Mike Green's New Adventure

Uh, yeah, I mean the news has hit over the p it's leaked out over the past week. I resigned from Simplify on Monday to launch a new investment firm, Tier One Alpha Asset Management. That capitalizes on the work that I've been doing on market structure. We've identified ways to utilize the information associated with passive flows and a unique framework where we're isolating to every individual stock that's positioned us to really start building implementable products and we'll be making our first announcements on that in the next week or so.

Thank you. But, you know, as I've talked to Ben repeatedly over this week, when I started doing this work over a decade ago, it very quickly translated into an exceptionally profitable trade. And it's taken me roughly nine years to figure out the next one. So, turns out it wasn't a trade. It's a firm. And we think that there's an extraordinary opportunity to harvest the distortions that are being created by the flows of passive into markets. Um, we think we're in a unique place to do so.

Uh we're going to launch two ETFs. We should either register tomorrow or on Monday. I'm not sure which one is going to clear the regulatory hurdle. Uh and we will also be launching SMAS. So, they focus on delivering excess return with the minimum amount of tracking error versus US large cap equities. We will also be launching an index that should come out by the end of this month that will allow people to see the serious history and the methodology all the way back to roughly 2013.

What?

Okay.

Okay.

Well, define work. It will clearly create volatility that reduces elements of the carry trade components where you have seen capital on a hedged basis coming to Japan to take advantage of the much higher interest rates. Conversely, when you run these strategies on a hedged basis, and just very quickly so people are aware, the difference between a US 10-year bond and a Japanese 10-year bond, when you calculate the forward spread differentials in the currency as well as the difference at the front of their respective curves, which is where financing happens for currency transactions. It means that there is a significant premium to investing in Japanese government bonds relative to US government bonds. You would think that that would strengthen the currency except of course for the hedge. And so the hedge mechanics actually somewhat frontload the currency impact weakening the currency and by interjecting a degree of volatility and uncertainty. They're trying to shake people out of these trades. It's just going to be very very hard to do this unless the respective interest rate policies shift significantly. Either Japan will have to increase short-term interest rates significantly or the US, which I actually would much prefer to see, will start cutting at the front end of their curve, steepening the surface and destroying elements of that carry trade differential.

Yeah it's I mean look we're in a very difficult situation you have a market fundamentalist bent both the Fed and to a certain extent the Treasury in which they recognize that the markets are sending signals that make it much more difficult for financing both the United States and Japan. Japan has to worry about the FX side of the equation. The United States has to worry about the fiscal impact of high interest rates as well as the implications that has on the interest rate sensitive components of the US economy. Housing would be the most obvious one, but autos are also quite weak in the United States, the two areas that have the largest consumer finance aspect to them. You know the Fed is a little bit trapped in zugzwang and to use the chess term in which there's no opportunity to improve your position with the next move. They either are going to have to cut interest rates which runs the risk of inflating an asset bubble that we're seeing in equities as well as perversely it will cut the fiscal stimulus that is coming through the higher interest rate channel due to very high levels of debt to GDP versus prior periods. And if they hike interest rates, the interest rate sensitive portions of the economy that are running at extraordinary drops. I mean, it is hard to explain to people how depressed the housing market is, we're running at record rates of new home building on a population adjusted basis, the cheapest that we've never seen. This is well below the post-GFC framework in terms of housing per capita. Um, and that of course, you know, would get even worse if we hiked interest rates higher. We would probably set off a wave of defaults in a variety of forms. We're already starting to see that in some of the rent to own to rent category. Airbnb owners are increasingly under pressure due to both changing regulations and higher cost of refinancing. Most commercial mortgages, if you actually were honest in your Airbnb and didn't say you were purchasing it for primary occupancy, um have a 5-year adjustable rate component to it. So, you're now starting to see those 2020 and 2021 mortgages that were taken on, even some of the 22s that were taken on at discounted rates are facing the threat of refinance. And even if you are not refinancing, the house next to you is refinancing and therefore runs the risk of coming onto the market in distressed form and creating lower price competition. That's ultimately good for those who are looking for housing, but it is potentially quite catastrophic in terms of the implications that that has in clearing prices in housing, which have been remarkably robust relative to what has seen to be a real deterioration in the new build housing markets.

