Simplify’s Michael Green on Passive Distortions

manager at Simplify Asset Management. Thanks for joining us, Michael. So, James, why don't you start us off?

more absolutist and how they view it everyone. It's kind of one of those things where like if you don't define it beforehand, people end up talking past each other. So, Mike, why don't you just walk through, like what your definition of passive is? When you tend to be talking about.

nineteen sixties. It was projected forward and added, you know, given it additional depth by Bill Sharp in nineteen ninety one with a paper called the Arithmetic of Active Management, which is the source of all the analysis that you hear that you know active managers and passive managers own the same underlying securities, and therefore the only difference between them is the fee structure. That's what drives the outperformance

of the passive strategies quote unquote. Unfortunately, Sharpe's definitions was highlighted by a partner at AQR Las Peterson in twenty sixteen, relies on magic because his definition of passive as somebody who never buys or sells they simply hold. That means it's impossible for them to get into the market. It means it's impossible for them to get out of the market once you realize. And he defines an active investor as anyone who is not passive. So by definition, all

investment is active. What we were really referring to when we talk about passive is the attempt to replicate market cap weighted indices that largely dominates the passer world. There's lots of discussions around active ETFs, et cetera. Most of those are some variant of two times levered in video or call over writing strategies, et cetera. They aren't really active in the traditional sense. True active investing relies on the discretion of the allocator the portfolio manager to select

securities on the basis of candidly whatever they want. Right, they could choose all letters, start all stocks starting with the letter A, and they could also decide that they wanted to focus their research on predicting the forward cash

flows of a company. Both would be considered active. When we're talking about passive and when we talk about the scale and size and the impact what I am largely referring to as market cap weighted indices, in particular the S and P five hundred, to a lesser extent than NASDAQ one hundred and extensions thereof like the total market indices and the Russell two thousand.

their market capitalization. That has very predictable effects on price behavior, on what's referred to as market elasticity, how prices react to changes in supply and demand. And at this point, the academic work and the theoretical work has moved so far beyond where the practitioner space is that we increasingly are aware that this is turning into the driver in markets today.

This is because they'd grown to a size that when they went to transact in all the individual securities in the S and P five hundred or in smaller indices. They were having a noticeable impact on those securities, creating conditions under which they would experience tracking air they were diverging from the indices. They went to Wall Street for helpful advice. How can we solve this? The Street kind of looked at them weird and said, you know, why

are you buying every security? Why don't you just buy futures? And the answer to that was, well, we can because the forty Act restricts the ability of mutual funds to access leverage. Margin accounts are required to trade futures, and so we are restricted from using futures for the entry process.

The Street recommendation was to lobby the sec. Vanguard did so, received what's called a no Action letter in nineteen ninety four that allowed them, somewhat uniquely, along with other index investors, to ignore the rules of the forty Act and to begin to transact in futures. That ran headlong into a market structure issue, which is, at the time the indices were market cap weighted. Most people think they still are.

They're not. They're floate adjusted today. That change happened in two thousand and three, but in the early nineteen nineties, what it meant was that passive investors were trying to buy more shares than were actually freely available in low float stocks companies like Microsoft, Cisco, Dell, et cetera, stocks with high levels of insider our ownership. And we began to see the effects of this almost immediately in market structure and market behavior. Passive one point zero was really

what facilitated the dot com bubble. In two thousand and three, we changed the structure of the Indussies to float adjusted that bought us additional capacity, and my work suggests that somewhere around twenty fifteen twenty sixteen, we exceeded the thresholds that that increased capacity allowed us and began to meaningfully impact markets again. And today I think it is the single most dominant force in markets.

objective fact than anything else. Can you just talk about the idea of basically one hundred dollars or one thousand dollars being invested into an index or a stock having much more of an impact on the underlying valuation than you know, the one hundred or thousand dollars that's covering in. Can you explain how that works and why it happens and what the consequences are.

The actual specification for the efficient market hypothesis is that a dollar into the stock market, because there has to be a seller on the other side, really only changes market value by roughly the bid ask spread, so a dollar in creates about a penny of additional market cap.

Is the EMH framework. In twenty twenty two, academics Zbagabe at Harvard and Ralph Coagia and at Chicago did a very disciplined analysis of this and found that the average over the time period from nineteen ninety two to twenty nineteen was actually between about five and eight dollars of market capitalization being created for each dollar that was going in.

