Justin: Hi Mike. Welcome back to Excess Returns.
Mike: It feels like I was just here.
Jack: Ah, you gotta come back more often though. You were, yeah, exactly. You were also with Dave so you’re used to probably getting like highly intelligent questions. You’re gonna get the opposite of that today from Justin and I.
Mike: Oh, I don’t agree with that at all. But, not that Dave is not highly intelligent and doesn’t offer highly intelligent questions, but you guys very thoroughly prepared. Just sent me some really nice notes.
Justin: Yeah. Awesome. Today we wanted to sort of have you back on to talk about the topic that a lot of people know that you are pretty much become an expert in, and that’s the impact of passive investing on market structure and the role that flows are playing in driving prices.
You’ve been one of the earliest voices and one of the leading voices in explaining how markets have become more inelastic and how the growth of passive investment strategies are changing the way that kind of risks is showing up in the markets and manifesting itself, but maybe underneath the surface in a way that a lot of investors don’t fully appreciate.
So that’s gonna be the bulk of the conversation today. There’s been some larger firms that have come out and kind of pushed back on some of your reviews. And so, to some extent we’ll kind of work through those arguments and see sort of how your research plays into what some of those counterpoints have been basically saying.
And so, yeah, it’s gonna be a good conversation. Before we get into all of it, Mike, you can follow along at his substack, which is substack.com, at Michael W. Green and also, Mike is Chief Investment strategist and portfolio manager at Simplify Asset Management. That’s just simplified at us. Where the firm runs a number of differentiated investment strategies, within the ETF wrapper.
So that’s how you can kind of learn more about Mike if you don’t know about him already. So. Alright. So Mike, where we want to start with you is, I think let’s just set some definitions here so our audience kind of knows a little bit about what we’re gonna be talking about. So a lot of times when you’re talking about this passive impact.
You’re citing this idea of the inelastic market hypothesis. So we just thought, maybe if we could briefly just start there to set the stage and then we can get into some of this other stuff.
Mike: Well, it’s interesting, so the inelastic market hypothesis refers to a paper by Xavier Bay and Ralph Coy, and they came out in 2020.
My work on passive actually proceeded that I started in 2016 and really I credit La Saint Peterson at AQR. For writing the paper that ultimately, in my opinion, broke the mental log jam around how passive influences markets. In 2016, he wrote a paper called Sharpening the Arithmetic of Active Management, which refers back to Bill Sharp’s Seminole paper in 1991.
The Arithmetic of Active Management, which is the source of all the languages that you hear. That active and passive at the end of the day own the same things in the same proportions, and therefore the only difference between the two is ultimately going to be the fees that active managers charge. That helped to explain or provided the fundamental explanation for the outperformance of passive strategies and encouraged people to deploy assets in that direction for the simple reason that they could become free riders onto the system.
Last St. Peterson pointed out something very, very important, which is the definition that Bill Sharp provided for passive versus active. His definition of passive management was somebody who never transacts, never transacts, can’t get in, can’t get out. And he did it as a thought experiment where he articulated that well, let’s presume that they trade in the limbal hours when the markets aren’t really opened or closed.
That’s obviously impossible, and Lase was correct to highlight this. What he noted was that there are distinct events, index Reconstitutions in particular, he focused on where the end portfolio of the passive investor has to change and so they have to transact and during that time period they become active managers and are no longer subject to the rules that Bill Sharp articulated.
That actually is absolutely correct. It’s turned out to now become the largest hedge fund strategy is actually index arbitrage. Basically taking advantage of passive strategies, trying to use statistical arbitrage to protect, to, I’m sorry, to project or predict what is going to go into an index or leave an index and to trade those appropriately.
That’s why we have things like the runup in Tesla in December of 2020 in anticipation of it joining the s and p 500. And as I said, it has become an incredibly large business for hedge funds. The second source of portfolio change though, is actually caused by the end customer. Anytime you contribute cash to a portfolio, you’re changing the composition of that portfolio and forcing it to transact to match the benchmark.
That was really my contribution to the process and recognizing that every single day these index funds and ETFs receive inflows or outflows occasionally that actually means that they’re continually trading, they’re continually executing in markets, and as a result, they don’t at all fit the definition that Bill Sharpe provided in the arithmetic of active management.
Basically, none of his work has any theoretical framing in a world in which their portfolios are changing. That’s what really set me off on that. ‘cause all of a sudden, the minute you realize that you recognize what they actually are, which is just a systematic algorithm that operates off of the world’s simplest algorithm, did you give me cash?
If so, then buy. Did you ask for cash? If so, then sell. And that becomes a much easier thing to understand in terms of how it’s going to impact the markets. So that’s where the whole thing starts now. By 2020, the academics began to wake up to components of this Xavier Gibe and Ralph Cogen wrote the Inelastic Market Hypothesis that challenged another precept to the efficient market hypothesis, which all index funds are based on in the efficient market hypothesis is presumed that markets are highly elastic, that they can basically absorb nearly any amount of supply and demand change.
With very limited impact on either individual securities or certainly the market in its totality. The actual specification within the efficient market hypothesis is that a dollar into the market because every buyer has a seller, really should only impact market capitalization by basically the difference in the bid ask spread typically about a penny.
