I'm Adam Butler. This is Raise Your Average. Here's a question nobody in finance likes to ask out loud: What if the market stopped working? Not crashed, not corrected, but stopped doing the one thing it's supposed to do—figure out what things are worth. In the last 15 years, trillions of dollars have moved into index funds that buy automatically, mechanically, with no opinion about value whatsoever. Every paycheck, every 401k contribution, every RRSP contribution goes into the biggest stocks, making them bigger, giving them a bigger claim on the next dollar in. Nobody is asking whether the price is right. And the people whose job it was to ask that question—the active managers, the short sellers, the contrarians—have been defunded, benchmarked, chained, and when they showed up anyway, run over.
Meanwhile, the real economy is showing cracks. The headline numbers are designed to hide. Jobs data that counts DoorDash signups as new businesses. Private credit defaults dressed up as liability management exercises. Young people being quietly crushed by student loans and buy-now-pay-later debt landing at the same time. The market goes up. The fundamentals say something else, and the mechanism that used to reconcile the two has been quietly removed.
Today's guest called this over a decade ago. His predictions were dismissed as far-fetched. His blowup scenario was called fatuous. The disentanglement of passive's effects was called impossible. The research has now done all three. Our guest is Michael Green, chief investment strategist at Simplify Asset Management.
Mike Green is chief strategist and portfolio manager at Simplify Asset Management. But I don't think that credits him with the breadth and depth of experience that he's going to bring to this conversation. You know, he writes the Yes, I Give a Fig Substack, which I look forward to every week. He comes out every Sunday and covers a huge variety of different topics, but tends to center on policy themes, macro themes, investment positioning. And the topic that he's been focused on as a personal passion, as you mentioned, for the last 10 years: passive flows and their impact on markets and on policy and retirement, and how they generally corrupt the private economy in a wide variety of ways that don't get critically examined very often for a variety of reasons. So, I mean, the challenge with this conversation, candidly—I know Mike as a friend and have had many conversations with him over the years—and so the challenge is always: which part of Mike's vast knowledge base do we want to explore today? Right. I know you got a good plan, and I'm really excited.
I am too. You know, Mike has been really sort of an eye-opener for those, you know, who care to listen. And, you know, one of the things that, you know, I think before even meeting Mike the first time—now I think five, six years ago—was hearing about his track record and his career, the things, you know, the things he has accomplished and the places he's been and, you know, the things he's done, even, you know, right down to I think one of the most sort of prescient things that he called was the dislocation of Volmageddon.
You know, and among other things, that's just one of many. I mean, you know, his history goes back 20 years, but what we're talking about right now is something he's been actually working on for at least a decade.
And it's really controversial. I find it fascinating, and if you stop and think about it, it actually makes an enormous amount of sense, whichever camp you're in.
Yeah, definitely. What people don't realize, too, is that Mike started his career under Peter Thiel and worked at Peter Thiel's fund for several years. And I know that to some extent conversations and debates with Peter have informed his thinking in a variety of ways. Not that he agrees with Peter on all points—not even close. But just having those kinds of conversations and forcing him to forge his own opinions in a highly, you know, a high-pressure environment, I think has—he just has a very unique mind. And I think that that's a product, obviously, of his genetics, but also of his formative years in the business. So.
Yeah, I mean, he's one of the most, you know, he's one of the most rigorous and unconventional thinkers in macro and market structure working today. But yeah, that's just putting it mildly. I think when folks actually tune in to what, you know, Mike has to say, it's—I mean, it's astonishing. It's astonishing to me. I find his view and the amount of work he's done on digging into this topic and trying to either prove it or disprove it—because in that way, you know, Michael really has a scientist's mind in terms of the way he looks at it. If in the end he proves himself wrong, he'd be willing to accept it. That's the thing I think that people don't realize: is that if someone came along with a better argument and could prove it, and then he tore that apart and realized, you know, there was a mistake in my thinking, he would actually call himself out.
Well, it's one of these discoveries or thesis that you really hope is wrong, you know?
Yeah, it has all kinds of negative implications. And so while intellectually, you know, you've come up with a thesis, it becomes your baby, and it's hard to not look for confirming evidence while remaining open to disconfirming evidence. It's something that eventually you hope to discover was a false alarm, but it's becoming increasingly clear that it's not—that it's a real phenomenon and it's getting worse. And it's starting to feel like it's explaining a lot of the behavior of the market today, because I think a lot of practitioners, a lot of participants, allocators have often lately, at least, been scratching their heads, wondering, you know, the market's not behaving in a manner that is consistent with history. So when people are left scratching their heads, they will go looking for the answers.
This is Raise Your Average, dedicated to making you a better long-term investor. Join us as we sit down with some of the most interesting names in finance to discuss macro, markets, investment strategies, and more.
Michael, welcome. It is terrific to have you on the show.
Thank you very much. I'm glad to be here.
Really looking forward to our conversation today. Michael, let's start with where the world actually is right now. You come into mid-2026 having navigated the US-Iran conflict, the closing of the Straits of Hormuz, a 30 to 40% oil shock, fuel riots, general strikes, and global equities are sitting at all-time highs. That's a sentence that shouldn't make sense. So, walk us through what's really happening underneath, because your read is that the headline picture is badly misleading.