I'm actually not that worried about the back because a steepness of the US curve would start to reattract foreign capital that is currently looking at the differentials and saying, "Why would I buy US bonds when I can buy Japanese bonds, hedge them back into US dollars?" They do not speculate on the yen. This is actually really critical for people to understand. You're hedging your exposure to the yen in that transaction. And as a result, there is a relative shortage of demand for US bonds relative to what we would expect given the absolute level of interest rates. So this is one of the pieces. So as we talk about the last four pieces that I wrote on my Substack, the piece that I was highlighting made in Japan, which is a pun obviously on cleanup in Japan. Um the emphasis here is that what we really saw was a marginal buyer, the Japanese life insurance company hit a threshold in which they could earn in their home country enough to justify no longer investing and taking any form of risk about hedging in US dollars um which has a recurring financing component to it. They can just bring the money home. And that's what we're actually seeing is they are reversing that process. And again, because they had reverse hedged historically into yen, that means that there is less impact on the currency than you might actually think. And so it, you know, these are transactions that were largely yen hedged that are not changing the character of the currency nearly as much as people think. But with US rates now having hit levels that should be very attractive domestically, part of what I think is actually happening is the US Treasury trying to break some of this momentum and effectively draw people back into the United States by saying, "Hey, this might be a little riskier than you thought it was."

I mean most currency most transactions that happen coming out of developed markets are always going to be currency hedged, right? Your obligations, your expenses are in your local currency. It's very unusual that you'll see a sizable institutional player transacting in a manner in which they are speculating on the currency alongside speculation on the asset. Where you do see that play through are when components are coming from the rest of the world. Emerging markets, for example, rarely will hedge their exposures back into their home currency. Part of what they're ultimately playing for is a depreciation component in their own currency that is driving them to take capital and put it offshore effectively. Um because the rest of the world, the emerging market world has actually not had that much investable assets and the war in the Middle East has meaningfully decreased the quantity of cash flow that is currently going through the Saudis and Bahrain etc. You're creating conditions under which it's hard to see a scenario where there's a ton of capital that wants to invest on an unhedged basis around the globe. At least that's my interpretation of where we sit. The more important point that I would make is that we build all sorts of narratives about bond vigilantes and all sorts of nonsense. Right? The simple reality is that there is no bond vigilante that's putting on, you know, saddling up on their horse and strapping on their two six guns and saying, "Gosh, you know, because the Fed is failing to address, you know, inflation that has rebounded on the back of a war in the Middle East. I'm going to refuse to buy long-dated treasuries in the United States until they get their house in order." It just doesn't work that way. And that really is the key point of the past couple of pieces that I've put out to say much of what we're seeing is actually just a mechanical byproduct of investment mandates or fiduciary obligations that are created under contractual products like levered ETFs. And that really is the work that sits at the core of the launch of Tier One Alpha is our ability to track those flows on an individual security basis has exploded in the last 9 to 10 months. That is facilitating us pursuing these types of strategies where the primary objective is not what Mike Green thinks but simply what the flows are mechanically doing.

Right.

I think that's right. I also think though that there's a really interesting component to this. One of the papers I think I shared with you was a paper in around 2022 that evaluates the issuance of super high-quality US technology debt as a quasi sovereign risk-free asset. So basically you had a choice. Would you buy the US dollar or I'm sorry the US bond or would you buy the Apple bond, right? And in many ways we saw entities like Apple or Google on occasion trading inside the United States because there's actually a legitimate question. Would the United States under leadership like Donald Trump choose to do the unthinkable as Russia did with Boris Yeltsin in 1998 and default on an obligation in their own currency? Now, I personally think that's absurd, but it is plausible. Um, it is much less likely that on under anything other than extraordinary exigent circumstances that Apple would do so. And so, in many ways, that capital coming into those bonds was actually seeking in some ways diversification risk away from the political concerns in the United States by pushing it into a quasi sovereign private entity that had effectively no risk of default. As Ben is pointing out, companies like Google have seen their CDS and their credit spreads roughly double over the last 15 months. That's calling into question their ability to opportunistically issue as they historically did into markets that are experiencing stress and taking advantage of the low interest rate that is offered during those periods. So this is there are very fundamental changes that are playing out and candidly I think part of what is actually going on is the equivalent of a game of musical chairs. The analogy that I used in made in Japan was you know the Chuck Prince component of the music's playing you got to get up and dance. That is obviously true for a party but if you're playing a game of musical chairs you're actually not you're doing something very different. Musical chairs by definition is a contrived game. How many players do I allow to play? How many seats are being played? How, you know, rapid is the music? If you're playing it to Boach or you're playing it to Nirvana, the character of rotation around the chairs is going to be very, very different. Um, and this nonsense that you hear from market fundamentalists like Kevin Warsh is, you know, well, if we simply stop planning things and stop communicating things, then the market will be free to operate as it wants. But the reality is it is a game of musical chairs. Every once in a while, policy makers are forced to press the button with long and variable lags of transmission to shutting off the music or turning on the music. And when they're doing that, combined with the organization, how many chairs are there? how many players are there, who was put on the invite list, what was the music choice, etc. Those are all things that ultimately mean you can never escape to the idea that a market is anything other than contrived by the regulatory framework around it, which is exactly the point that I keep emphasizing is why I joined Simplify on a regulatory change in ETFs that facilitated the inclusion of derivative strategies. Now that that has increasingly matured and I've seen increasingly bad behavior coming through the ETF space on a variety of fronts and I think there are unique opportunities for a new firm to launch into that combined with the intellectual property that we put together. You find yourself saying it's always about regulations, right? It is always about how we allow the players to play the game. And to consider ourselves exempt from that under some false label of market fundamentalism, it's just absurd.

