Episode 332 - Randolph Cohen & Michael Green: How Concerned Should We Be About Index Funds?

24:35What I say is the vast, vast majority of people probably aren't very well qualified to do that kind of analysis and come up with a great answer. But to the extent that they are, they can move their money out of a target date fund. Anybody who's sophisticated enough to be making those kinds of decisions is sophisticated enough to not just stay in a target date fund because that was the default option on the program. Most people will stay with the default because most people don't want to do that calculation and figure out, should we be 55 % equities or 60? I sat on an investment committee of a school.

25:06We had a person on the team who was a consultant, an investment consultant, and there were all these top private equity people and hedge fund people on the board because it was a school with a lot of people who were in the finance business and kids there. He said, I think we should go from 60 % stocks to 55 % stocks because of this, that, and that's what we're recommending to our clients. And all these people sat around and we were all like, we don't know. We don't know if it should be 60 or 55. That's really hard stuff. And so I'm just saying, automating that process and then giving people the flexibility to change it if they want to, seems pretty good for individuals.

25:38But more importantly, it's anti-fragile. And so I feel like we should be able to agree that the target date fund, that people's 401k money going into, remember, people are going to save money. I'm a little confused listening to arguments across podcasts. Is Mike saying that people should save less? Or is Mike saying they should save a lot, but they shouldn't put as much into stocks? Or is Mike saying they should save a lot and put the same amount and put 60 % on average into stocks, but they should move it around more based on their own study and instincts rather than based on a formula because none of those sound like they've helped the situation to me.

26:10So very quickly, a couple of key points. One is there is actually a very material difference between a pension and a 401k, not just in terms of the process of money flowing in, but in terms of the underlying liability. What we've really done with the system is we have said we can't have any individual or entity responsible for your retirement. I work at General Electric for 30 years. They're not responsible for our retirement because as we showed in the 1960s into the 1970s, the liability incurred under that process is something that any one company couldn't bear. We then turn around and we say, but collectively, the answer is for all of us to invest into the stock market.

26:53If the stock market fails to perform, what have we actually done for future retirements. We've impaired them significantly across our entire society. That, by definition, is far more fragile than the failure of any one entity. The process of actually changing it from something that has turned from a responsibility for a small atomistic component in terms of a corporation to something that then turned into an atomistic component, say, you as an individual, to something that has now become a collective societal risk is really the key points that I'm highlighting there. I don't buy that, Mike. In other words, we had both those risks before.

27:31Before we had the risks, the GE could go down and fail to pay its pension obligations or that the whole economy and market could perform poorly and then all the companies would struggle to pay their benefits. Your point is we didn't get rid of the second one. If all the economies perform poorly, then people are going to be hurt on their retirement, but they've got a chunk in bonds. So if their stocks do, meh, but their bonds pay off because those are government bonds, it's going to be okay. It's not as good as you'd like, but it's not terrible. So I feel like we went from two major concerns to one concern that we partly mitigate.

28:02And that seems pretty good. And again, when you look at that on a collective basis versus an individual basis, I agree with you that there are some components of removing the fragility associated with the failure of an individual company. But when we allow the failure of an individual company, we actually are increasingly making a system robust. The company didn't deliver the products, it didn't deliver the outcomes, and we turn it into a societal and collective problem, the process of transmitting that risk actually raises the valuation of everything in the process, lowers the forward expected return, because by definition, it's less risky.

28:39And yet we've promised people that these underlying assets will offer the returns that allow them to secure the retirements that they desire. Those two are completely incompatible. I don't understand the argument as to why we raised valuations or made things more risky. Let's just be very, very clear. We have made the system less risky, but in the process of doing so, we've raised valuations. Because anytime I make something less risky, by definition, it is worth more if it delivers the same cash flows. That's not true. Of course it is. Let's say there's a pile of stock worth a million dollars.

29:12One thing we could do is say, we'll each take half a million. The other thing we could do is say, we'll toss a coin. and if it comes up heads, I get the whole million. If it's tails, you get the whole million. Well, the second one is riskier. If we switch from the second to the first, we made things less risky, but we didn't change the valuation of that million dollars. By doing risk sharing, we don't cause the stock market to be overinflated. I don't see that at all. I completely disagree with you. Option theory would fly directly in the face of that. I don't agree. Look at my coin toss example.

29:39The fact that we're both at risk doesn't change the value of the pile. Let's actually sell admission to the coin toss. There's three players. If we flip a coin and it comes up heads or tails, two of them get to actually split the million dollars. If under your game, only one person gets all of it, how much would you pay for a ticket that pays out two winners at$500 ,000 versus one that pays out for a third chance at a million? I can tell you that Elon Musk would pay pretty much the same thing for both. Correct. I'm not rich enough to pay the same thing for both, but the way the stock market works is that people with deep pockets are the price setters.

30:15No, that's actually not true. That's actually part of the point that I would make on this is that when you actually allow the participation of more people who actually are changing that component, Elon Musk is not marginally setting the price of the S &P 500. I think we're getting off track. Before, we had a thing where if you work for GE your whole life and then GE went bankrupt, you lost your pension fund. And now we've gotten rid of that. And your point is that makes GE overpriced? That doesn't fit. There's no connection there. What do you think it's overpriced? What I think is actually overpriced is the underlying asset.

30:46And by the way, I just want to be very clear. Overpriced is not actually what I'm referring to. You've lowered the riskiness of the investment. You've absolutely lowered the risk of my quote unquote pension by moving it from GE to the stock market. The stock market is less likely to fail than GE is. There's no price on my pension, right? I'm not selling my pension to anyone. Of course there is. I don't understand that. Every financial asset, whether it's a pension or whether it is a portfolio of stocks, has a value. Just the value of the underlying claim. This is actually really important. It's not actually true.

31:20What you are describing with a pension on GE is an annuity that is discounted at the value of GE's cost of debt. If I change it from GE to a societal component, by definition, it now lowers its cost of debt to the U.S. government. That annuity is worth more. I agree that I'm better off as a pensioner if I know the money's coming. That doesn't lead to overvaluation of the stock market or anything like it. And I don't understand why the fact that my pension fund is safer has somehow damaged anybody. Who's it hurt? It hasn't hurt me. I'm way better off. Who's worse off? I don't know what your concern is here.

31:52The point that I'm actually making is that by making the process less risky, forgetting any implementation component, by moving from something that was invested in by GE that It then was a claim against GE, against potential performance of that. That has a very different valuation than if I'm saying I'm going to do the exact same thing in the stock market in total. You referred to it yourself. You said we've taken these risks out of the system. If I take risk out of the system, that annuity has to be worth more. That's just creating value. Your point is, if you have an insurance company, you can make everybody better off through risk sharing.

32:28And I agree with that. But it's not like it pushes the stock market up or pushes the value of stocks up. Normally, I hear concerns from you that the value of stocks are being pushed up artificially. Maybe that's not the point you're making here. That's not the point I'm making here. So what are you worried about? What's the problem? So now everybody's better off because we have some risk sharing. So that's a plus. There might be minuses that outweigh. Which, to be clear, is exactly why I said I think that it's important to actually articulate. I'm not trying to take away passive investing. I'm not trying to take away people's 401ks.

32:56is I'm recognizing that there are benefits of distributing this on a societal basis. Absolute positives associated with that. The challenge is that we then specified a particular form of investment that should be available to people and gave it a liability advantaged component that has now forced everyone to believe what you started off with, which is I have options for my savings. I can put it in the S &P 500 or I could put it into an active manager. No, actually, you could invest that into your own business. You could invest that into your local community in a manner that is non-public. These are all things that have taken a backseat at this point.

33:38You're saying if people had no retirement, I thought your concern was with the switch from defined benefit plans to 401ks. You're saying if we just got rid of all retirement savings, then people would do whatever they want. Now, obviously, we know from history that what a lot of people do is they consume it. now because people are always challenging getting through the day. And so what you see is very little savings. And then you have a problem because you have people who are old and hungry and they can't work because they're too old or too sick or too disabled. And they consumed their stuff for perfectly good reasons, not criticizing those people.

34:15I'm saying they had kids who needed taken care of and they had lives they needed to lead and they had unexpected things happen. And now they find themselves and they're 82 years old and they can't work and they don't have any money. And then the question is, well, do we let them die or do we support them as a society? And I think we're the kind of humane society that will support them. But then once you know that as a society you're going to support them, then you kind of need to set up something. You have incentive compatibility problems if you don't set up solutions to encourage people to make sure they save.

34:44Again, I completely agree with that. I would point out the obvious contradiction, which is people used to save more prior to the introduction of these systems. They save less today than they did before. But that is absolutely correct, Randy. There's lots of ways of measuring these things and lots of other things in society change in terms of how many children people have and whether children take care of parents. And you have this weird situation where you introduce social security and then you give benefits to people immediately, but they didn't pay into the system. So this is a complicated subject.

35:12But fundamentally, yes, people will probably do. If you don't give people anything to rely on, then they'll have to do precautionary savings. But that's problematic too. There's real advantages to giving people setups like social security and pension funds so that they know that they have something to rely on in retirement. But you're right that if you say to them, hey, if you come up one penny short, then we're not going to treat your heart disease and you'll die. Then people are going to say, well, I better save enough to make sure I don't come up a penny short. Just on the amount people are saving.

35:41We did ask Antoinette Shore about that because she's looked at it in some of her papers. She sees no change in savings. I'll read you the quote. She says, actually, that's a very interesting question because you see they haven't necessarily affected how much people put into retirement savings, target date funds. According to research I've done with my colleague, Jonathan Parker, and a PhD student of ours, Alison Cole, we actually see that they don't necessarily increase the amount people save, but the way that people allocate their retirement savings. So she's saying no change in savings, but different asset allocation over the life cycle with target date funds.

36:08Which is exactly the point that I'm making. Do you want people to put more in stocks or less in stocks, or do you think they have it about right. I mean, that's what I'm trying to figure out. I feel like what you're saying is they're putting too much into stocks and it's pushing the market too high. I can't prove you wrong on that. So don't worry. I mean, if that's the answer, but is that your view that people being 60, 40 in stocks in middle age and then 70, 30 when they're younger, that you feel like they should have a lot less than that in stocks? I'm ambivalent in terms of what percent they should put into the stock market versus anything else.