Yeah, I think unfortunately that we can't really just look at it as 2026, right? We have to think about this in the context of a much broader theme that has been in place, I would argue, now for going on almost 50 years, which is this general idea that, you know, everybody should be invested in the stock market in one form or another. This period basically started with the Death of Equities headline in BusinessWeek, that's famously, you know, from 1980. And now it ends with, you know, the alternative, which is all equities all the time. And if equities aren't enough, we'll go into levered variants of equities because those provide slightly more excitement. Look, you know, when you start talking about all the things that are going wrong in the world, the one thing that is going right is that unemployment remains relatively low, employment remains relatively high, participation in 401k accounts, IRA accounts, and a growing participation in defined contribution around the world is sending a wall of money into US equity markets that has to be absorbed in one form or another. That it is coming through in a passive vehicle that has no judgment as it relates to where valuation should be. Cash as an alternate asset, alternate assets as alternate assets, means that they have to go up. It's just the solution to a supply and demand equation. And so we have seen somewhere in the neighborhood of a trillion dollars worth of inflows into ETFs. I would estimate about half of that is coming from mutual funds. The process of converting from a mutual fund to an ETF actually slightly raises the inelasticity of the market or lowers the elasticity of the market even further, because part of the calculus that you have to enter into is the periodicity with which the orders are placed. Mutual funds are placed over a one-day period and averaged into the close at the end of the day. ETFs are instant execution. And so an order comes through—if it is a net surplus in terms of demand—then ultimately shares have to be created and the underlying securities have to be purchased at that moment. So we've raised the inelasticity or decreased the elasticity of the market and created conditions under which that flow of capital is more than enough to offset almost everything that has been thrown at it.
So I think the broad thesis, Mike, is that there's a lot of fundamental factors that under different structural circumstances you might expect to represent tailwinds to equity prices, but the broader structural tide is so overwhelming, right? This consistent wall of systematic funds that flow into markets is so overwhelming that the vast majority of the time it's not useful to discuss what's going on in the broad macroeconomy or even really what's going on at the level of corporate fundamentals. That markets have largely become disconnected from the forces that most analysts historically might look at in order to figure out how to price the individual equities in the market as a whole. Right? Would you say that?
That's—I think that's correct, but I would put it into a broader category. Right. So if you were to go to work for one of the pod shops, a Millennium or Balyasny, etc., what you would very rapidly find is they have no interest in fundamentals or valuation as an argument because the catalyst is not in valuation. The catalyst that is created by valuation is people deciding it's cheap and choosing to buy it more aggressively. As those members of our population have diminished because they have underperformed, they've been redeemed, they've experienced adverse outcomes in terms of portfolio performance, that's created conditions under which a growing fraction of the market simply does not care. That is the passive bid, and it rewards market capitalization. It directs flows on the basis of that component. And I want to be very clear here: there are vehicles that are conceived of as passive. Things like a triple-levered SOXX ETF, for example, that is in no way passive. Right? That is a sectoral allocation. It is a decision to lend to or to invest in a particular sector on some basis—whether it's momentum, whether it is earnings, whether it is 'this is the future and the addressable market is unbelievably large and the cyclicality is gone'—those are discretionary choices. The fact that we are levering that in the form of an ETF actually does have a significant impact. And importantly, because many of the companies in indices like that overlap with the largest stocks in the S&P 500 or the NASDAQ 100, we're seeing a compounding effect. It's, you know, basically getting hit with both barrels of a gun as compared to only getting shot once, right? You're unlikely to survive the double-barrel blast, or in the case of momentum, you're likely to go skyward. That, I think, unfortunately, is really what's happening here. It sends the signal to me that we have entered the end stages—end stages, I want to be very clear on that—of this passive phenomenon. We're seeing two things. One, the increasing sense from people that, 'Oh, I get it. It's all about AI, or it's all about large cap, or it's all about X,' right? It doesn't really seem to matter what it is, but once they start directing flows into a subset, particularly into vehicles like levered ETFs that effectively just consume capital, right—the volatility drag associated with something like a 3x levered variant of something with 60% implied volatility is that it needs a 100% plus annual gain in the underlying to break even. Like, that's an astonishingly bad long-term investment. And so people crowd into these types of strategies, and there's actually some evidence that they're being used thoughtfully by professional investors for various forms of vol harvesting. But just to be clear, those are not permanent funds, and they are creating distortions that I would argue are similar to what happened in the '99 to early 2000 time period, in which people suddenly said about the internet, 'Oh, I get it. Let's just put it with Landon Netter or let's put it with Ryan Jacobs of the Jacobs Internet Fund or Cathie Wood of the ARK complex,' as we saw in 2021. She was a beneficiary in 1999 as well, and so at Sanford Bernstein. So we saw a component of that, and it looked very, very similarly. This time it's happening in some of the largest market cap companies, and we do see evidence that it is redirecting flow in fairly material ways. The work I do—Tier One is a research firm I'm associated with as a special advisor, and we're working on some research and insights on that—but what we're finding is that the daily rebalancings in things like the SOXL, which has an endogenous liquidity feature to it—if it moves significantly in either direction, it has to lever or delever, creating flow without any transactions by the end investor—those are currently dominating what we're seeing in terms of both volatility, in terms of the low levels of correlation, because these securities have an external influence that is not directly tied to the flows that the rest of the market is receiving. And in some ways, those flows are actually counter to what we're seeing in the overall market because people have decided, 'Well, I don't want to buy the S&P, I want to buy the stocks. And if I buy the semiconductor stocks, why not get it in three-times-levered form?' So, you know, we are seeing this have a huge impact, but I would argue that it's showing up right now largely in the volatility that is being created in the vehicles tied to these levered ETFs and extraordinarily low levels of correlation, which depresses index volatility and creates the perception that there is no risk out there.
