Randolph B. (Randy) Cohen is a Senior Lecturer at Harvard Business School.

Cohen will also be teaching Investment Management as a visitor at MIT Sloan School of Management.He has previously held positions as Associate Professor at HBS and Visiting Associate Professor at MIT Sloan.

Cohen's main research focus is the interface between the actions of institutional investors and price levels in the stock market. Cohen has studied the differential reactions of institutions and individuals to news about firms and the economy, as well as the effect of institutional trading on stock prices. He also has researched the identification of top investment managers and the prediction of manager performance, as well as studying the market for municipal securities.

In addition to his academic work, Cohen has helped to start and grow a number of investment management firms, and has served as a consultant to many others. He is currently a partner at Exsight Capital, a venture capital firm specializing in early-stage impact investments in innovative ophthalmic diagnostic and treatment solutions.

Cohen holds an AB in mathematics from Harvard College and a PhD in finance from the University of Chicago.

Michael has been a student of markets and market structure, for nearly 30 years. His proprietary research into the shift from actively managed portfolios and investment funds to systematic passive investment strategies has been presented to the Federal Reserve, the BIS, the IMF and numerous other industry groups and associations.

Michael joined Simplify in April 2021 after serving as Chief Strategist and Portfolio Manager for Logica Capital Advisers, LLC. Prior to Logica, Michael managed macro strategies at Thiel Macro, LLC, an investment firm that manages the personal capital of Peter Thiel. Prior to Thiel, Michael founded Ice Farm Capital, a discretionary global macro hedge fund seeded by Soros Family Management. From 2006-2014, Michael founded and managed the New York office of Canyon Capital Advisors, a $23B multi-strategy hedge fund based in Los Angeles, CA, where he established their global macro strategies, managing in excess of $5B of exposure across equity, credit, FX, commodity and derivative markets.

In addition to his work as a market theorist and portfolio manager, Michael has been noted for his work as a public speaker and financial media participant. He is a graduate of the Wharton School at the University of Pennsylvania and a CFA holder.

Are index funds a silent disruptor? Or are the concerns overblown? In this grab-your-popcorn episode, Michael Green returns to the show after his previous appearance elicited a wave of compelling feedback from listeners. These included very smart individuals in academia and practice who were interested in hearing a counter perspective. Joining Michael today for a lively debate is Randolph Cohen, Senior Lecturer of Entrepreneurial Management in the Finance Unit at Harvard Business School. In our conversation, Michael shares his deep concerns about how index funds and target-date funds might be distorting financial markets, honing in on the tension between market efficiency and price elasticity. Randolph counters with an academically grounded perspective, drawing on his PhD and years of research and teaching at one of the world’s leading business schools. With Ben and Cameron moderating, the discussion explores both sides without reaching a definitive conclusion. Tune in to witness this spirited, nuanced exchange and decide where you stand!

Key Points From This Episode:

(0:00:14) Introducing Michael Green, Randolph Cohen, and today’s topics of debate.

(0:06:00) Defining passive investing, distinguishing between the two different meanings of “the rise of passive investing”, and how much of the market is currently held by passive investors.

(0:12:53) Michael’s concerns with the high levels of passive investing and Randy’s response.

(0:20:55) Addressing the proliferation of target-date funds and their use in different scenarios.

(0:28:48) Debating risk in the market, raised valuations, and retirement savings diversification.

(0:42:22) A breakdown of the biggest thing Michael and Randy disagree on: how passive investing is impacting stock market valuations.

(0:57:06) Answering the question: does inelasticity rise with passive, and how does it shape the impact of active managers?

(01:06:14) Unpacking whether the rise of passive has made the markets more efficient; an accompanying refresher on the two types of passive.

(01:09:27) Reasons to doubt whether there really is a rise in both types of passive and the effect of the rise in mega firms.

(01:19:16) The state of fundamental analysis in the current market and Michael’s response to a recent paper by Goldman Sachs attempting to isolate the component of passive.

(01:23:30) Unpacking the cross-sectional impact on stock valuations from index investing and insights on the work of Valentine Haddad.

(01:31:28) The implications of today’s subject matter for investors and what they should be doing with this information.

(01:44:22) Reflection on why more experts don’t share Michael’s level of concern.

(01:47:42) Randy’s takeaways from today’s conversation, why he still does not share Michael’s level of concern, and what he might be worried about.

Read The Transcript:

Ben Felix: This is the Rational Reminder podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix, and Cameron Passmore, Portfolio Managers at PWL Capital.

Cameron Passmore: Welcome to episode 332. And today, we have a very interesting grab your popcorn kind of episode. I really enjoyed it. It's very thought-provoking. It goes back to the guest we had – which episode it was? 302, I believe. With Mike Green, the first time. So it's a follow-on to that. So Ben, I mean, that's about all I can add to this. It was really fascinating. Why don't you give us a back story on how you got these two guys to come on?

Ben Felix: We obviously did our episode with Mike Green, which helped us understand the difference between market efficiency, which is something that I had been making content about saying there's no issue here with index funds. And Mike got really upset about that and was not shy about saying so. He helped to understand the difference between market efficiency and price elasticity, which index funds may be having an impact on. So that was useful to understand Mike's perspective on that and just gain an understanding of what he's worried about. Because the reason he gets upset is that people sort of mischaracterize his argument and straw man against it, instead of understanding what it's actually trying to say. I think we took the time to understand what he was trying to say. He appreciated that. We learned a lot. So that was all great.

After our episode of Mike Green came out, a lot of very smart people listened to this podcast. People who were in academia, people who are in practice, but may also hold PhDs. I'm not going to say who they were, but people like that reached out to me and said, "Listen, your episode with Mike Green was interesting, but we don't really think this is as much of an issue as Mike does. If we can give you someone who speaks well on these topics and can give a counter perspective, would you be open to doing an episode?" And I was like, "Well, sure. Why don't we do that with Mike and just make it a discussion?"

This is a bit of an experiment. We've had episodes with two people, but we've never had episodes with two people who disagree with each other, where we're kind of hosting a discussion between them. We thought we would try. I thought it worked great. It was a great conversation.

Cameron Passmore: It's pretty easy for us.

Ben Felix: Yeah, we didn't have to say much. We did have a bunch of sort of key topics that we wanted to cover throughout the discussion and we didn't even have to moderate that. I think Mike and Randy really covered a lot of ground themselves.

Cameron Passmore: Those really have seen the point that Mike was making about the structural shift and pension systems going from DB, defined benefit plans, over to 401(k) auto deposit into target-date funds is really interesting. And that de-risks the system. The system has less risk. Did that increase price, therefore lower future expected returns? Quite an interesting thing to think about. I don't know who's right or wrong in this.

Ben Felix: That's one plausible argument. But just more generally, it's a plausible argument that if index funds make investing less risky for individual investors, the shift to index funds could plausibly reduce expected returns because stocks become less risky.

Cameron Passmore: But it also makes the company less risky, does it not? Because a company is not now liable for the pension fund.

Ben Felix: In the case of the corporate pension plan, yeah.

Cameron Passmore: The company like that – they mentioned GE as an example. GE, if it's shifted away from a DB to a 401(k) plan, structurally is a less risky company, I guess.

Ben Felix: It doesn't have that liability, I guess. Yeah, makes sense. That's one of my arguments. This is one of our longest episodes, if not our longest, when you include the introduction that we're recording right now. There's plenty of nuance and bits and pieces to pick up.

Cameron Passmore: I thought to Randy's point about – and Mike as well, just the rise of the mega -sized smart firms. And they say there's no more fundamental analysis going on. These mega firms with mega-access to leverage. Super smart people running these quant firms that are really having a huge impact on the market. It's kind of side-info.

Ben Felix: Hard to believe that nobody's setting prices. There's got to be someone doing fundamental analysis somewhere.

Cameron Passmore: Interesting point.

Ben Felix: Maybe not. I don't know. We haven't yet said who the second guest is, Randy Cohen from Harvard. He is the MBA class of 1975. Senior lecturer of entrepreneurial management in the finance unit at Harvard Business School. He is a University of Chicago graduate, PhD, and he told us he was Fama's TA for a while he was there. That was kind of cool. But he knows a lot of our past guests and stuff like that.

He also serves on the board of the Massachusetts Association for the Blind and Visually Impaired. And he's got a podcast, Dangerous Visions, that's about those topics where he interviews fascinating people who are in some way connected to the world of vision loss. He's a super interesting guy on multiple fronts, but very well-spoken, very well-informed perspectives on the topics that we talked about.

Mike kind of needs no introduction. He's at Simplify Asset Management. He's the chief strategist and portfolio manager. Or sorry, he was previously the chief strategist and portfolio manager for Logica Capital Advisers. He managed Peter Thiel's family office for a bit, Thiel Macro. Anyway, Mike gives lots of background on that Thiel experience specifically when he was on the podcast and bull stories there. Mike's a practitioner with lots of experience.

This topic is really – I mean, you can hear it when he talks about it and when he writes about it. He's very passionate about this concern that he has about how index funds and target-date funds and required contributions and investments into certain types of products are affecting financial markets. So that's what this is. It's a discussion with some light moderation from us with an overall intention of the information that we wanted to get to. But it's a discussion really between Randy Cohen from Harvard and Mike Green about whether index funds are breaking markets or whether they're not doing much. And I don't think we came to a conclusion. I think they both gave lots of arguments. But I don't think anybody came away saying, "Well, I've changed my mind. I agree with you completely."

Cameron Passmore: They said they'd keep discussing via email from here.

Ben Felix: Interesting conversation. We'll leave it at that. And hope you enjoy the large amounts of nuance and little bits and pieces of detail in this fairly long episode.

Cameron Passmore: All right, let's go.

***

Ben Felix: Randy Cohen and Mike Green, welcome to the Rational Reminder Podcast.

Michael Green: Thank you for having us.

Ben Felix: And Mike, we're welcoming you back to the podcast. This is your second time here. All right. To kick this off, what is passive investing?

Michael Green: The definition of passive investing in the academic literature is somebody who holds but never transacts. That's really important because it provides no mechanism for how to get into a market or how to get out of a market. It is presumed you're effectively born like Aphrodite from the forehead of Zeus into a position of holder in the markets. That means you never transact. You never influence prices. You are simply able to participate without any of the frictions that would be "normal" in transacting in a market.

That doesn't exist in the real world. And so, from a practical standpoint, when you refer to passive investing, I would describe this as systematically investing into indexes. People will choose different indices to represent the most accurate would be something like a total market index. In practical terms, the vast majority of that is simply invested into the S&P 500 index.

Randolph Cohen: I just want to say, if we're going to have this kind of serious discussion, we got to keep our facts straight. It's Athena who comes out of the far head of Zeus. Aphrodite is the one who's in the clientele in the waves.

Michael Green: You're right. She comes from the phone. You're correct. I appreciate it.

Randolph Cohen: I'm comfortable with what you say about passive. But I do want to highlight one thing. I listened to some of your podcast. Fascinating stuff. And I talked to a lot of my friends about this stuff in the last couple of weeks. And sometimes the conversations get confused. And I think I figured out why, which is, in a way, we're using phrases like the rise of passive to mean two different things. They're a little bit overlapping, but they're pretty different.

One is, you take a job, they put you on a 401(k) plan more or less automatically. They put it in a target-date fund more or less automatically. And then every day, automatically, or every month or whatever, money goes into the stock market. It's all extremely passive. And so, there are some concerns. Does that push the market up too much? Does it make the market too volatile? I don't think those are big worries. But I know you're concerned about them. And so, that's one set of issues.

Then there's a separate set of issues that there's a whole bunch of money, some of which is that 401(k) target-date money, but a lot of which isn't, which is in passive that people chose to put it into the market. It's not going into the market passively. But what stocks they're buying are just based on percentages in the index. It's not Scala Zeus. And so, consequently, then you have a cross-sectional worry. Might it be the case that Microsoft is too high compared to Delta Airlines in an example I've heard you use because of this proportional buying happening? I'm not convinced that that's a concern either, but I could see it. In other words, on that one, I think we don't have the evidence to say that that's a problem, but it's worth talking about. Whereas on the first one, I actually feel pretty confident it's not a problem. So I just want to highlight that distinction on what passive is all about.

Michael Green: Just to be clear though, the first one you're saying is automatic contributions to 401(k)s, the systematic investing process that emerged with the Pension Protection Act and the QDIAs. You're saying you're not concerned about that.

Randolph Cohen: I'm really not worried that 401(k)/target-date fund/QDAI, is making the market too high or too volatile. I think it's pretty clear that if anything, they're opposite. Whereas the issue of is it possible that if a huge percentage of people put their money in passive funds instead of active, that it leads to mispricing, to reduce the elasticity, et cetera, et cetera, that I think there's something to talk about.

Michael Green: Unfortunately, I see those two as inevitably linked because of the existence of qualified default investment alternatives that force the vast majority of those investors who are now being automatically defaulted in exactly through the passive process that has the distorted effects in part two that you're saying you're not concerned with.