Therefore, a dollar into the market only creates about a penny of additional market capitalization. Gbe and cogen using some very sophisticated mathematical techniques derived that that number wasn’t even remotely closed. They estimated it was between five and eight. They were using a time period average, and so didn’t actually capture the trend of that rising over time.
We have subsequent research from Valentine Haddad and others, and I’ve done my own research on this that suggests that that’s actually a rising factor. That we’re seeing larger and larger impacts associated with the market’s, loss of elasticity tied to the growth in share of passive investing.
Justin: So the latest numbers that I’ve seen is that right now the market is roughly 50% passive. And I know that you and one of your peers are working on a new paper, and we were talking about it before we started here, where you’re sort of trying to get at the number that would, if we got to this number, in terms of the percentage of the market being dominated by passive.
It should strike fear in the minds of equity investors sort of everywhere. So can you just talk to sort of where, I know this research is preliminary, it’s not public yet, but what, where is this research sort of bringing you and do you have any insights into, do you know the rough range of what that number might be, where it would be very problematic for the markets?
Speaker 3: Yeah, so, so Hari shared some of our initial findings over Twitter, and it’s important to specify the characteristics that we assumed in that. So one of the assumptions is actually that’s not having any inflows or outflows. And so that number of about 83% is actually a static number. That if you get to that level of passive effectively, the market becomes so impossibly volatile that it becomes an inevitable event that it will eventually cause its closure.
In an unrestricted market like XIV where we were at very similar levels, you had the capacity to go to zero with the circuit breakers in place and the restrictions on that type of trading in place on the US equity markets. Our underlying presumption is effectively that the markets would stop clearing, they would close the markets.
And that this would happen over a repeated period of days as people tried to get, make redemptions in response to the market being closed. That’s a very conservative model. I wanna emphasize a couple of features that are being put in there. One is that we are assuming that anyone who is not passive.
Is fully active, effectively having a historical elasticity of about 0.75 to 0.8. Secondly, we are presuming no flows, as I mentioned. So that doesn’t include any redemptions. It doesn’t include any contributions, et cetera. It’s simply an endogenous feature that plays out in the market. And some of this work was actually replica is, is effectively a replication of work that was done by Andrew Lowe on a similar topic where he came to a very similar conclusion between 75 and 80% passive.
The market would effectively cease functioning. If we make some assumptions about declines in elasticity for active managers, which have absolutely happened. I’ll share a few slides on that. That number moves significantly lower. If we start incorporating components of flow into that, that number also begins to fall dramatically.
And so we basically treat that 83% as an outer limit.
Mike: To your point about where we are right now, we’re, I, my estimate is actually we’re about 54% passive by market share and we picked up about 4% last year. So if that pace continues itself, we would be looking at somewhere in the neighborhood of five years out the world comes to an end. Again, this is, we have high confidence in the outer limits of the model. Again, it replicates some of the work that I did with Peter Thiel. It also replicates some of Andrew Lowe’s work, and so I would consider this basically the starting point, not our endpoint.
Jack: How do you think this plays out? Like if we ever got near that, how does this play out in the real world? Like, you said there’ll be curbs put in place, the government will intervene. Like, do you think like a major decline like that is something that’s probable, or do you think probably a bunch of other things are gonna happen and it wouldn’t play out that way?
Mike: Well, this is part of the problem, right? Is once it becomes a mathematical certainty, right? If you actually have built a closed form solution that says this is just what the math says will happen, then we’re effectively debating math. And to my knowledge, math doesn’t fail.
The assumptions could certainly fail. And so, that’s kind of the point that I would emphasize, like, could they change the rules? Could the Federal Reserve inject trillions of dollars into the US equity markets? Could we have a fiscal package that includes an exchange stabilization fund, et cetera.
Those are all legitimate responses. It is also legitimate to close the market and say, everybody has to deal for a while. We’ve done that before. We did it at the start of World War I, regardless, the point I guess I would emphasize is, do I think it will happen?
Yes, I do. Do I think that there will be extraordinary responses in response to extraordinary events? Yeah. I do
Justin: is, is the pace that 4% increase over the last 12 months, is that, is that picking up relative, relative to where maybe we’ve been over the last, let’s say five to seven years with passive? Or is that kind of slowing and plateauing based on what’s in the data?
Mike: No. So what the data suggests is an acceleration, which unfortunately makes sense because we know that more than a hundred percent of the marginal flows that are coming in are passively managed assets.
Effectively what that means is, is that the active managers are facing a shrinking pool of assets. Their resources are deteriorating. I think there’s gonna be an imminent restructuring of the active management space. As the reality of trying to manage significantly less assets at much lower fees begins to clash with the business models that have historically had this as a highly re remunerative industry where you were willing to spend a significant amount of money.
Jack: How does more and more people retiring play into this? ‘cause I would think that a lot of these regular 401k flows are a huge portion of the money into passive. And then when people, if we do get some sort of larger number of people retiring, you could see these reverse. And will that, will that be slowing these flows over time?
Or is that not the way it works?
Mike: Yeah. It is slowing these flows, right? And so this is actually one of the interesting features that happens as more and more of those approaching retirement actually own passive vehicles and start to sell those passive vehicles to finance their retirements. Those flows will slow and they will begin to reverse.
