Episode 322 - Prof. Marco Sammon: How are Passive Investors Affecting the Stock Market?

22:43And so what Robin and I find is that over time, we've had more and more migration. So in the modern era, when a stock gets added to the 500, a lot of times now it comes from the 400. And importantly, the$400 has been tracking dollars has also been increasing over time. So the way index funds work, and this is something that I think is kind of interesting, in a weird way, indexing is kind of a fixed point problem. The weights are determined ex post, right? We take the total float adjusted cap, we take the AUM of your fund, and you buy a constant percentage of the float adjusted cap of every constituent.

23:15So if 400 funds own about 7 % of every constituent's float adjusted cap, and 500 funds, which use the same float adjustment, own about 7%, when you move from the 400 to the 500, those two demand shocks offset and the net demand shock is zero. And if the net demand shock is zero, why would prices move? And finally, you can imagine that over the last 30 years, if you look at some of the data from the 80s, just even simple stuff like vidass spreads, or you look at how much prices move five minutes after an order, markets were much less illiquid. I mean, we had pieces of eight based on the pirate code.

23:46We didn't have decimalization until I think around 2002 is when we fully had decimalization. Markets have just become a lot more liquid and people understand these huge events are coming. Russell, I think, has a huge party every year. I've talked to people who work there who celebrate this like it's a holiday. These things have become focal and markets have likely adapted to how focal these huge index events are. That's so crazy. The migration thing is super interesting. It's like more assets being in index funds reduces price effects because stuff's just migrating from one index fund to the other.

24:16Exactly. You move from one to the other. It's literally the demand shops could perfectly offset. And actually, we've seen sell side reports, like many investment banks for their clients will publish lists of like possible ads to the 500s, like a merger happens, a slot opens up, and then they're like, oh, these are the most likely ads. They also have a notional expected demand shock in these reports. And if you look at these reports, you'll see that like the notional demand shock for the migrations is tiny. So like market participants, going back to the Grossman Stiglitz kind of rational expectations equilibrium, everyone knows what the migrations are.

24:46Everyone knows, if you go back to our other thing, they're both going to submit market on close, market on close, market on close buy, market on close sell, those things are going to offset and have very little effect on prices. That's crazy. What would you say the implications are of the findings in this paper for market efficiency? Now, let me ask you a question. What is market efficiency? It's a great question. I don't have the answer. Cameron, you want to take a try at it? I will let you take it, professor. Well, I think, and maybe we can talk about this more because I've worked on this before.

25:15I actually think measuring price efficiency, whatever that means, is really hard. And one of the reasons it's really hard is that it kind of assumes that you have some way to know what a stock is worth at any given point in time. And there's, I guess, two things I'd say kind of on this front. So one is, suppose I tell you, you go around, you figure out, you drive, you know how many RVs they sold. If they sold 10 more RVs than you thought, what does that translate into the value of the company? Is that a persistent shock to RV sales? Is it a temporary shock to RV sales. I think even people whose job it is to predict how much stocks are worth, that's a really hard job.

25:51And it's really hard over the long run. And the second thing is the horizon. So suppose you believed even back in the 80s that when a stock gets added to an index, prices go up and then they go back down. Like, okay, so for two weeks, prices were high. And then two weeks later, prices went back down. Okay, maybe it was inefficient or prices moved away from fundamentals for two weeks. But is the company now suddenly not functioning? Are they not investing? Is it having real implications because prices were temporarily distorted? Is it any different than if, I don't know, Elon Musk needs to sell 100 million shares of Tesla and that pushes the price down a little bit while that demand gets absorbed?

26:24This is a really tricky area, I guess. That's like the joint hypothesis problem, right? Any test of market efficiency, the test of your model and the test of market efficiency? Right. That's a really, really good way of putting it. And I don't want to call people out, but I'll just give a really great example of this. There are two really famous papers. They're both publish very well. I don't want to get too much information. One of them measures efficiency by regressing future fundamentals on current prices, essentially. And what that's saying is, well, if prices are a better predictor of future fundamentals, that suggests that the market is more efficient.

26:57That's kind of intuitive, right? Another paper by two people I know, which has a different model of the data generating process of the world, flips the right-hand side and left-hand side and says, okay, do fundamentals predict prices? And they're saying, well, the logic is that, well, if fundamentals are the key driver or should be the key driver of prices, we want to figure out how much of the variation in prices determined by fundamentals and not vice versa. So we've now taken the same variables and swapped the right-hand and left-hand side. This is kind of like trying to measure supply and demand by regressing prices on quantities and then quantities on prices.

27:30In some model, it makes sense to do one. In some model, it makes sense to do the other. It can't make sense to do both, especially if you believe that you need shifts to the supply curve to estimate the demand curve. When you shift the domain curve, you have to make the supply curve. It's actually a much bigger problem even. But yes, you put it very well with the joint hypothesis problem. How has index fund ownership affected price informativeness? So index fund ownership, I think is good. Let's be precise. I have a paper on this, but I'm looking narrowly at things that are defined as index funds.

27:59And we have to also be really careful about what I mean by price informativeness. And so in that paper, I am zooming in on the incorporation of earnings information ahead of earnings announcements. So just to be clear, I'm defining the rules of the game over a very narrow time window before a very clear release of information. Now, before we get into the answer, I think it's important to highlight some of the trade-offs, like the economic mechanisms that actually might be in play. So I think people think, look, well, if we think back to our Grossman-Stiglitz-style framework, and we have a bunch of people who are essentially saying, I'm going to index my money.

