Why Passive Investors Lose | Contrarian Investor Michael Green

Michael:
[0:00] If money in a Bitcoin framework gets too expensive, there is no mechanism for adjustment.

Michael:
[0:06] And so, ironically, Bitcoin is actually anti-human ingenuity. In a scenario in which the price of money is going up, it cuts off access to many forms of capital, especially debt.

Ryan:
[0:22] Welcome to Bankless. This is Ryan Sean Adams. It's just me today. So I'm here to help you become more bankless. Michael Green thinks the dominance of passive investing has made an absolute mess, a catastrophe, out of our existing financial system. And someday, he thinks it's going to bite us in the ass. We're going to pay a very high price for blindly following the crowd. This was a fascinating idea. And very much like crypto, it's certainly not the mainstream take, which is exactly why I found it so interesting. A few things we discuss. The problem with index funds. Why passive investors lose. Volmageddons and mega firms. fundamentals versus narrative, which one's more important, why he doesn't like Bitcoin, but likes tokenization and smart contracts. And I thought, most curiously, his case for long duration bonds. I found that I agreed probably with about 50% of what Michael had to say and the other 50%, I found myself thinking about it in the very least. And that to me is the mark of a successful episode. So let's get into why passive investors lose with Michael Green. Bankless Nation, I'm very excited to be joined by Michael Green.

Ryan:
[1:31] He's a chief strategist at Simplify Asset Management. He is also a 30-year market structure contrarian who just simply hates passive index funds. Michael, welcome to Bankless.

Michael:
[1:42] Oh, thank you for having me. I actually, I have to clarify that. I don't hate index funds. I hate what they are doing to the market and the fact that they are effectively, that an external forcing has been introduced on them by the government. So let's be very, very clear on that.

Ryan:
[1:58] I like that. Yeah. I, you know, there's a tweet sized summary of my take on your take, but yes, we do want to get into that. The clarification of, the problems that you see in passive investing in general. But before we do that, the way sometimes you actually pop up on my Twitter feed is just occasionally, and I'll see you in kind of arguments in, I guess, the finance Twitter. So much of the bankless audience, I myself, very much in this realm of crypto Twitter, crypto X, basically. And that's a bubble in and of itself. And then you've got finance Twitter. And sometimes there's some cross, like sometimes I see your stuff. I see arguments you have.

Ryan:
[2:37] On crypto Twitter, we get in the weirdest arguments, man. We talk about whether layer twos are parasitic. We talk about whether layer one token should be valued based on revenue output or whether they're the special snowflake monetary assets. These are the types of weird arguments we get into. What weird arguments do you get into in finance Twitter?

Michael:
[2:57] Well, we largely get into weird arguments about whether level two are parasitic. Sometimes we'll it's the same sort of esoteric stuff, right? So you will have discussions around, should these assets be valued as money? We'll have discussions around, well, what is actually money? Is gold a monetary asset? Is the dollar a monetary asset? Is Bitcoin a monetary asset? Should it be thought of as a store of value? Is there something unique to that? How should you think about valuing securities given that they are financial claims? These are all the same sort of discussions that we are having. Part of the reason why that's so interesting is that as you talk about it and you describe the two as separate, ultimately, we're all describing financial assets. And so the question is, how are those ultimately going to integrate in a way

Michael:
[3:41] that is beneficial to the vast majority of the population? That's really what matters.

Ryan:
[3:46] Yeah, I tweeted this out this morning, Michael, because I was just thinking about doing this episode with you. And I said, in my darker moments, I wonder whether fundamentals actually exist or if it's just narrative all the way down. What do you think about that? Do you think fundamentals exist?

Michael:
[4:00] I think that fundamentals exist in a statement as to what has happened in the past, right? It's a little bit like the written word on paper. At every step in that process, there's interpretation. Do we classify this as a short-term liability? Do we classify it as a long-term liability? Do we monetize certain assets? Do we recognize a gain on sale? Do we treat recurring costs as one-time costs? These are all interpretive components that go into the quote-unquote factual fundamentals that we receive. And there's no better illustration of that than things like write-offs, right? We talk about kitchen sink quarters in TradFi, the idea effectively that when something adverse happens, companies will often use it as an opportunity to effectively clean all the skeletons out of their closet and say, oh, some bad assumptions were made, but everybody made bad assumptions. So let's clear that out. We'll have a one-time charge that writes off all those things in a single period, but you should ignore that. Those are fundamentals, but the interpretation of the fundamentals is what has been put on the page and how we choose to handle that is very much dependent on the context in which it exists. So like, are there fundamentals? Yes. Are those fundamentals fuzzy? Yes.