I think is actually really critical to understand across the mutual fund complex and mutual funds are the predominant vehicles in 4 0 1 Ks. Those, the retirement assets that we talk about when we talk about 4 0 1 Ks are almost inevitably in mutual funds.
You are seeing growing use of ETFs in there. And so I do wanna be very cognizant that there is a difference there. So the, so there is a degree of inevitability to those flows, turning and beginning to decline.
That doesn’t mean money is going to flow into active management, though, just to be very, very clear, right? It actually means that you’re gonna see simultaneous redemptions out of active management and passive management, and that’s the scenario that concerns me most effectively. Those who should be searching for value are deprived of capital.
At the same time that those who are trying to gain cap, gain, convert equities into cash, face very challenging situation because they are trying to sell to people who don’t have cash to meet those redemptions. Lemme pull this up here quickly. What we’re seeing is we’re actually now starting to see redemptions coming from passive mutual funds. This is a change, right? This tells you that those retirements are beginning to accelerate. Now. What’s happening to the positioning is, is that you’re seeing Vanguard Index Mutual funds get redemptions Now.
That is an indicator that the boomers are retiring. At the same time, we have more than offset flows into the ETF. Currently if you look at something like the positioning in Nvidia or the positioning in Apple or Microsoft, you’re seeing evidence that there are redemptions coming out of these funds and the net right now is getting quite a bit closer to zero.
If that flips, then that changes that calculus we talked about before. I want to be very, very clear. It’s possible that Vanguard is losing share. It’s possible that other firms are taking share from them given Vanguard’s relatively sparse representation within ETFs. But I don’t think that’s what’s going on.
I think we’re actually starting to see indications that we’re, we are actually beginning to see outflows, and that should be concerning. That pulls those numbers closer, that pulls those dates closer.
Jack: So that that also decelerates the 4% a year growth of passive, over time. You think? It depends on what
happens.
Mike: It depends on what happens to active manager. It depends on what happens to active managers, right? Because if they continue to lose at the pace that they have been losing last year, active managers lost assets somewhere in the neighborhood of $600 billion worth of redemptions while passive pulled in somewhere in the neighborhood of a trillion dollars worth of inflows.
And let that 600 billion is a larger share of the active manager share at this point than the change that we would expect to see within the passive vehicles.
So it continue to show share gain, and I would also assume like the bucket into past becomes leak. Leakier.
Jack: And I would also assume the younger investors who are con, the younger investors who are contributing, are more passive. And the older investors that are selling, at least in general, are more active.
Right. I would like, pretty much most young people today are just contributing to kept passive funds. So is that a fair way to look at it?
Mike: We actually know that. So, somewhere in the neighborhood of 95% of the contributions that are coming in through the younger generation are flowing straight into target date funds.
Through their 401k retirement plans, which they are automatically defaulted into. That’s less true for the boomers. That’s, if you basically go from boomers who never really had forced allocations to 4 0 1 Ks, and hence where the source of the active manager flows into mutual funds all the way down to the current crop of those entering the labor force, those entering the labor force.
Today, it’s almost exclusively passive.
Jack: Vanguard wrote a piece, I think it was late last year, where they tried to challenge a little bit about the impact of passive investing. And I wanted to, you wrote a great response on your blog, and I just wanted to go through maybe some of the main points they made, because I think it would be good to hear you refute these and how you think through these.
Sure. So I’m just gonna take these through one at a time. And I’ll put up some charts too as we go here from your blog about this. But the first one was that passive only represents a small portion of overall trading volume. So how do you think about that?
Mike: I think that’s stupid. So you could pull up the chart that I have that shows the composition of trading volumes.
What they are ignoring and focusing on is strictly the direct trading that is going into passive vehicles. You had figure six from their paper, which shows the index trading volume adjusted for cash flows. Which means the inflows that I was talking about, right? So all they’re capturing when they adjust for cash flows is basically the index reconstitution trading, which by definition only happens three or four times a year and is effectively meaningless, right?
These are very small changes that they’re capturing in their data, where they’re effectively looking at things like new issuance or share repurchases that may modestly change the overall positioning, new index inclusion, et cetera. What they’re excluding is those inflows, right? That’s what the cashflow adjust, the cashflow adjustment means.
And so they know the impact that they’re having. They are being intentionally misleading in this chart. If you go to the one before that from Hagstrom in 2013, that and market structure edge. You can get a much more holistic view of what ultimately is going on here, which is that passive trading now makes up roughly 80% of market volume on a daily basis.
That’s tied to the direct trading, the market making that facilitates ETFs and index funds trading close to fair value. Their navs, the options that need to be traded and the hedging around options that are struck against indexes, et cetera. I candidly think that Vanguard should be held liable for misleading people at this point, but that’s what I think they’re doing.
Jack: And that that 80% of trading volume, that’s also rising over time as passive increases here. Do you have, like how much that’s rising? Go back
Mike: to, yeah. If I go back to 1995, active management made up 80% of the trading activity. My estimate today is it’s around six or 7%.
And part of that is also happening because the active managers themselves have shared work on this. The mechanics of this type of motion where money is flowing into a very specific algorithmic allocation is effectively pushing those securities at higher at rates that exceed the overall market. I’m not the only one who’ve identified this.