36:36What I am very much objecting to is the fact that We have created a form of investing that actually prioritizes, exactly as Ben points out, scarce savings because the savings haven't increased. We're exclusively allocating that now to a small segment of the U.S. infrastructure in the form of public equities and then a random component abroad. And because this is happening in such a concentrated fashion, it is actually meaningfully affecting the structure of our economy and our society. And you say it's a concentrated fashion because it's in the 3 ,000 publicly traded companies instead of you took your retirement savings and invested it in your neighbor's store or something of that nature, and people would be doing more of that, you think?

37:19Yes. I see. Interesting. We could reduce the amount that people put into retirement savings and then hope that they'll take the extra money and put it into things that are socially productive instead of consuming. And they might. It's not like I have studied the rules on 401k and say, hey, people are putting in three percent and damn it, 2.9 would be a horror show. It has to be three. You know, I don't know what the right number is. And so if you think that number should be a little lower, I'm open to that possibility. I can't help but think it's like there's a part of me that wants to say, gosh, there's probably been in the last 18 months, 150 articles in The Wall Street Journal about how people are saving too much in their retirement.

37:56Oh, wait, the opposite. All you ever read in the financial press is criticisms that people aren't saving enough. Now, I understand your point is, well, if we didn't force them to save so much, they'd save just as much, but in other ways. And maybe it's true. I just don't know the answer. I mean, I think Antoinette's referring to a change when we went from other kinds of investment vehicles into target date funds being so popular, and that that didn't really change savings amounts. What she's actually referring to is mandated employer contributions and the opt-in versus opt-out framework. My guess is if you reduced the amount that people contribute, the overall savings would go down, but not by the full amount of the difference.

38:30You're absolutely right that they would save some, and who knows, maybe they would save just as much. So my mind is open on that. You guys lost me a bit on the pension example. I didn't really understand how eliminating corporate retirement pensions would affect market valuations, or I don't know if that was an analogy. I was a little bit lost there. Initially, it wouldn't, actually. But as you effectively take people who don't want to make these decisions and you provide them with an approved path through a qualified default investment alternative, and you tell them this is the way you have to save, that collective decision is going to push the values of those entities higher, lowering their marginal cost of capital versus every other company that's out there, and in turn facilitating a concentration in our economy that ultimately adds dramatically to risk.

39:14It's really important that people understand this. All risk and all diversification has effectively a U-shape to it. If I invest in just one stock, risky. Two stocks, less risky. Three stocks, less risky. If I invest in 3 ,000 stocks, not appreciably less risky than investing in 35, as you know from diversification benefits. But if everybody is invested in those exact same 3 ,000 stocks in exactly the same proportions, actually, that's paradoxically much more risky. I don't really find that persuasive, But the 35 graph that we've all seen in intro textbooks is the number if you have zero correlation among the stocks, which is not the norm.

39:56I think there's substantial diversification benefits to having thousands of stocks instead of just a few dozen. The notion that if people had half as much in the stocks and then the other half they put into a building across the street, a triple-decker that they then rent out, that that's somehow safer because now they're more diversified by adding that local investment. I don't find that persuasive. I think a broad-based investment in thousands of companies plus low-risk or safe bonds is pretty good. Now, that's not to say we couldn't find ways to make it even more diversified. And obviously, you see talk about adding other kinds of alternative investments to the mix in retirement funds.

40:30And that's something that's worth exploring. I'm a finance professor, so I'm never going to tell you, oh, let's have less diversification. But I don't think that you get more diversification if people take a chunk of what's currently spread out among thousands of companies plus bonds and put it into private local investments I think those are going to tend to be pretty undiversified. You're not going to put$5 each into 100 different local buildings or whatever. In part, because we don't have the opportunity to do that, because we now have mandated this type of vehicle. There's nothing that would have prevented a local real estate fund from popping up to invest in Cambridge real estate, for example.

41:05That could be a component of the local community. It would be a very important component, particularly as it relates to things like large institutional accounts. It's insane to me that an entity like Harvard or an entity like CalSTRS in California allocates its capital on a fiduciary responsibility in which that fiduciary model is held against the performance of the S &P 500. Instead of recognizing that as CalSTRS, your members benefit from California flourishing. And as a result, there are ancillary benefits associated with capital investment in your local markets. on an individual basis, Randy, I completely agree with you.

41:44I am far more diversified because I have access to large-scale financial assets. That's a positive. And again, I can't understand how you don't understand or don't see how that raises valuations by seeing that things have less risk associated with them. But at the same time, there is a societal cost that's associated with the mandating of that behavior. That's what my complaint is against. I think that systematic passive investing is like any other form of investing. It is a style of investing. Why it receives priority and the implications of it rising to a certain scale is all I care about. It sounds like the difference between us is you think you know what the right percentage is that people should have in simple, low-cost, forced savings vehicles.

42:32I'm just saying to you, if they're saving 3 % and you tell me it ought to be 2.5%, my mind is open to that. But is the reason you know the answer because the answer is zero, that they shouldn't have to put any of that? Or are you saying, no, no, they should have to put some in that, but the amount that companies are currently doing is too high? I don't actually know what the right answer is and would argue that the tools that we have for trying to estimate that have been corrupted by this process of transitioning. We need to understand the impact of what happens when we increase the proportion of passive or systematic index investing on valuations and forward expected returns before you can come to that answer.

43:11You cannot use history in deriving that answer. Can we push on that? Because this, I think, is the biggest thing we disagree with. I've heard you speak on this update a number of times, and it seems very clear. You said the last time you were on Rational Reminder that this money flowing into these 401k plans instead of, I mean, I assume you don't mean instead of the alternative where they just set it on fire. The alternative is that, let's say, the old school defined benefit pension plans, which we had for 100 years. And in those plans, they were pretty much investing 60-40. Now you have this money going into 401k plans and investing 60-40.

43:46And your notion seems to be that that's going to make the market be five, six, seven times overvalued. I don't buy that at all. And I guess I would like to understand your argument better because, A, it's about the same amount of money going into stocks either way. And B, the flows aren't nearly large enough to have a big impact. And I guess maybe you could start by saying, how overvalued do you think the market is now as a result of this? We've had this stuff going since 2006. I forgot to look what the market's at today. It was like 5 ,700 or something like that. How much lower do you think it would be if we just stuck with defined benefit pension plans?

44:22If we had not changed the process, in other words, if we X out the component of passive bias, it would be somewhere in the neighborhood of a 50 % reduction in valuations. So that is super helpful. So help me think this through. When I got to grad school, the most famous paper in the field at that moment, this is early 90s, was Merrill and Prescott's paper on the equity premium puzzle. And they said, if you look at the riskiness of stocks and bonds, stocks are riskier and they should have to pay a premium. But if you do the analysis, that premium should be something in the neighborhood of half a percent a year.

44:52But historically, stocks had outperformed bonds by something like 6 % a year, depending, you know, let's say if you use long bonds or whatever. Currently, stocks are priced to return something like bonds plus two, maybe 3 % a year, let's call it two. Based on the best theories that we have, it seems like stocks still look cheap. And you're saying, no, no, stocks should cost half as much. Stocks should be so cheap that they just crush, kill and destroy bonds every year. And then people shouldn't go out and race out to buy them any more than they currently do. if stocks were way cheaper, everybody should buy a huge load of them until the equity premium is lower and that would push the price up back to where it is today or arguably even higher.

45:32Why do you think that the equity premium needs to be so much higher than it is? Why do you think people shouldn't buy stocks unless they get a gargantuan premium for it? So there's two separate components to that. First, Prescott and Mara operate under an assumption of an ergodic versus non-ergodic system. And this is actually really critical to understand. And if I think about normal distributions and standard deviations of returns and run Monte Carlo simulations on that basis, or I look at history, which has a survivorship bias associated with it, mere fact, I'm able to look back at history of stock market implies a component of survivorship bias that doesn't exist in many regions around the world.

46:08So let's be very clear on that. If I try to model this as an ergodic system, saying stocks are expected to return 8 % with standard deviation of 16 % on either side of it, in other words, roughly mimicking history. I'm presuming that the future is exactly like the past. And secondly, I'm presuming that each individual's experience is actually distributed in a similar manner. An ergodic system is one in which the time series average is the same as the ensemble average. That works for many games of chance, or things like rolling two sets of die. If I roll two sets of six-sided a dive a thousand times in a row, I'm going to get the same distribution as a thousand people rolling at one time for a very, very similar distribution.

46:53On the flip side of that, if a thousand people invest for one year in the S &P 500, that's not going to have any resemblance to my return if one person invests over a thousand years in the S &P 500. Those are radically, radically different experiences. What's a fair equity premium deal? I understand there's a question of Maren Prescott estimated the historical equity premium by history. And obviously, if the market then doubles, the history gets higher, but the future gets lower. So fine, you and I might have a difference of opinion on the forward looking. I don't know if we do. But what do you think the right equity premium is that should set things in equilibrium?

47:30I think it's completely conditional. First, when you define equity risk premium, you're using a valuation assumption. You're simply reporting dividend yield versus treasury yield or an earnings yield inclusive of stock buybacks, you're making some assertion about the forward expected returns that I'm simply arguing you can't make. I'm making an assertion. I'm asking you what forward expected returns would cause you to say the stock market's at the right price. You think the stock market should be half where it is now. If I were really clever, I could just translate that into a forward-looking expected return.

48:01It sounds like if I'm doing some quick back of the head calculation, you'd be saying instead of stocks paying long bonds plus two, you're saying it should pay long bonds plus four or five or something like that. Is that in the ballpark? You asked me actually a very different question. You said, what would be the impact if this hadn't occurred? What was the impact of that in terms of valuations? If we were to remove that, I think stocks would be 50 % lower. Let's switch to that then. I don't understand that at all. Ralph and Xavier have this wonderful paper. It's controversial. So they say, wow, markets are way less elastic than people thought.