Yeah, there's this procyclical element to these leveraged sector ETFs, as you describe, right? Where, you know, if they go up a lot in a day, they actually have to lever up and buy more, notwithstanding whether new units were created, right? And so it injects this procyclicality. It, you know, exacerbates the procyclicality of the market, especially when the sectors that are getting the most leveraged flows are also the same as the sectors that have the largest weight in the cap-weighted indices, right? So you've got this sort of multi-dimensional feedback loop. You invoked the 2000 kind of bubble experience, and all three of us are old enough to remember that, having lived through it, right, fairly vividly. And, you know, this just has so many characteristics of that bubble, qualitatively. But also, you know, I'm just wondering whether, as a bit of a sidebar, what your thinking is on the circular funding nature of the earnings environment at the moment, and the fact that, you know, $50 billion of MAG7 earnings in the last quarter came from the appreciation of ownership in companies that they then vendor finance to buy their compute, etc. Like, what are your general thoughts on all that?
I think it was very similar, and I've drawn the direct analogy, obviously, to Cisco's vendor financing in the late 1990s. The narrative was the exact same: Cisco is the real company. They're selling tools to, you know, the mining equipment to the miners. Buy the vendor of mining equipment. Don't buy the miners because they're inherently uncertain in terms of their outlook. The problem, of course, was that Cisco's extraordinary earnings, margins, etc.—which pale in comparison to the levels that we see today for many of the semiconductor companies and memory companies—were being created by financing activities. Now, it's not as bad in the memory sector there. I think you largely just have a hugely cyclical component, in which I would emphasize that China has very clearly declared that they're coming for that market. You know, there's not a long history of industries that have stood up against China's onslaught in terms of capacity. So I find this a little bit humorous. I think it's a specious forecast that semiconductors have solved their cyclicality. But they at least are being driven by demand, because once you buy an overpriced GPU and contract to build an overpriced data center, you might as well buy the overpriced memory to go along with it. It's a little bit like a pocket square and a finely designed suit, right? You don't need all of it, but man, would it really finish it off? And, you know, that I think unfortunately is kind of what's going on, is that we have this, you know, complementing component or complementary component where GPUs are being financed, data centers are being put into shadow vehicles and financed—effectively SPVs, many of which are variable interest entities that if there's failure to take the contracts, ultimately it falls back onto the parent itself, and so it really should be considered as debt on the parent balance sheet, but it's not. All of these factors are compounding right now to create extraordinary growth. And then it is exacerbated by the way that we actually report GDP in the United States. The primary driver of GDP growth is now what's called investment in intellectual property. And this is one of these unbelievable shenanigans that, you know, as you know, I am an anti-conspiracy theorist. I generally think people want to do their job, go home and kiss their wife and hug their kids. They aren't, you know, rubbing their hands together to figure out how to deprive their neighbors of, you know, 0.2% on CPI reimbursement. But when the government calculates investment in intellectual property, what it assumes is the profitability is constant and any increase in profit margins must be the result of almost, in an astrophysics sense, the dark matter of intellectual property. They literally assume it cannot be market power. And so if profits expand, investment must have expanded. And that's a huge chunk of the investment that we're actually seeing. It's not real money. It's effectively a multiplier that is being put on the R&D spend that is coming from these companies and their anti-competitive activities. So, you know, I think the economy is significantly and materially weaker than the headlines suggest. I find it ironic that people quote retail spending and then point to credit card usage and say, 'Gosh, look how healthy it is.' And it's like, wait a second—people are putting gas bills on their credit cards. This is not healthy. This is basically, you know, somebody twirling back a donut two steps from the emergency room with a heart attack. You know, and they don't have a choice because part of what I've highlighted in some of my other work is that expenses, particularly coming out of the avoided expense environment of COVID, have exploded at rates that are far higher than wages have actually risen. And this is why we've seen the collapse in the savings rate. It's, you know, it's a very challenging environment, and I think unfortunately more and more Americans and Canadians feel that they are on the gaslit side of the equation, where they're being told everything's great and they're watching the stock market go up and they're looking at their own balance sheet and saying, 'Wait, my money is not compounding. My, you know, my ability to live is not compounding. I go to the grocery store and I have to put things back that I didn't have to put back before.' This is the real world for most people, and gasoline on credit cards is just one example of that.