Randolph Cohen: I'm not overly concerned with either, but my point is just to say I have a strong argument I want to make as to why the aggregate market issues are not concerning. And that if anything, the things that have happened have probably alleviated problems with the aggregate market being either too high or too volatile. And then when we ask the question, "Hey, is it possible that there are greater mispricings?" I'm not convinced of that either. But I'm just saying that one seems more like something plausible.

Cameron Passmore: Here's one for you. How much of the market is currently held by passive investors?

Michael Green: My work several years ago suggested that we were north of 35 % and climbing at about 3% year. I would estimate we're around 45%. That stands at distinct odds to what many would arrive at if they simply add up the holdings of Vanguard, BlackRock, etc. Unfortunately, that approach actually misses what I would describe as effectively the surface under the iceberg or under the surface of the water on an iceberg in which passive representation in the institutional space is far, far greater accessing it in everything through futures, total return swaps, collective investment trusts, etc., that are not disclosed in that fashion.

Recently, the work of Marco Sammon and then independently validated through a different approach by Valentin Haddad and the latest rewrite of some of his work suggests that my numbers are very close to directionally correct. Marco Sammon estimates that about 38 % of the market is passively held in just five indices, importantly, not including the total market indices. Valentin Haddad comes to the number around 45%.

Randolph Cohen: I just ran into Marco in the hallway here at HBS and he says, "Hi." He said, "Oh, you're talking to Mike? That's great. He's my buddy." I don't have any particular dispute with those numbers. I'll just point out a lot depends sort of what you count. I was just reading one of Marco's papers, the one with Robin Greenwood, which I'm sure we'll talk about at some point today. They did a thing where they looked at index funds and they just set a cutoff of over 99.5 % correlated with the index was their definition of an index fund.

And what that tells you is, man, there is a lot of money out there that is probably closet index that's at 98% or 99%. Okay, that's not technically an index fund, but that's pretty high. And I strongly suspect there always has been. And then there's a question of, "Well, if you have a sector index, is that an index fund? Is that passive?" Because obviously, if I'm saying, "You know what? I'm selling all my oil sector stuff and I'm buying the tech sector," then that feels like an active bet. But I may have just moved from one index fund to another. I'm comfortable to go with numbers in the '30s and '40s, as you and Mark are suggesting, for purposes of this discussion. But just highlighting that for different things that we talk about, different numbers may be the important numbers.

Michael Green: Just to be very, very clear, in my definition of passive, I exclude things like sector funds. I do not treat those as passive. I do not view them as passive. They are, as Randy said, simply trading a basket of stocks to reflect an active bet.

Ben Felix: That's a good distinction to draw there. We did do an episode with Marco. If listeners want to hear him describe in detail how he came to that number, he does that in his episode.

Mike, I know you explained this in detail when you did your episode. If people want to hear the detailed arguments, they can tune into that. Just for this discussion at a high level, can you explain what your concerns are with the rise of passive investing?

Michael Green: Like any other type of investment strategy. Again, remember, passive is active in my terminology because there are flows, because there is purchasing and selling activity associated with it. It does influence the market. My concern is actually not with the need to get rid of passive, because the introduction of a new style of investing actually adds heterogeneity to a market. It makes it more robust and less fragile in its construction as it initially is introduced and as it becomes a viable member of the environment in which it exists. No different than having a robust ecosystem.

The problem is, is that we have advantaged passive through a variety of tools, most importantly the Pension Protection Act with the opt-in component associated with 401(k)s. And the liability production created by qualified default investment alternatives. It has pushed the share of passive to an extraordinary degree. Anytime you narrow down an ecosystem into a point at which any one particular approach becomes dominant, it introduces fragility into the system.

And in my view, we are well past that point in terms of US equity markets. On my math, we crossed it somewhere around 25%. Part of what I'm actually trying to do is raise the alarm in some ways to preserve access to these types of vehicles and effectively put a tax on those who should have the capacity to make allocation decisions in an active manner to continue to do so. That's part one, is effectively the risk that is created by a system that is overly dominated by one particular approach.

Second is the mechanical properties of a market cap-weighted approach. In a world in which you have inelastic flows, ironically the elasticity of the largest companies is smaller than the other companies. The process of making markets requires you to put up capital. The profitability of that capital is determined by trading volumes and the spread between the bid-ask because the spread between the bid-ask is narrow. And the volumes are large but not that much larger in many of the large-cap names. The influence of these types of strategies is overly large on those companies that has societal implications.

There's a fantastic paper out by Jiang at the University of Michigan talking about the impact on the rise of super firms in the component of the impact of passive. It has created disincentives for economic activity. We see recently the influence of the launch of a "passive product into micro strategy", a two-times levered version of that, that exploded the relative price performance of micro strategy. Again, that's not a passive component, but it's illustrative of an inelastic market that has actually changed economic history by potentially facilitating a transfer of tremendous amounts of resources to a single individual who otherwise wouldn't have been influenced in that way. That's a microcosm picture of the broader macro story we have in our economy in which a select group of individuals are being enriched by these dynamics. And the rest of us are somehow attributing it to insight or performance.

The third component is ultimately the outsourcing of retirement systems around the world from systems of "savings and investment in local communities" to the concentration of those investments into U.S. equities. And this is happening around the globe. Again, this is leading to underinvestment in local areas and small businesses, and overinvestment and an imbalanced economy.

Ben Felix: That's all pretty compelling, I got to be honest. That's interesting. Randy, you're not worried.

Randolph Cohen: That's a lot to respond to. At the big picture level, where can people put their equity investments? They can put it with active managers who are picking stocks and who have the ability, as Mike siloed, to keep some money in cash. So that if the market's up, they could say, "Hey, too rich for my blood. I'm putting more in cash." They could put it in old-school index funds, let's say the S&P 500 or the total market. And you ride it up and down. And then you can do target-date funds where you have, let's say, 60/40, or 70/30, or 50/50, if you're older, perhaps allocation to stocks and bonds and it rebalances.

Mike makes the point about fragility. What I want to say is that there are big differences between different products in terms of how much fragility they add. Mike had a big success in the XIV trade that he talked about on his previous appearance. That is a pro-fragility type of product. That is a dangerous kind of product. It doesn't take that much money in XIV to potentially lead to explosive outcomes.

A passive index fund is a pretty solid. It's not a big pusher of fragility. You need an enormous amount of money in passive index funds to create fragility. Mike thinks we're over the line there. And we can discuss that, but I'm not convinced. But I'll tell you what is a fantastic anti-fragile product, and that is the target-date fund. And so, to me, the biggest thing that I think I disagree with Mike on based on the views I've heard and he expressed, I may have misunderstood, is that, to me, target-date funds are just what you want if you want an anti-fragile market and economy.

What happens is you have COVID and the market goes down a whole bunch. Obviously, COVID was legitimately bad news for companies. But maybe there was an element of panic in there. And what happens towards the end of the quarter? The target-date funds come in and they buy a whole bunch of stock to get back in balance. And so, they avoid. They reduce the problem of markets overreacting to news.

And then if you have good news and the market's going up, up, up. Well, what is the target-date fund? Every time it's up, that target-date fund is selling stock and buying bonds with the money and putting things back into balance and reducing the tendency that you might worry that a market would have. And by the way, that tendency is not in any way related to the passivity.

I mean, I understand there's this triple bank shot argument about big stocks being different elasticity than small stocks. And maybe it's true. Maybe it's not. People have written some theory papers. And history will be the judge on those papers 25 years from now. But fundamentally, if you say the old way was people did their retirement savings in a pension fund, they put the money in and those managers put 60% in stocks and 40% in bonds. And now the money goes into a target-date fund and it goes 60% in stocks and 40% bonds. Those seem like they should be pretty similar.

And if anything, by the way, I've listed the three things at the top. And let's talk about active. The problem with active is it seems like active could be a solution. You got these smart reasonable people sitting around a conference table saying, "Hey, market's gone up so much. We're putting more into cash." That's just not what happens. You can look at the data. I have the data of money held in cash and mutual funds through the COVID period. Before the crash, they were super low in cash because the markets had been doing well and they didn't want to miss the boat. And then the market crashed and then they put a whole bunch of money in cash. And then the market rocketed back up and they missed it with a big chunk of their portfolio because they were sitting in cash. They got it exactly backwards.

And there's a long history of human beings, as the economist Brad DeLong likes to say, we're really fundamentally just overclocked East-African planes apes. And we have gut reactions to things. Dan Kahneman Thinking, Fast and Slow, the second brain, all that stuff. Humans tend to be trend chasers. And so, the passive eliminates the trend chasing and the target-date goes the extra mile and says, "Let's do the opposite."

And that's why when Antoinette Schoar was on the podcast, Rational Reminder, and when Ralph Koijen was on the podcast, both of them – Antoinette, who studies target-date funds, Ralph, who studies elasticity, they both said this is not something to worry about. I think it's pretty clear. If anything, we've done the right thing to push in the right direction against a potential problem.

Ben Felix: Antoinette, we did talk to her specifically about marketing elasticity and target day funds. And she explained that her paper with Jonathan Parker, which I know you've referenced in some cases, Mike, they find that marketing elasticity has increased with the rise of target-date funds.

Randolph Cohen: As you'd expect. How could it not?

Ben Felix: Right. Mike, you mentioned one paper there. I know you've also referenced Valentine Haddad's paper. If you had to give three pieces of evidence proving that your concerns are real, what would they be?

Michael Green: Before we do that, I actually just want to very quickly address the key point. I don't think target-date funds are a bad product. I actually think the systematic rebalancing that Randy is describing is overall a good thing for an individual. The actual ability to do that, there are some really key assumptions behind target-date funds that I think are actually quite important. And I would push back against Randy's assertion that it doesn't actually create trend-like behaviour and chasing.

In fact, what we actually see with passive investing is that it reinforces momentum trends. In many ways, strengthens trends further in markets. The dynamics that Randy is referring to are well written about by Jonathan Parker. They're much further explored by Jiu Lui is now at the University of Washington, I believe, and work that she did as PhD candidate under Hanno Lustig at Stanford, the process of influencing actually financial policy through targeted funds and the rebalancing that is created there is one of my concerns.

The second concern as it relates to target-date funds is simply that like any good idea, once they become increasingly crowded, they presume that the underlying behaviour continues. If you actually look at the assumptions of target-date funds, what they have at their core is an assumption of a positive correlation or a negative correlation between certain asset mixes that allow me to say I'm going to be at 95% in equities in young stages in my career because I presume equities offer an embedded return of X. And I'm going to become with volatility that is higher. And I presume that bonds are going to offer a return of Y at some point in the future.

The cross-asset rebalancing or the cross-asset allocation that would allow me to say something like, "Well, I think bonds yielding 1% are unattractive. Therefore, I'm going to increase my equity allocation," simply does not exist. Now, as Randy points out, that can be an advantage. But where it actually really becomes an advantage is when you are trading in a contrarian fashion to the rest of the market. If everybody figures this out, if everybody tries to trade in the same way, you ultimately eliminate the volatility. But you haven't eliminated in terms of the price component. You've lowered that elasticity and effectively said, "I don't care what's actually happening to equities. I'm always going to add back to them. I don't care what's actually happening to bonds. I'm always going to add back to them."

That process of not caring induces its own fragility into the process. It manifests itself at high share. And again, I agree with Randy that, for most people, target-date funds are actually a positive component in terms of their retirement portfolio. But when everybody starts doing it – and today, under qualified default investment alternatives, the US retirement system has effectively outsourced itself to the target-date fund industry with roughly 90 cents on every retirement dollar now flowing into these types of products and never really changing.

Randolph Cohen: I want to just really try to sort of keep focused on one thing at a time, because if we jump from what's good for market fragility to what's good for individual investors, to the regulatory environment, to what's good for local businesses, it's gonna be hard to get to consensus on some of these points.

The example you gave, I think, is exactly where target-date funds shine. If the bond rate goes down to 1%, well, when bond yields go down, bond prices go up. So, bonds will go up, and then the target-date fund will sell some bonds and shifts to equity. Now, it is certainly true that as an individual, you could do your own research, and you could say, "Hey, it's going to sell all 7 % of my bonds and put into equity." But I think 11 % is the right amount to sell.

What I say is the vast, vast majority of people probably aren't very well qualified to do that kind of analysis and come up with a great answer. But to the extent that they are, they can move their money out of a target day fund. Anybody who's sophisticated enough to be making those kinds of decisions is sophisticated enough to not just stay in a target-date fund because that was the default option on the program. Most people will stay with the default because most people don't want to do that calculation and figure out, "Should we be 55% equities or 60?"

I sat on an investment committee of a school. We had a person on the team who was an investment consultant. An investment consultant. There were all these top private equity people and hedge fund people on the board, because it was a school with a lot of people who were in the finance business and kids there. He said, "I think we should go from 60% stocks to 55% stocks because of this, that, and the other. That's what we're recommending to our clients." And all these people sat around and we were all like, "We don't know. We don't know if it should be 60 or 55. That's really hard stuff."

