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.
Hosts Ben Felix and Cameron Passmore welcome Harvard Business School senior lecturer Randy Cohen and Simplify Asset Management's Mike Green for an in-depth debate about passive investing's impact on financial markets. They explore whether the rise of index funds and target date funds poses systemic risks, discussing market efficiency, price elasticity, and implications for investors.
Whether you're trying to understand the mechanics of passive investing or evaluating potential market risks, this episode provides a balanced debate between two leading thinkers with contrasting views on one of today's most important market structure questions.
Key Points From This Episode:
(0:00:15) Introduction and context setting from Cameron and Ben
(0:06:03) Defining passive investing and discussion of current market share (estimated 45%)
(0:16:10) Mike Green's critical concerns about the rise of passive investing
(0:28:11) Debate on target date funds and their impact on market stability
(0:54:57) Analysis of elasticity, valuations, and market structure
(1:24:33) Discussion of forward market returns and investment implications
(1:36:00) Practical implications for individual investors
(1:44:38) Examining why many experts seem unconcerned about passive risks
(1:50:56) Concluding thoughts on market valuations and policy implications
Read The Transcript:
RR - EP.332
[00:00:00] Ben: 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.
[00:00:15] Cameron: Welcome to episode 332 and today we have a very interesting grab your popcorn kind of episode.
[00:00:24] I really enjoyed it. It's a very thought provoking. It goes back to the guest we had, I forget 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 backstory on how you got these two guys to come on?
[00:00:44] Ben: So 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 us understand the difference between market efficiency and And price elasticity, which index funds may be having an impact on.
[00:01:06] 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 he's actually trying to say. So I think we took the time to understand what he's actually trying to say.
[00:01:22] 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 listen to this podcast. People who are 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.
[00:01:43] 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? So this is a bit of an experiment. We've had episodes with two people, but we've never had episodes of two people who disagree with each other where we're kind of hosting a discussion between them.
[00:02:02] We thought we would try. I thought it worked great. It was a great conversation. It's pretty easy for us. 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.
[00:02:21] Cameron: 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 401k auto deposit into target date funds is really interesting and that de risks. The system. So the system has less risk. Did that increase prices, therefore lower future expected returns?
[00:02:39] Quite an interesting thing to think about. I don't know who's right or wrong in this.
[00:02:44] Ben: 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.
[00:02:56] Cameron: But it also makes the company less risky, does it not? Because the company is not now liable for the pension fund. In the case of the corporate pension plan, yeah. So the company like that, like they mentioned GE as an example, GE, if it's shifted away from a DB to a 401k plan, structurally is a less risky company, I guess.
[00:03:12] Ben: It doesn't have that liability, I guess, yeah. Makes sense. That's one of Mike's arguments. This is one of our longest episodes, if not our longest, when you include the introduction that we're recording right now. So there's plenty of nuance and bits and pieces to pick up.
[00:03:24] Cameron: I thought to Randy's point about, and Mike as well, is the rise of the mega size smart firms.
[00:03:30] And they say there's no more fundamental analysis going on. It's 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. So it was kind of side info.
[00:03:44] Ben: Hard to believe that nobody's setting prices. There's got to be someone doing fundamental analysis somewhere.
[00:03:49] Interesting point. 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 while he was there.
[00:04:09] So 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. It's about those topics where he interviews fascinating people who are in some way connected to the world of vision loss.
[00:04:27] So 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.
[00:04:46] Capital advisors. He managed Peter Thiel's family office for a bit, Thiel Macro. Anyway, Mike gave us lots of background on that Thiel experience specifically when he was on the podcast and full 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.
[00:05:17] 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.
[00:05:37] 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, I've changed my mind. I agree with you completely. I agree.
[00:05:45] Cameron: They said they'd keep discussing via email from here.
[00:05:47] Ben: 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.
[00:05:58] All right, let's go.
[00:06:03] Randy Cohen and Mike Green, welcome to the Rational Reminder Podcast.
[00:06:07] Mike: Thank you for having us.
[00:06:08] Ben: And Mike, we're welcoming you back to the podcast. This is your second time here. All right. So to kick this off, what is passive investing?
[00:06:15] Mike: The definition of passive investing in the academic literature is somebody who holds but never transacts.
[00:06:22] 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.
[00:06:40] Without any of the frictions that would be normal, quote unquote, in transacting in a market that doesn't exist in the real world. And so from a practical standpoint, when we refer to passive investing, I would describe this as systematically investing into indexes, people will choose different indices to represent.
[00:07:00] 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 and P 500 index.
[00:07:10] Randolph: I just want to say 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 forehead of Zeus.
[00:07:17] Aphrodite is the one who's in the clam shell in the waves.
[00:07:20] Mike: You're right. She comes from the foam. You're correct. I appreciate it.
[00:07:25] Randolph: I'm comfortable with what you say about passive, but I do want to highlight one thing. I listened to some of your podcasts, fascinating stuff. And I talked to a lot of my friends about this stuff in the last couple of weeks.
[00:07:34] And 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 in a 401k plan, more or less automatically.
[00:07:50] 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? Transcribed Does it make the market too volatile?
[00:08:04] I don't think those are big worries, but I know you're concerned about them. 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 401k target date money, but a lot of which isn't, which is in passive that people chose to put it into the market.
[00:08:18] 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 Skull of 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?
[00:08:39] 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.
[00:08:54] Mike: Just to be clear, though, the first one you're saying is automatic contributions to 401ks, the systematic investing process that emerged with the Pension Protection Act and the QDIAs. You're saying you're not concerned
[00:09:06] Randolph: about that. I'm really not worried that 401k slash target date fund slash QDI is making the market too high or too volatile.
[00:09:14] I think it's pretty clear that if anything, the 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.
[00:09:29] Mike: 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 distortive effects in part two that you're saying you're not concerned with
[00:09:48] Randolph: 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.
[00:10:05] 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 that's plausible.
[00:10:14] Cameron: So here's one for you. How much of the market is currently held by passive investors?
[00:10:19] Mike: So my work several years ago suggested that we were north of 35 percent and climbing at about 3 percent a year.
[00:10:25] 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, et cetera. 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 and everything through futures, total return swaps, collective investment trusts, et cetera, that are not disclosed in that fashion.
[00:10:57] Recently, the work of Marco Salmon and then independently validated through a different approach by Valentin Haddad, the latest rewrite of some of his work, suggests that my numbers are very close to directionally correct. Marco Salmon estimates about 38 percent of the market is passively held in just five indices, importantly not including the total market indices.
[00:11:17] Valentin Haddad comes to the number around 45%.
[00:11:20] Randolph: 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.
[00:11:36] They did a thing where they looked at index funds and they just set a cutoff of, you know, Over 99. 5 percent 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.