Yeah. The accounting—you've got accounting increasingly abstracted from the reality on the ground, right? And I think, like, I'm hearing you say that that's true in the corporate sector through these types of circular financing and off-balance-sheet type vehicles and, you know, definitional games, balance sheet games, and it's also at the GDP level, right? And so you've got this sort of GDP bubble, but it's an abstraction, not reality. You've got this earnings bubble, which from a GAAP standpoint—
It's real on paper. Yes. It is effectively a forward credit contract that has not yet been properly priced.
And it's been—and that's been circularly funded between the various players.
And yet to add one more level is that most of the financing that's coming out of areas like private credit or out of banks, where they're still doing the financing, will often reference the underlying asset value. It's a little bit like if you took out a mortgage on a house and you put 20% down, the bank would say, 'Okay, you're fine.' But if that was a $200,000 house and you put a million dollars down and financed it for $5 million, the bank is still going to take an absolute bath.
Yeah. And, you know, despite the fact that you're going to lose everything you put into it, but the key is you had a call option and the bank is short a put, and those are very different payout functions.
Yeah. Which in the current market means that the taxpayer is short a put, right? Or, you know, they're not going to let the banking sector go under, and all the deposits are guaranteed. So.
Which is totally fine because we are told over and over again that the wealthiest 1% pay the majority of taxes. So, what does the average person have to worry about?
That's right. That's right. There's going to be people who are watching this and saying, you know, how—like, how can this be possible, right? And then—and that's one question. And then, you know, the same question is really, how can this be possible? You know, like, you're acting like it's never happened before, or it's never, you know, this kind of thing hasn't occurred before in the past, and it has. You do have a very specific explanation. I think we've, you know, we've already sort of touched on it to begin with, for why the market behaves the way it does. And it has little to do with fundamentals, and nothing to do with momentum in the traditional sense. It has everything to do with the plumbing.
Yeah, I mean, I think that's right. And again, this is the underlying component of the passive bid, and it is part of that 50-year arc. 1977—we in 1978, I'm sorry—we create the 401k as an extension of the ERISA language that allows companies to shed the responsibility for defined benefit pension plans, but importantly, put it on the backs of individuals. And there's a variety of impacts of this. One of the best papers I've read in a long time is a brand new paper that came out in February by Coimbra and Gomes. It looks at the implications of the shift from defined benefit plans, which offer income in retirement that allows you to meet your obligations, versus a 401k or defined contribution plan that offers assets that you accumulate and then theoretically either sell or harvest the interest or dividends associated with them to provide income into retirement. We've allowed dividend yields to become—the demand that that creates is significantly larger for a variety of reasons, but the most important one being: I have no idea how long Pierre is going to live. I have no idea how long I'm going to live or how long Adam is going to live. If I'm building insurance portfolios for their retirements, I have to assume the quote-unquote worst, and you're going to live to be 110 years old. If I'm doing that across a large pool of individuals in the form of a pension plan, I can assume the actuarial outcome, and that is somewhere around 86, right? So that's a radically lower number than 110. I need far less assets, and I need far higher cash flow associated with it. That shift drives an outward shift in aggregate demand for financial assets that drives dividend yields, all else equal, significantly lower. And so unfortunately, we now confront that uncertain retirement length with uncertain expenses, and we're confronted with an uncertain cash flow associated with it because the dividend yield has been depressed to such an extraordinary level—which is just another way of saying valuations are really high. Ultimately, that means that we will almost certainly necessitate selling. And I think one of the great ironies, of course, is that interest rates have been hiked to the point that the vast majority of households that have saved for their retirement can probably take off most of that risk, go into fixed income in various forms, and replace the income they would have received from a pension plan. But nobody wants to do it.
Yeah. I've been saying for a long time that one of the greatest policy errors of the last 50 years was the privatization of retirement. And I'm sure you've come to similar numbers, but I've calculated that the individual needs to save about 25% more than he would otherwise—that than the pension would otherwise need to save in order to produce the same level of income at the same probability of, you know, not depleting the total pool. Because we're forcing individuals to underwrite their own longevity risk, right? And so I think what you're saying is that that translates into higher necessary savings rates, and because of the individual preference for yield-producing assets—which itself is actually, you know, I would argue weirdly irrational—but there is this preference for dividend-yielding or yielding assets over just crystallizing gains, even though it's tax disadvantageous to do that—that there's larger flows into the sort of dividend sectors, but there's also just larger flows into the markets for saving purposes, and that has driven down the earnings yield of the market. In other words, it's driven up the price of the market.
Yeah. So there's a couple of things you said in there that I just want to be very clear on. One, when you're saying a preference for yielding assets or dividend-yielding assets, I would suggest that much of—like, if that were actually what was really going on, I would be a little bit more enthusiastic about it. Instead, what we're seeing is people largely seek to create synthetic income, right? By creating low-quality corporate bonds. If you think about what a call-overwriting strategy is, you are capping your upside. You are accepting all the downside in exchange for a yield, and that's just a bond right now. It's a bond that also has no contractual terms to it other than whatever the price is at X rate.