28:31I'm going to put it in Vingart. They're not driving the car around Massachusetts. And so as fewer and fewer people drive the car around Massachusetts, maybe ahead of earnings announcements, less and less of that information gets incorporated ahead of time, right? And therefore, about that earnings information, prices maybe are a little bit less informative. That's one part of the story. But there's other parts of the story. So for example, suppose you're an active manager, suppose you want to take a bet on Facebook. Now you have ETFs that make it easier to hedge, right? So you can go long Facebook, short some tech sector ETF, rather than having to go out and short a bunch of individual stocks, it might help you isolate that bet.

29:07Or a lot of passive funds lend out their shares, they're allowed to lend out a certain fraction. And so suppose some bad news is coming, well, if we've increased the lendable supply of shares, or we've decreased the relative cost of shorting, maybe now bad news can get into prices more efficiently, because we can short easier ahead of bad news. And so if we just think the growth is in stigma, it's like really simple, but I want to highlight that like, there's a lot of different forces. One other thing to think about is that there's different types of information. There's systematic information and there's idiosyncratic information.

29:34And so if you think about the RV dealership, maybe we have some information about that one RV company, but it also could be if consumer sentiment is low and people aren't buying RVs, that's systematic information. And maybe having an RV ETF lets you bet on the systematic information in the easier way. And so we have to be really, really precise that I'm talking about firm-specific information, ahead of earnings announcements. And I find that it does decrease the earnings information and prices ahead of time. But again, there's work that has shown everything else, increasing systematic information, increasing long run information.

30:05So I'm really making a narrow claim about less earnings information being incorporated into prices ahead of time. When earnings are released, prices contained less information about those earnings at that time. Yeah. Okay. That's the very narrow point that I have zoomed in on in that paper. I remember we talked to Ralph Coyne a while ago on this podcast, and he talked about findings in one of his papers suggesting that the shift to passive has not affected price informant. Do you know why your findings are different? Well, I think it goes back to the point you raised before is that. So first of all, I guess the thing that I like about looking at earnings announcements, and I'm working on a new project on this.

30:40And so hopefully, you'll have me back or we'll talk about it another time. Suppose you have a one cent earnings beat versus a two cents earning beat. We don't know maybe how much more prices should move for the two cent earning beat than one cent earning beat, but we know that that's good news. Similarly, if you don't beat earnings, we know that it's bad news. And so we could think about a response function to earning surprises. That's pretty clear what we should do with good news buy, bad news sell. And so I actually don't even have a theoretical model in the paper. I'm really just looking at this idea of like, well, if the news was going to be good, prices should have went up ahead of time.

31:14My thing is very simple going back to the 60s, like ball and brown, like classic finance stuff. They have a model and they're also using one of these measures where they're regressing long run future earnings on prices today. And we've said before that even really smart people can disagree what the right-hand side and left-hand side of that regression should be. And so when you're measuring, also you're measuring it over a much longer horizon than I have. That original paper looked up to five years afterward. I'm looking at a span of 22 days. And so it could go back to what we said before. It could be that passive has a short effect.

31:47And it could be once that news comes out, because it's easier to short stocks, because it's easier to incorporate systematic information. For all the other reasons, once the news comes out, people could trade it into prices faster. And so the effect is really not a long run effect, but a short run effect. Man, I want to move on to a paper that I enjoyed reading all your papers, but this one, man, is so cool. To start off with that one, can you talk about how does the index funds demand for securities differ from that of other investors? Right. So index funds are really special in the sense that if you give a dollar to SPY, they don't get to go like, hmm, Apple looks cheap, but Facebook looks expensive.

32:25Let me buy a little bit of one and less of other. They have to allocate it based on a mechanical rule. Now, of course, your decision to allocate to SPY could be because you think the securities in the 500 are undervalued or whatever, but conditional on you giving a dollar, and this is going to be important because our whole thing in this paper about flows, conditional on giving a dollar, they have to allocate it in a mechanical way. And going back to Ralph and Javier Gbe's work and Moto Yogo's work, they have this whole big thing about the inelastic markets hypothesis. And if you want to think about passive, they are completely inelastic.

32:56That market on close order that's completely insensitive to prices, that is completely inelastic demand. And that's one way that it's this rule-based inelastic demand is really special in response to flows, especially. Can you explain the concept of market clearing? So this is actually something funny. So I have another project looking at newspaper articles going back to 1900 and trying to understand what caused large moves in the stock market going all the way back. And if you read an article from like 1925 or 1929, even is a great one. Like when the stock market's going down, the Wall Street Journal journalists, and this is, you know, remember like 100 years ago.

33:30So we're not like ragging on them. This is 100 years ago. They might say something like, well, the market went up because there were more buyers than sellers. It makes sense, right? People are buying. Prices go up. But like, well, it may make sense. Like it can't be, right? For every share that someone bought, someone had to sell them that share. And so the idea of market clearing is going to be for every person who bought a share, someone had to sell it to them. For every someone who sold a share, someone had to buy it from them. That's kind of like the fundamental premise of the exercise we do in this paper.