Jang at Michigan State, for example, wrote an entire paper on it. The implications of that are quite profound, but one of them of course is that from an active manager perspective, in order to maintain performance close to the benchmark and not run the risk of losing their jobs, are themselves becoming more and more index like and closet indexers that’s driving reduced elasticity amongst the active managers.
I could share a chart with you on that as well. But before, before I do that, the other component that I would just emphasize on it is, this is mechanically why active managers are underperforming more and more, even as theoretical frameworks like Grossman STIGs suggest that it, this should be a field day for active managers.
‘cause we have all these non thoughtful investors that are going out and going out and buying things at ridiculous valuations. It, if I, let me just quickly show you the chart. Yes. It’s funny. This is again, from Hadad.
This is looking at the change in elasticity for those they continue to designate as active managers. And so this is another one of these interesting pieces of research. That talks about how much larger the passive share actually is than is measured. But they are treating anyone who doesn’t have elasticity effectively of zero as an active manager. And so the active managers themselves used to have elasticities in the range of 0.75 to 0.8.
Today, that number is well below 50%. Part of what’s happening here is more and more active managers like Fidelity are emphasizing index funds. One of the reasons why that’s happening is the regulatory framework changed radically in 2006. It was implemented in early 2008. That required 4 0 1 Ks to default into passive vehicles and any selection of non-passive vehicles actually exposed the sponsor of the 401k to liability.
This has become one of the nice businesses for trial lawyers. And so we’re seeing firms basically become more and more passive in their construction, effectively mimicking the successful species. If we think about it in evolutionary terms
Jack: Yeah. It’s funny, we, Matt and I just did an episode where we went through all the market outlooks for this year and like we just wanted to understand what the consensus was, and one of the consensus things people were saying is, this is gonna be the year for active management. Oh yeah. I guess that’s every year.
They’ve been saying that for years. And I guess based on your research, we may not wanna hold our breath for that.
Mike: Yeah, yeah. No, it’s, by the way, I would say the same thing about forecast for small caps, resurging and rotations into emerging markets, et cetera. There’s a lot of people who are hanging their hat.
Well on a very substantive change, one of the points I would make is like if people do decide to rotate their portfolios and pursue alternative approaches, that also is a mechanism effectively of reasserting flows out of passive vehicles and just pulling that point closer and closer.
Jack: So another point Vanguard made in the piece was this idea that they were arguing that basically index funds owned own a higher percentage of mid-cap stocks.
Then they do large cap stocks. So I think their point there was, if this is true, we should, if, if this is true, we should be seeing this impact in mid cap stocks. So how do you think through what they were saying there?
Mike: I think that there’s a couple of things, and again, I think they’re being intentionally misleading.
So when they’re describing index funds in this con, in this context, they’re taking a slightly different approach. They’re including index funds. That would be like the REIT index or nuclear power index. Right. Those push the ownership of quote unquote passive strategies that are not at all passive strategies, not even remotely close to what we’re talking about in a market cap weighted framework.
And many of those are actually being forced into mid-caps by virtue of concentration limits that exist within portfolio construction. And so often you’ll see something like a re index that has a modified cap weighted exposure. Where if they were to simply buy in proportion of the market cap, it would be, three stocks for all intents and purposes, by, by conforming to the modified cap waiting formulas to meet the diversification requirements of the 40 Act.
It pushes them into large ownership of some mid cap companies. Those absolutely have an impact on those mid-cap companies, but nobody in their 401k has the REIT ETF as their default investment vehicle. So almost everything that we’re talking about, they’re intentionally avoiding and obfuscating with this analysis.
Jack: So the other point they made is, is one that we’ve talked about a lot with you on the podcast, but this idea that the biggest companies, apple, they can handle the flows, yet they’re getting flows in proportion to their market cap. They can handle ‘em. So the relative positioning of companies shouldn’t really change based on these flows.
So can you just address that one?
Mike: Yeah. Again, they’re being intentionally obfuscating, right? What they’re highlighting here is, is that after they trade, they own the same share of every company. There’s no discussion about the impact of that trade on the price and the market capitalization of the individual companies.
They intentionally avoid that. They’re simply showing us the math of market cap waiting. What we know, and you have this directly below, in below that in the notes that you sent me, is the work of JP Booth showed on market impact. Market capitalization plays no meaningful role in the provision of liquidity.
What matters for liquidity is the dollar value of trading and the size of the order relative to the idiosyncratic volatility of the individual name. If you actually pull that formula up on screen, which I assume you’re gonna do in the edit of this, yes, the impact of an order. The, I, the impact of an order of size Q is going to be a function of the volatility of that, either market or individual security times the square root of the quantity, the dollar quantity traded, divided by the average daily volume that’s traded.
This makes intuitive sense. If I go into a market that on average trades a million dollars and I try to execute a billion dollar trade, I’m gonna have a big impact on that market. That impact is going to be larger for highly volatile stocks because they have effectively less anchor to them. So what this tells us is that we should be looking at dollar volume of the size of the order relative to the dollar volume of the trading liquidity.
This is part of what I actually ran through on one of my sub stacks. Lemme just pull that up quickly.