And so, you know, you don't have the ability to claim assets in the event that the company has a materially adverse event. You just take the loss, and that lack of recourse is really what you're receiving a much higher premium for. And the demand for those assets, as you're highlighting, Adam, has depressed implied volatility to the point that the compensation associated with it does not appear to offset the risks that they are taking, particularly with high valuations. But it's part of the perverse component that people point to, and they're like, 'Well, there's no debt out there.' Well, the minute you enter into a call-overwriting strategy, you've just actually incurred debt.
Yeah, you have an obligation, and you cannot sell your underlying until you've cleared that option contract. And if that option contract goes the exact wrong way, guess what? You get to take the loss.
Yep. Yep. Absolutely. So it allows investors to hold on to their stocks, use them to collateralize income strategies, not realizing that what they're doing is selling effective corporate debt to the market. They're underwriting corporate debt.
That's what they're doing, right? Without any skill in terms of, you know, credit appraisal or anything else. And by the way, I'm not picking on the individual retail industry here. First of all, most of this is done through fund structures.
Secondly, it's really critical to understand that even within the credit-writing world itself, these types of shortcuts are all over the place. It is very easy to write a $10 billion loan against a trillion-dollar market cap company. If that trillion-dollar market cap company has no cash flow and earnings, though, that $10 billion is actually very much at risk. You know, I hate when people do this, but you can't help but do it as we analogize in the manner that we're doing. And I'm thinking about the implications of this stuff. And I said this relatively early on when SpaceX managed to get the indices to start to change their methodology to drive inclusion into the indices. A lot of people looked at this and said, 'Oh, this is obviously the end.' Right? Now we've got this huge blow of supply coming in. And I guess the point that I would emphasize is that this feels very much like almost a Netscape IPO—almost the kickoff to the process. Now, could it be compressed and condensed this time around? Absolutely. But, you know, with people who look at the SpaceX IPO and say, 'Oh, it traded off its highs. It's clearly a failed IPO,' my reaction to that is just like, 'Are you kidding me? Do you realize how much capital was liberated for the insiders at this firm, and you gave them the ability to issue overpriced debt within a couple of days of the IPO? Like, this is a home run that generated extraordinary fees for Wall Street.' And of course, right behind it is SK Hynix, and then Samsung's going to come, and then we'll see any number of companies come through. We're in the, you know, again, this is to me the final stage, you know, indicators that basically say, okay, now we've cleared the path to radically increase supply, which is part of the process of offsetting that increase in demand. That it's occurring at exactly the point that alternatives like treasuries exist, or alternatives like simply getting older and dying exist. You know, we are navigating an increasingly narrow path.
Yeah. I mean, the HBM—the high-bandwidth memory makers—are going to issue stock and raise more money than their entire market cap two or three years ago. You know, like, it's absolutely astonishing. This is unfortunate. Like, I mean, you talk about the analogies to the dot-com. Anyone who has listened to me at some point has heard me refer to Michael Jensen's 2005 paper, 'The Agency Costs of Overvalued Equities.' This paper was written in the aftermath of the dot-com to help explain the behavior of management teams who clearly knew that their securities were overvalued but still engaged in uneconomic activity. And the reason why is very straightforward. What else are they going to do? Are they going to stand up and say, 'Hey, our stock is terribly overvalued. You should sell it now,' and negatively impact the employees that they just granted stock options to as well as their own personal finances? Should they stand up and say, you know, 'Oh, we're issuing a whole bunch of stock because you idiots are paying way too much for it'? Well, that doesn't feel like a particularly strong marketing pitch. Well, today we've unlimited capex opportunities, and, you know, the total addressable market is, you know, all of space and time. It's totally predictable. Like, it's just an incentive structure that exists, and eventually those incentive structures take things to their logical, if absurdist, conclusions.
The thing that worries me most about this at this stage is that the US equity markets are the retirement system for the US economy, and increasingly similar systems are set up to fund retirements around the globe, with incredibly adverse impact on real-world investment. That is one of the shocking things that comes out of the Coimbra and Gomes piece: is you would think that an increase in savings would translate to an increase in real investment. But it does the exact opposite, because most real investment doesn't offer the sort of unlimited speculative narrative that you can get from an equity investment. Right? If I'm going to build infrastructure, it's going to stay in one place. Its totally addressable market is limited by population growth. It has limited returns, and it's typically financed through debt. Well, think again about that difference between a defined contribution and a defined benefit plan. The defined contribution plan is going to bias towards equities, and in our current structure, it biases heavily towards equities. A defined benefit plan tends to focus on debt, and that debt can underwrite all sorts of infrastructure. And so this is one of the shocking findings in that Coimbra and Gomes paper, is just that if you run through the implications of this, everything that we're experiencing—from reduced investment to infrastructure to over-allocation to equities, etc.—is really explained by what feels like an administrative choice that was made in 1978.
Yeah, that's pretty wild when you stop. It really goes—it really goes a long way to explaining this non-stop bid in the market.