34:00Oh, yeah, and it's so interesting. So who's clearing the market when there's a demand shock from index investors? Okay, so we have to answer this. Again, maybe I'm being a little bit pedantic, but we have to be really careful about answering this because there's two different ways to think about clearing the market. One is going to be a level effect, like on average, who's clearing the market? And one's going to be a slope effect, which is like when passive investors demand a little bit more, who's clearing the demand for the marginal share? We find on an equal weighted average basis, on average, it's firms.

34:32And so what do we mean by that? How does the firm clear the market, our estimates, especially when index funds are net buyers, suggest that when index funds buy 1 % of a firm's shares outstanding, firms issue roughly 98 basis points of shares outstanding. So firms, when index funds are net buyers, firms are issuing almost one for one on an equal weighted average basis. Now, I know you're thinking, Marco, wait, like something's wrong here. The market has to add up. We know over the last 10, 20 years, buybacks in dollar terms have been really big. We know over the last 10 to 20 years that index funds have been buying stocks.

35:05And so it literally can't be that on a evaluated average basis that index funds were net buyers and firms were net buyers. And that's true. However, there's two nuances there. One is we find that on a evaluated average basis, at the margin, our estimates are pretty similar. Meaning when index funds demand more than average, firms initially buy back less and then eventually supply shares. But for the level effect, it's different for evaluated, right? There's been outflows out of active mutual funds. There's been outflows out of certain things like hedge funds and those things. On an average basis, yes, that's where they came from.

35:41But on the margin, we find that firms, even on a evaluated average basis, firms are still the most responsive group. So that means when index funds have a little bit more demand, firms are issuing shares and index funds are buying them. Firms like that's like Apple's issuing stock and the index fund is buying So we have to be a little careful. I guess I'm being a bit imprecise here. So let's be a little more precise. That is a measure of net issuance. That includes all types of issuance, including employee compensation, the exercise of warrants, the exercise of convertible debt, SEOs, changes in buybacks.

36:13And so I think that we call all that firms. But to be more precise, some of that stuff is decisions firms made in the way past that can be happening now. So I have a friend who works at Google, right? She gets some stock options. She was granted those on a four-year basis. And so if index fund buying comes, index fund buying pushes the prices. She goes, oh, wow, this is amazing. I'm going to exercise my options. I'm going to have some Google shares now. Then Google doesn't get a choice like, oh, well, we don't give you the shares. They promised in the past that they were going to give the shares and she gets the shares.

36:48See what I mean? So it's not necessarily that they're saying, oh, my God, we're printing these shares so that index funds can buy them, it might be, and actually when John and I do decomposition into these different channels, we find that this employee compensation part is the largest part. And that, again, it may not necessarily be that the firm at that point is making an active decision. Other stakeholders in the firm, actually, to give you a little more of, you said, professor, that I can explain, I teach this corporate finance class. And we have this idea of the market value balance sheet.

37:17Rather than an accounting balance sheet, it's like the market value of the assets, the market value of the claims. You can imagine that employees who have stock options or stock grants or PSUs, RSUs, MSUs, they're actually all on the right-hand side of a market value balance sheet in the sense that they do have a claim on the cash flows of the firm. However, that claim only materializes when stock prices are high, when their options are in the money, when they get granted the stock. And so they go from being on the market value balance sheet to the accounting balance sheet. And that also, if you look at that kind of figure two in our paper, we have this really cool kind of, and I wish I could pull up a graphic right now, this really cool kinked shape where we show that basically when index funds are net buyers, firms respond a lot.

37:59When index funds are sellers, they don't. And if you think about, again, our mechanism of employee compensation, if index funds buy a lot and push up prices, employees can exercise their right to get shares. If index funds sell a lot and prices go down, employees can't force their employer to buy back shares, right? They have a one-sided compensation contract. And that may explain that super option-like feature we observe in figure two of the paper. So interesting. So on causality though, how do we know the direction? So like in your example with your friend, she exercises stock options, index funds need to increase their holdings in response to issuance, right?

38:34Just to explain a little bit more. So there's two things here, or at least two things here. One is a reverse causality story, which I think is what you're getting at, right? So the idea is if a firm does say an SEO, a seasoned equity offering, and they sell 20 % of shares outstanding, I'm picking a big number, but let's pick a big number to make it easy. Now, suppose previously index funds held 10 % of that firm's shares outstanding. Let's suppose also there's no float adjustments to make it easy. They're going to have to buy 10 % of that issuance to maintain their 10 % ownership of the float adjusted cap of the firm.

39:08So you're saying, well, Marco, what you're actually getting is a firm issues a lot of shares, index funds need to, in response to issuance, buy shares. And so you're going to get a reverse causality where it's actually the issuance that causes the buying, not the other way around. That's one problem for us identification-wise. Second problem for us identification-wise is going to be an omitted variable story. So the idea is, suppose that there's some new technology shock. Suppose that now generative AI is getting commercialized. Everyone loves generative AI. Well, all the firms that are exposed to generative AI that can leverage that are going to say, issue equity to buy GPUs.

39:43They're going to pay equity to their employees to get new people to work there. And at the same time, people like you and me who want to be in on it might buy ETFs that are exposed to it and say, and then we'll have at the same time, the firm will be issuing ETFs or buying, but it's really because of a common omitted variable. And so we're going to try to attack the reverse causality and the omitted variable problem at the same time with an instrumental variable strategy. So what are we going to do? The first thing is we're going to focus on flows, like I highlighted before. Why flows? Because the flows part is not necessarily going to be subject to this specific reverse causality you talked about.