48:35I think it's a terrific paper, but there's plenty of people who think, no, no, no, it's not as inelastic as they say. Let's take theirs as given. So they say a dollar goes into the market, it moves the market$5. If you take all the money that went into 401k plans last year, it was about 2 % of the size of the market. I looked it up. Something like 60 % of that went into stocks, being 65%. So that's like 1.2 % of the market. And then you apply a 5 to it and you say, okay, that should push the stock market up 6%. Then you have to ask yourself, well, how long does the impact of that trade last? And let's say it lasts forever with a half-life of one year.

49:12So you make a trade, you push the market up a bunch, and then a year later, it's still half that effect is in there. And a year later, it's half that and so forth. That's, I think, a pretty long half-life. Most people think the half-life should be a month or a quarter or a week, not a year. But let's make it a year. Under that math, all the 401k contributions that have ever happened would make the market something like 12 % higher. So how do you get 50 % higher? And by the way, I want to be clear, that's if zero of those dollars had gone into stocks. In other words, if they'd gone into the fine benefit pension plan, they'd bought just as much stock.

49:46But let's imagine that instead they lit it all on fire. Then I feel like the market would be 12 % lower, not 50 % lower. That would be great and absolutely true if we are looking at a single period. But because those 401k flows are happening on a continuous basis. But I accounted for that. No, you didn't. What you actually did was you said, if I put all the money in, that would have raised valuations by 6%. And then last year's would have been 6 % then, which is 3 % now because it's half, that's 9%. And then the year before that would be 6%, which would be 3, 1.5%. So I'm just using the easy math that 1 plus 1.5 plus 1.25 plus 1.8 plus 1.16 equals 2.

50:23And that's why I doubled the 6%. Now turn it into a time series in which is a multiplication as compared to an addition. It's 1.06 times 1.06 times 1.06 times 1.06. No, that's not true. Yes. No, it's 1.06 times 1.03 times 1.015. So maybe it's a tiny bit over 12 because the compound is still going to be 12. No, not at all. In order to get the number doing, you have to assume that if somebody made a trade 13 years ago and pushed up the market, every single bit of that 13-year-old trade is still pushing the market up. Do you actually believe that? That can't be true. I'm saying there's a half-life where the effect of that trade deteriorates a little bit each year.

51:11Walk through the math very simply. First year, 1.06. We agree on that. Right. But then three of it, you give back the next year. Hold on. after one year, I'm at 1.06. Now I have another flow come in that has a similar impact. So that's actually 1.06 times 1.06. This is the heart of the matter. I'm saying at the end of the second year, it's 1.06 times 1.03 because the first year's effect, it goes up 1.06 % when you make those purchases. But then by a year later, you've given some of that back. You can't just keep adding up forever, that would be crazy. It does. Nobody thinks that the impact of every trade is a permanent impact.

51:52Of course, it has to have a half-life. I totally agree. So what do you think the half-life is? I used a year, which I thought is super long. Do you want to use something even longer? Let's use a year. Let's stick with your number, but let's recognize that each year has a similar compounding effect. Run through the math. Let's do five years and I'll tell you what I think Can you tell me if you agree? The most recent year is a factor of 1.06. The year one back is 1.03 because it did 1.06, but then half of it mean reverted over time. And then the year before that is 1.015. And the year before that is 1.0075.

52:26And the year before that is 1.00375. So then you multiply those out. Basically, it's like six plus three plus one and a half, which gets you to 12. It's a tiny bit higher than that for compounding. In order to get giant effects of the type you're worried about, you have to make two crazy assumptions. First, you have to assume none of those dollars would have gone into the stock market if it weren't for 401k plans. But that's not true. We know that in the old days, they had defined benefit plans, and those went into stocks in about the same proportion. So I would argue there should be no effect.

52:56But even if you make the super extreme assumption that if this money hadn't gone into 401k, it all would have been lit on fire or buried in the backyard or something, then you still only get 1.06 times 1.03 times 1.015. You're up 12%. Even 10 years from now, it's still only 12 % because you always have the most recent year as a six, and then a year that's half as big and a year that's half as big. So you never get an explosive thing from this, again, even with that first crazy assumption. Randy, again, the math that you're doing is wrong. Stop for one second. Let's accept your proposition. 1.06 the first year, it degrades to 1.03 the second year.

53:35Now I introduce another 1.06 onto a market that is 3 % more expensive. So that actually takes it a tiny bit over nine. Okay, so now let's do it again. So let's say that effect degrades by 50%. That 0.918 is now down to four and a half. I multiply it four and a half. So 1.06 times 1.045. Now we're at 10 and a half. So now I take that number. I divide it by two. I add it to one. And I take 1.06 times that. Five and a quarter. That's next. Now you're at 11 and a quarter. do you see that you're closing in on a little over 12? It's going up less every time. This is like a Zeno's paradox. If you use no compounding, it ends up exactly at 12.

54:18But with compounding, it'll be a little over 12. Okay, so after four years, I'm already past 12 in that analysis. Do you agree that if we use simple instead of compounded, it would be exactly 12 after 100 years or 1 ,000 years? Yes, of course I do, but that's the problem. I agree that it's compounded. We'll pull out Excel and you'll see, I'm not saying it won't be 15 instead of 12. It might be 12 and three quarters or it might be 15, but it's not going to be 50 or anything. It's not going to go up that much because you're adding these tiny little factors on the end. You're adding 1.00375. There just isn't that much compounding.

54:49Anyway, we'll do the math. Randy's math seems to make sense, Mike. I'm missing why it's wrong. Let's run through this here very quickly. We're doing Excel right now? I love it. Might as well, right? Do seven years. 1.06 times 1.03 times 1.015 and you can do the rest. while you're working on that, Mike, the follow-up question I have, and Randy kind of alluded to it, we'll finish this discussion. We'll run the Excel. After that, I want to talk about why is this different? We're talking about money going into target date funds or index funds. Why is that different from flows going into active, which is kind of a different version of the DB pension plan?

55:24Why are flows going into this specific type of investment having a more concerning impact than flows going into actively managed funds or whatever? Anyway, park that. I want to hear what the Excel says. Right, because you can see by the time you get to seven years, you're down to really tiny factors that you're adding on. So unfortunately, I'm still trying to get the Excel numbers in because I'm working off of a single laptop. Let's see how Siri does. Hang on. What's 1.06 times 1.03 times 1.015 times 1.0075 times 1.00375 times 1.002 times 1.001 times 1.0005. I went a little high at the end because I couldn't do the dividing 37 and a half in my head fast enough, but it got us up to 16 instead of 12.

56:11It just doesn't go that high. At first or seven years, it's not going to add much if you keep adding those tiny factors. So it's probably between 15 % and 16%. So I come to a similar conclusion. Again, it just becomes a question of what is the degradation and what is the process of actually switching? And so, Ben, this is exactly the point that's making. And I want to grant your point there. If the half-life is five years, not one year, you could get to something big. So I leave it to our listeners to ask themselves, do you think if you go into the market and you buy 10 ,000 shares of Apple, that five years later, Apple is still the full amount higher of your price impact, or even half as much higher.

56:47I feel like we all know that it degrades faster than that. What Ralph and Zavi did is that they showed us, people thought it degraded in minutes or hours. And what they showed us is it could be weeks or months, maybe it's even a couple quarters. And that's why I'm granting a year, which I feel like is kind of the outside. But I don't think it's plausible that it's five years as a half-life. I admit I don't have proof on it. I think this ultimately is what boils down to the question. And when I look at papers like Jang or others, it really does matter in a really big way what that degradation is.

57:17To your point, if that degradation is very temporary, and now you have to provide me with a mechanism that says why the price falls by that amount, why does it degrade by 50 percent? Who is the seller that is actually showing up and lowering those prices? If your argument is that it is active managers, as they become a smaller and smaller share of the market, you have to believe that that impact period is rising and creating the exponential features that I'm describing. The number one seller these days is probably target date funds. If the market gets pushed up artificially, target date funds automatically sell stocks and buy bonds.

57:54That's one seller that you know is in there in a big way. Then there's a bunch of institutional investors who default to 60-40 or 50-50 or some other number. And that may be old school pension funds or who knows, it may be insurance funds that only are allowed to have 10 % in stocks. And so every time stocks go up, they have to sell some and so forth. You've got wealthy individuals who have an advisor who tells them, hey, we shouldn't go over 70 % in stocks or you shouldn't go over 50 % in stocks now that you're older or what have you. And by the way, there's companies that can issue stock. And obviously, right now, companies are buying back more than they're issuing.

58:26But I would argue that's evidence that the market's not overvalued. The people who are in the best position to know what these companies are worth are buying back rather than issuing. And you see they do it when it's crazy. Look at GameStop. What happens is some person puts up some emoji on the web, and then GameStop goes up 38%. And then the guys who run GameStop say, hey, we're issuing another billion dollars worth of stock. There are a lot of mechanisms out there to get things back under control. And I'm granting, it might literally last forever, but by a year, half of it's gone. And by two years, three quarters of it's gone and so forth.

58:58I'm granting the fundamental point that you're making and that Ralph and Xavier are making that this stuff takes longer than you think and that there aren't as many natural fixers in the market as you would think. But I'm saying, boy, I can grant an awful lot of that and still not have an explosive problem. And that's, again, if we come back to our host's point, what about this issue that people were going to put money in the stock market anyway? TDF is just one way of doing it, back with old school pension funds. Why is this so different? The single biggest difference is that the elasticity of an active manager is much higher than a passive manager because endogenous inside the fund, they are making the choices that Randy is describing.

59:39If I remove that, I'm presuming that everybody is reacting, which is exactly what Randy is talking about in this period of how long does it take to take out that response. If you actually look at GNK's, Xavier Guibbe and Ralph Coijin's work, they're taking that five as an average. But if you look within, what's actually happened is that average has gone from two, which is roughly the impact of an active manager. 1.88 is the number that Valentin Haddad and I come down to. As you add passive, you're making the participants of the market less elastic and less capable of allowing that degradation that Randy is highlighting.