So there are two things that happen right one is that I personally am guilty of the gambler's curse. So I figured out in 2016 2017 that the growing role of systematic strategies was creating conditions under which very predictable behaviors that seemed unimaginable under a fundamental framework could occur very quickly under systematic frameworks where there are things like systematic rebalancing of positions which the XIV ETF had to do in order to maintain a consistent exposure to the VX futures contracts that underpinned it. The gambler's curse was created because I stepped up to the lottery, you know, to the slot machine and I won on the very first turn and I won pretty big. And as a result, there is an element of saying, "Okay, I got this figured out, right? This is the lucky machine. This is how you play it, etc." And it blinded me honestly for almost nine years to the reality of what had allowed that trade to work. And so, you know, anyone out there who's sitting there saying, you know, hey, Mike Green's a pretty smart guy, understand I spent nine years hunting in the wilderness to figure out the second trade, because what I didn't understand was what was unique about the XIV and the inverse VIX complex was that it had an underlier that was effectively a single security. And so the index and the underlying behaved in exactly the same manner. The right way to think about ETFs or index funds is instead of basically like fire hoses, they are directing liquidity at a series of underlying securities. Imagine crowd control at Kent State, for example. Um, a fire hose turns on, blows at the crowd. Everybody is hit by the fire hose, but some are affected more by it than others. And that's really the breakthrough in our research that happened about nine months ago where we started to really dig in and say, "Wait a second, what would happen if instead of thinking about it as an ETF or an index, we started thinking about it as 500 individual securities or a thousand individual securities that are receiving fire hose flows from some very large fire hoses and some minor fire hoses." And that actually perversely requires you to build the capability to track roughly 3500 ETFs as well as the underlying securities. Identify what flows are coming into each security and then identify effectively a decay pattern associated with those flows so that you can identify who is off-balance from that last fire hose shot. Right? Again, imagine the crowd control scene. If somebody gets hit by the blast of the fire hose and they're off balance and then they get hit again, they're going to have a much more dramatic reaction than if you know Frank the tank is sitting there and he's fully planted and absolutely nothing is going to move him from his position. And so that really was the work that we've done uh to give you some idea of the progress that we've made on the technical stack in terms of bringing this in. So again, it requires us ultimately to have about 3,500 individual stocks. We will expand this to the total market index. We've started that process already. We have about 3,500 ETFs of size that are providing liquidity inputs to that. We also track mutual funds and 401k contributions under the same framework. We've built models that allow us to model effectively replicator strategies that allow us to model the behavior of CTAs, vol control strategies, risk par to determine where those flows would be coming into futures and effectively build a signal for each individual stock that says on an individual stock basis, how sensitive is this to the next dollar that comes in? And if you then look at the predictable components of flow, things that are tied to things like 401ks etc. or the models of CTAs or vol control strategies, you can actually get a very strong sense for what security is going to be or which securities are going to be most affected by that next influx of capital. Some of those techniques are what you saw us break out in the piece that I wrote around semiconductors is we tried to understand how much of the move in semiconductors was fundamental and how much of it was a function of vehicles that had been created like levered ETFs on single stocks or levered ETFs on the industry structure and how those had influenced the components. Our net conclusion in the case of semiconductors is about 40% of the price move and about 60% of the volatility change was simply tied to the mechanical behaviors associated with the single stock leverage ETFs, leverage sector ETFs, the introduction of the DRAM ETF, etc. And that's a pretty remarkable finding when you think about the magnitude of the move that occurred to say that you can isolate almost half of it off of just very predictable components.