40:19And the second piece is we need to identify shocks to passive demand that come from flows that are not related to fundamentals. And so this AI revolution is like a fundamental shock. It's about how you were doing as a firm or how you're expected to do as a firm. And so I don't know how much detail I should go into, but I'm going to try to distill down the ideas, the intuition of this instrument we have, which is going to be basically, we're going to try to predict changes in passive demand that are uncorrelated to your own fundamentals and that come from flows. And so the way we do that is we actually leverage something interesting that we noticed, which is that there's a strong flow performance relationship in passive funds.

40:55First of all, at some level, this is weird, right? Like when you think about, oh, this active manager is doing really well. I'm going to give them money because I think they're skilled. Like when the Russell 1000 does well relative to the 2000, it's not because IWB was better at stock picking. It was because those stocks happened to do better. It's not like you're giving them money, you're getting access to their skill. But that's true in the data. And it's actually, there's a lot of heterogeneity across funds. That's true in the data. And then what we exploit is look like, well, maybe my company is in the cows 100.

41:22Your company is in the cows 100. The cows 100 actually is pretty sensitive flow performance. And you and I are unrelated. So we are going to look at basically the co-holdings that are not in the same industry, not in the same momentum, value, size, kind of like factor exposure buckets. And all these unrelated stocks do well. This leads to flows into your fund, which leads them to buy you passively. And we're going to do an instrumentals variable. We're going to instrument or observe passive demand with this exogenous part of passive demand. And we're actually going to find almost identical results.

41:56So we're going to find that even in this IV setting where we've really narrowed the scope of the flows we're looking at, our point estimates are nearly the same. Wow. How important has firm issuance been to the growth of assets managed by index funds? So again, we need to be a bit careful about equal weighted versus value weighted. So something interesting we found out, net issuance, meaning just change in shared outstanding. On an equal weighted basis, 80 % of firms in a given year over the past 20, 30 years have done net issuance. Equal weighted average basis. On a dollar weighted average basis, it's net buybacks.

42:28And so we could say that, look, John and I's estimates suggest that overall for every one percentage point of a firm bought by passive index funds and ETFs, firms on the, this is marginal, firms issue say 65 basis points. And that comes down to about 35 basis points from employee comp, warrants, like 25 basis points from SEOs. But that's kind of misleading because those are really lumpy. the average SEO is like 10, 15 % of shares outstanding. And then the rest is coming from adjustments and buybacks. So we have to be careful about that. The second thing we have to be careful about is that even though about 20 % of firms have buyback programs, if we narrow in on those firms, those firms buyback programs are much more responsive to passive demand than firms that did not say in the past year or two years have a buyback program at all.

43:14And so to say how much actually came from issuance, it's really tough to exactly nail it down. And also, there's a counterfactual like, well, if firms weren't issuing and passive demand was coming in, prices might have adjusted up a lot more, which would have changed the incentives. And so I don't think that John and I really have the exact counterfactual for all those reasons to answer that question, but those are at least the factors you might need to think about if you were trying to answer that question. You threw out a bunch of numbers just now. Can you say where are the shares provided by firms to meet passive demand actually coming from?

43:49So we do this decomposition exercise, and I'll just kind of break it down a little bit slower. So like that main figure one and figure two in the paper, we're looking at an overall measure of issuance that includes all changes in shares outstanding. Now, the ways that a lot of people think about it just comes from buybacks, where the firm literally is going out buying shares, adjusting the supply. We hand collect data from Bloomberg on seasoned equity offerings. What's actually really interesting if you think about this, Tesla sold shares directly to the market before being added to the 500. That's kind of a very clear example of the firm accommodating passive demand.

44:20Facebook did a traditional SEO, I think just a day before or a few days before being added to the 500. So we're going to hand collect data on all those shares being sold by the firm, the market. That's a second source. Then we have this residual category. Now, it turns out that as far as I understand, you do not have to report to the SEC, at least in the 10Ks, how every possible change in shares came about. Now, some people do. So NVIDIA, if you look at their 10K, they'll have like, okay, we have this many restricted stock units, this many preferred stock units, this many employee options, this many were exercised.

44:52And so John and I are in the process of scraping all that data. And for a subset of firms, we do have the option-based comp, share-based comp, and we can kind of do an even finer decomposition. But for now, let's lump together all of that kind of forms of issuance that come through basically employee comp, PSUs, RSUs, MSUs options, and then warrants and convertible debt. And so, you know, if you think about like, for example, a company like Carnival, Carnival during COVID issued a lot of convertible debt, their stock price recovered after COVID, and they ended up having to issue a significant amount of equity.

45:25However, not everyone does. And so this is another tricky thing that John and I are working on is that you might hedge that. you might have an investment bank on your behalf provide the shares to the people who you promised the shares to with the convertible debt, and then that doesn't lead to issuance. And so you can't just like go in and like use convertible debt right away because that might be hedged. So for now, we have a very simple other group that captures all of these different features. And so among our baseline total effect, a little more than half is gonna come from this employee comp warrants convertible debt.