Yeah, I mean, look, I started sharing this viewpoint a decade ago. There was a lot of pushback at the start. Most people thought that I was somewhat insane. Adam, I think, was a relatively early convert, you know, convert to the belief system. Now it's increasingly accepted, although as my last Substack highlighted, there are many market participants and market commentators that simply refuse to look into the light. And that's one of the reasons this is going to keep going. In 2018, after the XIV event, they gave me some credibility around this type of discussion. I met with the Federal Reserve in Boston. They wrote a paper titled, 'Is Passive Investing a Systemic Risk?' And who's the first person you call after Mike Green comes into your offices and tells you that this is a catastrophe in the making? You call Vanguard, right? And so the entire piece reads like a he-said, she-said. You know, some market participants dispense facts. Other market participants with significantly more capital say why. And, you know, this is what we're going to continue to play through. And from a regulatory standpoint, Vanguard and BlackRock and the passive complex largely control the narrative. There is no desire to change this. There is no capacity to change this, even as the academic literature just explodes to support my underlying thesis.
Yeah. So actually, I want to dig into this because I want to address what might be a bit of an elephant in the room for some of the RIAs that are watching this, the advisors that are watching this. Right? So you've got an active manager. You were an active manager in 2016. You're an active manager now. You're the chief strategist of a firm that leans on and profits from the narrative that there's value in active management, right? And you are making the case that passive indexing is corrosive, and, you know, that the reason why active managers have been underperforming is because there's been such a shift to passive. So you can sort of see this resistance forming, right, in the minds of many advisors who have increasingly sort of embraced this passive phenomenon over the last 10 years and each year been vindicated by the fact that their passive allocations have outperformed comparable active managers. Right? If you look at the SPIVA data and a variety of other sources, year after year, passive does continue to outperform. Your thesis is, yes, of course, almost definitionally that's going to happen, and nine years out of 10, for the very reasons I've been giving. The other side is saying, well, of course, but this is just sour grapes. Let's address that head-on.
Yeah, I mean, the other side's right. It is just sour grapes. [laughter]
Yeah. To make hay while the sun shines, right?
Exactly. No. Look, first, that is a valid approach. It's an ad hominem attack, which in general we look down upon. And so I do want to actually emphasize that, you know, we would not tolerate this line of argument in most other areas. Right? The second is that I've been very straightforward and said outright: active is going to underperform passive in large-cap equities in particular, and increasingly in areas like small-cap. And the mere allocation to small-cap is going to be adverse to your financial health because of the rules of passive, as is allocations to emerging stocks, value stocks, etc. Right? All the traditional approaches, precisely because the active managers who have been the adherents of those approaches are being redeemed. That forces them, on net, to sell their portfolios. That places downward pressure on the securities that are in their portfolios relative to the overall market. And then the second component that ultimately occurs is that the momentum feature associated with a market-cap-weighted index has become effectively overwhelming. And importantly, it's not the momentum that we think of in the traditional quantitative sense. Adam, your quant is your training, and you know that 12-minus-2 momentum has really not worked. What has worked extraordinarily well is just momentum with an emphasis on basically the last month. And that sort of autocorrelation again is a prediction that comes from the continuous bid from a passive flow-type framework. So, you know, I can't open up my heart and show the inside to say, you know, look, I'm being honest in my representation of this. I have from day one said that, you know, the reality of this situation is that it is creating a unique portfolio that, unless you match that unique portfolio and even better effectively leverage that portfolio, the odds are very high that you are going to underperform. If you add leverage to that portfolio, your risk of ruin begins to multiply exponentially depending on the degree of leverage you add to it. So there's not a lot of easy solutions out here other than being aware. And yeah, I mean, that's really what it boils down to.
I just—yeah. I guess I was—I think there's an enormous amount of testable, falsifiable hypotheses, right, that fall out of that accusation. Right? Like, if what you're saying is true, if I'm just trying to, like, excuse the poor performance of active managers, active stock pickers, then there's a number of different studies that we can conduct, right, that would prove your thesis or my thesis more likely to be correct, right? And over time,
All of those theses have been tested, and as they've been tested, they've all fallen your way. Right. So I really wanted to give you an opportunity to kind of go through...
Um, the... because I feel like you've...
I have to push back a little bit, because as you said, all of that has occurred, and yet the Financial Times will look at it and say, 'We're going to seek an alternate explanation that is literally dismissed within the paper they were reviewing.'
Right. Totally. Yes. [laughter] Right. And so, you know, look, have an AI read the paper first, right? It's not that hard. But to simply turn around and reflexively say, well, we actually think it's all about skill, right? Um, and you know, the fact that the game has become more skillful, which is empirically disprovable.
Exactly. Hold on though, before you go into that, like I feel like we actually want to dwell here. So, Malbus's paradox of skill, and Grossman-Stiglitz, that whole thesis I think needs to be unpacked for people to be able to grasp what came after.
Sure. So, um, we have to take ourselves all the way back into the 1950s and the development of modern portfolio theory, which made a number of assumptions around them. One is generalized Brownian motion, or stochastic random distributions associated with security prices. Basically, the economics world looked at the stock market and said, we can't predict it, and therefore let's just assume it's random, and from that we can build any number of theorems. If we assume the distributions are random and structured in a lognormal way, then a mean-variance optimization portfolio becomes the most efficient frontier-consistent portfolio.