Their paper was called the inelastic market hypothesis and was really one of the primary academic revolutions that is underway and finance right now understanding this concept of elasticity and how it is changing in markets. But really importantly is that observation that it was an average from nineteen ninety two to twenty nineteen that was cited in that paper. Subsequent work by Valentine Hadad at UCLA has identified that this is actually a trending series. It is a function

of passive share. And my work at this point, which Valentine would largely echo, is that we are looking at somewhere for the megacap stocks like Apple, Nvidia, Microsoft, about seventy dollars of market capitalization being created for every dollar that is going into the market. This is why you can see a three hundred and forty billion dollar market cap swing on a company like Microsoft, nowhere close to three hundred and forty billion, or more accurately on the EMH.

You know, three and forty billion would be thirty four trillion in order to get that impact, it really was more on several hundred million to possibly a billion dollars in relatively thin markets that are closed that cause that type of impact. So we're discovering that markets are radically less elastic than we had assumed.

This doesn't make any sense. As we continued through that pandemic, people increasingly became unhinged from the historical price level and they basically accepted whatever price was available for eggs. That's the same phenomenon that happens with passive You effectively lose the memory of what is a meaningful price level, and you effectively adopt whatever the last price is. Passive is like an investor who has zero memory.

will become increasingly disjointed from the fundamentals. We will construct a narrative around it. Right, they're better companies, they have better growth opportunities, productivity is going to surge right around the corner, et cetera. Because that's what we do as human beings. Right, Remember, we as a species, for thousands of years, believe that the sun transitd the sky being dragged behind a golden god. We will literally believe anything,

including stuff that Elon Musk says. You know, this simple reality is that when you create those conditions, you set the stage for what was very well articulated in a two thousand and four academic paper by Michael Jensen called the agency cost of Overvalued Equities, and he highlights that effectively, if an equity becomes overvalued, there really is no mechanism to discipline the management team, and they have every incentive in the world to justify the existing valuation in their behaviors.

If they believe that they are being rewarded for incredible growth opportunities, they will invest like they believe there are incredible growth opportunities. And unfortunately, I think that's what we're

largely seeing. On flip side of it, many industries that suffer from neglect under this framework are told that capital is not available to them, and as a result, they underinvest, and that broadly is a pattern that's playing across our economy where privileged companies that happen to be large enough to be in the public equity indices are receiving differential cost of capital and in much lower cost of capital that allows them to invest, while businesses that are not

privileged in that way, your local mom and pop grocery store, hardware store, are suffering from neglect and an inability to obtain investable funds.

depends on which regulators you refer to. I like to point people to a conversation I had in twenty eighteen, soon after the events of Allmageddon, which I think you both know I was involved with, in which I met with the Bank of International Settlements and their Financial Crisis Group, and their reaction to my work was, yeah, we think you're right, and they've subsequently written a few papers on it that tread very lightly on this topic. My reaction

to that was, Oh, that's fantastic. How can I help? What can we do to ameliorate this condition. I did not go public. My goal was not to incite panic in the crowds. My goal was to get regulators to change it. And their response, unfortunately, was there's nothing we can do because what you don't understand is the regulatory apparatus is controlled by black Rock and Vanguard. And if we raise the alarm and the event didn't happen immediately, we would simply be fired.

a direct byproduct of how we calculate things. So if you think about a market that has a function that causes valuations to increase over time, in other words, there we're at any unit of risk are actually rising. That creates a positively convex surface. The measures that we use, as you talk about alpha for calculating active manager performance, is actually a linear equation. Why equals mx plus b. The return on my portfolio is the beta times the

market plus some idiosyncratic factor we call alpha. That alpha is simply the intercept. And if you just draw a curved surface and you run linear equations on it over time, you will actually find that those intercepts are forced negative. That perfectly matches the experience of the active manager community so very quickly. This is actually proprietary research that I did back in twenty seventeen. I asked the question of portfolio managers. You're a portfolio manager, you are given new capital,

or capital is taken away from you. What's the likelihood that you'll deploy funds or sell securities to meet redemption given some type of valuation. Valuation is on the x AXI, your marginal propensity to either buy or sell is on the Y axis. These are the cumulative results across roughly four hundred and fifty responses, and unsurprisingly, you find a marginal propensity to sell as valuation rises, and a marginal propensity to buy as valuations fall. That's not surprising. Those

are standard downward sloping demand curves and economics. It's this intersection between the two that's actually really interesting. The two cross and remember this is just a random survey by an idiot at the market's historical valuation average. That's actually really important because if you build an agent based model, feed these responses in them, then randomly give them cash and take cash away, which you discover as a mean reverting valuation in markets. This is why things like the

Shiller pe have historically worked. If you introduce passive investors into the mix, remember that they have a hundred percent marginal propensity to buy and sell. Did you give me cash, If so, then buy? Did you ask for cash if so, then sell. That pushes the marginal propensity to both buy and sell off of that mean reversion towards what's called mean expansion. That takes the form of rising valuations over time, which unfortunately perfectly matches the underlying data that we see.