[00:11:54] 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.
[00:12:11] I'm comfortable to go with numbers in the thirties and forties, 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.
[00:12:22] Mike: Just to be very, very clear in my definition of passive, I exclude things like sector funds.
[00:12:27] 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.
[00:12:36] Ben: 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.
[00:12:44] So 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?
[00:12:54] Mike: 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.
[00:13:07] 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 401ks.
[00:13:41] And the liability production created by qualified default investment and alternatives. It has pushed the share of passive to an extraordinary degree. Anytime you narrow down a 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.
[00:14:06] On my math, we crossed it somewhere around 25%. So 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.
[00:14:32] 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.
[00:15:13] It's a fantastic paper out by Zhang 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 quote unquote passive product into a micro strategy, a two times levered version of that that exploded the relative price performance of micro strategy.
[00:15:41] 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.
[00:16:10] The third component is ultimately the outsourcing of retirement systems around the world from systems of quote unquote savings and investment in local communities. So the concentration of those investments into us equities, and this is happening around the globe. Again, this is leading to under investment in local areas and small businesses and over investment and an imbalanced economy.
[00:16:37] Ben: That's all pretty compelling. I gotta be honest. That's interesting. Randy, you're not worried.
[00:16:41] Randolph: 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 likes, I like to keep some money in cash so that if the market's off, they could say, Hey, too rich for my blood, I'm putting more in cash.
[00:16:58] They could put it in old school index funds by let's say the S and P 500 or the total market and you write it up and down. And then you can do target date funds where you have, let's say, a 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.
[00:17:16] 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.
[00:17:36] A passive index fund is a pretty solid, like it's not a big pusher of fragility. You need an enormous amount of money in passive index funds to create fragility. Many things were 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 8 Fund.
[00:17:55] And so to me, the biggest thing that I think I disagree with Mike on based on the views I've heard and expressed, I may have misunderstood, is that to me, Target 8 Funds are just what you want if you want an anti fragile market and economy. So what happens is you have COVID and the market goes down a whole bunch.
[00:18:13] Obviously COVID was legitimately bad news for companies, but maybe there was an element of panic in there. And so 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.
[00:18:29] 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.
[00:18:46] 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.
[00:19:03] People did their retirement savings in a pension fund. They put the money in and those managers put 60 percent in stocks and 40 percent in bonds. And now the money goes into a target date fund and it goes 60 percent in stocks and 40 percent 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.
[00:19:23] The problem with active is it seems like active could be a solution. You have 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 in mutual funds through the COVID period.
[00:19:39] 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.
[00:19:53] 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 plains apes, and we have gut reactions to things, you know, Dan Kahneman, thinking fast and slow, the second brain, all that stuff.
[00:20:09] 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 Shore was on the podcast, Rational Reminder, and when Ralph Coggio 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.
[00:20:28] I think it's pretty clear if anything, we've done the right thing to push in the right direction against a potential problem.
[00:20:33] Ben: Antoinette, we did talk to her specifically about market elasticity and target date funds, and she explained that her paper with Jonathan Parker, which I know you've referenced in some cases, Mike, they find that market elasticity has increased with the rise of target date funds.
[00:20:46] Randolph: As you'd expect, how could it not?
[00:20:49] Ben: Mike, you mentioned one paper there. I know you've also referenced Valentin Haddad's paper. If you had to give three pieces of evidence proving that your concerns are real, what would they be?
[00:20:57] Mike: 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.
[00:21:02] 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 behavior and chasing.
[00:21:21] In fact, what we actually see with passive investing is that it reinforces momentum And so 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 Zhu Liu, who is now at the University of Washington, I believe, in work that she did as PhD candidate under Hannah Lustig at Stanford.
[00:21:44] The process of influencing actually financial policy through target date funds and the rebalancing that is created there is one of my concerns. The second concern as it relates to targeted funds is simply that like any good idea, once they become increasingly crowded, they presume that the underlying behavior continues.
[00:22:06] So if you actually look at the assumptions of targeted 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 95 percent 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.
[00:22:32] 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 percent 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.
[00:22:51] 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.
[00:23:09] 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.
[00:23:28] 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 U S 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.
[00:23:54] And never really changing.
[00:23:55] Randolph: 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 going to be hard to get to consensus on some of these points.
[00:24:12] 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 7 percent of my bonds and put it in equity.
[00:24:33] But I think 11 percent 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 date fund. Anybody who's sophisticated enough to be making those kind of decisions is sophisticated enough to not just stay in a target date fund because that was the default option on the program.
[00:24:57] Most people will stay with the default because most people don't want to do that calculation and figure out, hmm, should we be 55 percent equities or 60? I sat on an investment committee of a school We had a person on the team who was a consultant, you know, an investment consultant, and there were all these top private equity people and hedge fund people on the board.
[00:25:13] Cause you know, it was a school with a lot of people who were in the finance business and kids there. He said, you know, I think we should go from 60 percent stocks to 55 percent stocks because of this, that, you know, that's what we're recommending to our clients. And all these people sat around and we were all like, We don't know.
[00:25:27] 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, the people's 401k money going into, remember, people are going to save money.
[00:25:47] 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 percent on average into stocks, but they should move it around more based on their own study and instincts rather than based on a formula?
[00:26:08] Because none of those sound like they've helped the situation to me.
[00:26:11] Mike: So very quickly, a couple of key points. One is there is actually a very material difference between a pension and a 401k, not just in terms of the process of money flowing in. But in terms of the underlying viability, what we've really done with the system is we have said, we can't have any individual or entity responsible for your retirement.
[00:26:33] I work at general electric for 30 years. They're not responsible for my retirement because 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.
[00:26:54] 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, say you as an individual, to something that has now become a collective societal risk, is really the key point that I'm highlighting there.
[00:27:28] Randolph: I don't buy that, Mike. In other words, we had both those risks before. Before we had the risk that 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.
[00:27:43] If all the economies perform poorly, Then people are going to be hurt on their retirement, but they've got a chunk in bonds. So if their stocks do meh, but their bonds pay off because those are government bonds, it's going to be okay. It's not as good as you'd like, but it's not terrible. So I feel like we went from two major concerns to one concern that we partly mitigate.
[00:28:02] And that seems pretty good.
[00:28:04] Mike: 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 company.
[00:28:22] Didn't deliver the products. It didn't deliver the outcomes. When we turn 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 the retirements that they desire.
[00:28:46] Those two are completely
[00:28:47] Randolph: incompatible. I don't understand the argument as to why we raise valuations or made things more risky.
[00:28:53] Mike: Let's just be very, very clear. 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.
[00:29:07] That's not true. Of course it is.
[00:29:09] Randolph: 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.