This was in a piece that’s on my substack called Pay Attention to Your Privates. If you take the example of Apple and CarMax, which at the time that I wrote this, were respectively close to the largest and close to the smallest stocks in the s and p 500. If you put in a billion dollar order to buy the s and p 500 and not a typical order for an index fund, about $70 million of that order is gonna go to Apple, and about a hundred thousand dollars is going to go to CarMax.
Right now their trading volumes are such that that differential, that 700 to one differential isn’t even close. This is about a 60 time differential, so it’s a roughly order of magnitude differences They share. Their volatility are somewhat similar. The volatility of CarMax is slightly higher. So if we run through this formula, what we discover is on a daily basis, apple is receiving a positive impulse.
And again, Vanguard’s inflows last year were about $350 billion. The, that would suggest about a billion dollar order every day. So we’re looking at every single day. Vanguard gets inflated by that order by 0.167%, right? CarMax gets inflated by 0.06%. If you scale that to an annual number, that works out to about a 6% increase in CarMax and about a 23% increase in Apple.
By the way, that’s actually more than Apple gained last year. So it, there are offsetting components to it among them, the fact that candidly, apple is not growing anymore. It doesn’t have superior profitability or investment opportunities, it’s failed in almost all of its new product introductions.
Sure, there may be something fantastic out there, but that’s a really big leap to make at the scale that we’re talking about with Apple. So what we should be seeing in Apple is lower multiples. We should be seeing lower valuations, reflecting the fact that the law of large numbers has largely caught up to apple, and it should be trading at lower valuations.
Instead, it’s trading near the highest valuations in its history, and I would ascribe that to the impact of passive investing. Vanguard, of course, would say we have no role in it whatsoever.
Jack: Wonder, are there active managers out there trying to figure this out in terms of like trying to model liquidity and then the flows relative to liquidity and say like, here are the companies I should most own because of this, or, I mean, is owning the s and p really the best way to take advantage of something like this?
Mike: My hunch is, is that there are people smarter than me that have taken my research and converted into this. I’ll be totally candid with you. It took me basically nine years to get here, which reinforces why I call myself the dumbest man alive on a regular basis. And it really was kind of a breakthrough where I realized, wait a second, the s and p 500 isn’t a single security.
When I did my initial trades around this, I did it on the XIV, which was a security that referenced a single Underlier two underlayers. But that’s splitting hairs. This is, there’s 503 securities within the s and p 500, and so it actually turns out that there’s much more impact occurring at the individual stock level.
And that’s driving behaviors within the index that will ultimately turn the index into something that looks like a single stock, which is increasingly what we’ve seen with the rising concentration. Again, a forecast that I made all the way back in 2017 that everybody thought was insane at the time, but has continued to play out.
Jack: And I know even even active managers who are not trying to necessarily take advantage of this are definitely altering their strategy because of this. I know like you did a great interview with David Einhorn at your annual event for Simplify. Like, active managers are taking note of this and understanding that parts of their strategy may not work anymore the way it has in the past.
Mike: I think that’s exactly right. And again, for those who are paying attention to that chart, you’ll also notice that I had a line for the median stock in the s and p getting about nine basis points impact every day. The market cap weighted average gets about 13 basis points every day. Those don’t sound like small numbers, but you compound those over the course of a year and you’re talking six, 7% differentials, which is exactly the differentials that we keep seeing between an equal weighted s and p and a market cap weighted s and p.
So these numbers just unfortunately have very strong backing in terms of both the theoretical frameworks and what we’re experiencing in an empirical framework. But hey, Vanguard’s free to publish anything they want. I just hope they’re held liable for it later.
Jack: How does as fees get cut here? Like how does that impact this?
‘cause it was interesting, there was, there was like sometime last year there was an announcement that Vanguard was cutting fees and like 10 funds or something like that. And pretty much across Twitter. Everybody was very excited. This is fantastic, this is great for the individual investor. And then Mike was saying, this is actually terrible.
Like this is not good at all. So can you explain why that is?
Mike: Yeah. So first of all, it was touted as Vanguard’s largest fee cut ever, right? They cut them by 30, ba 30% from three basis points to two basis points. Right? Now, the reality is that has absolutely no impact on the investor portfolio. One basis, point per year.
Differential and management fee has no impact on your return. I don’t care how long of a period that you’re talking about. So it’s really not any meaningful savings for investors. So then you have to ask yourself why they’re doing it, and the answer is very straightforward. The legal framework that is adopted under the fiduciary rule and under, under many court rulings is that a firm will be held liable if they select investments as the default investments that are higher cost.
And so all this is, is Vanguard saying, well, we don’t really care about the fees anyway ‘cause we make all of our money off of securities lending and the ancillary products that we sell at slightly higher fees. We’re just gonna raise the barriers to entry even further. And that’s what they did.
And so, yes. Is it a short, is, is it an admirable thing to cut fees? Absolutely. Is it an admirable thing for the market leader to use price to drive out competition? Ooh, that’s a little bit more debatable.
Jack: I just wanted, before I switched to Justin for some macro stuff, I just wanted to ask you about the response to this, because I know you’ve thought about this a lot and it’s very interesting to think about on one side, for every individual, it is very, very rational to continue to invest in passive funds.