This is the valuations rising. This is the median stock. This is the market cap weighted stock, which again plays into theoretical frameworks. So why the largest stocks are more impacted on this, so we see rising valuations over time. If we then think about that in the context of how we measure manager performance. Historically we're used to thinking about a mean reverting market. The reality is now we have a mean expansionary market that causes those valuations to rise.

If I take that same linear equation and I run it at various points in time against different passive share my alphas are pushed negative. And that is, unfortunately exactly

what we're seeing. So contra to the argument that most people focus on, which is this idea under a Grossman Sigletz type framework, that the opportunity tunity set for active managers is growing, the path to that is actually very destructive to the process of price discovery and market functioning and ends up killing the active managers along the way. That creates a feature that's been very well documented what's

called effectively defection. Active managers increasingly become closet indexers, basically trying to preserve their career by minimizing their tracking error against that benchmark. So two things on that.

along those lines. So how much of it is like like I guess, my question is how different is this from a couple of decades ago where the active managers. Yes, they were trying to outperform here and there, but for the most part they were still, you know, hamstrung within a bandwidth of where, where and what they can invest in.

Four oh one K is from an opt in framework where you would get a job and then choose to participate in a four oh one K to an opt out framework where you would choose, you would get a job, and you would automatically default it into a four oh one K. When you created that, you had to establish what you were going to automatically default them into the established what was called the qualified default investment alternative. Initially

that was balanced funds. There was some competition from active managers, but very quickly over time we established legal precedent that said, if you choose anything other than the lowest cost passive exposure as the sponsor of a four oh one K, you run an inordinate risk of being sued by your own employees. My favorite example is a class action lawsuit by Fidelity employees against Fidelity for offering them actively managed

Fidelity products. So, unfortunately, what you're describing, James, is exactly what you would expect because of two features. One, fewer and fewer active managers have access to that pool of capital. Because of the QDIA, about eighty five percent of four oh one K participants never change their designation away from that qualified default investment alternative, and as a result, there's really no new entrant customers into the active manager space,

or very small fraction of it. The second feature is is that that then means because there are no new customers, the worst thing that can happen is losing an existing customer, and the easiest way to lose an existing customer is by underperforming versus your benchmark. Outperformance will retain it. But underperformance guarantee is that you're going to get fired and

your business moves rapidly into a terminal stage. This has driven a very clear defection that's actually well documented by the work of Valentine Hadad and Paul Hubner in the behavior of active managers themselves. They have shifted from being historically highly elastic and sensitive to valuation. Today they're effectively very close to passive investors in many ways.

in the index. Like if you're an adept active manager and you accept and see that this is happening, Like why wouldn't active managers just lean into it and take advantage of this theoretical framework that you're laying out here, Like why wouldn't an active manager who sees this happening, understands it just lean into it and take full advantage of it.

Going beyond that, if you look at the production of research and where value is created in research today, the single most valuable piece of research is not ten k's or analyst reports. It's what's called payment for order flow, which effectively gives details of what the noise traders, the remaining retail traders, who now outnumber active managers roughly two

to one, what they are doing. Citadel pays on the order of four and a half billion dollars a year for access to transparency and the order books of Robinhood and other participants precisely so they can position and trade ahead of that and maximize the value that they're creating in their option models and option market making. So, James, the quick answer is they are doing it right. There's also a lot of people out there that are still unaware of this phenomenon and really don't understand how to

exploit it. And then finally, there's a lot of people, myself somewhat included, who are basically saying, look, you know, this is a systemic risk that we are creating. Your question to me, James, is some variant of you know, well, if everybody's getting high, why don't I get high with them? Right? Somebody has to keep an eye out for the cops.