45:56About a third is gonna come from SEOs. But again, we have to be careful with that because that's very tail heavy. SEOs are kind of rare, but when they happen, they're big. So that's that. And that also might be more subject to the reverse causality, at least if we're running an OLS regression, the reverse causality problem there is probably larger. And then the rest is buybacks. So does this imply the compensation of skilled labor income is tied to index funds buying up shares in companies? Right. So this is a really good question. And I think one, when I first started thinking about this and I've talked about the project.

46:30It's like, oh, if you're a VC investor and you invest in a company, when the company goes public, maybe that's your opportunity to exit. And like, maybe there's this other weird thing going on that like one employee's option to exit is that they effectively, of course, some intermediation has to happen. Like when my friend works at Google, gets her shares, she doesn't like call up Vanguard and go like, okay, guys, here are the shares. Like I'm sending them to you. Like some intermediation might happen there. But you could say that her skilled labor is being bought out by Vanguard or whoever else.

46:59I think that's one thing, but I think that we have to zoom out and think about more broadly, how important is this relative to other factors? So Nvidia is a great example. Nvidia's stock went up a ton. And I heard this story kind of casually that like, so Nvidia, as far as I understand, you can exercise your stock options anytime within two years of them being granted. And so the price went up a ton and a bunch of people who had worked there for a while had these options, they exercise them. And then house prices in San Jose went up a lot because these people who were suddenly much wealthier than they were before were able to afford much nicer houses in San Jose.

47:32And so like when we go to your question of how does this link to the compensation of skilled labor income, like we have to think about how variation in prices is due to like how much of variation in prices and specifically positive or like outperformance is due to index fund buying versus say fundamental outperformance. NVIDIA didn't go up as much as it did because it got bought by index funds, NVIDIA had a product that a lot of people wanted and would be really, really useful. And so while to some degree, yes, maybe index funds might push up prices around a little bit, but I think that at the end of the day, fundamentals are likely much bigger driver of prices than index fund demand, at least casually.

48:09I don't have a quantitative estimate of that, but that's my intuition. Yeah, that's an interesting answer. Can you talk about the conditions that affect the responsiveness of firms in accommodating the passive demand? So like, if we think about the most basic advice you could give my MBA students is like, you want to buy low, you want to sell high. And so you could imagine that firms and like Jeremy Stein had this 1989 paper in the QJE. And it kind of hints at this idea that firms ultimately are the arbitrageurs in their own shares. Who knows better how much a firm is worth than the firm itself.

48:39But firms obviously don't have unlimited flexibility in doing this, right? Like they can't go out and like, you know, just buy whenever they want. They can't, for example, buy a certain part of the day, buybacks can't happen at certain times. There's a lot of rules, but firms could be the ultimate arbitrageurs in their own shares. So John and I say, well, if we think about this simple advice, when would you want to sell shares in the face of passive bond? Well, you would want to sell shares when your shares look relatively expensive. And so in the paper, we look at kind of two very simple measures of expensiveness, excess earnings yield and book to market.

49:09And we find that it looks like firms are much, much more likely to accommodate passive demand when their shares look expensive, when they look like a growthy firm, when their excess earnings yield is low. So who clears the market under conditions when firms are less likely to respond to prices? So this is something I know you guys had Mike Green on the podcast before. And Mike and I actually talked about this. When I was working on this paper, early on in the paper, I sent it to Mike and he noticed right away, I told you we have this kind of hockey stick picture, which said that when index funds are buying, firms are issuing, but when index funds are selling, firms are not buying back.

49:45And so that means that when index funds are selling, someone else has to clear the market. Now we, in our data set, try to do as very careful accounting exercises we can for a bunch of different groups of investors. So we look at active funds, passive funds, foreign funds, pension funds, insurance companies. We have all these different individual investor groups. However, because of market clearing, for every buyer, there has to be a seller. And there are some groups we can't see, like foreign institutional investors, retail investors, institutions smaller than 100 million. And we find that in the case of aggregate index funds selling, it's this other category made up of retail investors, foreign institutions, and small institutions that tends to clear the market.

50:26Now, John and I is thinking about this is that, well, given that on average, index funds have been buying a lot over the past 20, 30 years over our sample, maybe stuff that has really big index funds selling is stuff that's leaving the investable universe, right? For example, like maybe you do a tax inversion and you become a Canadian firm, index funds sell, but then maybe many US institutions have mandates against holding those stocks. We're going to need someone else to clear the market. But when I showed this to Mike, he was like, oh man, like this is kind of scary, right? All the people who you think might be clearing the market when index funds are selling or not, we need this other group.

50:57And that was something that I think is kind of a something in the paper we don't push too hard, but we've been trying to amp up a little more as we need a different group to clear the market when there's big index funds selling. Wait, so do we know who's clearing the market? Do you know what dead reckoning is? No. Dead reckoning, as far as I understand, is a type of navigation system for missiles. There's this joke that a missile knows where it is by knowing where it isn't. And it knows where it isn't by knowing where it is. It's basically like a relative positioning system. We know that we don't have market clearing coming from above the institutional groups and mutual fund groups and insiders and short sellers that John and I can track down.

51:35But it's coming from somewhere. Yeah. And that's why I said, most likely we think it's small institutions, foreign institutions, or retail investors. These are the groups that John and I cannot track. And so mechanically, it has to be among these groups, but we can't say, oh, it's retail. Oh, it's foreign institutions. Because we literally, for many of these groups, cannot track their holdings. Okay. So, I mean, you brought up Mike Green. How do you think the market would respond to significant net selling by index funds? Well, I guess what I would ask Mike is that how is that different than significant net selling by say active funds?