Um, once you accept that generalized Brownian motion, then you're one step away from saying, well, you know, there's really no point to doing any research because a room full of monkeys throwing darts at a newspaper could pick stocks as effectively as active managers. And so, you start with that assumption, right? Then you have to make additional assumptions. And what does cause transactions to occur? Why don't people completely ignore research and simply throw darts? Part of it is labeled as hubris, right? Everyone wants to believe that they have skill in the casino at playing blackjack in one form or another. But the more important component actually came out from what is called the Grossman-Stiglitz framework, which highlighted that for a market to be efficient, it has to have access to information. The production of that information is costly, and therefore there has to be a return associated with that information that should translate to alpha for the active managers that may or may not be offset by fees. That's the entire theory behind Grossman-Stiglitz.
The problem with Grossman-Stiglitz is a couple of things, again, and it always boils down to the assumptions. One is that it presumes that any decrease in effort from other market participants is matched by a one-for-one increase in the active market participants. We now know that is untrue. The work of Valentin Haddad in a paper called 'How Competitive Is the Stock Market?' suggests that only approximately one-third to two-thirds of the impact of the decline in effort from a subset is matched by an increase in effort from those who remain in the market. In other words, there is a partial competitive response, not a full competitive response.
So if one active manager leaves the market, right, because their fund is no longer viable because they've been redeemed, the idea Grossman-Stiglitz says that's fine. That manager did not sufficiently demonstrate skill. He's been weeded out of the market, but another manager will come in and replace him one-for-one. Right? In reality...
Actually, under the full theory, it is an instantaneous replacement. There's no diminishment of the number of market participants.
The second assumption is just absolutely, provably false, but somewhat realistic when it was initially made, which is that every market participant has the exact same endowment. In other words, everyone gets the same voice. All right? Now, what that means is my portfolio is the same size as your portfolio. Pierre's portfolio is the same size as ours, and we all basically get to argue without any net transfer of wealth on a permanent basis in any meaningful way. Um, that's not the world I live in. Um, and it turns out that the implications of that assumption are quite profound. It's similar to the idea if you play poker with your friends, you all start with the same amount of money. It becomes a game of skill. If one person shows up and has a thousand times the bankroll of everybody else, it's no longer a game of skill. Or even more perverse, if four out of the five players at the table have wives coming up and continually asking them for money to go, you know, gamble at the slot machine, and another has a wife who works all the time and shows up to give them money, that's going to be a very different game. It's not going to reflect the skill and luck distribution of the cards. It's largely going to reflect the bankroll capability.
And so again, we actually know this. We can model it. We can build it, but it completely violates the assumptions under Grossman-Stiglitz in terms of equal endowment, and the implications of it are that the large-stack player, i.e., the largest player in the market, is increasingly going to set the terms of engagement. That happens to be passive players.
The third component that I would argue is now completely wiped out is the general idea that markets are highly elastic. In other words, they can accommodate almost any amount of activity in terms of buying and selling. And so the efficient market hypothesis presumes, because every buyer is matched with a seller in an exchange market, that the impact of order flow is diminutive. The actual number is a dollar into the market creates about one penny of market capitalization. In 2021, Gabaix and Koijen — maybe it was 2020 — Gabaix and Koijen come out with a paper, 'The Inelastic Market Hypothesis,' that documents between 1992 and 2019 the average multiplier is not one penny, it is $5. And so a 500-to-1 misspecification, right? You do not get into airplanes that are being flown with 500-to-1 misspecifications. This is just life advice.
Um, the problem with that Grossman-Stiglitz — or, I'm sorry, the problem with the Gabaix-Koijen analysis — it's similar to a brand new paper that just came out, um, that hits on another topic I'm going to address — is that it uses an average from 1992 to 2019. And going back to Haddad, what he has shown us is that the increase in passive actually is driving an increase in inelasticity. My analysis suggests that the historical multiplier for an active manager is about 1.8 or 2. For a passive manager, it is a function of the pool of remaining active managers, but it tends to be about six times higher multipliers for passive vehicles than it does for active managers. And that number begins to expand as the share of active declines, or more accurately, even the flow of active turns negative.
That's highly convex. Yeah.
Yeah. It's highly convex, and so my current estimate is the multiplier has risen to 22. Um, wow. And for the largest stocks, it's approaching 100. And so a relatively small influx of capital can create extraordinary market cap gains that are then interpreted by the rest of the world as, 'Oh my gosh, these are the greatest thing in the world. Why don't we lend people money against these securities so they can buy more of them,' right? Which just exacerbates and adds additional fuel to the fire.
Um, the last one that I think is actually really critical is this idea behind Grossman-Stiglitz that ultimately, if the share of market participants who don't care about valuation rises large enough, then the multiple opportunities emerge for active managers to correct those prices profitably. Part of that assumes the endowment, part of that assumes the elasticity components to it. But much more importantly, it actually presumes that the growth of the noise traders — or not the noise traders, the growth of the passive market participant — is not negatively affecting the active manager and creating conditions under which they lose their capital and ability to respond. It also ignores that there's two types of roles for active participants. They can be a contrarian or a corrector and bet against an extreme move either up or down, or they can be a facilitator like a market maker. And what we have actually seen is the facilitators' profits have done exactly what Grossman-Stiglitz would suggest. They have exploded. Look at the profitability of Citadel or Jane Street. The participants that are very active in their underlying construction but are not trying to stand in the way of this valuation increase. Instead, they are actually providing the tools that facilitate that valuation increase.
