Michael Green’s Thesis On The Risks To The Market From Passive Investing

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During his recent interview with Tobias, Michael Green, Partner and Chief Strategist at logicafunds discussed his thesis on the risk to the market from passive investing. Here’s an excerpt from the interview:

Michael Green:
Yeah, I mean, I think the core of the observation with passive, what we absolutely know about passive is that it doesn’t meet its own definition, right? If you go back and you read Bill Sharpe’s, the Arithmetic of Active Management, which of course passive managers will trot out in a very enthusiastic fashion to say, “See, it’s self-evident why passive outperforms. It’s all a function of the fees.”

Michael Green:
The definition of passive investing is that you hold securities, you hold all the securities. If you transact and this is explicitly stated, if you transact in any way, then you are no longer a passive player, right? You have to, by definition, influence the market if you transact.

Michael Green:
The idea that passive players are passive players is just completely absurd. What they are is active players that have super, super simple rules and a massive regulatory advantage. You have to start with that recognition and the minute you do that, then you recognize that you should be looking for why you aren’t seeing the influence of this as compared to searching for the influence of it.

Tobias Carlisle:
Just to be clear, you’re not saying that passive… The S&P 500 is famously constructed by a committee. It’s not just buying the largest float-adjusted companies. That’s not your argument but you’re saying it’s not passive because they have to trade?

Michael Green:
Correct.

Tobias Carlisle:
Okay.

Michael Green:
I mean, the theory behind passive has its own challenges, which is the idea that the market has to be complete, right? The markets are clearly not complete. As you point out, the construction of the S&P 500 itself is not actually an observation of all of the available securities and all of the available potential investments that are available to the private sector, which is what would be required in terms of the construction of a truly passive index is presumed that it is a subset and that it becomes somewhat self-limiting.

Michael Green:
That has its own problems, which is what most people tend to focus on. I’m actually saying something very different, which is that the actual participants themselves are what’s driving the phenomenon that we’re seeing. They’re just another form of quantitative investor that operates under a tremendous regulatory advantage.

Tobias Carlisle:
What’s the regulatory advantage that they have?

Michael Green:
Well, the simplest one is with the introduction of what are called qualified default investment alternatives in 401(k)’s and to a lesser extent IRA plans and the focus in the DOL fiduciary rule in the United States on the need to provide for companies that are offering 401(k) plans to provide low cost passive index choices. This was accomplished because of lobbying by Vanguard and others.

Michael Green:
With that type of framework, there’s no alternative for many to invest in terms of their biweekly paychecks. The money goes into the market and then automatically is defaulting into these vehicles. That’s just a massive regulatory advantage and it’s driven a phenomenon that is much more demographic in nature than people really understand. Passive penetration in aggregate is closing in on about 40% of the total market cap.

Michael Green:
Of managed assets, it’s now greater than 50% and I just distinguished between those two to be clear that some of the phenomenon, it matters more what assets are traded than the assets that are actually invested in terms of total market gap. That split though, is not uniform across demographics. Millennials are almost 95% passive.

Tobias Carlisle:
Really?

Michael Green:
I mean, it’s just like it’s absolutely insane and boomers are only about 20% passive and that brings, what?

Tobias Carlisle:
Is that because of the markets that they’ve seen? For the last decade, it’s been the best performing asset in the world is probably the S&P 500.

Michael Green:
On a risk-adjusted basis, it’s probably the NASDAQ, but yeah, overall, I would say yes, it’s something like the S&P 500.

Tobias Carlisle:
Boomers have seen different markets where value has worked.

Michael Green:
I think you’re assigning too much thought to it.

Tobias Carlisle:
Okay.

Michael Green:
I actually think it is literally as simple as the vast majority of the investments that millennials have in markets are a function of the withholding that has done in their 401(k) and the increased prevalence of things like employment matching as we’ve entered in an increasingly tight labor market and benefits begin to be offered both because of a tax dynamic that was introduced. I want to say it was in 2005 and then enhanced with the SECURE Act they passed in December of 2019 that makes it very important and much more advantageous for employers to pay a portion of the savings that go into the 401(k). This is the classic 401(k) match.