52:09There's this very famous paper in the Journal of Finance 2007 by Koval and Stafford that shows that there was something that happened. It's called fire sales and mutual funds. Basically, because of something that happened, a bunch of active mutual funds had to sell a bunch of shares and prices went down. And so the first thing I would say is, is there something special about index funds selling a lot of stocks versus say, like when CalPERS reduced their allocation to equities from like 60 % to 40%, is there something different than that? I don't know. That's the first thing. And the second thing I'd say is that, yeah, if you take our estimates seriously and you take our paper seriously, it would need to be that other groups step up.

52:43Now, something I didn't highlight is that everything we've been talking about so far is really focused on results due to flows. Now, in 2 % of firm quarters, we have stocks that are out of their drop from indices. So you might, if you're, for example, dropped from the S &P 1500 universe, have massive index fund selling. We find that in these cases, hedge funds and financial institutions actually do step up a lot. Active funds do step up a lot. So then the second question is, okay, suppose you believe passive selling is special, what is the reason for the passive selling? If it's an anticipated passive selling due to indexing, rebalancing, like we've talked about, these salient events that people prepare for for months, then I'm not that worried, right?

53:23We know in the data that these other groups, I guess the thing that I don't quite have that you might imagine might have a relatively larger price impact is if we had a very large flow-driven shock to passive selling, then it might be that that has a significant price impact because a lot of people who tend to trade the same way as passive might also be selling, amplify that demand shock that might have a larger effect on markets. A lot of things would have to happen at the same time. Yeah, it's flow-driven. It's a lot, like it's large. Because also, remember that hockey stick, for small passive selling, we have these really cool bin scatters in the paper in the appendix.

53:58The financial institutions group actually kind of has a little U shape. And for small passive selling, financial institutions, which include hedge funds, do accommodate the market a little bit. But once passive starts selling a lot, they don't necessarily for flow-based passive selling. So again, it would have to be significant flow in the same direction. Financial institutions don't have the capital. It'd have to be like a perfect storm of a lot of stuff. And then maybe that could be not great for security prices. But also, like you said, that's not necessarily unique to index funds, right? Yeah, exactly.

54:26If CalPERS and everyone else decided to reduce their equity allocation by 20%, I think prices would probably go down. How active are index funds in the market for IPOs? Ah, okay. So I have a new paper on this. I'm impressed that we're talking about this. I literally, I think, put this on my website like two weeks ago. And so this is a paper with Chris Murray. Now, Chris Murray is a guy who has worked in the indexing world for many years. So he brings a lot of real world expertise. And it's been awesome working with him on this project. Oh, and I should also highlight, I should say that the last project was with John Shim.

54:56I don't know if I said his name, you know, John and I have had a blast working on that project. So I should really highlight again, John deserves a lot of credit. We worked on that together. I really want to say that. Okay. So Chris and I worked on this project. Chris, because he worked in this industry, he brought up to me something interesting, which is, look, there was this 2017 rule change. So remember, I said in 2014, Vanguard switched to using CRISP indexes. Now, CRISP, starting in 2017, had this new rule where they said, look, any stock above the small cap threshold, we're going to add to the index four days after the IPO and the closing auction.

55:27And now, well, we talked about what do index funds like to do? Index funds like to minimize tracking error. Now, VTI is a very, very, very large fund. Those Vanguard cap-based funds are very large. So if you're above the small cap threshold, you're going to be added to many of these things, the growth and the value. And so we find that for fast tracks, crisp tracking funds are buying around 7 % of the float in those IPOs four days after the IPO. How do firms with fast track index inclusion perform relative to their non-fast track peers? So here we got to be careful because a lot of IPOs are a little underpriced.

56:03There's this well-known IPO pop. And so that number, I think in our sample is around 22%. So that's already like a very large return on one day. We have to be careful. We find that even controlling for that, controlling for the relative strength of the IPO market, controlling for how small caps did and a whole bunch of other factors, we have like a difference in difference inspired design. We find from the IPO itself, like the IPO initial pricing to when the crisp tracking funds buy, they outperform by 15 percentage points, not percent, percentage points. So like if it was a$10 stock, it would go up by another$1.50.

56:38Now, not everyone can access that price. You would have had to have gotten into the IPO to access that 15 percentage points. However, like we talked about, this is all perfectly predictable. Based on T plus zero close, we know what your eligibility is gonna be. From the T plus zero close to the T plus four close, it's five percentage points. So it's still a substantial, even just based on totally public information, outperformance for the fast track stocks. How does it affect the IPO pricing and the capital that gets raised by firms? So if we go back to our grossman stiglets and our rational expectations equilibrium, suppose I'm book building an IPO.

57:14And I think to myself, well, I know that crisp tracking funds are going to buy 7 % of this four days later. And now also suppose I'm an intermediary. I have access to getting to the IPO. I know that I can sell some number of shares in the closing auction on T plus four to these mechanical buyers. Well, then maybe I think, well, I can maybe price the IPO a little bit higher. I can sell a little bit more shares. We actually find, and we think this is kind of a coincidence, and I'm happy to talk about this offline because I was just talking to Chris about this yesterday. Between the pricing higher and upsizing, they raise about 7 % more capital, which is very coincidentally aligned with the 7 % buying.

