Interviews and Videos with Experts on Passive Investing

Realvision – The Perils of Passive Indexation – Featuring Mike Green – December 11, 2019

This excellent video from RealVision was one of the first easy-to-understand explanations of the distortions index funds were creating in the market.

Among the highlights of the interview:

  • Passive is the world’s simplest algorithm
  • How indexing has inflated the median price-to-earnings ratios for stocks over time
  • Passive is more than 100% of the inflows into the market. Millennials have 90% of their investments in passive funds while the older generations are the primary holders of active funds. This causes a inevitable shift to passive through demographic change over time.
  • 90% of every dollar going into 401(k) accounts now is going into target data funds. About half of all 401(k) accounts only hold target date funds and no other assets
  • Bond index funds are distorting the fixed income market as well, introducing a momentum effect into the bond market
  • As passive share increases in the market, volatility will increase dramatically
  • An example in the Chinese stock market where stocks in the Shanghai Composite went limit up for 30 days in a row because of flawed index construction
  • The liquidity mismatch between the ETF vehicles themselves and the illiquidity of some of their holdings
  • How index funds becoming the majority of the market is similar to the XIV collapse in February 2018
  • How all the stocks in the S&P 500 moved together in the same direction on February 5, 2018 for the first time in history

Robert Shiller CNBC Interview from November 2017

Robert Shiller is a Yale economist and a Nobel prize winner and has made major contributions to finance with his Shiller price-to-earnings ratio and his work on historical housing cycles.

While it is several years old, this CNBC interview with Dr. Shiller highlights some excellent points about passive investing. The interviewer, Eric Chemi, expresses the logical argument that not everyone can be a passive investor, because index funds and ETFs are free-riders on the valuation work of informed, active investors.

Eric Chemi : It feels like a lot of retail right now, they’re just buying ETFs, they’re not really individually picking stocks and some people have said that is going to bring a lot of leverage, that’s going to end badly because you can’t have the whole market in ETFs. What are your thoughts on that?

Shiller: If you are talking about passive indexing, that is something that is really free-riding on other people’s work. So people say, “I’m not trying to beat the market. The market is all-knowing.” Well, how in the world can the market be all-knowing if not as many people are trying to beat it? So that’s a concern.

Eric Chemi: If everybody just put their money in ETFs and everybody was a passive investor, then how would you know the value of any company relative to another? The thing would fall apart. You need at least one active investor to make some sort of benchmark and then everyone else could follow him.

Shiller: And you hope he or she isn’t schizophrenic! I think the strength of this country was built on the people who watched individual companies. They had opinions about them. All this talk about indexes, it is a little bit diluting of our intellect. You know, it becomes more of a game.

Eric Chemi: So would you say all this indexing, the ETFs, the passive investing approach, do you think that has been a net bad thing for the markets?

Robert Shiller: Yeah, I think it’s kind of pseudo-science that these indexes are perfect and all I need is some kind of computer model instead of thinking about business.

Grant Williams and Bill Fleckenstein interview Mike Green on Grant’s The End Game series – July 6, 2020

Grant Williams on Mike Green: “And at the end of the hour-long, I mean, my jaw was on the floor at just how brilliant this guy was…”

Highlights of the interview:

  • Discussion of the Shanghai stock market rise of 500% from Dec 2014 to June 2015. It was due to the stocks in the index having low floats (not many shares available for trading) and a lot money flowing in.
  • Also saw a similar effect with technology companies in late 1990s. They had high insider ownership and low floats, so when money flowed in, it boosted the prices more than the typical stock.
  • It was in 2016 that Mike had the revelation that passive was distorting the market. In 2015-2016, things stopped making sense from a valuation standpoint, so he needed to figure out what was happening
  • Individuals under age 40 have very high passive ownership. They are the ones providing the cash flowing into passive investments. Investors greater than 65 years old  are selling to finance their retirements. The 65+ years old demographic has very low exposure to passive investments, about 15% to 20%. The net result of these conditions is that active managers are being sold and passive funds are being bought.
  • Cash cannot be created or destroyed. Myth of cash on the sidelines. It has to go somewhere.
  • He ran a survey of investors to see what valuations they would buy and sell at. It had intuitive results: people more likely to buy at low valuations and sell at high valuations. However, with passive that is no longer true.
  • The simple rule of passive investing: if you give me cash, then buy. If you ask for cash, then sell.
  • Jim Simons, founded Renaissance Technologies, probably the most successful quant fund of all-time. He was a brilliant mathematician. In an interview Simons said the efficient market hypothesis is crap. He explained the most complicated part of running Renaissance funds was not the trading algorithms or figuring out which investments to buy. It was designing the systems that monitored how the firm’s trading affected the market as they bought and sold securities.
  • Simons knew this was important and he was running $75 billion in total capital. Mike knows for a fact at Vanguard and Blackrock, they do not analyze their impact on the market, and they are running trillions of dollars!
  • One of best books you can read is by Leon Levy, called The Mind of Wall Street. Levy made a conscious choice when building Oppenheimer in the 1940s not to hire people who were around in the 1930s because they are so scarred by the carnage in those market that it impaired their ability to invest.
  • How passive causes markets to violate the efficient market hypothesis with regards to options pricing. The Black-Scholes Model no longer works.
  • Mike sat down with legendary value investor Seth Klarman, founder of the Baupost Group, and presented his passive thesis. Klarman said to Mike, you will die if you are right about this because you will have all the money and everyone is going to kill you.
  • The dominant force in passive is momentum. Since money is allocated by market cap, if it goes up, passive funds buy more of it. If it goes down, they buy less of it. This prevents the mean-reverting effect that value investors exploited for decades before passive became dominant.
  • Going from a world where active funds had typically about 5% of cash to passive funds that carry 10 bps of cash. The way the math works, moving from funds holding 5% cash to 0.1% cash makes the market go up 50X. Since cash cannot be created nor destroyed. This is the theoretical maximum if passive funds held 100% of the market (which in practice will not occur), but it illustrates the dynamics.
  • Think of what happens when you get to 99.9% passive, how much do prices have to go up to get the last active investor to sell? Volatility skyrockets.
  • Then, what if just 1% of passive holders decide to sell. Prices go to zero.
  • The market will not get to 99% passive, obviously. The system will break down long before that point.
  • Mike believes we saw some of this in February to March of 2020. Passive did not really sell, it is just they did not buy more as active wanted to exit.
  • Mike talked to Leon Cooperman, founder of Omega Advisors, and talked to him about Mike’s simulations of passive in which the market goes to zero. Leon’s comment, “Well, that just makes you sound stupid.” Then after the extreme volatility in March 2020, Leon started to believe.
  • Fed believes in the Euler coefficient – lowering rates gets people to consume. The empirical data actually demonstrates the opposite.
  • This is at the heart of the Fed’s models but reality suggests the complete opposite
  • Fed cuts boost markets because the value of collateral (bonds) rises when interest rates fall. Then increased value encourages more leverage in the system.
  • With risk parity and other strategies leveraging bonds, when does that end? When no longer have a positive carry. That is when rates go negative.
  • After Mike talks with Fed governors, he goes home and tells his wife, “Oh my God, we are in so much trouble.” They lack of understanding of how markets work in reality. All theory.
  • Mike explains, “I can count on one hand the number of weeks in its history where Vanguard has received net sale orders.” [this is why the consequences from passive dominance have not harmed the market yet]
  • For any active stock position in today’s market needs extraordinary conviction and a catalyst that will draw new buyers or an acquisition. For example, with gold stocks, all gold fund managers are convinced so they own them. To get their stocks prices to ride, you need to convince others outside of that circle, so new money flows in. This is hard when everyone is going passive and other active funds are experiencing outflows.
  • “We’ve built a death trap for active managers,” They cannot win this game because it is essentially rigged against them.
  • The positive story to the end game is if more people recognize this and we are able to change markets back to their intended role, to allocate capital by discretionary investors analyzing facts about companies.
  • If we continue down the same path, the result will be catastrophic and capital markets will cease to function.
  • Passive is similar to the Nazi stock market in 1930s. Germany had laws that you could only execute a transaction at all-time high price. Under that system it means markets can only go up. However, it created lower and lower volume of trading, so the markets ceased to function.
  • Then, when markets were reopened after World War 2, they were allowed to trade freely and the German market fell 90% in a single day. Passive is setting up a similar scenario.
  • No one can stop this now. The government lobbying activity of Blackrock and Vanguard and other passive players is so large. Fed paper 2018 by Boston Fed on passive investing risk had all sorts of hedging because the big indexing firms insist there are no issues.
  • Some form of debt jubilee is likely in the future.
  • Conditions that would kick off a debt jubilee.
  • Modern Monetary Theory (MMT) is an accurate description of a world in which fiat currency exists but no limitation on the government’s ability to print (i.e. gold standard). But it would be negative to get rid of the fiction that deficits are limited because makes govt all powerful. MMT tells us how the system works, it does not tell us what to do with that power.
  • The welfare state arose in Europe because people had exit voice. Governments needed and incentive to keep them there instead of emigrating to America
  • Why Mike’s avatar on Twitter is Vizzini from the Princess Bride