And so, I'm just saying, automating that process and then giving people the flexibility to change it if they want to seems pretty good for individuals. But more importantly, it's anti-fragile. And so, I feel like we should be able to agree that the target-date fund, that people's 401(k) money going into – remember, people are going to save money. I'm a little confused listening to arguments across podcasts. Is Mike saying that people should save less? Or is Mike saying they should save a lot but they shouldn't put as much into stocks? Or is Mike saying they should save a lot and put the same amount and put 60% on average into stocks but they should move it around more based on their own study and instincts rather than based on a formula? Because none of those sound like they've helped the situation to me.

Michael Green: Very quickly. A couple of key points. One is there is actually a very material difference between a pension and a 401(k). Not just in terms of the process of money flowing in, but in terms of the underlying liability. What we've really done with the system is we have said we can't have any individual or entity responsible for your retirement.

I work at General Electric for 30 years. They're not responsible for my retirement. Because as we showed in the 1960s into the 1970s, the liability incurred under that process is something that any one company couldn't bear. We then turn around and we say, "But collectively, the answer is for all of us to invest into the stock market. If the stock market fails to perform, what have we actually done for future retirements?" We've impaired them significantly across our entire society.

That, by definition, is far more fragile than the failure of any one entity. The process of actually changing it from something that has turned from a responsibility for a small atomistic component in terms of a corporation to something that then turned into an atomistic component that you as an individual to something that has now become a collective societal risk is really the key points that I'm highlighting there, Randy.

Randolph Cohen: I don't buy that, Mike. We had both those risks before. Before we had the risk, the GE could go down and fail to pay its pension obligations. Or that the whole economy and market could perform poorly, and then all the companies would struggle to pay their benefits. Your point is we didn't get rid of the second one. If all the economies perform poorly, then people are gonna be hurt on their retirement, but they've got a chunk in bonds.

If their stocks do meh, but their bonds pay off, because those are government bonds, it's gonna be okay. It's not as good as you'd like but it's not terrible. I feel like we went from two major concerns to one concern that we partly mitigate and that seems pretty good.

Michael Green: And again, when you look at that on a collective basis versus an individual basis, I agree with you that there are some components of removing the fragility associated with the failure of an individual company. But when we allow the failure of an individual company, we actually are increasingly making a system robust. The company didn't deliver the products. It didn't deliver the outcomes. We turned it into a societal and collective problem. The process of transmitting that risk actually raises the valuation of everything in the process. Lowers the forward expected return. Because by definition, it's less risky. And yet, we've promised people that these underlying assets will offer the returns that allow them to secure their retirements that they desire. Those two are completely incompatible.

Randolph Cohen: I don't understand the argument as to why we raised valuations or made things more risky.

Michael Green: Let's just be very, very clear here. We have made the system less risky. But in the process of doing so, we've raised valuations. Because anytime I make something less risky, by definition, it is worth more if it delivers the same cash flows.

Randolph Cohen: That's not true.

Michael Green: Of course it is.

Randolph Cohen: Let's say there's a pile of stock worth a million dollars. One thing we could do is say we'll each take half a million. The other thing we could do is say we'll toss a coin, and if it comes up heads, I get the whole million. If it's tails, you get the whole million. Well, the second one is riskier. If we switch from the second to the first, we made things less risky, but we didn't change the valuation of that million dollars. By doing risk sharing, we don't cause the stock market to be overinflated. I don't see that at all.

Michael Green: I completely disagree with you. Option theory would fly directly in the face of that.

Randolph Cohen: I don't agree that – look at my coin toss example. The fact that we're both at risk doesn't change the value of the pile.

Michael Green: Let's actually sell admission to the coin toss. There's three players. If we flip a coin and it comes up heads or tails, two of them get to actually split the million dollars. If under your game, only one person gets all of it. How much would you pay for a ticket that pays out two winners at 500,000 versus one that pays out for a third chance at a million?

Randolph Cohen: I can tell you that Elon Musk would pay pretty much the same thing for both.

Michael Green: Correct.

Randolph Cohen: I'm not rich enough to pay the same thing for both. But the way the stock market works is that people with deep pockets are the price setters.

Michael Green: No. That's actually not true. That's actually part of the point that I would make on this, is that when you actually allow the participation of more people who actually are changing that company – Elon Musk is not marginally setting the price of the S&P 500.

Randolph Cohen: I think we're getting off track. Before we got a thing where if you work for GE your whole life and then GE went bankrupt, you lost your pension fund. And now we've gotten rid of that. And your point is that makes GE overpriced? That doesn't fit. There's no connection there. What do you think is overpriced?

Michael Green: What I think is actually overpriced is the underlying asset. And by the way, I just want to be very clear. Overpriced is not actually what I'm referring to. You've lowered the riskiness of the investment. You absolutely lowered the risk of my "pension" by moving it from GE to the stock market. The stock market is less likely to fail than GE is.

Randolph Cohen: But there's no price on my pension, right? I'm not selling my pension to anyone.

Michael Green: Of course there is.

Randolph Cohen: I don't understand that.

Michael Green: Every financial asset, whether it's a pension or whether it is a portfolio of stocks, has a value.

Randolph Cohen: Just the value of the underlying claim.

Michael Green: This is actually really important. It's not actually true. What you are describing with a pension on GE is an annuity that is discounted at the value of GE's cost of debt. If I change it from GE to a societal component, by definition it now lowers its cost of debt to the US government. That annuity is worth more.

Randolph Cohen: I agree that I'm better off as a pensioner if I know the money's coming. That doesn't lead to overvaluation of the stock market or anything like it. And I don't understand why the fact that my pension fund is safer has somehow damaged anybody. Who's it hurt? It hasn't hurt me. I'm way better off. Who's worse off? I don't know what your concern is here.

Michael Green: The point that I'm actually making is that by making the process less risky, forgetting any implementation component, by moving from something that was invested in by GE that then was acclaimed against GE against potential performance of that, that has a very different valuation then if I'm saying, "I'm going to do the exact same thing in the stock market in total." You referred to it yourself. You said, "We've taken these risks out of the system. If I take risk out of the system, that annuity has to be worth more."

Randolph Cohen: That's just creating value. Your point is, if you have an insurance company, you can make everybody better off through risk sharing. And I agree with that. But it's not like it pushes the stock market up or pushes the value of stocks up. Normally, I hear concerns from you that the value of stocks are being pushed up artificially. Maybe that's not the point you're making here.

Michael Green: That's not the point I'm making here.

Randolph Cohen: What are you worried about? What's the problem? So now everybody's better off because we have some risk sharing. So that's a plus. There might be minuses that outweigh it.

Michael Green: Which, to be clear, is exactly why I said I think that's important to actually articulate. I'm not trying to take away passive investing. I'm not trying to take away people's 401(k)s. I'm recognizing that there are benefits of distributing this on a societal basis. Absolute positives associated with that. The challenge is that we then specified a particular form of investment that should be available to people and gave it a liability advantage component that has now forced everyone to believe what you started off with, which is I have options for my savings. I can put it in the S&P 500 or I could put it into an active manager. No. Actually, you could invest that into your own business. You could invest that into your local community in a manner that is non-public. These are all things that have taken a backseat at this point.

Randolph Cohen: You're saying if people had no retirement, but I thought your concern was with the switch from defined benefit plans to 401 (k)s. You're saying if we just got rid of all retirement savings, then people would do whatever they want. Now, obviously, we know from history that what a lot of people do is they consume it now because people are always challenging getting through the day. And so, what you see is very little savings. And then you have a problem because you have people who are old and hungry. And they can't work because they're too old, or too sick, or too disabled. And they consumed their stuff for perfectly good reasons. Not criticizing those people. I'm saying they had kids who needed taken care of and they had lives they needed to lead. And they had unexpected things happen. And now they find themselves and they're 82 years old and they can't work and they don't have any money.

And then the question is, well, do we let them die or do we support them as a society? And I think we're the kind of humane society that will support them. But then once you know that as a society you're gonna support them, then you kind of need to set up something. You have a set of compatibility problems if you don't set up solutions to encourage people to make sure they save.

Michael Green: Again, I completely agree with that. I would point out the obvious contradiction, which is people used to save more prior to the introduction of these systems. They save less today than they did before. But that is absolutely correct, Randy.

Randolph Cohen: There's lots of ways of measuring these things and lots of other things in society change in terms of how many children people have. And whether children take care of their parents. And you have this weird situation where you introduce social security and then you give benefits to people immediately but they didn't pay into the system. So this is a complicated subject.

But fundamentally, yes, people will probably do. If you don't give people anything to rely on, then they'll have to do precautionary savings. But that's problematic too. There's real advantages to giving people set ups like social security and pension funds so that they know that they have something to rely on in retirement. But you're right that if you say to them, "Hey, if you come up one penny short, then we're not going to treat your heart disease and you'll die," then people are going to say, "Well, I better save enough to make sure I don't come up a penny short."

Ben Felix: Just on the amount people are saving, we did ask Antoinette Schoar about that because she's looked at it in some of her papers. She sees no change in savings. I'll read you the quote. She says, "Actually, that's a very interesting question because you see they haven't necessarily affected how much people put into retirement savings, target-date funds. According to research I've done with my colleague, Jonathan Parker, and the PhD student of ours, Allison Cole, we actually see that they don't necessarily increase the amount people save, but the way that people allocate their retirement savings." She's saying no change in savings, but different asset allocation over the life cycle with target-date funds.

Michael Green: Which is exactly the point that I'm making.

Randolph Cohen: Do you want people to put more in stocks or less in stocks? Or do you think they have it about right? I mean, that's what I'm trying to figure out. I feel like what you're saying is they're putting too much into stocks and it's pushing the market too high. I can't prove you wrong on that. So don't worry, I mean, if that's the answer. But is that your view that people being 60/40 in stocks in middle age and then 70/30 when they're younger, that you feel like they should have a lot less than that in stocks?

Michael Green: I'm ambivalent in terms of what percent they should put into the stock market versus anything else. But I am very much objecting to is the fact that we have created a form of investing that actually prioritizes exactly as Ben points out, scare savings. Does the savings have an increase? We're exclusively allocating that now to a small segment of the U.S. infrastructure in the form of public equities and then a random component abroad. And because this is happening in such a concentrated fashion, it is actually meaningfully affecting the structure of our economy and our society.

Randolph Cohen: And you say it's a concentrated fashion because it's in the 3,000 publicly traded companies instead of you took your retirement savings and invested it in your neighbor's store or something of that nature. And people would be doing more of that, do you think?

Michael Green: Yes.

Randolph Cohen: I see. Interesting. We could reduce the amount that people put into retirement savings and then hope that they'll take the extra money and put it into things that are socially productive instead of consuming. And they might – it's not like I have studied the rules on 401(k) and say, "Hey, people are putting in 3%. And damn it, 2.9 would be a horror show. It has to be three." I don't know what the right number is. And so, if you think that number should be a little lower, I'm open to that possibility. I can't help but think it's like there's a part of you that wants to say, "Gosh, there's probably been, in the last 18 months, 150 articles in the Wall Street Journal about how people are saving too much in their retirement. Oh, wait, the opposite." All you ever read in the financial press is criticisms that people aren't saving enough.

Now, I understand your point is, well, if we didn't force them to save so much, they'd save just as much, but in other ways. And maybe it's true. I just don't know the answer. I mean, I think Antoinette's referring to a change when we went from other kinds of investment vehicles into target-date funds being so popular. And that didn't really change savings amounts.

Michael Green: What she's actually referring to is mandated employer contributions in the opt-in versus opt-out framework.

Randolph Cohen: My guess is if you reduced the amount that people contribute, the overall savings would go down but not by the full amount of the difference. You're absolutely right that they would save some. And who knows? Maybe they would save just as much. My mind is open on that.

Ben Felix: You guys lost me a bit on the pension example. I didn't really understand how eliminating corporate retirement pensions would affect market valuations. Or I don't know if that was an analogy. I was a little bit lost there.

Michael Green: Initially, it wouldn't actually. But as you effectively take people who don't want to make these decisions and you provide them with an approved path through a qualified default investment alternative, and you tell them, "This is the way you have to save." That collective decision is going to push the values of those entities higher, lowering their marginal cost of capital versus every other company that's out there, and in turn, facilitating a concentration on our economy that ultimately adds dramatically to risk.

It's really important that people understand this. All risk and all diversification has effectively a U-shape to it. If I invest in just one stock, risky. Two stocks, less risky. Three stocks, less risky. If I invest in 3,000 stocks, not appreciably less risky than investing in 35, as you know, from diversification benefits. But if everybody is invested in those exact same 3,000 stocks in exactly the same proportions, actually that's paradoxically much more risky.

Randolph Cohen: I don't really find that persuasive. But the 35 graph that we've all seen in intro textbooks is the number if you have zero correlation among the stocks, which is not the norm. I think there's substantial diversification benefits to having thousands of stocks instead of just a few dozen. The notion that if people had half as much in the stocks and then the other half they put into a building across the street, a triple-decker that they then rent out, that that's somehow safer because now they're more diversified by adding that local investment. I don't find that persuasive. I think a broad-based investment in thousands of companies plus low-risk or safe bonds is pretty good.

