Is Passive Investing Distorting the Market? | Interview with Mike Green From Simplify

Thank you. It's a pleasure to be here.

Coming out of the Northeast, it's nice to get some vitamin D, so.

Sure. So, I've been in markets for a long period of time, over 30 years at this point. My focus at Simplify is as the chief strategist and portfolio manager for the high yield strategy which you mentioned. I have a career that spans everything from mutual funds, hedge funds, and now into ETFs with regulatory changes in 2020 that facilitated the introduction of many of the more complex strategies that you're now starting to see out through ETFs. Whether those are simpler versions like covered call strategies or even some elements of structured products are beginning to make their way into ETFs. It ultimately allows investors to define how they want to receive their returns. Do they want to receive it in high dividend form? Do they want to receive it in capital gains? Do they want to have it in a protected form? Are they looking for extraordinarily high income accepting some volatility associated with that? There's been an explosion of opportunities for people to express their individual investment philosophies over the last 5 years, and that really was facilitated by the same regulation that gave birth to Simplify.

Well, this is one of the real challenges. We have extraordinarily, you know, sophisticated and recognized strategies for how to build wealth. One of the real questions that we have is how do we harvest wealth? This becomes an increasing challenge, particularly as the baby boomers are moving deeper into retirement. How do we convert an asset pool into an income stream that funds both themselves and hopefully some part of the next generation.

Well, I think the real challenge with the 4% rule is just that it works very well if you have a portfolio that is largely built around fixed income and that fixed income is yielding in excess of that. That makes sense. That allows you to smooth those withdrawals. The challenge is the way we save for retirement in the United States is increasingly in a lump sum format. The volatility of that when it is an equity-centric portfolio discourages people from taking that full 4% distribution. As a result, it often encourages them to try to raise incomes and yields in other ways, some of which may be appropriate, some of which might be a little more risky than people fully appreciate.

Correct.

Well, this is one of the really interesting components is that actually we've seen very, very low levels of realized volatility. Typically we measure volatility from close to close and in that framework the S&P has been among the least volatile that we've seen for an extended period of time. But that intraday volatility that you're describing, the reaction to news that is coming through, the market's behavior on the open or the close tends to be much more volatile than that very muted volatility would suggest.

More than anything else that suggests to me that people are trying to move money around, right? They're taking it from one place and putting it into another. That will create that type of intraday volatility. You move to sell your S&P exposure and buy a bond exposure or you flip out of a plain, you know, total market index into something that looks like a covered call strategy. That'll have implications that flow through the realized intraday volatility, but at the end of the day we're not seeing that much radical change in terms of either flows or positioning. Probably the most important story I would argue that's going on in the ETF space right now is the conversion of mutual funds into ETFs.

That's awesome for many mutual fund investors in terms of creating greater tax efficiency.

But I also think it's giving the perception of some growth that may be a little overstated.

Yeah, my math suggests about 70% of the increase we've seen this year is really just an acceleration of mutual fund conversions.

Sure. So the entire theory of passive investing unfortunately is predicated on the idea that all people do is hold. And what you just described is really the key insight in understanding how that's not the case and therefore why it meaningfully affects the market. If every 2 weeks you are sending a check to an index fund, their portfolio is changed by that inflow of cash. That forces them to transact. That's where the impact in the market is ultimately occurring. Because the indices are market cap weighted, that next dollar that you send in will buy more of things that went up. And that's reinforced momentum and large cap characteristics that are increasingly defining how we think about how's the economy going, for example, etc., right? It also creates, if you just think about the regularity of every 2 weeks, the vast majority of Americans are now putting money and their employer is matching that money into the stock market, into an S&P 500 or total market fund. When that occurs, it creates a, you know, undercurrent, a relentless bid that effectively can inflate markets and prevent them from reacting appropriately to economic information.

Well, when I do the work to understand how important this is, it's pretty extraordinary how much this is inflating valuations. And so, when we look at the rising valuations and things like cyclical PEs at all-time highs, my work suggests that the majority of that is actually not tied to Federal Reserve interest rate policy. We've now seen low interest rates and relatively high interest rates and no meaningful impact on the market. That flow of money into passive, my work suggests it's adding close to 15% a year to the total return of the market. So, it's a really interesting question of what happens as those flows slow as we move towards maturation of index investing.