1:00:18That's why inelasticity rises as passive share rises. The multiplier effect gets larger and larger. So help me understand why the active guys have less impact. If it were the case that when the market goes up, they held more in cash, then they might be better than passive, although still they probably wouldn't be as good as target date funds for the elasticity effects. But the reality is that when the market goes up, they have less in cash because they're terrified of missing the run-up because it's so crucial that you have to be a five-star fund when the market's doing well. So you have to be fully invested when the market's running because that's the only time inflows come in.

1:00:57It's very clear in the data and it's very clear logically that they don't even go the right direction. They're trend chasers. And so if they're trend chasers and pass it as flat and target date funds are actually going against the trend, then why would going from active to target date funds create an elasticity problem? Again, it is not a question of the target date fund vehicle per se. What I'm highlighting with target date funds is something very different, that they are causing people to behave en masse. Absolutely agree. If you actually look at the importance of what you just said, it could cause people to buy too much of any one asset as its price goes up or down.

1:01:37Paradoxically, if I look at something like what happened in 2022 with the bond market sell-off, if I looked at the construction of the indices, the bond indices, they had become heavily overweighted to long-penner, low-coupon instruments. Why? Because those are the ones that rise most in value when interest rates are cut. And that in turn means that they're most heavily weighted in the index. So the within bond performance was far worse than anything that had ever come before because we had actually driven this inside the asset class. Again, I'm not disagreeing with you. Now the target date funds are actually, let's say that they're 60-40.

1:02:17The reality is they're more like 70-30 in terms of the aggregate dollar value that's been invested in them. They are not weighting bonds anymore today at 4.5 % yields than they were at 1 % or 0.5 % yields. That flies in the face of cross-asset return expectations, unless you somehow believe that equity expected returns have risen by an equivalent amount to bonds, even as bonds have fallen dramatically in prices and equities have risen in valuation. So what you end up doing is you end up creating a position in which you are correct. The aggregate impact of it is actually, it causes bonds and stocks to become anti-correlated in an individual portfolio, But it doesn't do anything to address the underlying issues of each of those individual portfolio components, allowing them to go deeply off the rails and forcing outcomes for a broader index like a stock market that could be far worse than you had ever anticipated in your historical modeling, exactly as we saw in bonds in 2022.

1:03:22Two. Three points. One, it is the normal assumption that if interest rates rise, expected returns on stocks are also higher for things to be in equilibrium. Now, you may feel that you can outsmart the market and that you know when the market's making a mistake and the market wasn't affected enough by the rise. Given how much interest rates went up, you would have expected the stock market to go down. And it didn't. I think it's pretty obvious. The reason it didn't is people believe the technology change story, whether it's AI, whether it's the incredible healthcare breakthroughs that are happening.

1:03:52People are saying, we think cash flows are going to be a lot higher. So even with this higher denominator in the net present value formula, we think these stocks are still going to do well. Maybe people are wrong about that, but a lot of people who thought they could outsmart the market with timing like that have turned out to be wrong. The targeted funds absolutely took action. When interest rates went way up, bonds went way down, and then they sold stocks and bought bonds. And your point is, well, I know, but they just went back to 60-40 or 70-30. But the point is, they absolutely took money off the table in the stock market and poured it into the bond market because of interest rates rising.

1:04:27So I think it's not right to think, oh, they didn't do anything because they just got back to 60-40 or 70-30. And then the third point I wanted to make is, Ralph and Savvy's thing looks like something that, oh, gosh, it's scary for the markets. They're going to get way out of whack. They're going to go too high. They're going to be too volatile. But look how powerful it is that their result is so large in the target state fund context. Let's say you're 70-30, you're 70 % stock. Market goes up 10%. Now you're 77-30. Let's say bonds didn't move. So you're 77-30. Well, to get back to a 70-30 proportion, you have to sell what?

1:04:58I don't know, 3 % of your stocks and put it in the bond market. Maybe it's two. Let's say it's two. So you sell 2 % of the 77 and now you're 75-32. And that's probably pretty close to a 70-30 mix. I can't quite do the math fast enough in my head. So you sell two or three percent. Ralph and Savi say two or three percent times five. If target date funds were a quarter of the market, then you're going to have two percent times five is 10 times a quarter is you're knocking the market down two and a half percent. It's hugely impactful. I'm just saying that the result they have, which says, boy, elasticity is potentially scary, is saying that these target date funds, they're very powerful in helping rebalance markets if they overreact to news.

1:05:41I would actually agree with that. I have no dispute around that. This is the critical component. When I highlight target date funds, my issue with target date funds has nothing to do with the fact that we are using automatic systematic rebalancing. I completely agree. That actually changes behaviors of markets and makes portfolios vol dampening in that process. This is exactly Parker's point. If I sell equities and buy bonds, to your earlier assertion, Have I made an assertion about the forward expected returns to the market? Have I offered any insight in terms of the development of AI? I'm not saying the target date fund did that.

1:06:16What I'm saying is, your point is, boy, it seems like bonds are a better deal than stocks now because the interest rate went up, so the bonds are paying more, but the stock price didn't go down, so it doesn't seem like the yield on the stock should be any higher. And the answer is, well, the yield on the stocks is higher if they're going to make a ton of money. Let's take a moment and talk about NVIDIA. The forward multiple on the stock market is 22. Let's say it's 22. Your feeling is, hey, if it weren't for this artificial forcing people into things, it would be 11, which I'd say, boy, if you could buy stocks for 11 times earning, no sane person would buy bonds.

1:06:51Everybody would pour all their money into stocks. So I do not see that 11 multiple as some kind of natural figure. But OK, that's a disagreement. Let's bracket that. Markets at 22. NVIDIA's forward PE is 33. Are you really worried that NVIDIA is crazy high relative to the market? Shouldn't it be higher? Shouldn't it have a higher multiple in the market? There were three big anomalies I learned about early in grad school. One was the equity premium puzzle, which we've talked about. A second was the post earnings announcement drift that says when there's news, the stock moves the right direction for the news, but it doesn't move nearly far enough.

1:07:22And then the third was the quality anomaly. Of all the quantitative cross-sectional anomalies, the one that is the biggest in price terms is that high quality companies seemed to trade way too cheap. They don't seem like they're riskier. These are the quality companies. And yet their returns were really high. And I feel like your argument amounts to, boy, because of the rise of passive, all three of these anomalies still exist, but they're not as big as they were. The equity premium isn't as far out of whack with what theory would suggest it ought to be. The post earnings announcement drift is much smaller.

1:07:54In other words, firms come closer to going up the right amount when there's news. And then quality firms like NVIDIA now trade more expensive instead of trading just a little bit higher multiple in the market. They trade decently higher in the market, although still probably not as high as they should on a relative basis. So hasn't the rise of passive made the markets way more efficient and better? So we got a couple of quick points. One, I actually asserted at the start that the contribution of passive is positive up to a point. So I just want to be very, very clear on that. The second component that I would highlight is that when you talk about something like quality factor, part of the components of quality is effectively saying that there's lower volatility associated with the underlying fundamentals that's creating less news on which people would either actively buy or sell the security in response to the information that's coming through.

1:08:44A passive format effectively grants a special status onto that low volatility component. If a company is up 10 % one earnings report and down 10 % the next earnings report, it's net down 1%. Company is up 20 % one earnings report, down 20 % the next, it's down 4%. The first company under a passive framework is going to receive additional premium because it's consistently being added to in size as compared to the more volatile company. My point on this is not to actually say the quality component doesn't exist. In fact, I actually exploit it in many situations in portfolio construction. But with that said, we can't actually tell what the quality factor is because we are simultaneously dealing with the rise of passive.

1:09:34I pointed out at the beginning, there's these two kinds of passive. So there's sort of passive in the sense of these 401k type things where the money's just flowing in the market every day without anybody thinking about it. And I think that's a really good thing to look at. I'm not as concerned as you are about it, but you're absolutely right. Hey, could we every once in a while stop and think, is this a good idea to just pour it in without anybody pausing and checking? That's why. And then the second passive is this cross-sectional stuff, which we've sort of gotten to now, where we're sort of saying, hey, are the wrong companies getting purchased too much of?

1:10:03Are we sure the second kind of rise of passive has even occurred? do we really think there aren't more smart people managing more dollars trying to beat the market now? I mean, there are two points. Intuitively, it feels like there's way more smart people with way more dollars that can be impactful in markets than there were 30 years ago. And second, it seems like if you ask any quant, where does beating the market come from? They'll say, well, one of two things has to be true, at least one. Either there have to be bigger anomalies. Oh, post-journance announcement drift is 3%, not 1%. Or the anomalies have to last longer.

1:10:38It gets you 3 % for three, you know, gets you 1 % for four months in a row instead of 3 % for a single month. Every quant I know, and I know a lot, would tell you that both those things are way smaller, that the markets are way closer to fair price, way more fit. Of course, there's wacky things like GameStop. There were wacky things like Pets.com in the old days. There's always been wacky things. But fundamentally, it seems like there's more smart people trying to get prices right. And they find it harder and harder every day because they're all so smart and they're all working so hard and they all have so much money to use to get prices right.

1:11:08Is there a rise of passive at all? Well, empirically, there has been a rise of passive. So we actually know that. Are you sure they're counting it right? That's what I'm asking you. Are you sure that we are accounting for all those family offices with trillions of dollars? Do we know how much leverage they're using to make the big bets that they're making? Do we know what's really going on inside Citadel and how levered that firm is. When I started studying the hedge fund business in the late 90s, a big hedge fund was like$3 billion. And now you've got awe-inspiring amounts. And again, they don't all call themselves hedge funds.

1:11:41They go by all kinds of different names and they use tons of leverage and they use derivatives that don't show up as leverage, but might 50x their buying power. There were things I said to you before, I'm like, I'm pretty sure I'm right about this. This I'm not sure I'm right about. I'm asking you to help me think it through because maybe I'm wrong. But my instinct is that if you counted it the right way, it's not actually more tilted towards passive. And the fact that mispricings seem to be much harder to come by suggests that that's the case. I would actually reverse that and say, one, to argue that there hasn't been an increase in passive investing feels completely counterfactual and not even something we can really entertain.