[00:29:22] 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. I completely disagree with you. Option theory would fly
[00:29:35] Mike: directly in the face of that.
[00:29:37] Randolph: I don't agree with that. Look at my coin toss example. The fact that we're both at risk
[00:29:41] Mike: doesn't change the value of the pile. 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?
[00:30:00] Versus one that pays out for a third chance at a million. I can tell you that Elon Musk
[00:30:05] Randolph: would pay pretty much the same thing for both. Correct. 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.
[00:30:15] Mike: No, that's actually not true.
[00:30:17] 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 component, Elon Musk is not marginally setting the price of the S& P 500.
[00:30:28] Randolph: I think we're getting off track before we had a thing where if you work for GE your whole life and then GE went bankrupt, you lost your pension fund.
[00:30:34] 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 it's overpriced?
[00:30:43] Mike: 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.
[00:30:51] You've lowered the riskiness of the investment. You've absolutely lowered the risk of my quote unquote pension by moving it from GE to the stock market. The stock market is less likely to fail than GE is. But there's no price on my pension, right? I'm not selling my pension to anyone. Of course there is.
[00:31:07] I don't understand. Every financial asset, whether it's a pension or whether it is a portfolio of stocks, has a value.
[00:31:14] Randolph: Just the value of the underlying claim.
[00:31:17] Mike: This is actually really important. It's not actually a true, what you were describing with a pension on GE is an annuity that is discounted at the value of GEs.
[00:31:26] Cost of debt. If I change it from GE to a societal component, by definition, it now lowers its cost of debt to the U. S. government. That
[00:31:34] Randolph: annuity is worth more. 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.
[00:31:43] 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.
[00:31:52] Mike: 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 a claim against GE against potential performance of that, that has a very different valuation than if I'm saying, I'm going to do the exact same thing in the stock market in total, you refer to it yourself.
[00:32:16] 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.
[00:32:23] Randolph: 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.
[00:32:33] 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. That's not the point I'm making here. So 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.
[00:32:46] There might be minuses that outweigh it.
[00:32:48] Mike: Which to be clear is exactly why I said, I think that it's important to actually articulate. I'm not trying to take away passive investing, I'm not trying to take away people's 401ks. I'm recognizing that there are benefits of distributing this on a societal basis.
[00:33:01] Absolute positives associated with that. The challenge is, is that we then specified a particular form of investment that should be available to people and gave it a liability advantaged component that has now forced everyone to believe what you started off with. Which is I have options for my savings.
[00:33:21] 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 back seat at this point. So
[00:33:38] Randolph: you're saying if people had no retirement plans, I thought your concern was with the switch from defined benefit plans to 401ks.
[00:33:46] 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.
[00:34:01] 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.
[00:34:25] 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 going to support them, then you kind of need to set up something. You have incentive compatibility problems.
[00:34:39] If you don't set up solutions to encourage people to make sure they say it.
[00:34:44] Mike: 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.
[00:34:55] Randolph: 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 parents 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.
[00:35:10] 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 Setups like social security and pension funds so that they know that they have something to rely on in retirement.
[00:35:29] 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.
[00:35:39] Ben: Just on the amount people are saving. We did ask Antoinette Shore about that because she's looked at it in some of her papers.
[00:35:44] 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 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.
[00:36:03] She's saying no change in savings, but different asset allocation over the life cycle with target date funds.
[00:36:08] Mike: Which is exactly the point that I'm making.
[00:36:10] Randolph: 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.
[00:36:20] 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?
[00:36:32] Mike: 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, scarce savings because the savings haven't increased.
[00:36:48] 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.
[00:37:05] Randolph: 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, you think?
[00:37:19] Yes. 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 401k and say, Hey, people are putting in 3 percent and damn it, 2.
[00:37:38] 9 would be a horror show. It has to be three, you know, like, 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 me 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.
[00:37:56] 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.
[00:38:11] When we went from other kinds of investment vehicles into target date funds being so popular and that didn't really change savings amounts
[00:38:17] Mike: What she's actually referring to is mandated employer contributions in the opt in versus opt out framework
[00:38:24] Randolph: 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.
[00:38:30] You're absolutely right that they would save some of that and who knows, maybe they would save just as much. So my mind is open on that.
[00:38:35] Ben: 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.
[00:38:43] I was a little bit lost there.
[00:38:44] Mike: 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 say 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.
[00:39:08] And in turn, facilitating a concentration in our economy that ultimately adds dramatically to risk. It's really important that people understand this all risk and all diversification as 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 3000 stocks, not appreciably less risky than investing in 35, as you know, from diversification benefits, everybody Is invested in those exact same 3000 stocks in exactly the same proportions.
[00:39:42] Actually, that's paradoxically much more risky.
[00:39:46] Randolph: 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.
[00:40:01] 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.
[00:40:22] 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.
[00:40:38] 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 that those are going to tend to be pretty undiversified. You know, you're not going to put five dollars each into a hundred different local buildings or whatever.
[00:40:51] Mike: 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.
[00:41:13] 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.
[00:41:34] 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.
[00:42:00] 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
[00:42:22] Randolph: I care about.
[00:42:23] 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 percent 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?
[00:42:41] 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?
[00:42:48] Mike: 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.
[00:42:58] 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.
[00:43:15] Randolph: Can we push on that? Because this, I think, is the biggest thing we disagree with.
[00:43:18] 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 401k 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 had for 100 years.
[00:43:39] And in those plans, they were pretty much investing 60 40. Now you have this money going into 401k plans and investing 60 40. And your notion seems to be that that's going to make the market be 5, 6, 7 times overvalued. I don't buy that at all. And I guess I would like to understand your argument better.
[00:43:56] 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.
[00:44:15] It was 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?
[00:44:22] Mike: If we had not changed the process, in other words, if we x out the component of passive bias, then it would be somewhere in the neighborhood of a 50 percent reduction in valuations.
[00:44:30] Randolph: 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 Mara 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.
[00:44:47] But if you do the analysis, that premium should be something in the neighborhood of half a percent a year. But historically, stocks had outperformed bonds by something like six percent a year, depending, you know, let's say if you use long bonds or whatever. Currently, stocks are priced to return something like bonds plus two, maybe three percent a year, let's call it two.
[00:45:06] 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.
[00:45:22] 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?
[00:45:40] Mike: So there's two separate components to that. First, Prescott and Mara 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, or I look at history, which has a survivorship bias associated with it.
[00:46:00] 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. So let's be very clear on that. If I try to model this as an ergodic system saying stocks are expected to return 8 percent with standard deviation of 16 percent on either side of it, in other words, roughly mimicking history, I'm presuming that the future is exactly like the past.
[00:46:24] 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 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, or a very, very similar distribution.