Now, that's not to say we couldn't find ways to make it even more diversified. And obviously, you see talk about adding other kinds of alternative investments to the mix in retirement funds. And that's something that's worth exploring. I'm a finance professor. So I'm never going to tell you, "Oh, let's have less diversification." But I don't think that you get more diversification if people take a chunk of what's currently spread out among thousands of companies plus bonds and put it into private local investments. I think those are going to tend to be pretty undiversified. You're not going to put $5 each into 100 different local buildings or whatever.

Michael Green: In part because we don't have the opportunity to do that because we now have mandated this type of vehicle. There's nothing that would have prevented a local real estate fund from popping up to invest in Cambridge real estate, for example. That could be a component of the local community. It would be a very important component, particularly as it relates to things like large institutional accounts. It's insane to me that an entity like Harvard or an entity like CalSTRS in California allocates its capital on a fiduciary responsibility in which that fiduciary model is held against the performance of the S&P 500.

Instead of recognizing that as CalSTRS, your members benefit from California flourishing. And as a result, there are ancillary benefits associated with capital investment in your local markets. On an individual basis, Randy, I completely agree with you. I am far more diversified because I have access to large-scale financial assets. That's a positive. And again, I can't understand how you don't understand or don't see how that raises valuations by seeing that things have less risk associated with them.

But at the same time, there is a societal cost that's associated with the mandating of that behavior. That's what my complaint is against. I think that systematic passive investing is like any other form of investing. It is a style of investing. Why it receives priority and the implications of it rising to a certain scale is all I care about.

Randolph Cohen: It sounds like the difference between us is you think you know what the right percentage is that people should have in simple low-cost forced savings vehicles. I'm saying to you, if they're saving 3% and you tell me it ought to be two and a half, my mind is open to that. But is the reason you know the answer because the answer is zero? That they shouldn't have to put any of that? Or are you saying, "No. No. They should have to put some in that. But the amount that companies are currently doing is too high."

Michael Green: I don't actually know what the right answer is. And would argue that the tools that we have for trying to estimate that have been corrupted by this process of transitioning. We need to understand the impact of what happens when we increase the proportion of passive or systematic index investing on valuations and forward expected returns before you can come to that answer. You cannot use history in deriving that answer.

Randolph Cohen: Can we push on that? Because this, I think, is the biggest thing we disagree with. I've heard you speak on this subject a number of times, and it seems very clear. You said the last time you were on Rational Reminder that this money flowing into these 401(k) plans, instead of – I mean, I assume you don't mean instead of the alternative where they just set it on fire. The alternative is that let's say the old-school defined benefit pension plans which we have for a hundred years. And in those plans, they were pretty much investing 60/40.

Now you have this money going into 401(k) plans and investing 60/40. And your notion seems to be that that's going to make the market be five, six, seven times overvalued. I don't buy that at all. And I guess I would like to understand your argument better. Because A, it's about the same amount of money going into stocks either way. And B, the flows aren't nearly large enough to have a big impact.

And I guess maybe you could start by saying how overvalued do you think the market is now as a result of this? We've had this stuff going since 2006. I forgot to look what the market's at today. Was it like 5,700 or something like that? How much lower do you think it would be if we just stuck with defined-benefit pension plans?

Michael Green: If we had not changed the process, in other words, if we X-out the component of passive, my estimate would be somewhere in the neighbourhood of the 50% reduction in valuations.

Randolph Cohen: So that is super helpful. So help me think this through. When I got to grad school, the most famous paper in the field at that moment, this is early '90s, was Mehra and Prescott's paper on the equity premium puzzle. And they said if you look at the riskiness of stocks and bonds, stocks are riskier and they should have to pay a premium. But if you do the analysis, that premium should be something in the neighbourhood of half a percent a year. But historically, stocks had outperformed bonds by something like 6% a year depending, let's say, if you use long bonds or whatever.

Currently, stocks are priced to return something like bonds plus 2, maybe 3% a year. Let's call it two. Based on the best theories that we have, it seems like stocks still look cheap. And you're saying, no, no, stocks should cost half as much. Stocks should be so cheap that they just crush, kill, and destroy bonds every year. And then people shouldn't go out and race out to buy them any more than they currently do. If stocks were way cheaper, everybody should buy a huge load of them until the equity premium is lower. And that would push the price up back to where it is today or arguably even higher. Why do you think that the equity premium needs to be so much higher than it is? Why do you think people shouldn't buy stocks unless they get a gargantuan premium for it?

Michael Green: There's two separate components to that. First, Prescott and Merah operate under an assumption of an ergodic versus non-ergodic system. And this is actually really critical to understand. If I think about normal distributions and standard deviations of returns and run money parallel simulations on that basis where I look at history which has a survivorship bias associated with the mere fact and able to look back at history of stock market implies a component of survivorship bias that doesn't exist in many regions around the world. Let's be very clear on that.

If I try to model this as an ergodic system saying stocks are expected to return 8% with standard deviation of 16% on either side of it, in other words, roughly mimicking history, I'm presuming that the future is exactly like the past. And secondly, I'm presuming that each individual's experience is actually distributed in a similar manner. An ergodic system is one in which the time series average is the same as the ensemble average. That works for many games of chance or things or things like rolling two sets of die. If I roll two sets of six-sided die a thousand times in a row, I'm going to get the same distribution as a thousand people rolling at one time for a very, very similar distribution.

On the flip side of that, if a thousand people invest for one year in the S&P 500, that's not going to have any resemblance to my return if one person invests over a thousand years in the S&P 500. Those are radically, radically different experiences.

Randolph Cohen: What's a fair equity premium? I understand there's a question of Mehra and Prescott estimated the historical equity premium by history. And obviously, if the market then doubles, the history gets higher but the future gets lower. So fine. You and I might have a difference of opinion on the forward-looking. I don't know if we do. But what do you think the right equity premium is that should set things in equilibrium?

Michael Green: I think it's completely conditional. First, when you define equity risk premium, you're using a valuation assumption. You're simply reporting dividend yield versus treasury yield or an earnings yield inclusive of stock buybacks. You're making some assertion about the forward expected returns that I'm simply arguing you can't make.

Randolph Cohen: I'm thinking assertion. I'm asking you what forward expected returns would cause you to say the stock markets at the right price? You think the stock market should be half where it is now? If I'm a really clever, I could just translate that into a forward-looking expected return. It sounds like if I'm doing some quick back-of-the-head calculation, you'd be saying instead of stocks paying long bonds plus two, you're saying it should pay long bonds plus four or five or something like that. Is that in the ballpark?

Michael Green: You asked me actually a very different question. You said what would be the impact if this hadn't occurred? What was the impact of that in terms of valuations? If we were to remove that, I think stocks would be 50 % lower.

Randolph Cohen: Let's switch to that then. I don't understand that at all. Ralph and Xavier have this wonderful paper. It's controversial. So they say, "Wow, markets are way less elastic than people thought." I think it's a terrific paper, but there's plenty of people who think, "No, no, no, it's not as elastic as they say." Let's take theirs as given. They say a dollar goes into the market, it moves the market $5. If you take all the money that went into 401(k) plans last year, it was about 2% of the size of the market. I looked it up. Something like 60% of that went into stocks being 65%. That's like 1.2 % of the market. And then you apply a 5% to it and you say, "Okay, that should push the stock market up 6%."

Then you have to ask yourself, "Well, how long does the impact of that trade last?" And let's say it lasts forever with a half-life of one year. So you make a trade, you push to market up a bunch. And then a year later, it's still half that effect is in there. And a year later, it's half that and so forth. That's, I think, a pretty long half-life. Most people think the half-life should be a month, or a quarter, or a week. Not a year. But let's make it a year.

Under that math, all the 401(k) contributions that have ever happened would make the market something like 12% higher. So how do you get 50% higher? And by the way, I want to be clear, that's if zero of those dollars had gone into stocks. In other words, if they'd gone into the defined benefit pension plan, they'd bought just as much stock. But let's imagine that instead they lived it all on fire, then I feel like the market would be 12% lower. Not 50% lower.

Michael Green: That would be great and absolutely true if we were looking at a single period. But because those 401(k) flows are happening on a continuous basis.

Randolph Cohen: But I accounted for that.

Michael Green: No, you didn't. What I actually did was you said, "If I put all the money in, that would have raised valuations by 6%."

Randolph Cohen: And then last year's would have been 6% then, which is three now because it's half. That's nine. And then the year before that would be six, which would be three, one and a half. So I'm just using the easy math that one plus a half, plus a quarter, plus an eight, plus a 16th equals two. And that's why I doubled the 6%.

Michael Green: Now, turn it into a time series in which it's a multiplication as compared to an addition. It's 1.06 times 1.06 times 1.06 times 1.06.

Randolph Cohen: No, that's not true.

Michael Green: Yes.

Randolph Cohen: No. It's 1.06 times 1.03 times 1.015. So maybe it's a tiny bit over 12 because the compound. It's still gonna be 12.

Michael Green: No, not at all.

Randolph Cohen: In order to get the number doing, you have to assume that if somebody made a trade 13 years ago and pushed up the market, every single bit of that 13-year-old trade is still pushing the market up. Do you actually believe that? That can't be true.

Michael Green: Absolutely.

Randolph Cohen: I'm saying there's a half-life where the effect of that trade deteriorates a little bit each year.

Michael Green: Walk through the math very simply. First year, 1.06. We agree on that.

Randolph Cohen: Right. But then three of it, you give back the next year.

Michael Green: Hold on. After one year, I'm at 1.06. Now I have another flow come in that has a similar impact. That's actually 1.06 times 1.06.

Randolph Cohen: This is the heart of the matter. I'm saying at the end of the second year it's 1.06 times 1.03. Because the first year's effect, it goes up 1.06 % when you make those purchases. But then by a year later, you've given some of that back. You can't just keep adding up forever. That would be crazy.

Michael Green: It does.

Randolph Cohen: Nobody thinks that the impact of every trade is a permanent impact. Of course, it has to have a half-life.

Michael Green: I totally agree.

Randolph Cohen: What do you think the half-life is? I used a year, which I thought is super long. Do you want to use something even longer?

Michael Green: Let's use a year. Let's stick with your number. But let's recognize that each year has a similar compounding effect. Run through the math.

Randolph Cohen: Let's do five years and I'll tell you what I think and you tell me if you agree. The most recent year is a factor of 1.06. The year one BAF is 1.03 because it did 1.06 but then half of it being reverted over time. And then the year before that is 1.015. And the year before that is 1.0075. And the year before that is 1.00375. So then you multiply those out. Basically, it's like six plus three plus one and a half, which gets you to 12. It's a tiny bit higher than that for compounding.

In order to get giant effects of the type you're worried about, you have to make two crazy assumptions. First, you have to assume none of those dollars would have gone into the stock market if it weren't for 401(k) plans. But that's not true. We know that in the old days they had defined benefit plans and those went into stocks in about the same proportion. I would argue there should be no effect.

But even if you make the super extreme assumption that if this money hadn't gone into 401(k), it all would have been lit on fire or buried in the backyard or something. Then you still only get 1.06 times 1.03 times 1.015. You're up 12%. Even 10 years from now, it's still only 12% because you always have the most recent years of six and then a year that's half as big and a year that's half as big. So you never get an explosive thing from this, again, even with that first crazy assumption.

Michael Green: Randy, again, the math that you're doing is wrong. Stop for one second. Let's accept your proposition. 1.06 the first year. It degrades to 1.03 the second year. Now I introduce another 1.06 onto a market that is 3% more expensive. So that actually takes it tiny bit overnight. Okay, so now let's do it again. So let's say that effect degrades by 50%. That .918 is now down to four and a half. I multiply it four and a half. So 1.06 times 1.045. Now we're at 10 and a half. So now I take that number, I divide it by two, I add it to one, and I take 1.06 times that.

Randolph Cohen: Five and a quarter. Next, now you're at 11 and a quarter. Do you see that you're closing in on a little over 12? It's going up less every time. This is like a Zeno's paradox. If you use no compounding, it ends up exactly at 12. But with compounding, it'll be a little over 12.

Michael Green: Okay. So after four years, I'm already past 12 in that analysis.

Randolph Cohen: Do you agree that if we use the bull instead of compounding, it would be exactly 12 after 100 years or 1,000 years?

Michael Green: Yes. Of course, I do. But that's the problem.

Randolph Cohen: I agree that it's compounded. We'll pull out Excel and you'll see. I'm not saying it won't be 15 instead of 12. It might be 12 and three-quarters or it might be 15. But it's not going to be 50 or anything. It's not going to go up that much because you're adding these tiny little factors on the end. You're adding 1.00375. There just isn't that much compounding. Anyway, we'll do the math.

Ben Felix: Randy's math seems to make sense, Mike. I'm missing why it's wrong.

Michael Green: Let's run through this here very quickly.

Ben Felix: We're doing Excel right now? I love it.

Michael Green: Might as well, right?

Randolph Cohen: Seven years. 1.06 times 1.03 times 1.015, and you can do the rest.