1:12:20What I'm saying before is that if you go back to the 80s, what you had was all the money in mutual funds that were basically closet indexers. I'm exaggerating, of course, they weren't all, but 80 % of them were closet indexers and 20 % of them were pretty indexed. But Randy, we actually have data on this that shows the proportion of index hugging has actually risen dramatically. The proportion of closet benchmarks has risen dramatically. What we don't know is about the real guys, the guys who actually have edge. Because again, those guys in the 80s, it's not just that they hugged the index a lot.

1:12:54When they weren't hugging the index, they didn't know what they were doing. Do they have any edge? We know they underperformed consistently. The point is, were they actually fixing mispricings very effectively? I mean, I'm not saying they weren't doing anything in the aggregate. I'm sure they were. I feel like if you say smartness times dollars, and you add it up across everybody in the market, where if you're fully passive, you don't count. Obviously, the people at Vanguard are very smart, but we're not counting that as smartness for this purpose, alpha smartness, whatever we want to call it.

1:13:20Is it obvious that there's less smartness times dollars now than there was back then? I'm just not sure how good we are at measuring. I've seen the papers. So I know a couple of people have made an effort. Ralph's made an effort. Other people have made efforts. But I'm just not completely convinced that they really know what's going on inside Citadel and all these other firms like Citadel, some of which people haven't even heard of. I'll just meet people and be like, oh yeah, I'm at QuantaQuest. We've got 23 billion and we use 40X leverage. And I'm like, I've never heard of you. They're like, oh yeah, we're in San Antonio.

1:13:49I made that one up. Do you see what I'm saying? I'm just asking if you share my concern at all, that it's possible that we don't actually know if there's been a rise of passive. The other kind of rise of passive absolutely happened. All that money in the target date funds, that's clear. I'm saying this kind, this cross-sectional passive, I just don't know that the average dollar is dumber than it used to be. We took money out of the hands of retail people. I don't know that they were doing that much to fix mispricing. We took money out of the hands of some mutual fund folks who I'm not sure how great they were at fixing mispricing.

1:14:17And we put a lot of it into pure passive, which obviously isn't doing anything to fix mispricing. I'll write that right away. And then we put a chunk of it into big, highly levered, exceptionally smart institutions. And I just wonder. So the quick answer to that is you are absolutely correct that there has been the rise of mega firms within what would traditionally be described as the hedge fund space. Their role, though, is actually radically different. So Citadel is a hedge fund and a market maker. Its role as a market maker dwarfs that of its role as a hedge fund. And the type of trading behavior that they've engaged in completely agree with you.

1:14:51But what we didn't track previously when we're thinking about that type of behavior was the behavior of the specialist firms who also ran heavily levered, had order books that provided transparency, et cetera. What Citadel and others have largely done is synthetically recreate order books. They pay for order flow to calibrate those models and they trade accordingly. That's just replacing a separate role. We actually do have data in terms of proportion of trading that is going traditionally through those who operate off of fundamental as compared to price or volatility insights. And we know that that's fallen from around 80 % of market activity to around 10 % of market activity today.

1:15:29Think about, we were talking about Marco Salmon and his work, and he wrote this paper with Robin Greenwood that's out now. He shows that this index inclusion effect, which was gargantuan, It was one of the main things that smart market makers and quant folks made money off of. It's totally gone now. We put enough smartness on that problem that that thing doesn't exist at all anymore. And so we don't have the firms inside the index trading at higher prices than the firms outside the index. And you don't even have any meaningful movement. I think they found the 0.6 % or something you go up when you get in the index.

1:15:59It's an astonishing result. But I'm just saying, if the post earnings announcements drift is gone, and if the quality effect is way smaller than it was. And if the index inclusion is gone, I would not expect a true rise of passive to make anomalies go away. And so I want to propose that maybe the anomalies went away because the world just moves towards less mispricing and that either there was no rise of passive at all, or if it happened, it wasn't a big enough effect to make it either pushed in the right direction, like with the quality effect in the post earnings announcement drift, or in other cases, it didn't do too much harm.

1:16:33So again, this is a question of what is the actual mechanism? Is it because effectively the markets have become more efficient or is in part our definition of market efficiency is skewed in that direction? Post-earnings announcement drift has been replaced by dramatically increased volatility on the earnings itself. As it needed to be. I used to argue with my dad about that. My dad's been trading stocks for 75 years. He's in his 80s. He started when he was 12 years old. He bought Bristol Myers. He's still proud of it. Still holds it. But he would call me and he'd say, can you believe these crazy markets?

1:17:04They missed by a penny and the stock's down 9%. And this is in the 90s when I'm in grad school learning this stuff. And I'm like, yeah, it didn't drop enough, dad. He's like, what do you mean? I'm like, look, obviously, I don't know about the specific stock, but I'm telling you that generally, they only drop between like a half and two thirds as much as they ought to. It needs to move a lot more. And the reason it doesn't is because of guys like you, dad. In other words, he's the guy who goes, it dropped too much. I'm going to buy the dip. But in fact, it needed to drop further. And people like my dad jumping in there.

1:17:32And now we've got enough institutions that it falls the full 14 % it should have fallen instead of only falling nine. Again, all numbers made up or money back. That can be true. That can be a statement of efficiency. But the question is the mechanism. Is it occurring because of greater efficiency? Or is it occurring because of greater illiquidity that is being created? But if it were the second one, then we'd see the quants printing money. But we know they're not. We know how tough it is. What we actually know is that the only business left is quants that are arbitraging that. In other words, the returns to fundamental analysis would deteriorate.

1:18:06The returns to the type of arbitrage that you're describing would increase. And that's exactly what we've seen. I don't think we've seen people making more money off things like betting on what happens right after earnings. Granted, we wouldn't necessarily call it post-training's announcement drift anymore, which is maybe now it's an overreaction on post-strainings or whatever. But the people who do that kind of trading, you buy it, you hold it for a day, a week, a month, not the millisecond guys, which obviously is a little bit of a different thing. You can read all the academic papers that their stuff is based on.

1:18:35And you see, oh, this one's 5 % a year, and this one's 7 % a year, and this one's 3%. And they've got two dozen of them. And then you look at the performance. Even if you only look at the survivors, they've outperformed by a few percent a year. It's pretty tough out there. And that's because a friend of mine once said to me, he said, yeah, sometime around 2000, somebody turned on the big computer and they just started pushing all the prices to the right places a lot faster than they used to. I've talked to a lot of quants because a lot of people I went to grad school with are now really, really top quants, former students and so on and so forth.

1:19:03I got 4 ,000 former students now. Nobody thinks it's gotten easier. Easier relative to what? Easier to what it used to be? No. Easier relative to actually trying to project the fundamentals? Absolutely. What do you think of fundamental analysis these days? I don't think anyone does it anymore. I don't think anyone really cares, in all seriousness. Shouldn't that create opportunity if you did it? Is your point that if someone did it, it would be great, but they don't do it? This is the second component of it, which is if you actually think about the parameters around the assumptions behind all the academic models on this, things like Grossman-Stiglitz, which is really what you're referring to when you talk about these types of parameters.

1:19:40Will it be easier for people to make money? Is there an incentive for them to make money off of fundamental analysis? Grossman Stiglitz is just a reformulation of the wisdom of the crowds. If everybody votes, we're going to get something that looks pretty close to the accurate. The wisdom of the crowds and the Grossman Stiglitz has its own assumption, not dissimilar to Sharpe's that Passive never transacts. Grossman Stiglitz assumes that the market has roughly equal endowment. Every participant basically gets one vote. That's how the wisdom of crowds works. But what we've actually done is substitute a market in which basically 45 % of the people get one vote of radical size and everybody else gets a tiny vote, that means that the wisdom of crowds breaks down under those simulations.

1:20:22You end up with the answer that the 45 come to, not that the 55 come to. So Goldman came out with this report the other day that I feel like was aimed at you, don't you think? I mean, it didn't put your name. It seemed like they were writing it to address you. Would you agree? Yes, I do think that's correct. I thought they had a couple of good points and some other points that weren't as compelling. So I feel like you deserve a chance to respond to that. Absolutely. So Goldman Sachs came out with a report headlined by David Koss and the head of strategy, in which they attempted to isolate the component of passive.

1:20:52And they pointed out that passive effectively had a very small impact relative to other controllable variables. This study, like almost every study that has been done, with notable exceptions of some of the academic work that has been done, relies on a definition of passive that is derived simply from something like fact set indicators. And so everything in an industry fund, everything in a sector fund, everything in XYZ is included in there. The most passively held stock, according to Goldman Sachs, was something like 42 % with NASDAQ, NDAQ, the ticker. That's absurd. They next came to the conclusion that the most passively held stocks were the REITs, et cetera.

1:21:32And Bloomberg did the same analysis earlier in the year. You end up with a conclusion that the least passively held stocks are actually the largest stocks. As a result, all parts of the analysis are just off of that because what we actually know is the most passively stocks are the largest stocks. Active managers can't hold Apple in proportion to its market cap in their portfolios. At least not the vast majority of active managers or individuals can hold it at a weighting that is consistent with what it's held in passive vehicles. Among other things, the 40 Act prevents them from a diversified basis in holding many products that are as concentrated as the indices are currently.

1:22:08that tells you that the analysis is completely wrong in its specification. And it's just that simple. I think you have a good point. When they said, oh, the average stock is 25 % passive and NVIDIA is only 22, and then they said they ran a regression and it showed that the lower passive ran up more, I thought 25 versus 22. And that's before we even get to your point about is that really properly measured. So even though in the end, I read similar conclusions to them about the rise of passive, I think you have some good points in response to what they're saying. I just want to recap a couple of things.