[00:46:53] 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 and P 500 was a radically, radically different
[00:47:07] Randolph: experiences. What's a fair equity premium deal? I understand there's a question of Merrin Prescott estimated the historical equity premium by history.
[00:47:16] 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?
[00:47:30] Mike: I think it's completely conditional.
[00:47:31] 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
[00:47:47] Randolph: make. I'm making an assertion.
[00:47:49] I'm asking you what forward expected returns would cause you to say the stock market's at the right price. Do you think the stock market should be half where it is now? If I were 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 2, you're saying it should pay long bonds plus 4 or 5 or something like that.
[00:48:13] Is that in the ballpark?
[00:48:15] Mike: 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 percent lower.
[00:48:25] Randolph: Let's switch to that then. I don't understand that at all.
[00:48:28] 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 inelastic as they say. Let's take theirs as given. So they say a dollar goes into the market.
[00:48:44] It moves the market 5. If you take All the money that went into 401k plans last year, it was about 2 percent of the size of the market. I looked it up. Something like 60 percent of that went into stocks, maybe 65%. So that's like 1. 2 percent of the market. And then you apply a five to it and you say, okay, that should push the stock market up 6%.
[00:49:05] 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 the 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.
[00:49:19] 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 401k contributions that have ever happened would make the market something like 12 percent higher. So how do you get 50 percent higher?
[00:49:37] 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 plunger plan, they'd bought just as much stock. But let's imagine that instead they lit it all on fire. Then I feel like the market would be 12 percent lower, not 50 percent lower.
[00:49:53] Mike: That would be great and absolutely true if we were looking at a single period. 401k flows are happening on a continuous basis. But I accounted for that. No, you didn't. What you actually did was you said, if I put all the money in, that would have raised valuations by 6%.
[00:50:09] Randolph: And then last year's would have been 6 percent then, which is three now.
[00:50:13] Cause 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 16 equals two. And that's why I doubled the 6%.
[00:50:25] Mike: Now turn it into a time series and which is a multiplication as compared to an addition.
[00:50:30] It's 1. 06. Times 1. 06. Times 1. 06. Times 1. 06. No!
[00:50:38] Randolph: That's not true!
[00:50:39] Mike: Yes!
[00:50:40] Randolph: No, it's 1. 06 times 1. 03 times 1. 015, so maybe it's a tiny bit over 12 because the compounding is still going to be 12. No, not at all. 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.
[00:51:04] Do you actually believe that? That can't be true. Absolutely. I'm saying there's a half life where the effect of that trade deteriorates a little bit each year.
[00:51:11] Mike: Walk through the math, very simply. First year, 1. 06. We agree on that. But then three of it you give back the next year. Hold on. After one year, I'm at 1.
[00:51:21] 06. Now I have another flow come in that has a similar impact. So that's actually 1. 06.
[00:51:27] Randolph: Times 1. 06. This is the heart of the matter. I'm saying if 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.
[00:51:43] You can't just keep adding up forever. That would be crazy
[00:51:46] Mike: It does
[00:51:47] Randolph: nobody thinks that the impact of every trade is a permanent impact Of course, it has to have a half life I totally agree. So what do you think they have? Like I used a year, which I thought is super long. Do you want to use something even
[00:52:00] Mike: longer?
[00:52:01] Let's use a year. Let's stick with your number, but let's recognize that each year has a similar compounding effect
[00:52:08] Randolph: run through the map. 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 back is 1. 03 because it did 1.
[00:52:19] 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 6 plus 3 plus 1 and a half, which gets you to 12. It's a tiny bit higher than that for compounding.
[00:52:37] 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 401k plans. But that's not true. We know that in the old days, they had to find benefit plans. And those went into stocks in about the same proportion.
[00:52:54] So 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 401k, 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 percent because you always have the most recent year as a six and then a year that's half as big and a year that's half as big.
[00:53:18] So you never get an explosive thing from this again, even with that first crazy assumption.
[00:53:23] Mike: 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 On to a market that is 3 percent more expensive.
[00:53:41] So that actually takes it tiny bit over nine. Okay. So now let's do it again. So let's say that effect degrades by 50%. That 0. 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.
[00:54:06] 06 times that.
[00:54:07] Randolph: Five and a quarter. 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.
[00:54:21] Mike: Okay. So after four years, I'm already past 12 in that analysis.
[00:54:25] Randolph: Do you agree that if we use simple instead of compounded, it would be exactly 12 after a hundred years or a thousand years? Yes, of course I do. But that's the problem. 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.
[00:54:42] 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.
[00:54:50] Ben: Randy's math seems to make sense, Mike. I'm missing why it's wrong. Okay.
[00:54:54] Mike: Let's run through this here very quickly.
[00:54:56] Ben: We're doing Excel right now?
[00:54:57] I love it.
[00:54:58] Mike: Might as well,
[00:54:59] Randolph: right? Do seven years, 1. 06 times 1. 03 times 1. 015 and you can do the rest.
[00:55:06] Ben: 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?
[00:55:14] 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 than flows going into actively managed funds or whatever.
[00:55:31] Anyway, park that. I want to hear what the Excel says.
[00:55:34] Randolph: Right, because you can see by the time you get to seven years, you're down to really tiny factors that you're adding on.
[00:55:39] Mike: Unfortunately, I'm still trying to get the Excel numbers in because I'm working off of a single laptop.
[00:55:45] Randolph: Let's see how serious it is.
[00:55:46] 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? 1.
[00:56:02] U/k: 0624.
[00:56:04] Randolph: I went a little high at the end because I couldn't do the dividing 37 and a half and a half in my head fast enough, but it got us up to 16 instead of 12. It just doesn't go that high. At 70%, it's not going to add much if you keep adding those tiny factors.
[00:56:16] So it's probably between 15 and 16%.
[00:56:19] Mike: So 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 that's making.
[00:56:29] Randolph: And I want to grant your point there. If the half life is five years, not one year, you could get to something big.
[00:56:34] 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 Xavi did is that they showed us people thought it degraded in minutes.
[00:56:55] 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 is 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 proof on it.
[00:57:08] Mike: 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.
[00:57:18] 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.
[00:57:46] The
[00:57:47] Randolph: number one seller these days is probably target date funds. If the market gets pushed up artificially, targeted 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.
[00:58:02] And that may be old school pension funds or who knows, it may be insurance funds that only are allowed to have 10 percent 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 percent in stocks or shouldn't go over 50 percent in stocks now that you're older or what have you.
[00:58:20] 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.
[00:58:34] 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.
[00:58:52] 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 that 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.
[00:59:09] 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, back when it was old school pension funds.
[00:59:24] Why is this so different?
[00:59:26] Mike: 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.