Ben Felix: While you're working on that, Mike, the follow-up question I have, and Randy kind of alluded to it. We'll finish this discussion. We'll run the Excel. After that, I want to talk about why is this different? We're talking about money going to target-date funds or index funds. Why is that different from flows going into active, which is kind of a different version of the DB pension plan? Why are flows going into this specific type of investment having a more concerning impact then flows going into actively managed funds or whatever. Anyway, park that. I want to hear what the Excel says.

Randolph Cohen: Because you can see by the time you get to seven years, you're down to really tiny factors that you're adding on.

Michael Green: Unfortunately, I'm still trying to get the Excel numbers in, because I'm working off of a single laptop.

Randolph Cohen: Let's see how Siri goes. Hang on. What's 1.06 times 1.03 times 1.015 times 1.0075 times 1.00375 times 1.002 times 1.001 times 1.0005.

Siri: 1.1624.

Randolph Cohen: I went a little high at the end because I couldn't do the dividing 37.5 and half in my head fast enough. But it got us up to 16 instead of 12. It just doesn't go that high. Seven years, it's not going to add much if you keep adding those tiny factors. It's probably between 15% and 16%.

Michael Green: I come to a similar conclusion. Again, it just becomes a question of what is the degradation and what is the process of actually switching. And so, Ben, this is exactly the point it's making.

Randolph Cohen: And I want to break your point there. If the half-life is five years, not one year, you could get to something big. So I leave it to our listeners to ask themselves. Do you think if you go into the market and you buy 10,000 shares of Apple, that five years later, Apple is still the full amount higher of your price impact or even half as much higher? I feel like we all know that it degrades faster than that.

What Ralph and Xavier did is that they showed us people thought it degraded in minutes or hours. And what they showed us is it could be weeks or months. Maybe it's even a couple quarters. And that's why I'm granting a year, which I feel like it's kind of the outside. But I don't think it's plausible that it's five years as a half-life. I admit I don't have good fun.

Michael Green: I think this ultimately is what boils down to the question. And when I look at papers like Jiang or others, it really does matter in a really big way what that degradation is. To your point, if that degradation is very temporary, and now you have to provide me with a mechanism that says why the price falls by that amount, why does it degrade by 50%? Who is the seller that is actually showing up and lowering those prices? If your argument is, is that it is active managers, as they become a smaller and smaller share of the market, you have to believe that that impact period is rising and creating the exponential features that I'm describing.

Randolph Cohen: The number one seller these days is probably target-date funds. If the market gets pushed up artificially, target-date funds automatically sell stocks and buy bonds. That's one seller that you know is in there in a big way. Then there's a bunch of institutional investors who default to 60/40, or 50/50, or some other number. And that may be old-school pension funds or who knows? They may be insurance funds that only are allowed to have 10% in stocks. And so, every time stocks go up, they have to sell some and so forth.

You've got wealthy individuals who have an advisor who tells them, "Hey, we shouldn't go over 70% stocks. Or you shouldn't go over 50% stocks now they are older." Or what have you. And by the way, there's companies that can issue stock. And obviously right now, companies are buying back more than they're issuing. But I would argue that's evidence that the market's not overvalued. The people who are in the best position to know what these companies are worth are buying back rather than issuing. And you see they do it when it's crazy.

Look at GameStop. What happens is some person puts up some emoji on the web and then GameStop goes up 38%. And then the guys who run GameStop say, "Hey, we're issuing another billion dollars’ worth of stock." There are a lot of mechanisms out there to get things back under control. And I'm granting, it might literally last forever. But by a year, half of it's gone. And by two years, three-quarters of it's gone and so forth.

I'm granting the fundamental point that you're making and Ralph and Xavier are making that this stuff takes longer than you think. And that there aren't as many natural fixers in the market as you would think. But I'm saying, "Boy, I can grant an awful lot of that and still not have an explosive problem.” And that's, again, if we come back to our host's point, what about this issue that people were going to put money in the stock market anyway? TDF is just one way of doing it. That was old-school pension funds. Why is this so different?

Michael Green: The single biggest difference is that the elasticity of an active manager is much higher than a passive manager. Because endogenous inside the fund, they are making the choices that Randy is describing. If I remove that, I'm presuming that everybody is reacting, which is exactly what Randy is talking about in this period of how long does it take to take out that response. If you actually look at G and K's, Xavier Gabaix and Ralph Koijen's work, they're taking that five as an average. But if you look within, what's actually happened is that average has gone from two, which is roughly the impact of an active manager. 1.88 is the number that Valentin Haddad and I come down to.

As you add passive, you're making the participants of the market less elastic and less capable of allowing that degradation that Randy is highlighting. That's why inelasticity rises as passive share rises. The multiplier effect gets larger and larger.

Randolph Cohen: So, help me understand why the active guys have less impact. If it were the case that when the market goes up, they held more in cash, then they might be better than passive. Although, still, they probably wouldn't be as good as target-date funds for the elasticity effects. But the reality is that when the market goes up, they have less in cash because they're terrified of missing the run-up. Because it's so crucial that you have to be a five-star fund when the market's doing well. So you have to be fully invested when the market's running because that's the only time inflows come in.

It's very clear in the data and it's very clear logically that they don't even go the right direction. They're trend chasers. And so, if they're trend chasers and pass it as flat and target-date funds are actually going against the trend, then why would going from active to target-date funds create an elasticity problem?

Michael Green: Again, it is not a question of the target-date fund vehicle per se. What I'm highlighting with target-date funds is something very different, that they are causing people to behave en masse. Absolutely agree. If you actually look at the importance of what you just said, it could cause people to buy too much of any one asset as its price goes up or down. Paradoxically, if I look at something like what happened in 2022 with the bond market sell-off, if I looked at the construction of the indices, the bond indices, they had become heavily over-weighted to long tenor, low coupon insurance. Why? Because those are the ones that rise most in value when interest rates are cut. And that in turn means that they're most heavily weighted in the index.

The within bond performance was far worse than anything that had ever come before because we had actually driven this inside the asset class. Again, I'm not disagreeing with you. Now the target-date funds are actually – let's say that they're 60/40. The reality is they're more like 70/30 in terms of the aggregate dollar value that's been invested in them. They are not waiting bonds anymore today at 4.5% yields than they were at 1% or 1/2 % yields. That flies in the face of cross-asset return expectations. Unless you somehow believe that equity expected returns have risen by an equivalent amount to bonds even as bonds have fallen dramatically in prices and equities have risen in valuation.

So what you end up doing is you end up creating a position in which you are correct. The aggregate impact of it is actually it causes bonds and stocks to become anti-correlated in an individual portfolio. But it doesn't do anything to address the underlying issues of each of those individual portfolio components, allowing them to go deeply off the rails and forcing outcomes for a broader index like a stock market that could be far worse than you've ever anticipated in your historical modeling. Exactly as we saw in bonds in 2022.

Randolph Cohen: Three points. One, it is the normal assumption that if interest rates rise, expected returns on stocks are also higher for things to be in equilibrium. Now, you may feel that you can outsmart the market and that you know when the market's making a mistake and the market wasn't affected enough by the rise. Given how much interest rates went up, you would have expected the stock market to go down. And it didn't. I think it's pretty obvious. The reason it didn't is people believe the technology changed story, whether It's AI, whether it's the incredible healthcare breakthroughs that are happening. People are saying we think cash flows are gonna be a lot higher. Even with this higher denominator in the net present value formula, we think these stocks are still gonna do well. Maybe people are wrong about that. But a lot of people who thought they could outsmart the market with timing like that have turned out to be wrong.

The target-date funds absolutely took action. When interest rates went way up, bonds went way down. And then they sold stocks and bought bonds. And your point is, well, I know, but they just went back to 60/40 or 70/30. But the point is they absolutely took – actually, they took money off the table in the stock market and poured it into the bond market because of interest rates rising. I think it's not right to think, "Oh, they didn't do anything because they just got back to 60/40 or 70/30.

And then the third point I wanted to make is Ralph and Xavier saying it looks like something that, "Oh, gosh, it's scary for the markets. They're going to get way out of whack. They're going to go too high. They're going to be too volatile." But look how powerful it is that their result is so large in the target-date fund context.

Let's say you're 70/30. 70%stock. Market goes up 10%. Now you're 77/30. Let's say bonds didn't move. So you're 77 and 30. Well, to get back to a 70/30 proportion, you have to sell what, I don't know, 3% of your stocks and put it in the bond market. Maybe it's two. Let's say it's two. So you sell 2% of the 77, and now you're 75/32. And that's probably pretty close to a 70/30 mix. I can't quite do the math fast enough in my head. You sell 2% or 3%.

Ralph and Xavier is saying 2 or 3% times five. If target-date funds were a quarter of the market, then you're gonna have 2% times five is 10. Times a quarter is – you're knocking the market down 2.5% . It's hugely impactful. I'm just saying that the result they have, which says, "Boy, elasticity is potentially scary," is saying that these target-date funds, they're very powerful in helping rebalance markets if they overreact to NIPs.

Michael Green: I would actually agree with that. I have no dispute around that. This is the critical component. When I highlight target-date funds, my issue with target-date funds has nothing to do with the fact that we are using automatic, systematic rebalancing. I completely agree. That actually changes behaviours of markets and makes portfolios fall dampening in that process. This is exactly Parker's point. If I sell equities and buy bonds, to your earlier assertion, have they made an assertion about the forward expected returns to the market? Have I offered any insight in terms of the development of AI?

Randolph Cohen: I'm not saying the target-date funded that. What I'm saying is your point is, "Boy, it seems like bonds are a better deal than stocks now." Because the interest rate went up, so the bonds are paying more. But the stock price didn't go down, so it doesn't seem like the yield on the stock should be any higher. And the answer is, well, the yield on the stocks is higher if they're going to make a ton of money.

Let's take a moment and talk about NVIDIA. The forward multiple on the stock market is 22. Let's say it's 22. Your feeling is, "Hey, if it weren't for this artificial forcing people into things, it would be 11." Which I'd say, "Boy, if you could buy stocks for 11 times earning, no sane person would buy bonds. Everybody would pour all their money into stocks." I do not see that 11 multiple as some kind of natural figure. But okay, that's a disagreement. Let's bracket that.

Market's at 22. NVIDIA's forward PE is 33. Are you really worried that NVIDIA's crazy high relative to the market? Shouldn't it be higher? Shouldn't it have a higher multiple in the market? There were three big anomalies I learned about early in grad school. One was the equity premium puzzle, which we've talked about. A second was the poster and announcement draft that says when there's news, the stock moves the right direction for the news, but it doesn't move nearly far enough. And then the third was the quality anomaly of all the quantitative cross-sectional anomalies. The one that is the biggest in price terms is that high quality companies seemed to trade way too cheap. They don't seem like they're riskier. These are the quality companies. And yet, their returns were really high.

And I feel like your argument amounts to, "Boy, because of the rise of passive, all three of these anomalies still exist, but they're not as big as they were." The equity premium isn't as far out of whack with what theory would suggest it ought to be. The post-earnings announcement drift is much smaller. In other words, firms come closer to going up the right amount when there's news. And then quality firms like NVIDIA now trade more expensive instead of trading just a little bit higher multiple in the market. They trade decently higher in the market, although still probably not as high as they should on a relative basis. Hasn't the rise of passive made the markets way more efficient and better?

Michael Green: Again, a couple of quick points. One, I actually asserted at the start that the contribution of passive is positive up to a point. I just want to be very, very clear on that. The second component that I would highlight this is that when you talk about something like quality factor, part of the components of quality is effectively saying that there's lower volatility associated with the underlying fundamentals that's creating less news on which people would either actively buy or sell the security in response to the information that's coming through.

A passive format effectively grants a special status onto that low volatility component. If a company is up 10% one earnings report and down 10% the next earnings report, it's net down 1%. Company is up 20% one earnings report, down 20% the next, it's down 4%. The first company under a passive framework is going to receive additional premium because it's consistently being added to in size as compared to the more volatile company. My point on this is not to actually say the quality component doesn't exist. In fact, I actually exploited many situations in portfolio construction. But with that said, we can't actually tell what the quality factor is because we are simultaneously dealing with the rise of passive.

Randolph Cohen: I pointed out at the beginning, there's these two kinds of passive. So there's sort of passive sense of these 401(k) type things where the money is just flowing in the market every day without anybody thinking about it. And I think that's a really good thing to look at. I'm not as concerned as you are about it. But you're absolutely right. Hey, could we every once in a while stop and think is this a good idea to just pour it in without anybody pausing and checking? That's why.

And then the second passive is this cross-sectional stuff, which we've sort of gotten to now, where we're sort of saying, "Hey, are the wrong companies getting purchased too much of?" Are we sure the second kind of rise of passive has even occurred? Do we really think there aren't more smart people managing more dollars trying to beat the market now?

I mean, there are two points. Intuitively, it feels like there's way more smart people with way more dollars that can be impactful in markets than there were 30 years ago. And second, it seems like if you ask any quant, where does beating the market come from? They'll say, "Well, one of two things has to be true. At least one. Either there have to be bigger anomalies. Post-earnings announcement trip is 3%, not 1%. Or the anomalies have to last longer. It gets you 1% for four months in a row instead of 3% for a single month."