1:22:41We've talked about aggregate valuations and we talked about how flows into passive funds drive up valuations at the aggregate level. How much depends on how quickly we think the effect decays. That's kind of where we landed on that. Cross-sectionally, maybe markets aren't as passive as they seem because there are growth in hedge funds and things like that that we don't have as much visibility on. Hedge funds have not grown since 2012 other than the underlying asset values. So flows have been negative into hedge funds for an extended period of time. What Randy is describing is a component of hedge funds effectively within hedge funds itself.

1:23:14It's transitioned from fundamental analysis to increasingly high-speed quantitative trading to arbitrage out exactly the components that Randy is highlighting. And use of leverage and other kinds of things that wouldn't call themselves a hedge fund, but are working to make markets more efficient. We talked about that, but I don't know if we talked about where, Mike, do you think the cross-sectional impact is on stock valuations from index investing? I did. So I think the cross-sectional impact is to raise valuations significantly. The key question becomes exactly what Randy highlighted, which is effectively, what's the degradation factor associated with that?

1:23:49And what are the mechanisms by which that degradation occurs? That's aggregate market though. Cross-sectionally, how is it affecting large cap stocks versus small cap stocks? On a cross-sectional basis, there's a huge difference in multiplier effectively with the inelasticity component. So this is work I've actually been working with Valentin Haddad to derive some of the components of it. And if you actually look at the inelasticity or the elasticity, the smallest stocks are far more elastic than the largest stocks because they have readily available substitutes. I can choose to buy Delta Airlines or I can choose to buy United Airlines.

1:24:22I have no substitute for Apple or NVIDIA or anything else. The second is the smaller share of the market that is actually held by active managers, the greater that decrease in inelasticity. If you got to a market that was 100 % passive, the market by definition would be perfectly inelastic. There would be no marginal buyer or seller. Take it back to 99, the market is still highly inelastic. The point that I'm making is at a certain point, the market moves from benefiting from the contribution of this new entity to being degraded by the size gain and deterioration of the capacity of the other players in the system.

1:25:00This is exactly what Valentin's paper has written about, the strategic response component. Perversely, as passive gets larger and larger, the strategic response becomes exactly what Randy's describing. It effectively becomes around arbitraging the behavior of passive as compared to trying to make an articulation about the underlying fundamentals and the future cash flows associated with the firm. Because in any realistic form, those play a very small role in determining the valuations in any one period. When we talk about a stock jumping or falling by 20 % because of earnings in a single period, that is irrational, as Randy's father pointed out, if it's a complete one-off.

1:25:42But if it's a look forward, if you're effectively saying, well, all future cash flows are going to be affected by that one penny miss, this causes me to degrade my model, then that would be something different. But those are two very different mechanisms to have people simply arbitraging a price behavior versus having people make a attempt at understanding what the forward fundamental outlook is. A market that is shifted from that forward fundamental outlook becomes increasingly disassociated with those forward fundamentals unless a mechanism for increased strategic response arises. Valentin's whole point is that strategic response is a fraction of what historically thought it was.

1:26:23And it is falling as passive gets larger and larger and larger. Valentin's work's really interesting, very high quality work. First question you ask is, how much more passive are we than before? We have these funds, they don't call themselves hedge funds, they're institutional law only, but they have$100,$200,$300 billion and unbelievably, insanely smart people at them, including friends of mine and friends of theirs who I've gotten to know. Sometimes they're able to use leverage and derivatives and other things. And so there's some big players in there. So, okay, we've done that to death. So that's the first question.

1:26:55How much rise of passive is there in the cross-section? I'm not sure it's that much. It might even be negative, but let's say there is some. So then Haddad does the strategic response paper. It's a quality piece of work, but there's a lot of papers that estimate things a lot of ways and write theory. I don't think we should take any one of these and anoint it. It takes a long time before you can really have confidence in that kind of stuff. But if you have very solid methodology like Greenwood and Salmon, where you're using standard approaches to estimate time series effects and so forth, you can have a lot more confidence in that.

1:27:28So that's the second thing is, okay, are we sure it's right? Maybe it is right. The third thing is, what he finds is the strategic response knocks out two thirds of the effect, and there's only one third left. Now, I think it's your belief, Mike, that with the higher levels of passive that you believe in, maybe he would get a higher answer than a third. But all I'm saying is, you're starting out with something I think is either small or non-existent, then you have to put in some kind of fudge factor for how sure you are that this paper is the right answer. We all know, look, I'm an academic. We know we like to get meaningful effects and we tweak our models and we tweak our empirical work to get something that's interesting.

1:28:01We don't do anything sleazy. And I'm certainly not accusing Valentina Dodd of doing anything sleazy. If you build your model one way, you build another way and one of them gets a more interesting result, that's the one that tends to get published. And then the third thing is even taking the result to face value, you got to take a third. So it's like a piece of a piece of a piece. And so that's why I'm not worried on elasticity. It's not that there couldn't be something there, but I'm not convinced there's something there. And if there is something there, I'm not convinced it would be big, but my mind is open.

1:28:26It could be there's something there and it could be big. So as opposed to in the aggregate where I'm like really pretty sure there's not a problem on this side, my mind is marked. I'm not entirely sure how to respond to that because among other things to assert that there has not been a rise in passive index investing when indexes were not even created until 1957, with the exception of Charles Dow's Dow indices. It's about whether the average dollar is smarter, more impactful. Because as we know, a lot of those old mutual funds were 80 % passive, or they were 90 % passive or whatever. And your point is, the mutual funds with those same names may be even more passive than they were.

1:29:03Although I don't know if the thing that says that the average is more passive, that may include the index funds, but I'm not sure that the average active fund is more passive, but maybe it even is. But then there's just all these other folks out there doing stuff. I understand we disagree on that. I'm just highlighting. I've got two points. One is if you think about all the smart people, you know, who are doing this and how much money they control, including leverage and everything. And then you think about the person in your seat 30 years ago and how many smart people they don't know how much they would have controlled.

1:29:29These are the highest paying jobs in the world, other than starting a tech company. Think about how much talent there is from abroad. How many people from Europe and Asia and Latin America were there sitting in those chairs with 180 IQs 30, 50 years ago? Now we have zillions of them. I just feel like there's so much more talent being thrown at the bottom. So that's my intuitive answer. The outcome that we know in terms of it being hard to find mispricing, now the mispricing issue is different from the elasticity issue, but they are related. In other words, if things were just way more passive, the market was more kind of sloppy, then I think it would show up in mispricing as well as in elasticity.

1:30:04Absolutely, Grant, and you might be right. I have a strong opinion on this. I want to state my strong opinion, but it's loosely held. Six months from now, I might call you and be like, you know what, you were right on that point. As I often say on this, I hope I'm wrong, but I think I'm right. So effectively, I'm just on the flip side of Randy on this. The evidence in terms of what is actually happening in markets and behavior is best explained by models of inelasticity and the rise of passive. On Valentin's paper, we had him on the podcast. I think you listened to that episode. Maybe my question wasn't well-formed.

1:30:36Actually, Cameron asked the question, but we asked him if his research findings support the idea of a bubble in large stocks due to flows and index funds. And he said, I have mixed feelings about it. I'm going to give you the research answer, which is that we don't really know. So Valentin's done the work and I agree. It seems to support what you're saying, but I don't know if Valentin interprets it the same way. I don't want to speak for him, but as you could infer from that answer, the research answer is not the same as his individual conclusion at this point. That's fair. He said his feelings are mixed.

1:31:07I will tell you that I spoke with Valentin earlier this week, and many of the things that I raise as concerns, candidly, he had not considered. And his reaction to it was, not only do I think that you are directionally correct, and those are plausible, but it actually raises the importance of what we're doing. From the stuff that we've talked about, what do you guys think from each of your perspectives? What are the implications for end investors? I continue to stand by my underlying point, which is that as long as this process continues, you should expect rising valuations, which will lead to higher equity returns than should otherwise be realized.

1:31:46if the process stops or reverses, which could be due to a combination of rising prices because withdrawals are always a function of asset level, while contributions are always a function of income levels, or because of a regulatory change in any way, shape, or form, the process of reversing that could cause the system to go into reverse with much sharper corrections to valuations and wealth levels than people are currently anticipating. My thought is we have a canary in the coal mine on this stuff, and that is multiples. If NVIDIA was trading at a forward earnings multiple of 80, then we'd have real worry there.

1:32:29If the market as a whole was trading at a forward earnings multiple of 50, we'd have real worry there. As it is, it seems like the market has a yield of 4 % real. You can do it off dividends. You do it off earnings, but you're going to get an answer like 4 % real and long bonds are paying 2 % real. And so it looks to me like that's a pretty reasonable price for the market to be at. And if the market gets to an unreasonable price, then we have to worry about it, whether it's caused by rise of passive or anything else, we have to get scared. But I just don't see that yet. I had this conversation with Bob Schiller once after his book came out, Irrational Exuberance.

1:33:03I said, more or less what I said to you, Mike, I said, the equity premium puzzle says prices need to be this high. So shouldn't your book be called Rational Exuberance with stocks are finally getting to a price that sort of makes sense logically? And he said, no, he thinks there are two mistakes going on. That on the one hand, people don't want to hold stocks unless they have a 5 % premium or more from them. And on the other hand, the people were mistakenly expecting that they were going to get that very high premium. Bob's one of the smartest people in the world. So that's a great answer. And he absolutely might be right.

1:33:33So I'm sort of looking and saying the numbers seem pretty reasonable. And he's saying that's because people are making two counteracting mistakes. And that could be correct. And so you can get a crash without stocks getting to prices that seem irrational from a theoretical point of view. And that may happen. And look, we've always had crashes, and we'll probably continue to have them. But if prices get five, six, seven times higher than where we are today, without earnings multiplying by similar amounts, then we're going to have to get very concerned about this. I think right now we're in an okay place.

1:34:02But I think what's great is that you're looking to windward and asking the questions so that if things start to seem scary, we can go and say, look at all Mike's analysis, look at all his thing. If he was right all along, we probably should have acted a little sooner, but hopefully it's not too late to act. But if you weren't talking about these issues, then we wouldn't be positioned for that. I do think that there are a couple of really critical things to remember. One is that forward earnings estimate of 22 times presumes 20 % earnings growth into this year. Secondly, it's stated off of non-GAAP earnings, operating earnings as compared to GAAP earnings, trailing GAAP earnings are around 200.