Michael Green:
We’ve expanded all of those programs. For the vast majority of millennials, their only exposure to the market… We make a lot of hype about things like Robin Hood and stuff, but the actual assets and those are tiny. The vast majority of the money that they’re getting is actually just going into things like Vanguard target-date funds.

Tobias Carlisle:
Right. Okay. Why is it a problem that the flows seem to go to the largest, most liquid companies? Why does that create an issue?

Michael Green:
Well, the issue that is created is, again, because we presume… We could discard the idea that the markets are efficient allocators of capital. If you’re willing to do that, then it’s “not a problem.” But what we’re actually doing is, is we’re sending all the money to vehicles that allocate the capital on the basis of the current market cap or the current float-adjusted market cap.

Michael Green:
When you do that, one, you’re presuming that the market has actually done the work to say that that current level of price is the right price. The second is, is that you’re actually concluding that the price that it transacts at next is the price that it would have transacted at next had you not been involved. That’s kind of one of these weird things. Prices are a little bit like Schrodinger’s cat, they tell you where something was on the last transaction, but they don’t actually tell you what the price is, right? The price could be up, it could be down. We don’t know that until the next transaction occurs. Passive is assuming that they’re not having any influence on that next price but they have to be because they are transacting.

Tobias Carlisle:
But aren’t these companies the ones that are most… By virtue of the fact that they are the largest float-adjusted, the largest float-adjusted companies receive more than their fair share of the flows. Even just putting aside the question of valuation at the moment, because any other measure that we could look at if we looked at equal weight, that’s sort of a proxy for value in the sense that just getting away from market capitalization weighting means that you are getting closer to value or you could look at some sort of price ratio as a question of value. Just putting aside value, the price relative to the fundamentals completely, just in terms of which companies are able to absorb the most amounts of capital, wouldn’t you expect it to be those that have the largest float-adjusted market capitalization?

Michael Green:
Well, that’s part of the challenge, is when you… First of all, you made a couple of assumptions there, right? Equal weight does not actually have to be equated to value. You could have a scenario in which you have [crosstalk 00:22:43].

Tobias Carlisle:
Relative to market cap is all I’m saying. It’s just-

Michael Green:
Yeah, that’s not actually true though, right? Because you could actually have… A good example of this was in China in June of 2015 where you had a couple of large SOEs that traded at low P/Es and many, many companies in the Chinese stock market that traded at very high P/Es but represented very low market cap. The actual equal weighted was far more growth or momentum-oriented than the market cap was, right? That idea equal weight versus market cap weight tends to behave in that fashion, but there’s actually no requirement that it behaves in the fashion that you’re describing.

Michael Green:
The second dynamic that you mentioned is this idea of absorbing capital, right? The only way that the capital gets absorbed is through a transaction in which somebody is willing to sell their shares in exchange for cash. If I want to buy shares, I have to deploy my cash and find somebody who’s willing to sell to me.

Michael Green:
One of the challenges that it gets created as passive becomes a larger and larger share is because there is no discretion. There is no consideration of should the incremental dollar go in in the exact same fashion, right? That passive player has no instruction to sell. You exhibit increased inelasticity in terms of each incremental dollar that goes in.

Michael Green:
Imagine a scenario in which 100% of the owners of a company were passive and you tried to buy a share. There is no price at which they would be willing to sell to you unless they received an instruction from their end investors saying to sell shares to you. Prices could theoretically become infinite on that type of dynamic. Eventually, you would expect somebody to respond by saying, “All right, I will sell an additional share to you.”

Michael Green:
Traditionally, that’s been accomplished by price sensitive or return sensitive discretionary managers who say, “Okay, this price is unwarranted by the fundamentals. Therefore, I’m willing to sell some of these shares to this person who’s expressing, in my view, an irrational demand for these shares.” If that demand is so strong and it gets absolutely extreme, people can synthetically create shares by shorting but that is incredibly dangerous to do, an environment in which stocks are exhibiting this reduced elasticity. They have the potential, as we just saw with Tesla to explode to the top side, turning those who have synthetically manufactured shares, which is what a short seller is. Turning them into forced buyers and increasing the demand for the shares at exactly the wrong time.

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