Every quant I know, and I know a lot, would tell you that both those things are way smaller. That the markets are way closer to fair price, way more fair – of course, there's wacky things like GameStop. There were wacky things like pets.com in the old days. There's always been wacky things. But fundamentally, it seems like there are more smart people trying to get prices right. And they find it harder and harder everyday because they're also smart and they're all working so hard and they all have so much money to use to get prices right. Is there a rise of passive at all?

Michael Green: Well, empirically, there has been a rise in passive. We actually know that.

Randolph Cohen: Are you sure you're accounting right? That's what I'm asking you. Are you sure that we are accounting for all those family offices with trillions of dollars? Do we know how much leverage they're using to make the big bets that they're making? Do we know what's really going on inside Citadel and how levered that firm is?

When I started studying the hedge fund business in the late '90s, a big hedge fund was like $3 billion. And now you've got awe-inspiring amounts of money. Again, they don't all call themselves hedge funds. They go by all kinds of different names. And they use tons of leverage and they use derivatives that don't show up as leverage but might 50x their buying power.

There were things I said to you before, I'm like, I'm pretty sure I'm right about this. This I'm not sure I'm right about. I'm asking you to help me think it through because maybe I'm wrong. But my instinct is that if you counted it the right way, it's not actually more tilted towards passive. And the fact that mispricing seemed to be much harder to come by suggests that that's the case.

Michael Green: I would actually reverse that and say, one, to argue that there hasn't been an increase in passive investing feels completely counterfactual and not even something we could really entertain.

Randolph Cohen: What I'm saying before is that if you go back to the 80s, what you had was all the money in mutual funds that were basically closet indexers. I'm exaggerating, of course. They weren't all. But 80% of them were closet indexers and 20% of them were 3D indexers.

Michael Green: But Randy, we actually have data on this that shows the proportion of index hugging has actually risen dramatically. The proportion of closet benchmark has risen dramatically.

Randolph Cohen: But what we don't know is about the real guys. The guys who actually have edge. Because, again, those guys in the 80s, it's not just that they hugged the index a lot. When they weren't hugging the index, they didn't know what they were doing. Do they have any edge? We know they underperformed consistently. The point is were they actually fixing this pricing very effectively? I mean, I'm not saying they weren't doing anything in the aggregate. I'm sure they were. I feel like if you say smartness times dollars and you add it up across everybody in the market, where if you're fully passive, you don't count. Obviously, the people at Vanguard are very smart. But we're not counting that as smartness for this purpose. Alpha smartness, whatever we want to call it. Is it obvious that there's less smartness times dollars now than there was back then? I'm just not sure how good we are at measuring.

I understand. I've seen the papers. So I know a couple of people have made an effort. Ralph's made an effort and other people have made efforts. But I'm just not completely convinced that they really know what's going on inside Citadel and all these other firms, like some of which people haven't even heard of. I'll just like meet people and be like, "Oh yeah, I'm at Quanta Quest. We've got 23 billion. And we've 40x leveraged." And I'm like, "I've never heard of you." But like, "Oh yeah, we're in San Antonio." I made that one up. Do you see what I'm saying? I'm just asking if you share my concern at all that it's possible that we don't actually know if there's been a rise in passive.

The other kind of rise in passive absolutely happened. All that money in the target-date funds. That's clear. I'm saying this kind is cross-sectional passive. I just don't know that the average dollar is dumber than it used to be. We took money out of the hands of retail people. I don't know that they were doing that much to fix mispricing. And we took money out of the hands of some mutual fund folks who I'm not sure how great they were at fixing mispricing.

And we put a lot of it into pure passive, which obviously isn't doing anything to fix mispricing. I'll break that right away. And then we put a chunk of it into big, high-levered, exceptionally smart institutions. And I just wonder.

Michael Green: The quick answer to that is you are absolutely correct that there has been the rise of mega firms what would traditionally be described as the hedge fund space. Their role, though, is actually radically different. So Citadel is a hedge fund and a market maker. Its role as a market maker dwarfs that of its role as a hedge fund. And the type of trading behavior that they've engaged in, completely agree with you.

But what we didn't track previously when we were thinking about that type of behavior was the behavior of the specialist firms who also ran heavily levered, had order books that provided transparency, et cetera. What Citadel and others have largely done is synthetically recreate order books. They pay for order flow to calibrate those models and they trade accordingly. That's just replacing a separate role.

We actually do have data in terms of proportion of trading that is going traditionally through those who operate off of fundamental as compared to price or volatility insights. And we know that that's fallen from around 80% of market activity to around 10% of market activity today.

Randolph Cohen: We were talking about Marco Sammon and his work. And he wrote this paper with Robin Greenwood that's out now. He shows that this index inclusion effect, which was gargantuan, was one of the main things that smart market makers and quant folks made money off of, it's totally gone now. We put enough smartness on that problem that that thing doesn't exist at all anymore.

And so, we don't have the firms inside the index trading at higher prices than the firms outside the index. And you don't even have any meaningful movement. I think they found 0.6 % or something. You go up when you get in the index. It's an astonishing result. But I'm just saying, if the post-earnings announcement drift is gone, and if the quality effect is way smaller than it was, and if the index inclusion is gone, I would not expect a true rise of passive to make anomalies go away.

And so, I want to propose that maybe the anomalies went away because the world just moves towards less mispricing. And that either there was no rise of passive at all. Or if it happened, it wasn't a big enough effect to met – it either pushed in the right direction like with the quality effect in the post-earnings announcement drift. Or in other cases, it didn't do too much harm.

Michael Green: Again, this is a question of what is the actual mechanism? Is it because effectively the markets have become more efficient? Or is in part our definition of market efficiency is skewed in that direction? Post-earnings announcement drift has been replaced by dramatically increased volatility on the earnings itself.

Randolph Cohen: As it needed to be. I used to argue with my dad about that. My dad's been trading stocks for 75 years. He's in his 80s. He started when he was 12 years old. He bought Bristol Myres. He's still proud of it. Still holds it. But he would call me and he'd say, "Can you believe these crazy markets? They miss by a penny in the stocks down 9%." And this is in the 90s when I'm grad school learning this stuff. And I'm like, "Yeah, it didn't drop enough, dad." He's like, "What do you mean?" I'm like, "Look, obviously I don't know about the specific stock. But I'm telling you that generally they only drop between like a half and two thirds as much as they ought to. It needs to move a lot more. And the reason it doesn't is because of guys like you, dad." In other words, he's the guy who goes and said, "It dropped too much. I'm gonna buy the dip." But in fact, it needed to drop further and people like my dad jumping in there. And now we've got enough institutions that it falls the full 14% it should have fallen instead of only falling nine. Again, all numbers made operating money back.

Michael Green: That can be true. That can be a statement of efficiency. But the question is the mechanism. Is it occurring because of greater efficiency? Or is it occurring because of greater illiquidity that is being created?

Randolph Cohen: But if it were the second one, then we'd see the quants renting money. But we know they're not. We know how tough it is.

Michael Green: What we actually know is that the only business left is quants that are arbitraging that. In other words, the returns to fundamental analysis would deteriorate. The returns to the type of arbitrage that you're describing would increase. And that's exactly what we've seen.

Randolph Cohen: I don't think we've seen people making more money off things like betting on what happens right after earnings. Granting we wouldn't necessarily call post-earnings announcement drift anymore because maybe now it's an overreaction on post-earnings or whatever. But the people who do that kind of trade, you buy it, you hold it for a day, a week, a month, not the millisecond guys, which obviously is a little bit of a different thing. You can read all the academic papers that their stuff is based on. And you see, "Oh, this one's 5% a year. And this one's 7% a year. And this one's 3%." And they've got two dozen of them. And then you look at the performance, even if you only look at the survivors, they've outperformed by a few percent a year. It's pretty tough out there. And that's because a friend of said to me, he said, "Yeah, sometime around 2000, somebody turned on the big computer and they just started pushing all the prices to the right places a lot faster than they used to." I talk to a lot of quants. Because a lot of people I went to grad school with are now really, really top quants. Former students and so on and so forth. I've got 4,000 former students now. Nobody thinks it's gotten easier.

Michael Green: Easier relative to what? Easier to what it used to be? No. Easier relative to actually trying to project the fundamentals? Absolutely.

Randolph Cohen: What do you think of fundamental analysis these days?

Michael Green: I don't think anyone does it anymore. I don't think anyone really cares in all seriousness.

Randolph Cohen: Shouldn't that create opportunity if you did it? Is your point that if someone did it, it would be great. But they don't do it?

Michael Green: This is the second part of it, which is if you actually think about the parameters around the assumptions behind all the academic models on this, things like Grossman-Stiglitz, which is really what you're referring to when you talk about these types of parameters. Will it be easier for people to make money? Is there an incentive for them to make money off of fundamental analysis?

Grossman-Stiglitz is just a reformulation of the wisdom of the crowds. If everybody votes, we're going to get something that looks pretty close to the accurate. The wisdom of the crowds and the Grossman-Stiglitz has its own assumption, not dissimilar to sharps that passive never transacts. Grossman-Stiglitz assumes that the market has roughly equal endowment. Every participant basically gets one vote. That's how the wisdom of crowds works. But what we've actually done is substitute a market in which basically 45% of the people get one vote of radical size, and everybody else gets a tiny vote. That means that the wisdom of crowds breaks down under those simulations. You end up with the answer that 45 come to, not that the 55 come to.

Randolph Cohen: Goldman came out with this report the other day that I feel like was aimed at you, don't you think? I mean, it didn't put your name. It seemed like they were ready to address you, would you agree?

Michael Green: Yes. I do think that's correct.

Randolph Cohen: I thought they had a couple good points and some other points that weren't as compelling, so I feel like you deserve a chance to respond to that.

Michael Green: Absolutely. Goldman Sachs came out with a report headlined by David Kostin, and they had a strategy in which they attempted to isolate the component of passive, and they pointed out that passive effectively had a very small impact relative to other controllable variables. This study, like almost every study that has been done, with notable exceptions of some of the academic work that has been done, relies on a definition of passive that is derived simply from something like fact set indicators. So everything in an industry fund, everything in a sector fund, everything in XYZ is included in there.

The most passively held stock, according to Goldman Sachs, was something like 42% with NASDAQ, NDAQ, the ticker. That's absurd. They next came to the conclusion that the most passively held stocks were the REITs, et cetera. Bloomberg did the same analysis earlier in the year. You end up with a conclusion that the least passively held stocks are actually the largest stocks. As a result, all parts of the analysis are just off of that because what we actually know is the most passively stocks are the largest stocks.

Active managers can't hold Apple in proportion to its market cap in their portfolios. At least not the vast majority of active managers or individuals can hold it at a weighting that is consistent with what it's held in passive vehicles. Among other things, the 40 Act prevents them from a diversified basis in holding many products that are as concentrated as the indices are currently. That tells you that the analysis is completely wrong in its specification, and it's just that simple.

Randolph Cohen: I think you have a good point. When they said, “Oh, the average stock is 25% passive and NVIDIA is only 22,” and then they said they ran a regression, and they showed that the lower passive ran up more, I thought 25 versus 22, and that before we even get to your point about is that really properly measured. Even though in the end, I read similar conclusions to them about the rise of passive, I think you have some good points in response to what they're saying.

Ben Felix: I just want to recap a couple of things. We've talked about aggregate valuations, and we talked about how flows into passive funds drive up valuations at the aggregate level. How much depends on how quickly we think the effect decays. That's kind of where we landed on that. Cross-sectionally, maybe markets aren't as passive as they seem because there are growth in hedge funds and things like that that we don't have as much visibility on.

Michael Green: Hedge funds have not grown since 2012, other than the underlying asset values. Flows have been negative into hedge funds for an extended period of time. What Randy is describing is a component of hedge funds effectively within hedge funds itself. It's transitioned from fundamental analysis to increasingly high-speed quantitative trading to arbitrage out exactly the components that Randy is highlighting.

Randolph Cohen: Use of leverage and other kinds of things that wouldn't call themselves a hedge fund but are working to make markets more efficient.

Ben Felix: We talked about that, but I don't know if we talked about where, Mike, do you think the cross-sectional impact is on stock valuations from index investing.

Michael Green: I did. I think the cross-sectional impact is to raise valuations significantly. The key question becomes exactly what Randy highlighted, which is, effectively, what's the degradation factor associated with that, and what are the mechanisms by which that degradation occurs?

Ben Felix: That's aggregate market, though. Cross-sectionally, how is it affecting large cap stocks versus small cap stocks?

Michael Green: On a cross-sectional basis, there's a huge difference in multiplier, effectively, with the inelasticity component. This is work I've actually been working with Valentin Haddad to derive some of the components of it. If you actually look at the inelasticity or the elasticity, the smallest stocks are far more elastic than the largest stocks because they have readily available substitutes. I can choose to buy Delta Airlines, or I can choose to buy United Airlines. I have no substitute for Apple or NVIDIA or anything else.