[00:59:49] If you actually look at Gene Kaye's, Xavier Gabay, and Ralph Koyjian'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.
[01:00:08] 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.
[01:00:27] Randolph: So help me understand why the active guys have less impact.
[01:00:31] 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.
[01:00:53] 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 passive is 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?
[01:01:15] Mike: 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.
[01:01:37] 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 overweighted 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.
[01:02:01] So 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.
[01:02:24] They are not waiting bonds anymore today. At four and a half percent yields than they were at 1 percent or half percent yields 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.
[01:02:50] 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.
[01:03:11] 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,
[01:03:23] Randolph: 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.
[01:03:31] 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 change story, whether it's AI, whether it's the incredible healthcare breakthroughs that are happening, people are saying we think cash flows are going to be a lot higher.
[01:03:55] So even with this higher denominator in the net present value formula, we think these stocks are still going to 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 targeted funds absolutely took action when interest rates went way up, bonds went way down, and then they sold stocks and bought bonds.
[01:04:15] And your point is, well, I know, but they just went back to 60 But the point is, they absolutely took action. They took money off the table in the stock market and poured it into the bond market because of interest rates rising. So 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.
[01:04:33] And then the third point I wanted to make is, Ralph and Sofie's thing 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 percent stock, market goes up 10%, Now you're 77.
[01:04:52] 30, let's say bonds didn't move, so you're 77. 30, well to get back to a 70. 30 proportion, you have to sell what, I don't know, 3 percent of your stocks and put it in the bond market, maybe it's 2, let's say it's 2, so you sell 2 percent of the 77, and now you're 75. 32, and that's probably pretty close to a 70.
[01:05:08] 30 mix. I can't quite do the math fast enough in my head. So you sell 2 or 3%. Ralph and Savvy say 2 or 3%, times 5. If target date funds were a quarter of the market, then you're going to have 2 percent times 5 is 10 times a quarter is, you're knocking the market down two and a half percent. It's hugely impactful.
[01:05:29] 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 news.
[01:05:41] Mike: I would actually agree with that.
[01:05:42] Randolph: I have
[01:05:42] Mike: no dispute around
[01:05:43] Randolph: that.
[01:05:44] Mike: This is the critical component.
[01:05:45] But when I highlight target date funds. My issue with Target Aid funds has nothing to do with the fact that we are using automatic, systematic rebalancing. I completely agree. That actually changes behaviors of markets and makes portfolios ball dampening in that process. This is exactly Parker's point.
[01:06:02] If I sell equities and buy bonds to your earlier assertion, have I made an assertion about the forward expected returns to the market? Have I offered any insight in terms of the development of AI?
[01:06:15] Randolph: I'm not saying the target aid fund did 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.
[01:06:31] 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.
[01:06:51] Everybody would pour all their money into stocks. So 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?
[01:07:07] 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 post earnings announcement drift that says when there's news, the stock moves the right direction for the news, but it doesn't move nearly far enough.
[01:07:22] 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.
[01:07:39] 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.
[01:07:54] 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.
[01:08:09] So hasn't the rise of passive made the markets way more efficient and better?
[01:08:13] Mike: So I got a couple of quick points. One, I actually asserted at the start that the contribution of passive Is positive up to a point. So I just want to be very, very clear on that. The second component that I would highlight is that when you talk about something like quality factor, part of the components of quality is effectively saying that there is 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.
[01:08:44] A passive format Effectively grants a special status on to that low volatility component. If a company is up 10 percent one earnings report and down 10 percent the next earnings report, it's net down 1%. Company is up 20 percent one earnings report, down 20 percent 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.
[01:09:17] My point on this is not to actually say the quality component doesn't exist. In fact, I actually exploit it in 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.
[01:09:35] Randolph: I pointed out at the beginning, there's these two kinds of passive.
[01:09:37] So there's sort of passive in the sense of these 401k type things, where the money's 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?
[01:09:54] That's one. 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?
[01:10:12] I mean, the 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.
[01:10:30] Either there have to be bigger anomalies. Oh, post earnings announcement drift is three percent, not one percent. Or the anomalies have to last longer. It gets you three percent for three, you know, gets you one percent for four months in a row, instead of three percent for a single month. Every quant I know, and I know a lot, would tell you that both those things are way smaller.
[01:10:49] That the markets are way closer to fair price, way more fit. 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's more smart people trying to get prices right, and they find it harder and harder every day because they're all so smart and they're all working so hard and they all have so much money to use to get prices right.
[01:11:08] Is there a rise of passive at all?
[01:11:10] Mike: Well, empirically, there has been a rise of passive, so we actually know that.
[01:11:14] Randolph: Are you sure they're counting it 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?
[01:11:26] 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 nineties, a big hedge fund was like $3 billion. And now you've got awe inspiring amounts of money. And again, they don't all call themselves hedge funds.
[01:11:41] 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 50 x 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.
[01:11:57] 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.
[01:12:10] Mike: 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 can really entertain.
[01:12:20] Randolph: 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 percent of them were closet indexers and 20 percent of them were 3D
[01:12:34] Mike: indexers. But Randy We actually have data on this that shows the proportion of index hugging has actually risen dramatically.
[01:12:41] The proportion of closet benchmark has risen dramatically.
[01:12:45] Randolph: What we don't know is about the real guys, the guys who actually have edge. Because again, those guys in the eighties, 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?
[01:12:58] We know they underperformed consistently. The point is, were they actually fixing mispricings 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.
[01:13:14] 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. Now I understand, I've seen the papers, so I know a couple people have made an effort, Ralph's made an effort, other people have made efforts.
[01:13:31] 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, you know, what people haven't even heard of. I'll just like meet people. I'll be like, Oh yeah, I'm at QuantiQuest. We've got 23 billion and we 40X leverage. And I'm like, I've never heard of you.
[01:13:47] They're 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 of, the other kind of rise of passive absolutely happened. All that money in the target date funds.
[01:14:00] 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. We took money out of the hands of some mutual fund folks who I'm not sure how great they were at fixing this pricing.
[01:14:18] 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, highly levered, exceptionally smart institutions, and I just wonder.
[01:14:31] Mike: So the quick answer to that is you are absolutely correct that there has been a rise of mega firms within what would traditionally be described as the hedge fund space.
[01:14:39] 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.
[01:15:02] 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.
[01:15:22] And we know that that's fallen from around 80 percent of market activity to around 10 percent of market activities today.
[01:15:29] Randolph: Think about, we were talking about Marco Salmon 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.
[01:15:43] 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 the 0. 6 percent or something you go up when you get in the index.
[01:16:00] It's an astonishing result, but I'm just saying if the post earnings and outputs drift is gone, and if the quality effect is way smaller than it was, and if the index inclusion is gone, you're 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.