that is changing. And again that leans right into the index arbitrage, which I would highlight is happening not only in equity markets, but it is also actually the story behind the emergence of the basis trade, which is simply index arbitrage happening in fixed income markets, where in many ways I would argue the current impact is equally if not more distorted.

software ETF. So what ends up happening is like I know you specifically see the S and P five hundred, but what we find is happening in the market is like these things are being used actively, They're being used as like pseudo future, so they're betting on shorter term

bets on like these things. So theoretically, if you're betting on these baskets of stocks, there should be idiosyncrasies where something is getting bid up that shouldn't in that basket or in the theory of like the software stocks, there's probably some babies getting thrown out with the bathwater, Right, So theoretically, with things like this in markets like this, wouldn't you think, like in my mind, I'm like, as an active manager, I'd be looking into those trying to

figure out what's getting sold that shouldn't or bought that shouldn't and trying to bet on those and reversions to the mean, Like shouldn't this create some opportunities for active managers that are outside of just being benchmar huggers like we just spoke about.

And I identified that Vanguard and Blackrock and the growth of passive investing is having a clearly caustic effect on the historical functioning of markets, and Bloomberg would stand behind that. I would bet that many more people would actually do it. But that's not where we are today, and so I think it's unsurprising that most managers try to continue doing what they were doing before.

right now, there's a massive dispersion in their performance. I mean, if you just look at a video over the last couple of years, So there is still some sort of price discovery where videas of the world are getting to be the largest names. Things are being sold off. Microsoft is unperformed, underperforming the S and P five hundred over

the last few years, like there is dispersion. So like, from my point of view, I think what you're saying makes sense, like the it's the whole flows over pros argument,

where things are distorting over shorter time periods. But when I look at it, for the most part, things are selling off or being affected by what's going on with the underlying stocks and the earnings and some of these valuations and these you know, these big name tech stocks probably deserve premium valuations over you know, any company in history, considering the margin expansion, the size and growth at which

they're achieving despite being multi trillion dollar company. So I guess my question would be, like, what is your pushback on the you know, eye tesk argument. I mean, even if we go to like all the money still coming as far as US ets go into US domestic equity ETFs, I mean, we're seeing record inflows and still smaller caps are doing more better, equal weighting is doing well over the last few months, International is outperforming over the last

year or so. So like these eye test arguments, like, what is the main pushback I guess from your research, Well.

we're talking thousands and thousands of securities. Finally, when you talk about the largest stocks outperforming, that is largely a function of a misunderstanding of how passive impacts markets. We have formulas for market impact. Yes, size is a factor and that, but more importantly is actually the scaling of size relative to liquidity and the idiosyncratic volatility of the individual security. And once we started adjusting for that, James like,

the quick answer is there's nothing else really matters. Right, Yes, an individual security can have a holder decide that they no longer want to own it and sell it, and in that time period, particularly if it occurs during something like an earnings report in which there is an absence of trading by the passive indices, they don't change their trading pattern on the basis of that change in earnings report.

That information that flows through. That means that the market is going to be more volatile or the stock is going to be more volatile in response to that earnings report, as the remaining active managers effectively are forced to trade

amongst themselves with wildly divergent opinions. I can only buy from somebody who is short, I can only sell to somebody who was long or who is short, right, And so that process of idiosyncratic volatility has a meaningful impact on it then is immediately ignored as that memory machine shuts off, and the next day you walk in and Vanguard or black Rock says, this is the right price

for that next incremental dollar. I want to be very very clear, we would experience idios and credit volatility even in a market that was one hundred percent passive, for the very simple reason that there would be order books that would be of different depths across different securities. So it's you know, the answer to it is is that it's not actually the smoking gun that you think.

and you name it, even investment advisors. Part of it has to do with the fact that, like, active managers were doing so well in the eighties and nineties and there was no passing on on the economies of scale, Like I don't think Vanguard would have grown to be as big as it was if active managers actually adjusted their fees, did things so they got rid of twelve B one fees like I think a lot of this has to do with the greed of the astet management

industry and active managers overall over the preceding day decades, where they just it was easy for a passive fund to outperform by simply, you know, cutting the fees down to cost plus type of basis. Do you agree with that, like, do you think that was made worse? Do you think it matters? What are your thoughts there?

If your results don't work, that's a sunk costs that you've lost, right, is somebody returning that capital to you? No, you've lost it, right, So you need to regain that through the economist of scale. Should you prove to be successful? Now, should they have been more aggressive in terms of offering those returns of scale? And you highlight things like twelve B one fees which are largely actually distribution platform fees.