1:34:34When we talk about historical market multiples and the equity risk premium that Randy is referring to, the average to deliver that number was tied to something around 13 times on GAAP trailing, not forward at 22 times. On any metric, we're extraordinarily extended versus those historical averages. Now, Now, part of that could be, as Randy points out, a realization that we should have a lower equity risk premium, but it would be unrealistic then to forward project higher expectations, which is the second error that Schiller was highlighting. And as I've pointed out to you, Ben, we're actually seeing this.

1:35:11We're seeing the Vanguard investor surveys. They're actually expecting higher and higher returns, even as the forward potential is getting lower. So I disagree with Randy in terms of whether we're in a good place right now. The real question that I have is what's going to happen to the flows that's going to determine whether this gets realized in a short-term period or over a longer-term period than I expected. I asked ChatGPT for the forward trailing earnings model, and then I double-checked on Google to make sure it wasn't a hallucination. So clearly, I'm the world's expert on these. Now, clearly, you've thought a lot harder about how we should interpret these multiples of me.

1:35:46So I have asked it on that, and I'll think harder about it. It's a fair point. What do you guys think the typical retail investors listening to this podcast or financial advisor who's helping guide their clients listening to this podcast should be doing with this information, if anything? Here's the problem. If you've got an equity premium, you're going to get something like a 4 % yield on earnings. And that 4 % you're going to add to inflation, obviously, because these are real assets. You're at inflation plus four. And so you do have to decide, well, you've got clients and they've got stocks that are going to give you inflation plus four.

1:36:17And you've got bonds that are going to give you inflation plus two. And it's pretty hard to argue that you shouldn't have a pretty solid chunk of that in stocks. Is it possible that there's going to come a day when the world says, hey, we demand inflation plus five from stocks, and then they crash? Not only is it possible, it's almost certain. We've seen, I mean, geez, we've had crashes. It seems like now we get them every four years or so. But the problem is you kind of go nuts. One more quick Bob Schiller story. Bob came to Richard Thaler's class when I was in grad school. He did a seminar, and then Richard got him to come to the class, which was wonderful.

1:36:48Bob told us that he thought the market was ludicrously overvalued, and he made his case based on cyclically adjusted price earnings and all these other things that he's made his fortune and legend off of. I said to him, because I was a young wise ass, how long have you been saying that the market's massively overvalued and is likely to crash because it's up a lot the last few years? And then Thaler said, yeah, Bob, that's a good point. You've been saying this since 89. So this was in 94 that this conversation happened. So in 94, Thaler said, you've been saying this since 89. Now, then Bob wrote his book in around 2000, and then the market crashed.

1:37:24And then obviously timing is everything. None of the journalists said, Dan, but haven't you been saying this since 1989? And again, not to throw shade at Bob, he was amazing. It's just to say that you can be wrong for a long time before you're right, crash. And I know you're always very careful about this, Mike. I'm not throwing shade at you either. I know that you're very aware of this problem and how hard it is. So I'm just saying, if I'm a financial advisor, I'm looking and saying, if you buy and hold forever, you got an inflation plus four here in stocks, you got inflation plus two in bonds, something like 60 % in stocks is not unreasonable.

1:37:53And when that crash comes, it'll be painful for a year or two, but then we'll probably be back where we were pretty quick, like we usually are. You ride it out. So I'm interested in your thoughts, given those challenges, and given that I know you're keenly aware that we're never going to be able to time the crash. So I think that there's two separate components to that. First, I think your expectation for forward returns in terms of inflation plus four, to your point, Will there be a point at which that goes to inflation plus five and therefore stock valuations correct meaningfully? That would actually not be a meaningful correction because you're talking about going effectively from a PE of six to seven or seven to eight type dynamic.

1:38:27You're talking about a 12 and a half percent sort of crash. That's not what I'm actually talking about. If it goes to six, then it's a 20, 20, 25 percent crash. And that is a normal crash. Correct. So that is a component of the expectation path, which is if you actually think that that is correct, then you're talking about wiping out a significant fraction of returns over a holding period in which you're going to receive much greater returns from investing in fixed income, positioning you to be there. I'm not trying to suggest that that means that everybody should go all in into fixed income. It's simply saying, actually, that the mechanism by which you're proposing, which that decision making is done, has largely been sourced out to a rigid model of diversification that doesn't allow you to change those based on the valuation components.

1:39:12That's actually a critical component that lowers those feedback mechanisms, that strategic response, exactly as you were describing. The second thing that I would say around that is it's a very different thing to say that the stock market has historically returned 8 % a year. And my expectations over the next 10 years are that the stock market will return 8 % a year. Nobody invests for 100 years except for a very few select people. And as a result, that terminal risk is actually a really, really big deal. Stocks have a very different behavior set to fixed income. You can dollar cost average into both, but when you're taking money out, the volatility of equities works distinctly to your disadvantage.

1:39:55You have to sell more when prices are low. You have to sell less when prices are high. That whole process reverses itself. You're not into fixed income versus equities for the return characteristics as you get older. The reason why you switch into fixed income is because of the certainty of the payout component to it that causes that dollar cost averaging to work in your favor relative to simply holding equities. This is the case for the target date funds. Exactly. 100 % the case for target date funds. Except if you actually look at an aging America, it owns more equities than has ever owned in its history.

1:40:31Your thought is it may be the kids are all right, but that there's too many 68-year-olds who are still at 70 % equities or something like that. That might be true. 100%. So let's say we agree, not only could we get a normal 15%, 20%, even 25 % crash, which is horrible, but there's a chance of a 50 % crash out there in the next decade. I have a lot of smart friends who say, did you notice that the debt is over 100 % of GDP and that the deficit is gigantic? The newly elected president doesn't seem like somebody who is afraid to cut taxes or afraid to spend a lot of money if it'll make him popular.

1:41:06And when you put all that together, mightn't there be a day when the bond markets say, you know what, we're just not sure these long-term bonds are going to pay off. So in other words, isn't a 50 % bond crash about as likely as a 50 % stock crash or more likely? I mean, shouldn't we be scared of a big old bond crash? One, I think bonds have already crashed significantly. So a 50 % crash from the levels of 2020, sure. If I look at TIPS or anything else, or I'll give an extreme example, the Austrian century. About a real debt crisis. Okay, that is a great point. Let me salute you. But I'm talking about a real debt crisis where people say, where nobody wants those freaking bonds, and they go not 4%, but the 12 % or the 18%, you know what I mean?

1:41:47Couldn't that happen here? I think highly unlikely, but certainly not as likely as a 50 % correction in equities. The second point, though, that I would emphasize on that is if the US government loses control of its economic system in that manner, do you honestly think that Microsoft is going to retain control of its IP? It's a fascinating question as to how that would get handled. So good point. We had a guest, Scott Sederberg. I don't know if you guys are familiar with his research. His approach is a little bit conventional because he's using bootstrap simulations with global data, so not just US bond data, but he finds for retirees, Bonds are actually quite risky historically if you sample from around the world, not just the U.S., because in real terms, bonds are actually extremely risky at long horizons.

1:42:33Even in the U.S., there have been serious bond drawdowns. Recent history, not so much, but if you go back a little bit further, the real returns on bonds are pretty scary for long-term investors. Anyway, that's just a bit of a side point. It's hard to find anything that's truly safe, particularly in the world that Randy's describing. If you have a U.S. dollar crisis in which suddenly the U.S. dollar is no longer accepted around the globe. What you're really talking about is a radical deterioration of the purchasing power of the American public, and in turn, a broad collapse in economic conditions.

1:43:04It is a scenario that nobody wants. I think a lot of people fear it far more than they think. And unfortunately, I think that many of the discussions we're having today, people's behaviors are in part influenced by these narratives. It's safer to invest in the equity of Microsoft than in the debt of the United States. And that's a very strong statement. I've been a teaching expert once who told me that five years after taking an entire course, students only remember one thing from the course. So as a professor, you should make sure you know what you want to teach them. And so I took to asking students when I ran into them years later, what they remember.

1:43:38And very consistently, the thing they remembered from my course is that 1 % a year for life doubles your money. The natural log of two is about 0.7. So 1.01 to the 70th power is about two. And so a lifetime at 1%. So 2 % a year for life quadruples your money. So all I'm saying is, if you're even asking the question about the relative riskiness, boy, maybe take the extra 2 % because 4X is a lot. And I would highlight that the more people that believe that, the less the possibility of earning that excess return. Stock valuations are too high because people think they're too safe. What do you hear?

1:44:09You hear people say, I'm saving through my 401k. What are you saving in? I'm saving in the S &P 500. You're not saving. You're investing and investing is an inherently risky activity. That's why you're receiving the compensation that Randy is highlighting. Risk has to be there. Mike, I know you just tweeted about this. So I know some of your thoughts, but why don't you think BlackRock, Vanguard, but also academia, like Ralph Coyne, when he was on our podcast, he wasn't worried about this. Haddad, when I talked to him, wasn't too worried about it. Maybe you've talked to him more recently and he is.

1:44:38Antoinette Shore doesn't seem to worry about it. She thinks targeted funds are a good thing. Why don't you think more people who should know better, if we take your perspective, why don't they share your level of concern on this? So again, I think it really depends on how you ask the question. So I've watched your coagent episode. I've watched your Haddad episode. It really depends on how you formulate the question. So what coagent is actually saying, in which he says, I'm not particularly concerned about that. It says that he's actually anticipating the strategic response. I actually agree with that.

1:45:07I do think that there will ultimately be a strategic response, but strategic response comes at what level and what form does that strategic response take? Those are the key questions. I'll just be very straightforward with you in conversations with both Ralph and with Valentin. It becomes a question of them understanding either how far we are in the process or how favored we have actually made the process of passive investing in our legal framework that is driving the growth and preventing candidly a response function. Mike, what evidence would you need to be presented with? Obviously, we've talked about a whole bunch of stuff today.