The second is the smaller share of the market that is actually held by active managers, the greater that decrease in elasticity. If you got to a market that was 100% passive, the market by definition would be perfectly inelastic. There would be no marginal buyer or seller. Take it back to ‘99. The market is still highly inelastic. The point that I'm making is at a certain point, the market moves from benefiting from the contribution of this new entity to being degraded by the size gain and deterioration of the capacity of the other players in the system.

This is exactly what Valentin's paper has written about the strategic response component. Conversely, as passive gets larger and larger, the strategic response becomes exactly what Randy is describing. It effectively becomes around arbitraging the behavior of passive, as compared to trying to make an articulation about the underlying fundamentals and the future cash flows associated with the firm. Because in any realistic form, those play a very small role in determining the valuations in any one period.

When we talk about a stock jumping or falling by 20% because of earnings in a single period, that is irrational, as Randy's father pointed out, if it's a complete one-off. But if it's a look forward, if you're effectively saying, "Well, all future cash flows are going to be affected by that one penny miss. This causes me to degrade my model," then that would be something different. But those are two very different mechanisms to have people simply arbitraging a price behavior versus having people make a attempt at understanding what the forward fundamental outlook is. A market that is shifted from that forward fundamental outlook becomes increasingly disassociated with those forward fundamentals. Unless a mechanism for increased strategic response arises, Valentin’s whole point is that strategic response is a fraction of what people have historically thought it was. It is falling as passive. It gets larger and larger and larger.

Randolph Cohen: Valentin’s work is really interesting, very high-quality work. First question you ask is how much more passive are we than before? We have this fund. They don't call themselves hedge funds. They're institutional long only. But they have 100; 200; 300 billion dollars and unbelievably insanely smart people at them, including friends of mine and friends of theirs who I've gotten to know. Sometimes, they're able to use leverage and derivatives and other things. So there's some big players in there. Okay, we've done that to death. That's the first question. How much rise of passive is there in the cross-section? I'm not sure it's that much. It might even be negative, but let's say there is some.

Then Haddad does the strategic response paper. It's a quality piece of work, but there's a lot of papers that estimate things a lot of ways and write theory. I don't think we should take any one of these and anoint it. It takes a long time before you can really have confidence in that kind of stuff. But if you have very solid methodology like Greenwood and Sammon, where you're using standard approaches to estimate time series effects and so forth, you can have a lot more confidence in that. That’s the second thing is, okay, are we sure it's right? Maybe it is right.

The third thing is what he finds is the strategic response knocks out two-thirds of the effect, and there's only one-third left. Now, I think it's your belief, Mike, that with the higher levels of passive that you believe in, maybe we get a higher answer than a third. But all I'm saying is you're starting out with something I think is either small or non-existent. Then you have to put in some kind of fudge factor for how sure you are that this paper is the right answer. We all know, look, I'm an academic. We know we like to get meaningful effects, and we tweak our models, and we tweak our empirical work to get something that's interesting. We don't do anything sleazy, and I'm certainly not accusing Valentin Haddad of doing anything sleazy. If you build your model one way, you build another way, and one of them gets a more interesting result, that's the one that tends to get published.

Then the third thing is even taking the result to face value, you got to take a third. It's like a piece of a piece of a piece. That's why I'm not worried on elasticity. It's not that there couldn't be something there, but I'm not convinced there's something there. If there is something there, I'm not convinced it would be big. But my mind is open. It could be there's something there, and it could be big. As opposed to in the aggregate where I'm like really pretty sure there's not a problem, on this side, my mind has more.

Michael Green: I'm not entirely sure how to respond to that because among other things to assert that there has not been a rise in passive index investing when the indexes were not even created until 1957 with the exception of Charles Dow's Dow indices.

Randolph Cohen: It's about whether the average dollar is smarter, more impactful because, as we know, a lot of those old mutual funds were 80% passive, or they were 90 % passive or whatever. Your point is the mutual funds with those same names may be even more passive than they were. Although I don't know if the thing that says that the average is more passive, that may include the index funds. But I'm not sure that the average active fund is more passive, but maybe it even is. But then there's just all these other folks out there doing stuff.

I understand we disagree on that. I'm just highlighting. I've got two points. One is if you think about all the smart people you know who are doing this and how much money they control, including leverage and everything, and then you think about the person in your seat 30 years ago and how many smart people they know, how much they would have controlled, these are the highest paying jobs in the world, other than starting a tech company.

Think about how much talent there is from abroad, how many people from Europe and Asia and Latin America, where they're sitting in those chairs with 180 IQs 30, 50 years ago. Now, we have zillions of them. I just feel like there's so much more talent being thrown out of the box. That's my intuitive answer. The outcome that we know in terms of it being harder to find mispricing, now the mispricing issue is different from the elasticity issue, but they are related. In other words, if things were just way more passive, the market was more kind of sloppy, then I think it would show up in mispricing, as well as in elasticity.

Absolutely granting, you might be right. I have a strong opinion on this, or I want to state my strong opinion, but it's loosely held. Six months from now, I might call you and be like, "You know what? You were right on that point."

Michael Green: As I often say on this, I hope I'm wrong, but I think I'm right. Effectively, I'm just on the flip side of Randy on this. The evidence in terms of what is actually happening in markets and behavior is best explained by models of elasticity and the rise of passive.

Ben Felix: On Valentin's paper, we had him on the podcast. I think you listened to that episode. Maybe my question wasn't well-formed. Actually, Cameron asked the question. But we asked him if his research findings support the idea of a bubble in large stocks due to flows and index funds. He said, "I have mixed feelings about it. I'm going to give you the research answer, which is that we don't really know." Valentin's done the work, and I agree. It seems to support what you're saying, but I don't know if Valentin interprets it the same way.

Michael Green: I don't want to speak for him. But as you could infer from that answer, the research answer is not the same as his individual conclusion at this point.

Ben Felix: That's fair. He said his feelings are mixed.

Michael Green: I will tell you that I spoke with Valentin earlier this week. Many of the things that I raised as concerns, candidly, he did not consider. His reaction to it was not only do I think that you are directionally correct, and those are plausible, but it actually raises the importance of what we're doing.

Ben Felix: From the stuff that we've talked about, what do you guys think from each of your perspectives? What are the implications for end investors?

Michael Green: I continue to stand by my underlying point, which is that as long as this process continues, you should expect rising valuations, which will lead to higher equity returns than should otherwise be realized, if the process stops or reverses, which could be due to a combination of rising prices because withdrawals are always a function for the asset level, while contributions are always a function of income levels. Or because of a regulatory change in any way, shape, or form, the process of reversing that could cause the system to go into reverse with much sharper corrections to valuations and wealth levels than people are currently anticipating.

Randolph Cohen: My thought is we have a canary in the coal mine on this stuff, and that is multiples. If NVIDIA was trading at a forward earnings multiple of 80, then we'd have real worry there. If the market as a whole was trading at a forward earnings multiple of 50, we'd have real worry there. As it is, it seems like the market has a yield of four percent real. You can do it off dividends. You do it off earnings, but you're going to get an answer like four percent real, and long bonds are paying two percent real. It looks to me like that's a pretty reasonable price for the market to be at. If the market gets to an unreasonable price, then we have to worry about it. Whether it's caused by rise of passive or anything else, we have to get scared. But I just don't see that yet.

I had this conversation with Bob Shiller once after his book came out, Irrational Exuberance. I said, more or less, what I said to you, Mike. I said the equity premium puzzle says prices need to be this high, so shouldn't your book be called Rational Exuberance? Well, stocks are finally getting to a price that sort of makes sense logically. He said no. He thinks there are two mistakes going on. That on the one hand, people don't want to hold stocks unless they have a five percent premium or more from them. On the other hand, the people were mistakenly expecting that they were going to get that very high premium.

Bob's one of the smartest people in the world, so that's a great answer, and he absolutely might be right. I'm sort of looking and saying the numbers seem pretty reasonable, and he's saying that's because people are making two counteracting mistakes, and that could be correct. You can get a crash without stocks getting to prices that seem irrational from a theoretical point of view, and that may happen. And look, we've always had crashes, and we'll probably continue to have them. But if prices get five, six, seven times higher than where we are today without earnings multiplying by similar amounts, then we're going to have to get very concerned about this.

I think right now, we're in an okay place. But I think what's great is that you're looking to win the war and asking the questions so that if things start to seem scary, we can go and say, "Look at all Mike's analysis. Look at all his thinking. If he was right all along, we probably should have acted a little sooner, but hopefully it's not too late to act.” But if you weren't talking about these issues, then we wouldn't be positioned for that.

Michael Green: I do think that there are a couple of really critical things to remember. One is that forward earnings estimate of 22 times presumes 20% earnings growth into this year. Secondly, it's stated off of non-gap earnings, operating earnings as compared to gap earnings, trailing gap earnings are around 200. When we talked about historical market multiples and the equity risk premium that Randy is referring to, the average to deliver that number was tied to something around 13 times on gap trailing, not forward at 22 times.

On any metric, we're extraordinarily extended versus those historical averages. Now, part of that could be as Randy points out, a realization that we should have a lower equity risk premium. But it would be unrealistic then to forward project higher expectations, which is the second error that Shiller was highlighting. As I've pointed out to you, Ben, we're actually seeing this. We're seeing the Vanguard investor surveys. They're actually expecting higher and higher returns, even as the forward potential is getting lower. I disagree with Randy in terms of whether we're in a good place right now. The real question that I have is what's going to happen to the flows. That's going to determine whether this gets realized in a short-term period or over a longer term period than I expected.

Randolph Cohen: I asked ChatGPT for the forward trailing earnings, and then I double-checked on Google to make sure it wasn't a hallucination. Clearly, I'm the world's expert on these. No, clearly, you've thought a lot harder about how we should interpret these multiples than me. So I have asked it on that, and I'll think harder about it. It's a fair point.

Ben Felix: What do you guys think the typical retail investors listen to this podcast or financial advisor who's helping guide their clients listen to this podcast should be doing with this information, if anything?

Randolph Cohen: Here's the problem. If you've got an equity premium, you're going to get something like a four percent yield on earnings. That four percent, you're going to add with inflation, obviously, because these are real assets. You're at inflation plus four, and so you do have to decide. Well, you've got clients, and they've got stocks that are going to give you inflation plus four, and you've got bonds that are going to give you inflation plus two.

It's pretty hard to argue that you shouldn't have a pretty solid chunk of that in stocks. Is it possible that there's going to come a day when the world says, “Hey, we demand inflation plus five from stocks, and then they crash?” Not only is it possible. It's almost certain. We've seen – I mean, geez, we've had crashes. It seems like now we get them every four years or so. But the problem is you kind of go nuts.

I have one more quick Bob Shiller story. Bob came to Richard Thaler's class when I was in grad school. He did a seminar, and then Richard got him to come to the class, which was wonderful. Bob told us that he thought the market was ludicrously overvalued, and he made his case based on cyclically adjusted price earnings and all these other things that he's made his fortune and legend off of. I said to him, because I was a young wise ass, “How long have you been saying that the market's massively overvalued and is likely to crash because it's up a lot the last few years?” Thaler said, “Yes, Bob. That's a good point. You've been saying this since '89.”

This was in '94 that this conversation happened. In '94, Thaler said, “You've been saying this since '89.” Now then, Bob wrote his book in around 2000, and then the market crashed, and then, obviously, timing is everything. None of the journalists said to him, “But haven't you been saying this since 1989?” Again, not to throw shade at Bob. He was amazing. It's just to say that you can be wrong for a long time before you're right.

And I know you're always very careful about this, Mike. I'm not throwing shade at you either. I know that you're very aware of this problem and how hard it is. I'm just saying if I'm a financial advisor, I'm looking and saying if you buy and hold forever, you got inflation plus four here in stocks. Yes, inflation plus two in bonds. Something like 60% in stocks is not unreasonable. When that crash comes, it will be painful for a year or two. But then we'll probably be back where we were pretty quick like we usually are. You ride it out. I'm interested in your thoughts, given those challenges and given I know you're keenly aware that we're never going to be able to time the crash.

Michael Green: I think that there's two separate components to that. First, I think your expectation for forward returns in terms of inflation plus four, to your point, will there be a point at which that goes to inflation plus five and, therefore, stock valuations correct meaningfully? That would actually not be a meaningful correction because you're talking about going effectively from a PE of six to seven or seven to eight type dynamic. You're talking about a 12.5 % sort of crash. That's not what I'm actually talking about.

Randolph Cohen: If it goes to six, then it's a 20, 25 percent crash, and that is a normal crash.

Michael Green: Correct. That is a component of the expectation path, which is if you actually think that that is correct, then you're talking about wiping out a significant fraction of returns over a holding period in which you're going to receive much greater returns from investing in fixed income, positioning you to be there. I'm not trying to suggest that that means that everybody should go all in into fixed income. It's simply saying actually that the mechanism by which you're proposing which that decision-making is done has largely been sourced out to a rigid model of diversification. It doesn't allow you to change those based on the valuation components. That's actually a critical component that lowers those feedback mechanisms that's strategic response, exactly as you were describing.