[01:16:20] And that either there was no rise of passive at all, or if it happened, it wasn't a big enough effect to make 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.
[01:16:33] Mike: So again, this is a question of what is the actual mechanism?
[01:16:36] 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.
[01:16:51] Randolph: As it needed to be. I used to argue with my dad about that.
[01:16:53] 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 Myers. 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 missed by a penny and the stock's down 9%. And this is in the 90s when I'm in grad school learning this stuff.
[01:17:09] 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.
[01:17:24] In other words, he's the guy who goes, it dropped too much. I'm going to 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 percent. It should have fallen instead of only falling nine. Again, all numbers made up money back.
[01:17:40] Mike: 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?
[01:17:51] Randolph: But if it were the second one, then we'd see the quants printing money. But we know they're not.
[01:17:55] We know how tough it is.
[01:17:57] Mike: 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.
[01:18:13] Randolph: I don't think we've seen people making more money off things like betting on what happens right after earnings.
[01:18:19] Granted, we wouldn't necessarily call post earnings an announcement drift anymore, because maybe now it's an overreaction on post earnings or whatever. But the people who do that kind of trading, 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.
[01:18:32] You can read all the academic papers that their stuff is based on. And you see, oh, this one's 5 percent a year, and this one's 7 percent 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.
[01:18:45] It's pretty tough out there. And that's because a friend of mine once 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've talked to a lot of quants because a lot of people I went to grad school with are now really, really top quants.
[01:19:01] Former students and so on and so forth. I got 4, 000 former students. Now, nobody thinks it's gotten easier.
[01:19:07] Mike: Easier relative to what? Easier to what it used to be? No. Easier relative to actually trying to project the fundamentals? Absolutely. What do you think of fundamental analysis these days? I don't think anyone does it anymore.
[01:19:20] I don't
[01:19:20] Randolph: think anyone really
[01:19:21] Mike: cares
[01:19:21] Randolph: in all seriousness. Couldn't that create opportunity if you did? Is your point that if someone did it, it would be great, but they don't do it?
[01:19:28] Mike: This is the second component 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.
[01:19:40] 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 Sharpe's that passive never transacts.
[01:20:00] 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 percent of the people get one vote of radical size, and everybody else gets a tiny vote.
[01:20:18] That means that the wisdom of crowds breaks down under those simulations. You end up with the answer that the 45 come to, not that the 55 come to.
[01:20:28] Randolph: So 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 writing it to address you.
[01:20:36] Would you agree?
[01:20:37] Mike: Yes, I do
[01:20:37] Randolph: think
[01:20:38] Mike: that's correct.
[01:20:39] Randolph: I thought they had a couple of good points and some other points that weren't as compelling, so I feel like you deserve a chance to respond to them.
[01:20:44] Mike: Absolutely. So, Goldman Sachs came out with a report headlined by David Kostin that 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.
[01:20:59] 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 facts that indicators. And so everything in an industry fund, everything in a sector fund, everything in X, Y, Z is included in there.
[01:21:18] The most passively held stock, according to Goldman Sachs was something like 42 percent with NASDAQ and DAQ the ticker. That's absurd. They next came to the conclusion that the most passively held stocks were the REITs, et cetera. And Bloomberg did the same analysis earlier in the year. You end up with the conclusion that the least passively held stocks are actually the largest stocks.
[01:21:40] 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.
[01:21:57] 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
[01:22:12] Randolph: it's just that simple.
[01:22:14] I think you have a good point. When they said, oh, the average stock is 25 percent passive and NVIDIA is only 22, and then they said they ran a regression and it showed that the lower passive ran up more, I thought 25 versus 22. And that's before we even get to your point about, is that really properly measured?
[01:22:32] So even though in the end, I reached similar conclusions to them about their as a passive, I think you have some good points in response to what they're saying.
[01:22:39] Ben: 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.
[01:22:48] 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 their growth and hedge funds and things like that, we don't have as much visibility on.
[01:23:00] Mike: Hedge funds have not grown since 2012 other than the underlying asset values.
[01:23:05] So 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 the 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.
[01:23:22] Randolph: And use of leverage and other kinds of things that wouldn't call themselves a hedge fund, but are working to make markets more efficient.
[01:23:28] Ben: 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?
[01:23:37] Mike: I did. I think the cross sectional impact is to raise valuations significantly.
[01:23:42] The key question becomes exactly what Randy highlighted, which is effectively what's the degradation factor associated with that? What are the mechanisms by which that degradation occurs?
[01:23:52] Ben: That's aggregate market though. Cross sectionally, how is it affecting large cap stocks versus small cap stocks?
[01:23:57] Mike: On a cross sectional basis, there's a huge difference in multiplier, effectively, with the inelasticity work I've actually been working with Valentin Haddad to derive some of the components of it.
[01:24:09] And 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.
[01:24:26] The second is the smaller share of the market that is actually held by active managers, the greater that decrease in inelasticity. If you got to a market that was a hundred percent passive, the market by definition would be perfectly inelastic. There would be no marginal buyer or seller. Take it back to 99, market is still highly inelastic.
[01:24:47] 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.
[01:25:06] Traversely, as Passive gets larger and larger. This strategic response becomes exactly what Randy's 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.
[01:25:24] 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 percent 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.
[01:26:05] A market that is shifted from that forward fundamental outlook becomes increasingly disassociated with those forward fundamentals and less 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, and it is falling as passive gets stronger.
[01:26:26] Larger and larger and larger.
[01:26:29] Randolph: Valentines works really interesting, very high quality work. First question you ask is how much more passive are we than before? You know, we have these funds, they don't call themselves hedge funds. They're institutional long only, but they have 100, 200, 300 billion and unbelievably, insanely smart people at them, you know, including friends of mine and friends of theirs who I've gotten to know.
[01:26:48] Sometimes they're able to use leverage and derivatives and other things. And so there's some big players in there. So, okay, we've done that to death. So 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.
[01:27:01] So then, Hadad 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.
[01:27:17] If you have very solid methodology, like Greenwood and Salmon, where you're using, you know, standard approaches to estimate time series effects and so forth. You can have a lot more confidence in that. So 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.
[01:27:38] And I think it's your belief, Mike, that with the higher levels of passive that you believe in, maybe he would 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.
[01:27:52] 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.
[01:28:10] And then the third thing is, even taking the result of face value, you gotta take a third. So it's like a piece of a piece of a piece. And so 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. And if there is something there, I'm not convinced it would be big, but my mind is open.
[01:28:26] It could be there's something there, and it could be big. So as opposed to in the aggregate, where I'm like really pretty sure there's not a problem. On this side, my mind is more.