1:45:43You don't want this to be a problem. You think it is, but you don't want it to be. What evidence would you need to see to be like, you know what, there's no issue here? What I'd love to see is actually non-confirmation. In other words, the hypothesis that I formulated, I'd actually like to see that disproven in any one form. But the more frightening thing for me is at every step in this process that I go through, And I'll give a really simple example. I just ran through an analysis of the impact of introducing a levered ETF to trade Monster stock, which is a perfect example of the meme stock type phenomenon that Randy highlighted.

1:46:18The introduction of a two times levered ETF into Monster meant that$500 million created $14 billion of additional market cap. So a 28 times multiplier on a roughly$50 billion stock, which is far above what you would expect. Now, because it was two times levered, it meant that it's actually 14 times the amount of money that went in. But$500 million was able to create a 28 times multiplier in that particular stock. It subsequently has now led to the announcement of issuance of$42 billion of equity and debt. The impact of these things in terms of the misallocation of capital and resources and behaviors in our economy, allocating more capital to the largest firms that don't need it and simply are repurchasing stock, which ironically enriches their executives, but does nothing to invest in society.

1:47:08not that I'm suggesting they have some great brand responsibilities to society, but it is an important impact to understand, means that they have lower cost of employment, means they have lower cost of capital, et cetera, which further advantages them relative to small businesses where innovation and entrepreneurship typically happens in our economy. We've created a system that has negative feedback loops for both our society and our potential retirements. That's what I care about. Randy, you started off saying you're not worried about this stuff. After hearing Mike's arguments today and going through this discussion, where do you land now?

1:47:43I'm still not very concerned. I mean, I guess what I'd say is on the cross section, my view is if Microsoft's trading 10 % too high and Delta's trading 10 % too low because of elasticity issues with large companies, obviously we want prices to be as perfect as possible. But I think prices are closer to perfect now than they were in the past and we've muddled through as a society in the past. Of course, there are these wacky GameStop type situations. Maybe those become a huge issue in the future. I think for now, it's unfortunate that there's going to be people who lose a lot of money on those.

1:48:13So I'd like to see less of that. I don't think it's a society-wide crisis. It's something that's always been there. Confessions of a stock operator and all that sort of thing is 100 years old. The one that would scare me is the aggregate. If I came to believe that the market was either way, way too high or had become way more volatile or was going to as a result of passive investing. On that score, from an evidence perspective, well, yeah, if the multiples get high enough, I'll start to worry. That won't necessarily mean it's because of the rise of passive, but I'll certainly be open to that as one possible explanation for why multiples got so high.

1:48:47But mostly, I would say it would be more about understanding less about evidence and more about really trying to understand why it would matter if people are saving through defined benefit pension plans, 60 % stocks, 40 % bonds. And then And on the other hand, you put it in the target date fund and it's similar. It's not that clear to me why it should make a big deal. And obviously, I read the paper, Dimitri and Lujang. They've got an interesting argument. We put those things in the bucket of this might be a thing that's important. Let's do lots more research and maybe over time we'll discover there's a reason why doing it in the passive way creates problems.

1:49:23Even when that money came out of pension funds, they have a pretty similar percentage in large stocks to what people have now. I mean, in the end, the passive and the active have to add up to the whole market. And if the passive is representative of the market, then when you subtract the passive from the market, the active part looks just like the passive part. And I know, obviously, again, if you count as active funds, something like a sector fund, then that doesn't have to perfectly hold. But the fundamental idea, which I guess is Bill Sharp's idea, seems pretty solid. So it shouldn't really matter the format very much.

1:49:52It's a second or third order effect. It might matter enough to care about, but I don't see it as a scary thing because it's a second or third order effect. when I multiply out the numbers on these flows, I don't feel like even if somehow active didn't count and passive did, I don't feel like it should be that problematic. So I'll think hard about all the stuff we discussed and maybe I'll be like, oh, I'm starting to be convinced. But as of now, I still kind of feel like logically it shouldn't matter. And then empirically, I don't think the price increases we've seen are of a realm that looks scary to me.

1:50:20My immediate reaction to that is that to look at current valuations at 22 times forward and compare them to the past. It is not an appropriate approach. If I look at everything ranging from dividend yield to sales yield, the underlying expectations embedded in the market today are higher than we've ever seen in the past. Totally true. I just think those old prices were too low. And I want to be clear, I thought it in 1993 when I got to grad school. I came to grad school and I learned about the research and I said, oh, the stock market's way too cheap. And I feel like it's spent the last 30 years proving that right.

1:50:55And unfortunately, I didn't even have to go to grad school to get that because I learned that in undergrad. And we're roughly the same age. The point that I would make is that is very much an everyone knows. The problem is, is that as you've already agreed to, the transition from undervaluation to even if we say fair valuation, as embedded in an expected return that is now built into asset allocation models, that higher expected return, regardless of whether it's going to be realized over five years, 15 years, or 30 years, or never realized, realized is going to cause those asset allocations to change in a very slow fashion.

1:51:31If we add to that the impulse associated with passive, which I think even you would agree is positive, there is no data that suggests that it is negative. If you add those two components, then the risk that we're actually at very high valuations with very high equity allocations at exactly the time that we're going to begin to need those asset levels in order to fund the retirements that are in front of us is extraordinarily high. To your point that it's all the same, it's not. If I go back to 1929, a peak in activity in the stock market, 10 % of American households owned equities. If I go to the 1960s, which you're referring to in terms of pensions, almost nobody owned equities.

1:52:12What they actually had was a claim against their employer. Today, 62 % of American households own equities to their 401ks, and that is their requirement for retirement. So as a society, we have dramatically increased our participation and our exposure to levels that we've never seen before. To argue that that didn't contribute to the return profile that we're now relying on seems completely specious, even before I began the process of evaluating the impact of passive investing. There is an interesting paper on, I think it's a theoretical paper, they've got an equilibrium model by Schmals. Have you read that one?

1:52:47I may have, but I'm not entirely sure of the authors. Schmalz and Zaym, I think, is the co-authors. It's not published, but they talk about how basically what you're saying, that a shift away from individual stock holdings from households into index funds should increase market-wide valuations because it's getting less risky to invest, which increases equity participation, basically exactly what we're saying. Anyway, it's all plausible. One of the things that stuck with me last time we talked, Mike, was that we asked that question of what should people do, what should individual investors do? Your answer was, there's not much you can do.

1:53:16You've got to hold on and hope things are okay. And it's more about advocacy and trying to change the way things are structured as opposed to changing your asset allocation decisions. Do you still hold that view? I do, unfortunately, because I have to actually carry forward my beliefs and say that if passive investing is causing valuations to rise, then I should expect higher expected forward returns and equities and outperforming actually, as I've shown you through presentations, becomes a harder and harder challenge, regardless of the skill level of managers. That's very straightforward. Now, with that said, are we getting closer and closer to a point, both through valuation increases and through agings of society, at the process of which this begins to potentially reverse itself?

1:54:00Absolutely. And so those are key concerns. The last component that I would just highlight is policymakers increasingly rely on markets to tell them how the economy is going and what policies are appropriate. We're now on our third consecutive presidential election, in which a key focus of how well is the economy doing is measured by the stock market. It's one of the reasons I would argue that Kamala Harris's message was so roundly rejected, because the vast majority of Americans are experiencing a quote unquote, to steal from the language of the day, lived experience that is radically different than that implied by an S &P approaching all time highs.

1:54:37Awesome. All right, guys, this has been incredible. Appreciate the generosity with your time, both now and in preparing for this conversation. So thanks again for coming on. Take care, guys. Thanks. Great to see you.

1:54:53This is a quick addendum for the end of the episode based on some email conversations between Mike and Randy. I just thought I'd add it on to the end of the episode so it's all here as opposed to having it in a follow-up episode. A big sticking point during the discussion was how quickly and to what extent valuation increases from flows degrade back to normal. How long do those valuation effects last? If the effect degrades, say within a year, the impact on valuations is limited to the effect of flows in each year because it goes away after that. At the other extreme, if it does not degrade at all, the effect is exponential since valuation effects from the previous year are compounded by the following year, by flows from the following year.

1:55:31We did discuss this or Mike and Randy did discuss this at quite a bit of length in the podcast, but Mike followed up by email saying that the disagreement on the price impact of flows really comes down to the strategic response from active managers. How quickly and to what extent are active managers trading to resolve prices that are too high in quotation marks due to flows. We know from Valentin Haddad's work that it seems that as indexing increases, the strategic response from active managers decreases. Mike is arguing that this creates an exponential effect on valuations because they don't return to their initial level because active managers don't have the capacity to execute the full strategic response.

1:56:10Then Randy replied and disagreed that he was making any assumptions about strategic response, but that we need to take a stand on the half-life of the impulse response to a trade. Randy says that there's no published literature on this topic and he describes in the email how you would do that study, but it's impractical to do. However, practitioners that he has spoken with have run these studies internally, but they don't release the data. Based on those conversations, he thinks that something like half of the effect remaining after a year could be reasonable as a conservative assumption. Then the valuation effect degrades by another half the following year and so on and so forth.

1:56:45At that level of degradation, the effects of flows into passive on market valuations would be pretty modest. Randy also makes the point that I think is pretty interesting that this is the math. The math that we're talking about is the math if we assume that zero of the dollars flowing into 401k plans would have otherwise gone into stocks in the absence of the post-2000 regulatory changes. But we know that in the previous world, if there were to find benefit pension plans, for example, that money was still flowing into stocks. They were 60-40 portfolios roughly, which is not a whole lot different from target date funds.

1:57:21That's an interesting point, that there were flows into stocks previously just as there are now. Then Mike responded that, no, this is really all about the strategic response from active, which as again, Haddad's work shows is decreasing as indexing grows. So we can't assume that the valuation effect degrades the way that Randy is describing. I mean, that really becomes the point of discussion. So this follow-up didn't bring any resolution. They're still not agreeing with each other, but it does kind of give us the research question that would need to be answered to come to a resolution. Hope that addendum was useful.