The second thing that I would say around that is it’s a very different thing to say that the stock market has historically returned to eight percent a year. My expectations over the next 10 years are that stock market will return to eight percent a year. Nobody invests for a hundred years, except for a very few select people. As a result, that terminal risk is actually a really, really big deal. Stocks have a very different behavior set to fixed income. You can dollar cost average into both. But when you're taking money out, the volatility of equities works distinctly to your disadvantage. You have to sell more when prices are low. You have to sell less when prices are high.

That whole process reverses itself. You're not into fixed income versus equities for the return characteristics as you get older. The reason why you switch into fixed income is because of the certainty of the payout component to it that causes that dollar cost averaging to work in your favor relative to simply holding equities.

Randolph Cohen: This is the case for the targeted funds.

Michael Green: Exactly, 100 % the case for targeted funds. Except if you actually look at an aging America, it owns more equities it has ever owned in its history.

Randolph Cohen: Your thought is that maybe the kids are all right, but that there's too many 68-year-olds who are still at 70% equities or something like that. That might be true.

Michael Green: A hundred percent.

Randolph Cohen: Let's say we agree. Not only could we get a normal 15, 20, even 25 percent crash, which is horrible. But there's a chance of a 50% crash out there in the next decade. I had a lot of smart friends who say, “Did you notice that the debt is over 100% of GDP and that the deficit is gigantic?” The newly elected president doesn't seem like somebody who is afraid to cut taxes or afraid to spend a lot of money if it'll make him popular. When you put all that together, might not there be a day when the bond market say, “You know what? We're just not sure these long-term bonds are going to pay off.”? In other words, isn't a 50% bond crash about as likely as a 50% stock crash or more likely? I mean, shouldn't we be scared of a big old bond crash?

Michael Green: One, I think bonds have already crashed significantly. So a 50% crash from the levels of 2020, sure. If I look at tips or anything else or I'll give an extreme example, the Austrian century.

Randolph Cohen: About a real debt crisis. Okay, that is a great point. Let me salute you. But I'm talking about a real debt crisis where people said, “Well, nobody wants those freaking bonds.” They go not 4% but the 12% or the 18%. You know what I mean? Couldn't that happen here?

Michael Green: I think highly unlikely. But this is certainly not as likely as a 50% correction in equities. The second point, though, that I would emphasize on that is if the US government loses control of its economic system in that manner, do you honestly think that Microsoft is going to retain control of its IP?

Randolph Cohen: It's a fascinating question as to how that would get handled, so good point.

Ben Felix: We had a guest, Scott Cederburg. I don't know if you guys are familiar with this research. His approach is a little bit conventional because he's using bootstrap simulations with global data, so not just US bond data. But he finds for retirees that bonds are actually quite risky, historically, if you sample from around the world, not just the US because in real terms, bonds are actually extremely risky at long horizons. Even in the US, there have been serious bond drawdowns, recent history not so much. But if you go back a little bit further, the real returns on bonds are pretty scary for long-term investors. Anyway, that's just a bit of a side point.

Randolph Cohen: It's hard to find anything that's truly safe.

Michael Green: Particularly in the world that Randy's describing. If you have a US dollar crisis in which suddenly the US dollar is no longer accepted around the globe, what you're really talking about is a radical deterioration of the purchasing power of the American public and, in turn, a broad collapse in economic conditions. It is a scenario that nobody wants. I think a lot of people fear it far more than they think. Unfortunately, I think that many of the discussions we're having today are people's behaviors are in part influenced by these narratives. It's safer to invest in the equity of Microsoft than in the debt of the United States. That's a very strong statement.

Randolph Cohen: I've been to teaching expert once who told me that five years after taking an entire course, students only remember one thing from the course. As a professor, you should make sure you know what you want to teach them. I took to asking students when I ran into them years later what they remember. Very consistently, the thing they remembered from my course is that one percent a year for life doubles your money. The natural log of two is about 0.7. So 1.01 to the 70th power is about two, and so a lifetime at one percent. Two percent a year for life quadruples your money. All I'm saying is if you're even asking the question about the relative riskiness, boy, maybe take the extra two percent because 4X is a lot.

Michael Green: I would highlight that the more people that believe that, the less the possibility of earning that excess return.

Ben Felix: Stock valuations are too high because people think they're too safe.

Michael Green: What do you hear? You hear people say, “I'm saving through my 401(k).” What are you saving it? “I'm saving in the S&P 500.” You're not saving. You're investing. Investing is an inherently risky activity. That's why you're receiving the compensation that Randy is highlighting.

Ben Felix: Risk has to be there. Mike, I know you just tweeted about this, so I know some of your thoughts. But why don’t you think BlackRock, Vanguard, but also academia? Ralph Koijen, when he was on our podcast, he wasn't worried about this. Haddad, when I talked to him, wasn't too worried about it. Maybe you've talked to him more recently and he is. Antoinette Schoar doesn't seem to worry about it. She thinks targeted funds are a good thing. Why don't you think more people who should know, better if we take your perspective, why don't they share your level of concern on this?

Michael Green: Again, I think it really depends on how you ask the question. I've watched your Koijen episode. I've watched your Haddad episode. It really depends on how you formulate the question. What Koijen is actually saying in which he says, "I'm not particularly concerned about that," is that he's actually anticipating the strategic response. I actually agree with that. I do think that there will ultimately be a strategic response, but the strategic response comes at what level. What form does that strategic response take? Those are the key questions.

I'll just be very straightforward with you in conversations with both Ralph and with Valentin. It becomes a question of them understanding either how far we are in the process or how favored we have actually made the process of passive investing in our legal framework that is driving the growth and preventing candidly response function.

Ben Felix: Mike, what evidence would you need to be presented with? Obviously, we've talked about a whole bunch of stuff today. You don't want this to be a problem. You think it is, but you don't want it to be. What evidence would you need to see to be like, "You know what? There's no issue here."?

Michael Green: What I'd love to see is actually non-confirmation. In other words, the hypothesis that I formulated, I'd actually like to see that disproven in any one form. But the more frightening thing for me is at every step in this process that I go through, and I'll give a really simple example, it just ran through an analysis of the impact of introducing a levered ETF to trade Monster stock, which is a perfect example of the meme stock type phenomenon that Randy highlighted. The introduction of a two-times levered ETF into Monster meant that $500 million created $14 billion of additional market cap, so a 28-times multiplier on a roughly $50 billion stock, which is far above what you would expect now. Because it was two-times levered, it meant that it's actually 14 times the amount of money that went in. But $500 million was able to create a 28-times multiplier in that particular stock.

It subsequently has now led to the announcement of issuance of $42 billion of equity and debt. The impact of these things in terms of the misallocation of capital and resources and behaviors in our economy, allocating more capital to the largest firms that don't need it and simply are repurchasing stock, which ironically enriches their executives but does nothing to invest in society. Not that I'm suggesting they have some great brand responsibilities to society, but it is an important impact to understand. It means that they have lower cost of employment because they have lower cost of capital, et cetera, which further advantages them relative to small businesses where innovation and entrepreneurship typically happens in our company. It created a system that has negative feedback loops for both our society and our potential retirements. That's what I care about.

Ben Felix: Randy, you started off saying you're not worried about this stuff. After hearing Mike's argument today and going through this discussion, where do you land now?

Randolph Cohen: I'm still not very concerned. I mean, I guess what I'd say is on the cross-section, my view is if Microsoft's trading 10% too high and Delta's trading 10% too low because of elasticity issues with large companies, obviously, we want prices to be as perfect as possible. But I think prices are closer to perfect now than they were in the past, and we've muddled through as a society in the past. Of course, there are these wacky, game-stop type situations. Maybe those become a huge issue in the future. I think for now, it's unfortunate. But there's going to be people who lose a lot of money on those, so I'd like to see less of that. I don't think it's a society-wide crisis. It's something that's always been there, confessions of a stock operator and all that sort of thing. It's 100 years old.

The one that would scare me is the aggregate. If I came to believe that the market was either way, way too high or had become way more volatile or was going to as a result of passive investing. On that score, from an evidence perspective, well, yes, if the multiples get high enough, I'll start to worry. That won't necessarily mean it's because of the rise of passive. But I'll certainly be open to that as one possible explanation for why multiples got so high. But mostly I would say it would be more about understanding less about evidence and more about really trying to understand why it would matter.

If people are saving through defined benefit pension plans, 60% stocks, 40% bonds, and then on the other hand, you put in the target-date fund and it's similar, it not that clear to me why it should make a big deal. Obviously, I read the paper, Dmitry and Lu Zhang, they've got an interesting argument. We put those things in the bucket off. This might be a thing that's important. Let's do lots more research, and maybe over time we'll discover there's a reason why doing it in the passive way creates problems.

Even when that money came out of pension funds, they have a pretty similar percentage in large stocks to what people have now. I mean, in the end, the passive and the active have to add up to the whole market. If the passive is representative of the market, then when you subtract the passive from the market, the active part looks just like the passive part. I know, obviously, again, if you count as active on something like a sector fund, then that doesn't have to perfectly hold.

But the fundamental idea, which I guess is Bill Sharpe's idea, seems pretty solid. It shouldn't really matter the format very much. It's a second or third order effect. It might matter enough to care about, but I don't see it as a scary thing because a second or third order effect. When I multiply out the numbers on these flows, even if somehow active didn't count and passive did, I don't feel like it should be that problematic. I'll think hard about all the stuff we discussed, and maybe I'll be like, “Oh, I'm starting to be convinced.” But as of now, I still kind of feel like logically it shouldn't matter. Then empirically, I don't think the price increases we've seen are of a realm that looks scary to me.

Michael Green: My immediate reaction to that is that to look at current valuations at 22 times forward and compare them to the past is not appropriate approach. If I look at everything ranging from dividend yield to sales yield, the underlying expectations embedded in the market today are higher than we've ever seen in the past.

Randolph Cohen: No. I just think those old prices were too low. I want to be clear. I thought it in 1993 when I got to grad school. I came to grad school, and I learned about the research, and I said, "Oh, the stock market's way too cheap." I feel like it's spent the last 30 years proving that right.

Michael Green: Unfortunately, I didn't even have to go to grad school to get that because I learned that in undergrad, and we're roughly the same age. The point that I would make is that is very much in everyone knows. The problem is that as you've already agreed to, the transition from undervaluation to even if we say fair valuation has embedded in an expected return that is now built into asset allocation models. That higher expected return, regardless of whether it's going to be realized over 5 years, 15 years, or 30 years, or never realized, is going to cause those asset allocations to change in a very slow fashion.

If we add to that the impulse associated with passive, which I think even you would agree is positive, there is no data that suggests that it is negative. If you add those two components, then the risk that we're actually at very high valuations with very high equity allocations at exactly the time that we're going to begin to need those asset levels in order to fund the retirements that are in front of us is extraordinarily high. To your point, that it's all the same. It's not.

If I go back to 1929, a peak in the activity in the stock market, 10% of American households owned equities. If I go to the 1960s, which you're referring to in terms of pensions, almost nobody owned equities. What they actually had was a claim against their employer. Today, 62% of American households own equities to their 401(k)s, and that is their requirement for retirement. As a society, we have dramatically increased our participation and our exposure to levels that we've never seen before. To argue that that didn't contribute to the return profile that we're now relying on seems completely auspicious, even before I begin the process of evaluating the impact of passive investing.

Ben Felix: There is an interesting paper on – I think it's a theoretical paper. They've got an equilibrium model by Schmalz. Have you read that one?

Michael Green: I may have, but I'm not entirely sure of the authors.

Ben Felix: Schmalz and Zame, I think, is the co-authors. It's not published, but they talk about how basically what you're saying that a shift away from individual stock holdings from households into index funds should increase market-wide valuations because it's getting less risky to invest, which increases equity participation, basically exactly what we're seeing. Anyway, it's all plausible.

One of the things that stuck with me last time we talked, Mike, was that we asked you – when we asked that question of what should people do, what should individual investors do. Your answer was there's not much you can do. You've got to hold on and hope things are okay. It's more about advocacy and trying to change the way things are structured, as opposed to changing your asset allocation decisions. Do you still hold that view?

Michael Green: I do, unfortunately, because if I have to actually carry forward my beliefs and say that if passive investing is causing valuations to rise, then I should expect higher expected forward returns, inequities. Outperforming, actually, as I've shown you through presentations, becomes a harder and harder challenge, regardless of the skill level of managers. That's very straightforward. Now, with that said, are we getting closer and closer to a point, both through valuation increases and through ageings of society, at the process of which this begins to potentially reverse itself? Absolutely. Those are key concerns.

The last component that I would just highlight is policymakers increasingly rely on markets to tell them how the economy is going and what policies are appropriate. We're now on our third consecutive presidential election, in which a key focus of how well is the economy doing is measured by the stock market. It's one of the reasons, I would argue, that Kamala Harris's message was so roundly rejected because the vast majority of Americans are experiencing a, to steal from the language of the day, “lived experience” that is radically different than that implied by an S&P approaching all-time highs.

Ben Felix: Awesome. All right, guys, this has been incredible. Appreciate the generosity with your time, both now and in preparing for this conversation. So thanks again for coming on.

Michael Green: Take care, guys.

Randolph Cohen: Thanks.

Cameron Passsmore: Great to see you.

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