[01:28:35] Mike: 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 indexes were not even created until 1957 with the exception of Charles Dow's Dow indices.
[01:28:49] Randolph: It's about whether the average dollar is smarter, more impactful. Because as we know, a lot of those old mutual funds were 80 percent passive or they were 90 percent passive or whatever. And 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.
[01:29:11] 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 don't know how much they would have controlled These are the highest paying jobs in the world.
[01:29:32] 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, were there 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 at us.
[01:29:47] 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.
[01:30:04] Absolutely granting, you might be right. I have a strong opinion on this, 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.
[01:30:13] Mike: As I often say on this, I hope I'm wrong, but I think I'm right. So effectively, I'm just on the flip side of Randy on this.
[01:30:21] The evidence in terms of what is actually happening in markets and behavior is best explained by models of inelasticity and the rise of passive.
[01:30:30] Ben: 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.
[01:30:45] And 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. So Valentin has 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.
[01:30:56] Mike: 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.
[01:31:06] Ben: That's fair. He said his feelings are mixed.
[01:31:08] Mike: I will tell you that I spoke with Valentin earlier this week, and many of the things that I raised as concerns, candidly, he had not considered. And 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.
[01:31:28] Ben: 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?
[01:31:35] Mike: 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.
[01:31:47] If the process stops, Or reverses, which could be due to a combination of rising prices because withdrawals are always a function of 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.
[01:32:16] Randolph: 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 4 percent real.
[01:32:40] You can do it off dividends, you can do it off earnings, but you're going to get an answer like 4 percent real. And long bonds are paying 2 percent real. And so it looks to me like that's a pretty reasonable price for the market to be at. And if the market gets to an unreasonable price, then we have to worry about whether it's caused by rise of passive or anything else.
[01:32:57] We have to get scared, but I just don't see that yet. I had this conversation with Bob Schiller 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, when stocks are finally getting to a price that sort of makes sense logically?
[01:33:15] And 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 5 percent premium or more from them. And 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.
[01:33:30] So that's a great answer. And he absolutely might be right. So 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. And so you can get a crash without stocks getting to prices that seem irrational from a theoretical point of view.
[01:33:47] 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.
[01:34:02] But I think what's great is that you're looking to wind work 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 thing. If he was right all along, we probably should have acted a little sooner, but hopefully it's not too late to act.
[01:34:16] But if you weren't talking about these issues, then we wouldn't be positioned for that.
[01:34:20] Mike: 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 percent earnings growth into this year. Secondly, it's stated off of non GAAP earnings, operating earnings as compared to GAAP earnings, trailing GAAP earnings are around 200.
[01:34:35] When we talk about historical market multiples and the equity risk premium that Brandy 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 were extraordinarily extended versus those historical averages. Now, part of that could be, as Randy points out, a realization.
[01:34:59] That we should have a lower equity risk premium, but it would be unrealistic then to forward project higher expectations, which is the second era that Schiller was highlighting. And 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.
[01:35:19] So 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.
[01:35:33] Randolph: I asked ChatGPT for the forward trailing earnings model, and then I double checked on Google to make sure it wasn't a hallucination.
[01:35:40] So clearly I'm the world's expert on these, no, clearly you've thought a lot harder about how we should interpret these multiples to me. So I half assed it on that and I'll think harder about it. It's a fair point.
[01:35:50] Ben: What do you guys think the typical retail investors listening to this podcast or financial advisor who's helping guide their clients listening to this podcast should be doing with this information, if anything?
[01:36:00] Randolph: Here's the problem. If you've got an equity premium, you're going to get something like a 4 percent yield on earnings and that 4 percent you're going to add with inflation, obviously, because these are real assets, you're an 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, and it's pretty hard to argue that you shouldn't have a pretty solid chunk of that in stocks.
[01:36:26] 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 to almost certain we've seen, I mean, geez, we've had crashes and it seems like now we get them every four years or so, but the problem is you kind of go nuts.
[01:36:39] I will one more quick Bob Schiller 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?
[01:37:06] Because, you know, it's up a lot the last few years. And then Thaler said, yeah, Bob, that's a good point. You've been saying this since 89. So this was in 94 that this conversation happened. So 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.
[01:37:24] And then obviously timing is everything. None of the journalists said, Dan, but haven't you been saying this since 1989? And 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, crash land. I know you're always very careful about this, Mike.
[01:37:39] I'm not throwing shade at you either. I know that you're very aware of this problem and how hard it is. So I'm just saying, if I'm a financial advisor, I'm looking and saying, if you buy and hold forever, you got an inflation plus four here in stocks, you got an inflation plus two in bonds, Something like 60 percent in stocks is not unreasonable.
[01:37:53] And 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. So I'm interested in your thoughts, given those challenges and given that I know you're keenly aware that we're never going to be able to time the crash.
[01:38:06] Mike: So 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.
[01:38:27] You're talking about a 12 and a half percent sort of crash. That's not what I'm actually talking about.
[01:38:32] Randolph: If it goes to six, then it's a 20, 20, 25 percent crash. And that is a normal crash.
[01:38:37] Mike: Correct. So 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.
[01:38:51] 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.
[01:39:09] 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 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 8 percent a year.
[01:39:28] And my expectations over the next 10 years are that the stock market will return 8 percent a year. Nobody invests for 100 years except for a very few select people. And as a result, that terminal risk is actually a really, really big deal. Stocks have a very different behavior set to fixed income. Thank you.
[01:39:47] 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.
[01:40:08] 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.
[01:40:20] Randolph: This is the case for the Target
[01:40:21] Mike: Aid funds. Exactly. 100 percent the case for Target Aid funds. Except if we actually look at an aging America, it owns more equities than it has ever owned in its history.
[01:40:31] Randolph: Your thought is it may be the kids are alright, but that there's too many 68 year olds who are still at 70 percent equities or something like that. That might be true. 100%. So 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 percent crash out there in the next decade.
[01:40:49] I have a lot of smart friends who say, did you notice that the debt is over a hundred percent 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 and when you put all that together might 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.
[01:41:13] So in other words, isn't a 50 bond crash About as likely as a 50 percent stock crash or more likely. I mean, shouldn't we be scared of a big old bond crash?
[01:41:22] Mike: One, I think bonds have already crashed significantly. So 50 percent crash from the levels of 2020. Sure. If I look at tips or anything else, or I'll give it an extreme example, the Austrian century.
[01:41:35] Randolph: 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 say, well, nobody wants those fricking bonds and they go not 4%, but the 12 percent or the 18. You know what I mean? Couldn't that happen here?
[01:41:49] Mike: I think highly unlikely, but there's certainly not as likely as a 50 percent correction in equities.
