I haven't really seen it manifest. I can't speak to it currently. Well, it's something that I think warrants continuing to watch. I think it may be that right now the threat is not that you have an example of a premier passive ownership vehicle voting against their shareholders, but you have set the table for them to be wildly influenced by cultural influencers. And so you can get an op-ed in times where they're telling you, you better go stand up this or the that or whatever the kind of PC thing of the day is.

Some of the causes we might be really sympathetic towards. And again, there are people that would hear everything we're saying and saying, exactly, do that. Like they would say, this is good. I think that it warrants continuing monitoring. I don't personally, if I viewed my ownership of equities as something by which I wanted to have a degree of cultural influence, I can't imagine wanting to be in a passive vehicle and saying, I don't know the people at XYZ ETF company, but I bet they're going to go represent my conscience. I would think I'm going to vote my shares, my conscience and whatnot. So you could add as well.

I mean, you have to think that there's also the active um the active managers um you know we take uh activists actually i wanted to say so look i mean now you've had campaigns and some people they take just one two three percent and with three percent of in a company you really can't influence theoretically there's not much you can do to to influence the board but because of they are famous investors or because the boards are worried of when these guys show up, with 3%, you manage to push some changes.

I really tend to fall on the side of the activist investors in those cases because I believe that there is a price to being a publicly traded company. But when you decide to trade your equity

in the public markets, no one forced you to do that. You have funding mechanisms. You actually have highly sophisticated private equity funding in our society. You choose to go in the public equity markets and receive certain benefits and liquidity and transparency and price discovery in doing that. One of the downsides is now your shareholders have an input in how you run the

company. Now you set your board up the way you set it up. You have voting percentages the way you do. But if an activist investor is coming in and saying, hey, we disagree with strategy management. We want to talk to you and engage with you because we like this idea better than that idea. I think that they have the right to do it. Imagine it has the right to disagree. And there's processes that work around that. If all the activist investor is trying to do is manipulate the stock for a trade, I'm not crazy about that.

But if most of the famous activist endeavors of the last 10 years, and it's become a very big deal, and we're, of course, invested in some activist-oriented hedge fund strategies. If all of a sudden the activist was coming up and saying, we want to make a big public stink, but it's not about capital allocation. It's not about strategy. It's not about, you know, potential M&A that they're either critical of or fond of. It's about some social attribute. Like, we're becoming an activist investor because we want them to have more recognition of this, that, or the other. I think that becomes very distortive to markets. And it confuses the role of who's supposed to be doing what in capital markets.

Yeah, I totally agree with that. And I think to your point, an activist investor, like you said, we've invested with some of them. We know who they are. There's usually a profit motive there. I mean they're going in to reshape the business. They want to make it better. Well, there's always a profit motive. It's capitalism at its finest.

When you have the ETF side, do they really care about it? I mean, they have a fiduciary obligation to shareholders, for sure, of their ETF, yes. Do they care as much? Do they have as much direct skin in the game of real ownership of a company that's in their ETF? They technically don't, right? Whether they own that company in the top seventh holding or the 27th holding, eh, they get their basis points on the fee anyway.

You're exactly right. And that's the slippery slope. Yeah, and as far as what you were saying about capitalism, any time you are forcing social responsibility, and I'm sure everybody has, it's one of those things that everybody has a different definition of. Any time you're forcing social responsibility on a company,

you're reducing freedom of that company. And that's obviously that's against the very core tenet of capitalism, which is, you know, everybody's allowed to pursue their self-interest. A really quick rule of thumb I'll help close this out with. Whenever someone's efforts and social responsibilities start with a press release, be skeptical. Many good things come from people working behind the scenes. Very few good things come from people trying to get a trophy for it. Just remember, there's a biblical precedent here, by the way. Yeah, very true.

All right, guys. Anything else on the issue of index investing as we wrap up? So I'll start. So I am a proponent. I'm a fan of index investing as we wrap up? So I'll start. So I am a proponent. I'm a fan of index fund investing. I feel like it's done a lot to enrich investors as far as providing investors with very cheap beta. It's something that you should be very,

the listeners out there that do trade ETFs, be careful when you're trading them, especially in environments where there's gyration. There can be, how that ETF trades during that day can be a little funky. Set limits. Be careful when you're trading in and out of these things, especially if it's a new ETF. There's been explosion in ETFs around.

You have an ETF out there, video gaming, artificial intelligence, crypto. I mean, there are all sorts of niches being created for these ETFs. You're calling niches. I'm calling fads. Yeah. So if it's new, the more boring, the better for the ETF. But if it's a new type ETF, be very, very careful when getting in and out of these things. Excellent comments. Robert? No, I would agree with everything Daya said.

I think they're good for a lot of folks, specifically people that are in retirement plans, things like that, that just want access to a market with a very easy way to get that. They can be dangerous, so just be wary of the ability to trade them so frequently and the knowledge that sometimes ETFs and these deep specializations can really prey upon the worst aspects of human behavioral errors. Absolutely. I mean, I would say, yep, ETFs, and we're kind of painting a broad stroke here. ETFs can mean a lot of things. We talked about bonds.

We talked stocks. It can be different sectors, different asset classes, the whole thing. But generally, I mean, I think they serve a great purpose, but do you own them for a specific reason? So I think if you just own them because you want to just have your money go up and down with the wind with how the world turns and how markets trade, I guess that's great. But I don't know how that really accomplishes a certain goal. So I would just be mindful of what you're trying to accomplish. Beta is beta, meaning that you're going to go up and down with the stock market. Is that what you're trying to accomplish with your financial goals?

Excellent. I would say index funds, they're not toxic. What creates bubbles and crashes, it's human nature. So that's what you have to protect yourself against is your own human nature. Oh, Julian, that is like music to my soul. This is what we've been. I mean, how long did it take him to get acclimated into the DNA of the Bonson Group? He's exactly right.

It is the great closing thought here. The behavioral tendencies of investors. Our friend and mentor, Nick Murray, constantly says that human nature is a failed investor. And that is the thing that has to be guarded against most. There could be articles that come up here and there, usually on blogs, usually on social media, that want to scare you about this or that or the other. At the end of the day, the reality is that we have far bigger fish to fry than some of the potential mechanical inadequacies that

exist in some aspects of investment product. And I will close with the benefits to these ETF vehicles of intraday trading are no benefit at all to someone who's investing the right way. You do not need money at 1030 in the morning that you can't get to at one o'clock in the afternoon for a person who's properly allocated and investing around an investment policy in conjunction with an advisor who set a financial plan and so forth and so on. The risk that comes from such intraday issues are real and mechanical around certain asset classes like high yield and municipal and things of that nature. But fundamentally, we believe that transparency is the investor's friend, and we think alignment of interest, working with an advisor, having individual product, that you know what you own and why you own it works much better. So a lot of behavioral stuff we covered this week.

I love the fact we got to get into ideology of markets, some of the kind of social and cultural components. I got to plug my own book in here somewhere, but it really happened organically. I wasn't looking for some kind of plug there. And of course, you see an alignment and a real shared passion with these other four gentlemen around the table with me to do the right thing for our clients and give you more and constantly improving information. Reach out with any questions, any time. Write a review for Dividend Cafe. We'll send you a copy of our Dividend Growth book.

Thank you for listening to The Dividend Cafe. Thank you for listening to The Dividend Cafe, financial food for thought. The Bonsai Group is registered with Hightower Securities LLC, a member of FINRA and SIPC, and with Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC.

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