Those are not the greed of the portfolio manager, that is the greed of the broker who is distributing the product. It has nothing to do with the portfolio manager. That greed has completely retained itself. We now see platforms on a regular basis charging active managers, in particular access fees to the platforms that require us to effectively share a diminished revenue source with them. Larger firms like Vanguard Blackrock are of size and scale that they can actually tell

those guys to go take a hike. So the simple reality is is that the system is actually biased against new entrants into the space. And were people over the greedy? Did too many people make too much money? Honestly, that sounds like the sort of lament that only a socialist would make. James, we can't possibly know. Wow, you have any comment, James?

mutual fund sense. And so we actually are seeing accelerating share gain from passive strategies as I described them, the market cap weighted strategies. We've accelerated to picking up roughly four percentage points last year. In terms of market share, we're now well past fifty percent market share. This is actually setting up conditions for a purging not of the passive space, but of the active space, as the economies

of scale are rapidly running in reverse for active managers. So, if anything, I actually think that we will see a purge of active managers prior to the event. We'll see an acceleration in many of these symptoms in terms of is there a limit? Yes, right, So that was actually the intent and observation behind the XIV trade what became

the Volmageddon trade. I recognize that there was a point at which the size and scale of these strategies would exceed the available liquidity in the markets, and that that became an instantaneous go to zero event for that product. Unfortunately, it's the exact same math for the S and P five hundred. The difference is, instead of a two and a half billion dollar ETF, we're talking a seventy two trillion dollar market that has far more important societal implications.

And I'm far more loath to actually put myself in a position where I'm encouraging that to happen. But candidly, I'm a little annoyed that nobody actually wants to paying attention to this, and so maybe I'll have to Yeah, the last thing I would say, I agree.

down what's actually happening. There is a lot of growth happening on the active ets side, there is the likes of Capital Group, DFA and others, but it is not as big as like the headlines would make it seem. And from what we from my point of view, what I'm seeing more happen in the ETF space. You can see this when you look at the average fees being charged for the most part, like you said, beta has become to S and P five hundred has like basically

become commoditized. But people are willing to pay up for those premium fees for people who aren't hugging the benchmark

right there. So I think ultimately, I think the market at some point will sort this itself out if it's not if it's not sorted out regulatory in a regulatory way the way that you're kind of hinting at, might be needed, just because I think people are like, I don't want to pay, you know, one hundred basis points for exposure to the S and B five hundred plus or minus a little bit, But I will pay one hundred basis points or ninety basis points for somebody that's

truly active and going out there on the risk spectrum. And we're seeing that in the flows in like this core satellite type approach. But as you said, passive is gaining share, though I do see somewhat of a slowing stance from the acceleration that we had recently seen. But Passive is going to be sixty percent of the market before the end of the decade. As far as you look at mutual funds and need taps on an AM basis.

to use your margin account. Your margin account would charge you somewhere in the neighborhood of ten to eleven percent against a fifty percent increase potentially in your portfolio. You would be subject to individual margin calls, et cetera. It's far cheaper for them to access it. It's effectively an arbitrage phenomenon in which they access that same leverage through an ETF that charges them one and a quarter percent to buy a single stock two times levered. Right. So

you know, one, I think it's a little disingenuous. Two, I think it's actually really important to highlight that if you go on many platforms and you try to buy an actively managed product my high yield fund CDX, for example, on some of these platforms, you will actually be asked to sign a waiver of liability before they will allow

you to buy them. Because despite the fact that my high yield fund, which has done extraordinarily well and is designed to actually limit exposure to widening credit spreads, runs significantly lower volatility than the index while matching or exceeding their returns to the index, that product is perceived as risky under the regulatory framework and they don't want to get sued. Now, imagine your customer comes to you and says, hey, I was just asked to sign a waiver of liability

in order to buy your product. When I can go buy the underlying product without that waiver of liability, what's the deal here? Right, You're creating a friction into the process that is absolutely retarding the growth of those actual active managers which you highlight. James, I actually really strongly disagree with your observation.

cheap products? Is your view that the detriments outweigh the benefits of people that were forced to put money to work in the market versus people just sitting in cash at the time, because there are like, there's a there are definitive costs and downsize that you've highlighted here, but there are also definitive benefits to end investors who are getting exposure to the markets at much cheaper prices and actually being invested.