[01:41:56] The second point though, that I would emphasize on that is if the U S government Loses control of its economic system in that manner. Do you honestly think that Microsoft is going to retain control of its IP? It's a
[01:42:09] Randolph: fascinating question as to how that would get handled. So
[01:42:12] Ben: good one. We had a guest Scott Cederberg.
[01:42:14] I don't know if you guys are familiar with his 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, 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.
[01:42:33] Even in the US, there've 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.
[01:42:44] Mike: It's hard to find
[01:42:44] Randolph: anything that's truly
[01:42:45] Mike: safe. Particularly in the world that Randy is describing.
[01:42:48] If you have a U. S. dollar crisis in which suddenly the U. S. 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.
[01:43:10] And unfortunately, I think that many of the discussions we're having today, people's behaviors are in part influenced by these narratives. It's safer to invest in the equity of Microsoft and in the debt of the United States. And that's a very strong statement.
[01:43:25] Randolph: I met a teaching expert once who told me that five years after taking an entire course, students only remember one thing from the course.
[01:43:32] So as a professor, you should make sure you know what you want to teach them. And so I took to asking students when I ran into them years later, what they remember. And very consistently, the thing they remembered from my course is that 1 percent a year for life doubles your money. The natural log of 2 is about 0.
[01:43:45] 7. So 1. 01 to the 70th power is about 2. And so a lifetime at 1%. So 2 percent a year for life quadruples your money. So all I'm saying is, if you're even asking the question about the relative riskiness, boy, maybe take the extra 2 percent because 4X is a lot.
[01:44:01] Mike: And I would highlight that the more people that believe that, the less the possibility of earning that excess return.
[01:44:06] Ben: Stock valuations are too high because people think they're too safe.
[01:44:08] Mike: What do you hear? You hear people say, I'm saving through my 401k. What are you saving it? I'm saving in the S& P 500. You're not saving. You're investing and investing is an inherently risky activity. That's why you're receiving the compensation that Randy is highlighting.
[01:44:23] Ben: Risk has to be there. 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 like Ralph Coyne, when he was on our podcast, he wasn't worried about this. Hadad, when I talked to him, wasn't too worried about it. Maybe you've talked to him more recently and he is.
[01:44:38] Antoinette Schor 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?
[01:44:49] Mike: So again, I think it really depends on how you ask the question. So I've watched your co agent episode.
[01:44:53] I've watched your Hadad episode. It really depends on how you formulate the question. So what co agent is actually saying in which he says, I'm not particularly concerned about that. It says that he's actually anticipating the strategic response. I'm I actually agree with that. I do think that there will ultimately be a strategic response, but strategic response comes at what level and what form does that strategic response take?
[01:45:16] Those are the key questions. I'll just be very straightforward with you. In conversations with both Ralph and 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 a response function.
[01:45:38] Ben: 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.
[01:45:49] Mike: What I'd love to see is actually non confirmation.
[01:45:52] In other words, the hypothesis that I've 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.
[01:46:18] 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.
[01:46:40] 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 in 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.
[01:47:09] Not that I'm suggesting they have some great brand responsibilities to society, but it is an important impact to understand. 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 economy.
[01:47:28] Created a system that has negative feedback loops for both our society and our potential retirements. That's what I care about.
[01:47:36] Ben: Randy, you started off saying you're not worried about this stuff. After hearing Mike's arguments today and going through this discussion, where do you land now?
[01:47:43] Randolph: I'm still not very concerned.
[01:47:45] I mean, I guess what I'd say is on the cross section, my view is. If Microsoft's trading 10 percent too high and Delta's trading 10 percent 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 muddled through as a society in the past.
[01:48:02] Of course there are these wacky GameStop type situations, maybe those become a huge issue in the future. I think for now it's unfortunate that 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.
[01:48:18] Confessions of a stock operator and all that sort of thing. You know, it's a hundred 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, yeah, you know, if the multiples get high enough, I'll start to worry.
[01:48:40] 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 percent stocks, 40 percent bonds.
[01:49:00] And then on the other hand, you put it in the target date fund and it's similar. It's not that clear to me why it should make a big deal. And obviously I read the paper, Dimitri and Lu Zheng. They've got an interesting argument. We put those things in the bucket of this might be a thing that's important.
[01:49:16] 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 had 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.
[01:49:32] And 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. And I know, obviously, again, if you count as active fund something like a sector fund, then that doesn't have to perfectly hold. But the fundamental idea, which I guess is Bill Sharp's idea, It seems pretty solid.
[01:49:49] So 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 the second and third order effect, when I multiply out the numbers on the flows, I don't feel like even if somehow active didn't count and passive did, I don't feel like it should be that problematic.
[01:50:07] So. 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. And then empirically, I don't think the price increases we've seen are of a realm that looks scary to me.
[01:50:20] Mike: My immediate reaction to that is that to look at current valuations at 22 times forward and compare them to the past is not a appropriate approach.
[01:50:30] 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.
[01:50:41] Randolph: Oh, true. I just think those old prices were too low. And I want to be clear, I bought 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.
[01:50:52] And I feel like it's spent the last 30 years proving that right.
[01:50:56] Mike: And 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, 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.
[01:51:18] That higher expected return, regardless of whether it's going to be realized over five 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.
[01:51:38] 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.
[01:51:58] To your point that it's all the same, it's not. If I go back to 1929, a peak in activity in the stock market, 10 percent 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.
[01:52:15] Today, 62 percent of American households own equities to their 401ks, and that is their requirement Transcribed for retirement. So 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 specious, even before I began the process of evaluating the impact of passive investing.
[01:52:42] Ben: 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? Yeah.
[01:52:47] Mike: I may have, but I'm not entirely sure of the authors. Schmalz and
[01:52:50] Ben: 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 saying.
[01:53:06] 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? And your answer was, there's not much you can do. You've got to hold on and hope things are okay. And it's more about advocacy and trying to change the way things are structured as opposed to changing your asset allocation decisions.
[01:53:24] Do you still hold that view?
[01:53:26] Mike: I do, unfortunately, because 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 and equities and outperforming actually, as I've shown you through presentations, becomes a harder and harder challenge, regardless of the skill level of managers.
[01:53:45] That's very straightforward. Now, with that said, are we getting closer and closer to a point both through valuation increases and through agings of society, the process of which this begins to potentially reverse itself? Absolutely. And so 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.
[01:54:14] 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 message was so roundly rejected because the vast majority of Americans are experiencing a quote unquote, 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.
[01:54:37] Ben: Awesome. All right, guys, this has been incredible. I appreciate the generosity with your time, both now and in preparing for this conversation. So thanks again for coming on.
[01:54:44] Mike: Take care, guys.
[01:54:45] Ben: Thanks.
[01:54:46] Cameron: Great to see you.
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