Ryan:
[5:13] So those fundamentals need to be interpreted by narrative. So it is narrative all the way down.

Michael:
[5:19] Well, there is an element of narrative, right? The fundamentals themselves are influenced by the narrative. That's actually the point that I'm making. So yes, there is a degree of narrative. But if a company says I sold $100 million.

Michael:
[5:32] It either sold something very close to $100 million. We can debate whether that last million was a final sale that was facilitated by favorable financing terms, or whether that should really be deferred revenue or how you should calculate that. But at the end of the day, it's going to be pretty close. How I choose to react to those fundamentals is going to be a function of several things, right? One is who are the actual participants in the market? If the participants in the market change, you should expect the reaction to those fundamentals to change. Super simple example. Imagine we enter into, let's just take, for example, a 10-year bear market for value investing. That 10-year bear market for value investing has a narrative component to it. Value investing became very popular because it outperformed. We ascribed a narrative to it that said value investing makes sense, The proof is it outperforms. 10 years later, the pool of value investors has shrunk dramatically relative to the pool of momentum investors. And our argument is very straightforward, that momentum outperforms value because value companies are lower quality. They have less sustainable growth. The managers that are picking the securities have no idea what they're doing. And therefore, momentum has a fundamental justification behind it. They're just better companies. And the evidence is it works, right? in both situations, the evidence was it works.

Ryan:
[6:57] Hmm. Okay. I think we'll maybe circle back on this topic throughout this episode.

Ryan:
[7:01] I want to get to one, I guess, theme. And this goes back to when before crypto, before I was in crypto, personal finance for me was somewhat of a hobby. Investing was somewhat of a hobby. I had a day job. And the way I got into this hobby was by route of John Bogle. And he preached the word of low-cost index funds. The thesis was pretty simple. Why pay expensive fees for do-nothing mutual fund managers who are just going to underperform the S&P and cost you a lot of money? Ignore that. Also, ignore volatility. Just dollar cost average in to low-cost index funds. And basically, over time, they'll compound returns. They'll do very well. This was kind of, I guess, investment thesis for somebody getting into it. And it's still generally the advice that I would probably give to someone in the normal world coming to me and saying, Ryan, how should I invest? It might be the advice I'd give my kids. Is there a problem with this advice? What's your criticism of passive index investing?

Michael:
[8:04] Well, there's two separate components to it. One is the question, again, going back to the narrative of what is the evidence? Well, it's worked. Right. And so, you know, that is part of the argument. Again, just like we were talking about value investing, momentum investing. The answer is everybody should index because indexing has worked. The process of everybody adopting that indexing process, right, becoming passive investors.

Michael:
[8:27] Actually, by very definition, defies the definition of passive investing. And so that actually is the core of why I'm so concerned about the growth and dominance of passive investing that's now emerged, where over 50% of the total market is invested in one form or another in an index fund defined as a market cap-weighted strategy. The second issue is the preference that the government has provided for that,

Michael:
[8:55] effectively endorsing the John Bogle message that the safe way to invest is in U.S. Public equities through a total market index. And that receives, due to a designation introduced in 2006, the Pension Protection Act, what's called Qualified Default Investment Alternatives. That QDIA designation basically creates a liability protected form of investing for the sponsors of programs like 401ks or for RIAs. It's very difficult to sue somebody for losing money because they bought the S&P 500 or they bought the total market index because those are viewed as safe choices.

Michael:
[9:36] That thumb on the scale is very, very important. And part of a huge portion of my research basically involves identifying the various ways in which government has actually biased the system in this direction. The second issue is because passive investing, by definition, and I can actually bring up a slide to show this. Okay, so this is literally from the actual literature that underpins the idea behind passive investing. This is Bill Sharpe's The Arithmetic of Active Management, written in 1991. This paper is the source of the definition that you hear that active managers and passive managers in aggregate own the same thing. And therefore, the only difference is going to be fees and therefore passive managers will outperform due to fees. The issue is how you define a passive investor. And Bill Sharp's definition was a passive investor always holds every security from the market. And an active investor is one who is not passive. So in 2016, a partner at AQR named Lasse Peterson wrote a paper called Sharpening the Arithmetic of Active Management, in which he challenged this definition and noted that anytime an index rebalanced, the passive managers had to trade. And so by definition, they became active investors with a potential to not behave as you would expect. This has actually turned into the largest hedge fund business, index arbitrage. And so Lasse was 100% correct.