And it's become such an extraordinarily profitable part of the business, and nobody's paying any attention to it other than just to celebrate it. The entire canon of economic literature that leads to macroconsistency and cap-weighted indices being the most efficient portfolio completely ignores the existence of the intermediaries. Right? It assumes the only participants in markets are active decision makers, right? So it actually ignores passive decision makers entirely. Assumes that there's sufficient active decision makers in markets, sufficient in terms of number but also in terms of endowment, in order to equilibrate prices and achieve macroconsistency, and ignores the existence of these intermediaries that actually end up being the greatest beneficiaries of the...
On an individual basis, they absolutely are. Yeah. And I mean, look, we build models because the world is too complex. And so like leaving something out of a model is not a sin. It's not like you've, you know, done something bad. It is a necessary component. When you pull up your Google Maps, it doesn't show the cigarette butts on the sidewalk because they are irrelevant to your directions, right? You may want to watch for them so you don't step in them or other things that are often left on sidewalks. But the simple reality is they are unnecessary features of the model.
That is always true until you lever that model to an extraordinary degree. And we often think about these things in reverse, right? Newtonian physics got us to the moon. Quantum physics are necessary if you're building a microprocessor. And so like it feels like the scale is almost off. But the reality is a microprocessor is extraordinarily levered because it's effectively a map of a city. Like if you look at a semiconductor, it's a map of a city shrunk down to every road is, you know, one-tenth of the width of a human hair. And so precision becomes increasingly important when you leverage scale in that way. And I would argue that analogy is what we're now experiencing in financial markets. At 10% market share, passive was not a huge impact. In fact, it was a facilitator of lower volatility because it created a heterogeneous agent who simply said, 'Oh, I have some cash. I got to buy.' Right? That was a diversifying criteria.
As they become the dominant player, 'Oh, I have some cash. I need to buy' is running into a whole bunch of other 'Oh, I have some cash, I need to buy' players. And that is driving prices in a manner that wouldn't occur if somebody said, 'Oh, I'm a little short of cash. I need somebody to sell to.' Right? The only place that's happening is in the area that the active managers are being redeemed, or from companies themselves emerging to offer the shares at inflated valuations and changing structural outcomes. Right? This is one of the things that I emphasized during the GameStop phenomenon. There were a lot of young retail traders on Twitter who were saying things like, 'Oh, I'm shorting this. It's going to zero.' I'm like, 'What are you talking about? They just raised a whole bunch of money. Now there's cash underlying the shares, right? They have staying power and capability here. Will the stock price go down? Of course. But is it going to go to zero? It's a really long path to zero from here.'
On the flip side of that, you have guys like Michael Saylor who did the inverse. They raised a whole bunch of cash, used it to buy a non-cash-flow-producing asset, and then issued additional liabilities that require them to show up with US dollars to settle their obligations. And so that's, you know, that is a self-liquidating vehicle. Those are less problematic to me than the ones that effectively assume suspended animation forever.
So I want to make sure we bring this back to the implications for advisors. Um, one of the studies that I conducted over the last little while was, um, I wanted to know how much skill an active manager in US large-cap equities needed in order to be able to beat the index. So I ran a very large-scale study of random portfolios, and I isolated only managers with a level of skill that would have put them in the top 1% of managers over the last 25 years. And my experiments yielded the conclusion that actually no manager in the entire history of active management had demonstrated sufficient skill to actually be able to beat the market, gross of fees, over the last three years. There's just actually no level of plausible information coefficient or skill that would have allowed a manager to beat the market. And I feel like this is an enormous vindication for those advisors who, with a background in finance, who, you know, believe that markets serve a purpose, that allocate to active managers because they believe in manager skill. And yet year over year over year for the last 10 years, and the phenomenon has gotten worse, continue to get their heads stoved in every year by that bet, right? Um, do you see this trend continuing? And if so, is there a terminus? And how can advisors position for the ride to that terminus and also manage the risk of what happens after?
Let me just share a couple of slides with the audience just to walk them through this, and then I'm going to show a chart that illustrates exactly what you are articulating and highlight some of my more recent work, which is not yet available for distribution. Unfortunately, I've not yet filed, so I can still show it. Um, one of the many fun things that active managers get to deal with. Okay. Um, so look, what you are describing in terms of the way markets have historically functioned is a function of flows within the active manager community. Um, when I began doing my work on this, there was very little research on how did active managers behave in response to a flow of capital. So I went out and I surveyed managers and I asked them a question: You're a portfolio manager with 5% cash in your portfolio. You receive a new inflow or a redemption request. What is the likelihood that you will deploy funds or sell securities to meet a redemption given some type of normalized valuation? And so here on the chart on the left, what you have is valuation expressed in multiples. On the y-axis is your marginal propensity. You can see this, right? Adam, you can see this.