But you create a societal problem as more and more people do it. So it seems like it’s a very challenging thing to tackle. And I know you’ve talked to regulators, you’ve talked to people around like potential solutions. So I’m just wondering, like do you have any solutions that you think would work in the real world to potentially address this?
Mike: Oh, I have lots of solutions that I think will work. Do I think anyone will adopt them? No. And so like that, candidly, there’s a degree of fatalism for me at this point that. I was described in an institutional investor as the Cassandra of passive investing. Understand Cassandra’s curse was that she would be right, but nobody would listen to her.
And that ultimately drove her insane. So I have a choice. I can go insane, which I might have already, or I could choose to just resign myself to it and figure out how we’re gonna pick up the pieces afterwards. And increasingly, that’s what I’m finding myself focused on, both building products that try to take advantage of this.
In some to protect portfolio, to protect investor portfolios and others to try to enhance return. A lot of this work is actually making its way into various simplified products to try to take advantage of these insights. But the reality is, is that we’re in a very, very dangerous situation and regulators are not gonna change anything.
Jack: This is a broad question, but how would you think about like building products that would take advantage of this? Like on one hand just owning the s and p 500 takes advantage of this. I mean, I guess you could say, own the s and p 500 and do something to handle the tails of what could possibly happen.
Like how do you think at a broad level, like how someone might even think about constructing products to take advantage of this?
Mike: I’m gonna plead the fifth on that one right now. Okay. We’re too in the middle of things right now for me to really talk. Okay, cool. Progressively about it
Jack: may, maybe some stuff, maybe some stuff coming for the future there.
Mike: Yeah. No, har Hari and I are collaborating on some of the downside work. I’m spending a lot of time working on the upside work with the team at Tier one Alpha.
Jack: Okay. Well, we will get you, we’ll get you back if that ever turns into anything in the future. Most likely.
Mike: We’ll not, but we’ll see. As I said, like we’ve deployed elements of this in.
Some of the products I directly manage at Simplify, we are using some of these insights already in the CDX high yield product that I manage. It’s actually been pretty incredible. It’s added, even as we’ve run over hedged against a ridiculously low credit spread environment in the credit markets, we’ve been able to mitigate the impact of the cost of that hedge through some of these insights over the past couple of months.
Justin: We want to get your perspective on sort of, what, how you’re thinking about the current state of the US markets. But the one thing that this conversation got me thinking of is, so far this year we’ve come out of the gate pretty strong, and I’m wondering to some extent if you have, even though this wouldn’t necessarily happen in like the regular 401k flows, I mean, you have reallocation rebalancing.
Kind of new money being allocated possibly into equities at the beginning of the year. So I wonder if some of the strengths so far this year, I mean, it’s clearly a function of flows because stocks are up across the board for the most part. But, I’m just wondering if that sort of has something to do with the strength we’re seeing so far this year.
And I mean, any comments on that? And just generally where you think we are at right now in the markets, in the economy.
Mike: Well, I think we’re absolutely seeing that in the rotation that is going on in the small caps right now. So, basically we ended 2025 and every call that went out was in some form or another.
Okay, this is going to be this year for the stock pickers. This is gonna be the year for the mean reversion between Val, between value and growth. This is gonna be the year for the mean reversion between small and large, and that engenders flows in a portfolio rebalancing framework.
There still are many funds out there, many portfolios out there that are systematically rebalanced into a particular representation of small caps. 10% is not an uncommon allocation of small caps because they have historically outperformed, people keep trying to place those bets that tends to play out in the December to January time period.
My hunch is, is that that’s this is going to end prematurely and in a for me unsurprising fashion. But, but I could be surprised. I wanna be very, very clear about that. But I think that’s really what’s driving it. I mean, that’s why the Russell is up 8%. That’s why the s and p is only up 1.5%, is some of that rotation.
But I would would highlight that within the Russell, you’re not seeing value work. Right? People chose to buy the Russell, that means crazily enough, they’re out there buying companies like alo or these highly, highly speculative stuff. And really what’s running is the unprofitable technology names, the speculative names, the small caps that are highly volatile, which fits with my price impact models.
But
Jack: I don’t think it’s fundamental. I really don’t think it’s fundamental. So should I hold off on my small cap back tweet? I’ve got my drafts folder. I, you know what, put
Mike: it out there. ‘cause it’ll probably help my cause. So
Jack: you’ll probably, you’ll probably retweet and be like, look at this idiot
Mike: tweeting this.
No, I know. No, I wouldn’t. I try not to do that with people I know who are not idiots.
Justin: That’s Jack’s annual, the January effect prediction. That’s right. Deck up.
Mike: by the way, it’s a great prediction to make because as small caps get smaller and smaller as a fraction of the total market. That incremental inflow as people try to rebalance in those portfolios that basically are saying, well this time it’s gonna be different.
You know that that works. It generates extraordinary movements. As markets become more inelastic, small caps are experiencing this as well. They are not at the same level that you see within the large caps. But they are more inelastic than they used to be, and so as a larger pool of aggregate dollars tries to rebalance into those names, you can get some pretty extraordinary moves.
We’ve certainly seen that.