57:51We think that's kind of a coincidence for a few reasons. I don't want to get into that right now, but basically they can raise like 7 % more capital in the IPO. Wow. How do fast track IPOs perform after index inclusion? So we said there's this big 15 percentage point outperformance of the IPO itself to the T plus four. We actually find that over the long run, their total performance looks similar to the stuff that didn't get fast track. And so one way to think about that is Crisp has some rules for what gets fast-tracked, what gets not, how big it is, what percentage of the shares are floated, what the domicile of the company is, right?

58:27There's a whole bunch of rules. And it suggests that over the first 180 days, overall, the total performance is similar. So it doesn't seem as though the fast-tracks are systematically better than the other ones. It just happens that they get a big demand shock. That creates some temporary price pressure. Now, remember, you IPO'd four days ago. If you try to buy 7 % of any stock, you're going to move the price. If you try to buy 7 % of a stock four days later, even with world-class execution, you're going to move the price. So there's a little price pressure that kind of reverts, but we're not saying it's anyone's fault.

58:57This is like you're following the rule of an index provider and that creates price pressure. So firm IPOs meets the fast track criteria, price gets bid up and then it comes back down. And then in the longer run, there's no effect. It looks similar. It doesn't underperform in the longer run. If anything, it's still slightly higher. You could imagine that once you get added to VTI, unless you delist, BTI is not going to sell you. So maybe there's a little bit, like it's not statistically significant. Maybe you're a little bit better over the long run, but it's like almost no statistically significant difference by say 180 days after.

59:29So prices go up, prices come down, but over the long run, the companies, like if you talk about back my point, market efficiency, any long run measure will suggest that it doesn't look like there's some long run distortion in prices caused by this. Are index funds buying high though in that case? Like how does this end up affecting index fund investors? Right, so there's a few things. One is, suppose they are buying high. Well, if they put it in a market on closed order, they will have no tracking error, right? Because the price that the stock gets added to the index is going to be the price in the closing auction on T plus four.

1:00:03So even if they're buying high, they are doing what they say they are doing, which is minimizing tracking error, right? The second thing about that is that you could argue, I guess, that one alternative would be, say, why don't we just let them add it in the IPO? Well, then you wouldn't be buying high. That's tricky because you can't add a stock that's not at a public price. But then you might say, well, why don't we just buy later and wait, right? If over the 180 days or 60 days, performance looks similar, why don't we wait? And I think here's the trick, and this is something Chris highlighted to me that's actually really important.

1:00:35There's two problems. Problem one is the bubble in the rug problem I call, right? You ever had a rug in your house, you're trying to lay the rug perfectly flat, you have a little air bubble. And when you press on the air bubble in the rug, it just comes up somewhere else, right? And so if they have to buy 7 % of a company 30 days later, that could easily create price impact 30 days later. Or going back to my project with Robin, in anticipation of buying 7 % 30 days later, prices might slowly drift up ahead of time. Now, suppose they somehow, in a stealth way, were able to acquire the shares. Say they actually got into the IPO, but no one knew about it.

1:01:05Now, here's the problem. T plus four gets added to the index. All the intermediaries who thought the crisp trackers were going to buy sell in T plus four close. The crisp trackers are not there because they've already bought their shares. Prices go down. The stock gets added to the index at a low price, right? So you bought at 100. It gets pushed down by the price pressure to 90 bucks. Now you've created tracking error in exactly the wrong way. So first to highlight, even if they're buying high, it may be actually a stable equilibrium in the sense that by trying to deviate from that, you may actually make it worse for yourself by creating tracking error or creating unwanted price impact in one direction.

1:01:44I think another thing, and I don't want to push this too hard, but there's work by Antti Pedagisto on the hidden cost to index funds, investors of index additions and deletions. And so you could imagine that, right, that if you do believe that this is some intermediation cost, right, that you're essentially paying the people who get in the IPO and sell it to you as an index fund investor four days later, 15 percentage points for the right for them to do that intermediation, that accumulates to around four or five billion over our sample. So there may be a hidden cost, but again, like given the equilibrium we're in, I think it's actually tricky to think about a way to avoid that.

1:02:17I haven't totally figured it out yet. Yeah. Interesting. It could just be one of the costs of being an index investor. Yes. You're a price taker. You're submitting market on close orders. Exactly. It's just part of the rules. Okay. So based on your research on index funds, do you think index funds have had a net positive or negative impact on, I guess, two things, financial markets and people investing in index funds? Okay, this is a great question. So I think at some intuitive level, some of the very big benefits of index funds for people like me and you is that I get access to low cost diversification.

1:02:51We teach there's no free lunch. There is a free lunch. Diversification is like a free lunch. That's amazing. And getting access to low cost diversification across stocks, asset classes, that's amazing. And also, I actually think there's an old literature showing that people, retail investors used to make a lot of mistakes. They would trade too much. they trade within the day. Now, if you buy VTI and hold it in your portfolio for a long time, I believe that you'll probably be better off than if you were buying and selling the penny stocks that you were trading before. So there's obviously a lot of positives.