Justin: What’s your view on the underlying economy like right now, like, I think the last GDP print we got was like, whatever, 4% annual growth, but you could talk to some people and they could poke holes in that and there’s sort of some weakness under the surface that may not be reflected in.
Some of that data. So how are you looking at that currently?
Mike: Well, I think there’s a couple of things to keep in mind. One is when we talk about GDP, we are typically quarter, quoting the quarterly data that quarterly data is annualizing by basically multiplying it by four. And so the quarter over quarter GDP in Q3, which is the latest one that we have, was as you pointed out, about 4%.
The year over year was only about two point a half percent. So, we’re seeing a much more restrained metric. If we look at the year over year components which capture both an element of residual seasonality that continues to be there from the COVID experience, we will start to lose that in the next year.
And part of it also is just somewhat of an increase in volatility of GDP as we’ve seen political uncertainty play its way through the system. The institution of tariffs caused people to build inventories in advance. The draw down of those inventories detracts from GDP. The rebuilding of those inventories adds to GDP.
And if you’re doing that in relatively short order, you can get high, high variability in the quarterly data. But the year over year is much more muted.
Justin: What are your current, we ask, we’ve been talking a lot about obviously ai, everyone’s talking about it, but what about the massive amount that’s being kind of put into this CapEx build out?
Are you generally, do you see that as this is just over excess, a lot of the value here isn’t gonna be realized? Or do you have a different sort of take on. What’s happening within AI in general and the money that’s flowing into all this CapEx and stuff?
Mike: Well, I think that there’s a number of things that are going on.
One is something that I’ve highlighted repeatedly in the aftermath of the.com cycle. Michael Jensen, who is a phenomenal academic. And it was a creator of the Social Science Research Network, which all of us who read white papers regularly turn to, for low cost access to academic or other insights.
He wrote a paper in 2003 or oh four, I can’t remember which year it was, called The Agency Cost of Overvalued Equities. And what he highlighted is, is that if you enter into a period of perennial overvaluation. Management teams have an incentive to basically adopt that view that their stock is worth what it is trading at, and to behave accordingly.
And so if you’re Microsoft or your Apple, or your Google or your in private markets, open ai, the incentive is extraordinarily high to basically say, we’re gonna make these crazy, giant investments that are gonna create this total addressable market that the world has never seen before. And you’re gonna get mal-investment.
The only way that you can counteract that is by shorting the security to try to drive the price lower. And in an environment in which passive is causing securities to rise at an accelerating rate, certainly relative to their fundamentals, it damages the short world. Right. And, I mean, I’ve said this to you guys before on an individual basis.
I may have said it on camera with you, but like, I’ve literally spent the last five years basically playing therapist to short sellers saying a variant of the Robin Williams interaction with Matt Damon. It’s not your fault, right? It’s not your fault son. The reality is they’re still trying to fight the good fight and it’s really challenging.
Jack: How do you think about AI though, like from an overall economic impact standpoint? You’ve got people in the tech world who think it’s gonna result in like doubling GDP growth. You could argue it’ll increase productivity, but it also might lead to job loss. It seems like there’s so many different factors at play here that it’s hard to think about, like what the overall impact this will have on the economy as we move forward in the future.
Mike: So this is what a lot of my most recent macroeconomic stuff is focused on. My substack this week will actually hit specifically on this issue. Look, what what we’re trying to do is we’re trying to shift away from a world in which it was centered around the production of energy for human usage and human consumption, which meant that things like fossil fuels, about a third of which go to fertilizer, animal feed, transportation of food for humans, heating humans, et cetera.
Another third goes to the transportation of humans. That fossil fuel represents somewhere in the neighborhood of 75 to 80% of our total power production. Another 10% or so is going into nuclear and only about 15% of the realized power ‘cause there’s heat loss during electrical power generation, et cetera, comes through as our electrical grid.
In another 20, 30 years, I would expect that to have completely flipped. The effectively electricity will in one form or another, be the mechanism by which we receive energy for probably 75 to 80% of our usage. That’s gonna require an extraordinary amount of investment and innovation for it to be realized.
And it’s a bit of a pig in the Python component. And so when you ask me what is the impact of it. One from an individual, right? Like, it’s funny people talk about Warren Buffett or Howard Marx or others. I unfortunately now fall into that camp that my job basically is very similar to a journalist in a lot of ways, right?
I spend a lot of time writing. I spend a lot of time thinking. I spend a lot of time building models and exploring theoretical frameworks, and LLMs are an extraordinary tool in that context. I use them nonstop. Right. I use them nonstop. I have multiple pro level subscriptions to claw Chat, GPT, Gemini, gr I just expanded my usage of for the very simple reason that I view them effectively as first year an increasingly second year analyst.
I would probably say that Gemini has now become a second year analyst and is probably my favorite. Claude is still my favorite for writing, but from an analysis standpoint, Gemini is really, really good. You need a ton of domain specific knowledge to use them effectively, though. And so as I highlighted this internally.
It simplified. It’s like, look, there was a 33 year accelerated learning curve associated with how to utilize LLMs for financial markets. And I’m probably not even beginning to scratch the surface, right? There are programmers out there that can do things with LLMs that I can’t even begin to imagine doing.
But they don’t have the domain specific knowledge to say, okay, well what are the implications of this? How do we think about this in the context of this research paper that was written in 1973? They don’t have that capability. And so I continue to see myself as becoming more productive in many ways.
I would argue that the introduction of LLM subtracted 10 years from my chronological age in terms of the decay of my gray ma, my gray matter. And so the world has to be prepared for a 45-year-old Mike Green again. That said, I also think that we’re in a period of extraordinary hype and.
There’s gonna be negative ramifications, which we’re already seeing across a wide variety of assets as we exhaust the electric grid cap capacity and capability in the United States. That is forcing the incremental power to come on in much larger, discreet and much more expensive configurations. The price of natural gas combined cycle turbines, the installation of those has roughly doubled in price in the last five years.
We are now talking about nuclear, which has extraordinary upfront costs that we genuinely don’t know what those are going to be. If we’re building traditional nuclear, if we start approving things like small modular reactors, the installed costs will fall, but the ultimate permitting, demonstration, et cetera, costs are gonna be very, very high.
And that means that power bills are going up in American households, we’re paying more for electricity. And since the vast majority of people don’t do the type of work that I do, they’re not experiencing a meaningful ancillary benefit from the growth of LLMs. They’re just seeing their electricity bills go higher and that that’s gonna be an interesting.
sociological phenomenon to see how that plays out. You’re already seeing Donald Trump start to mention this, and Microsoft is gonna have to pay for its own data center power. We’re not gonna allow it to rely on the grid. If that’s the case, then all of a sudden Microsoft has to become both a utility and a software provider.
And at the end of the day, man, utilities don’t generate a lot of profits. Right. It tends to be a pretty rough business with very high fixed costs and maintenance costs and depreciation costs associated with it. And I would be surprised if the market on a fundamental basis believed that the right multiple for a utility, simply because it has the Microsoft logo emblazoned on the outside, is the same as for Microsoft’s software as a service business.
Justin: You mentioned Matt Damon earlier. Did you guys see that him and Ben Affleck have this new movie on Netflix called The rip? I have not seen it. I have not either, but,
Mike: I enjoy both of their acting and so I’ll probably check it out at some point. Yeah, no,
Justin: it’s supposed to be, and the premise is, and it’s kind of, sort of ties into some of this, it’s, they’re on like this, like law enforcement, like Special Forces drug team, and they come across this huge pot of money and then it becomes.
Like cops skimming off the top and the dynamic between maybe the good cops and the bad cops and supposedly it’s really good. But, anyways, just kind of got me thinking. So Mike, one, one last one for you here before, and we really appreciate your time. I wanted to, I don’t know if this is a good place to end, but we were talking before and you had mentioned that, you’re soon gonna be moving into a home.
Buying a house, you’ve been, you and your wife have kind of been moving around following your kids and following their sports and, and wherever they would have you in to to watch, whatever. But I’m wondering, do you think some of this stuff that Trump is doing on the possible side of like home ownership and trying to make things more affordable, will actually get things moving in the housing market?
Do you have any opinion on that? What are your thoughts?
Mike: Yeah. Oh, I mean, first of all, Trump’s announcement that the agencies were going to buy back significant quantities of MBS from the market has now been thwarted by the Fed announcing that they’re gonna sell the identical amount into the market.
Right? So, like, really part of what we’re watching is ineffective tribal government that is basically fighting, right? That tends to resolve itself with either the emperor or the counselor losing their head. I think that’ll take some time. My hunch is, is that unfortunately the emperor is gonna lose his head on this one.
I wrote two weeks ago about the housing market and the challenge that we have, we actually don’t have a meaningful shortage of housing. What we have is the wrong housing in the wrong places. And so effectively what’s happening is, is that the baby boomers have chosen to age in place because they saw the homes, the nursing homes that they put their parents into, and those are not for them.
And so they’re doing everything they can to age in place. And they’re also funding the development of assisted living facilities that they occupy for much longer periods of time than the traditional nursing home type regime. That’s creating temporary shortages that unfortunately is gonna look a lot like the stock market.
Eventually, the baby boomers are gonna sell, the quantity of housing in this country is not particularly short, relative to the number of people and certainly not the population growth that we’re now anticipating. But it, a lot of it’s in the wrong place and a lot of it is the wrong size and the wrong caliber, et cetera, and that will slowly sort itself out through price and liquidity frameworks.
My hunch is, is that we will eventually announce a major building program and the government is going to do the same thing, which basically put the wrong type of housing built for the needs of today. It’ll be completed five years from now when we no longer need that type of housing. It’ll be built in the wrong places.
And that’s why you don’t want the government to get involved in these things. The reality is, is what we should be doing is radically reducing the regulatory framework that’s required for the construction of new housing, removing a lot of the restrictions on residential construction that exist in false terms, facilitating the conversion of office real estate into housing or commercial real estate.
And reestablishing effectively the value of a city is a safe place to live where people consume far less energy than when they live in a rural environment. But as I said, I don’t think we’re gonna do that in a thoughtful way.
Justin: Alright, Mike, thank you very much for these deep thoughts and for spending this time with us and our audience.
We really appreciate it.
Mike: My pleasure. Thank you for having me guys.
I love your podcast. This one was another banger. It's led me to do some extensions of Mike's fantastic work too.