1:03:20And then you can say, well, Marco, your research shows that index effects push around prices, but maybe those effects aren't super persistent. Index funds create reduced price informativeness, but only for a certain amount of time. And so I don't want to say that the passive investing has no effect on markets, But I think that we don't necessarily have yet enough evidence about the real effects. I want to really understand how does this affect firms' investment decisions, right? John and I say firms clear the market for passive demand. For every dollar less that they have to pay their employees because they use stock options, like what do they do with that dollar?

1:03:52Do they invest it in NPV positive projects? Here's a scenario. Suppose you're a firm that has a really, really, really good project. You have no way to raise financing through traditional channels. You can't do an SEO. You can't raise debt. And then all of a sudden, the fact that you have these mechanical buyers buying your shares allows you to relax your financing constraints and invest in NPP-positive projects. That would be great. That would be growing the economy. We're growing the pie. Like everyone's happy. On the other hand, if they have no NPP-positive projects and they don't want the cash just sitting there, the example is like back in the 80s when oil prices were high and the oil companies were buying private jets and art collections and like the bathrooms in the executive offices were outfitted with literal gold.

1:04:30that would be a bad use of the fundraising from, well, I don't know, bad. I think that would be an end to be destroying for everyone except the executive's decision there. So like, that's like the super promising next step that I would love to answer and would love to see more evidence on would be what are the real effects of this? Like, I think prices being a little bit less informative ahead of earnings announcements. For people trading, like that's a huge deal. But for firms raising capital and making investment decisions, that's not super obvious. But like, I think this new thing with John and with Chris, If you're raising more capital in your IPO, that's amazing.

1:05:02But if these are all secondary shares that are going to early VC investors, that's very different than if it's like the firm isn't raising more money to invest in projects. This is the next thing that I'm really excited about. I haven't answered it yet, but I would love to work on this. You certainly do seem to be excited about this, Mark. And we have one final question to cap this amazing conversation. How do you define success in your life? So I'm going to give a bit of a long answer. And this is something that it's going to sound like a joke, but it's actually not. Is that OK? Fire away. Go for it.

1:05:31So there's this like old psychology theory called the Kluge-Ross model of grief, that like the five stages of grief that has been doubted, disproven, whatever. But I actually think that this is a very good summary of how academia works. So remember, there's five stages. There's denial, anger, bargaining, depression, and acceptance. And I actually think this mirrors exactly the journey of any academic paper. And because this is the journey, you have to actually just be okay with going on this journey, as opposed to defining success as the last step, which is going to be acceptance. So let me walk you through.

1:06:06This is just my own thinking. Like this is totally Marco opinion. So when you first start working on a project, people will say something to you like, you shouldn't write this. You have some new idea. It's crazy. I'm telling you, firms clear the markup or pass the demand. People are like, oh, no, no, no, you shouldn't write this. This is super speculative. This is never going to work out. And this is akin to denial, right? It's like, just like the first step, it's denial. It's doubting the validity of the idea. The second step is it can't be true. So you write the paper on firms clearing the market for passive demand and people are like, no, no, no, that's impossible.

1:06:36I know SEOs are rare. I know they've done net buybacks. There's no way. This is akin to anger, right? You're met with the anger of people and the harsh criticism and skepticism of your work. Now, the third part is I knew it already. So after everyone tells you it's not true, then it's like, oh my God, it's obvious. Of course, passive comes, passive pushes up prices. People have option like clams in the firm. I knew it already. And in fact, you're not citing this work, this work. This is like bargaining, right? You're like, well, if you want this to get in, like it's okay, but you got to cite this, this, this, this.

1:07:07The next step in terms of I knew it already is actually even stronger. It's actually, it was my idea. I'll make fun of Mike Green here. Mike is a friend of mine. Mike, if you're listening, I hope you're still listening at this point. When Mike was on this podcast a few months ago, Alex and I wrote this paper. And he says, well, Marco and Alex wrote this paper in response to a challenge that I issued them when I was discussing their paper at a conference. So in fact, not only did Mike know that passive ownership was bigger than we thought, it was his challenge that forced us to lead this. It was his idea to look into how big the passive ownership's here.

1:07:41And this is depression, right? You feel really depressed because you worked on the project for two years and someone else is saying it was actually their idea. And the final step is acceptance. I have a project that for eight years I worked on it, submitted to journal, rejection, journal, rejection, journal, rejection, revise, revise, revise. Finally, you come to the point where it's literally accepted, which is akin to the last stage of the Kluge-Rumas model, which is acceptance. And like, as you can see, this cycle is actually quite challenging because you have to go through people telling you you shouldn't write it.

1:08:07It can't be true. I knew it already. It was my idea. And so by the time it's accepted, the paper is actually not, it might even not be super relevant. A lot of time has passed. You may not care about it anymore. It's not your passion project. And so if you define success as acceptance, at the end of that cycle, this is going to be a really, really hard job. And you have to enjoy all the other steps of the process. And what I think success would be, and I'm not saying I do this, or I've internalized this, I think what success would be, would be being okay, and accepting actually each step along the way of the process.

1:08:40Because that's what makes this job fun. I get to talk to y 'all, I get to go talk to really smart people, I get to talk to Mike and John Shim, my colleague and everyone here. It's like, that's what this is about. And that's what success is, I think, at least in this profession. Wow. What an answer. Marco, this has been amazing. Thanks so much for coming on. Learned a ton. Fantastic. Thank you. Thank you. Yeah, this was amazing. Awesome. Thanks, Marco.