Michael:
[11:02] My analysis, my introduction to this was to add a second wrinkle, which is index rebalancing addresses the portfolio composition from the standpoint of the end portfolio. But anytime you contribute money to a passive fund, you aren't contributing the holdings of the market in its totality, you're contributing cash.

Michael:
[11:22] Therefore, you are forcing a change in their portfolio that requires them to become active to deploy that cash. So there is no such thing as a passive investor because they are continually receiving inflows and far less frequently outflows into these passive vehicles. So by the very definitions that Bill Sharp uses, they're never passive investors. What they actually are is a systematic algorithmic investor operating off of

Michael:
[11:50] the world's simplest algorithm. Did you give me cash? If so, then buy. Did you ask for cash? If so, then sell. And the minute you recognize that that is actually what they are as an algorithm, you can both appreciate the benefits that they bring to the market. This is a simplistic investor who simply says, did you give me cash? If so, then buy. Well, introducing that into the market that is dominated by active investors who say something along the lines of, I buy when I think it's a good value. Otherwise, I hold cash. If I think it's a particularly bad value, I might short it. Introducing a new type of investor introduces heterogeneity into the investment universe that lowers volatility because it becomes easier to match buyers and sellers.

Michael:
[12:34] But when that strategy becomes dominant, which is where we are today, it actually changes the market behavior quite dramatically from what we build our historical models off of.

Ryan:
[12:46] Okay. So you're saying there's really no such thing as the passive investor. What a passive investor actually is, they're running off of a very simple algorithm, which is if I have cash, then buy the market essentially. But for the purposes of the rest of this conversation, is that okay if we shortcut that algorithm and kind of call them passive investors so we can just differentiate?

Michael:
[13:04] We can call them passive investors to differentiate, but I want to recognize that that is part of the challenge, right? They're not passive investors. And so anything that labels them as such is effectively saying, you know, somebody is X when they're actually Y.

Ryan:
[13:18] Okay. Okay. Fair enough. So, so listener with that footnote, we'll maybe proceed. I guess my question to you, Michael, in this critique of passive investing is, is your critique more systemic? Like this is a problem because we have passive investing dominant and this is a problem? Or is your critique that for the individual, say I am a passive investor operating on that algorithm, if cash, then I just buy the market and I do that on a weekly basis with my excess cash into perpetuity. Are you saying that that strategy for an individual will underperform?

Ryan:
[13:51] Because to your point earlier, it has worked for, I don't know, the past 20 years or so. I mean, you tell me, but passive investing has shown a fairly good track record for individuals.

Michael:
[14:02] Absolutely. And this is one of the things I try to make very clear to people. The advice that I give any individual is effectively, it is incredibly hard to outperform this benchmark, Because among other things, it is actually attracting all of the flows. And so, you know, I used to use the analogy, I still sometimes do. Have you ever played the game of the carnival where you shoot a gun, a water gun at a horse race or a balloon that inflates?

Ryan:
[14:26] Yeah, you're trying to get it to get bigger and bigger. It's a race.

Michael:
[14:30] You become bigger and burst the balloon or the horse wins the race. The best strategy in that game by far is you and a buddy both sign up and you both shoot at the same target. raising the water pressure on that target, the percentage of the time that you're hitting it, et cetera, right? Each individually you're going to lose, but you're going to split the prize. It's a little bit like a Nash equilibrium, right? You don't actually try to win. You try to win in concert with other people. Passive investing is the same thing, right? If I've effectively designated, hey, everybody shoot at this target, that target is going to outperform. And so if I actually look at how the market would be expected to change under this framework, you know, before you start talking about how markets are going to change, you have to understand how they behaved in the past. And so in order to do that, I went out and I surveyed managers and I asked them a really simple question. I was kind of surprised the academic literature hadn't explored before.

Michael:
[15:21] Which is you're a portfolio manager. You receive an incremental inflow of capital. How do you react given valuations, right? So how do you react if you receive a dollar of inflows? What's your marginal propensity to buy a valuations or one times on a Shiller PE? What is your marginal propensity to buy if it's 100 times and all the points in between, right? Totally unsurprisingly, people's propensity to sell rises as valuation rises and people's propensity to buy falls as valuation rises. That makes perfect sense given the framework that active managers tend to approach things with, which is a higher price today, all else being equal. If my forecasts for the future have not changed, lowers my expected return, right?

Michael:
[16:07] What was surprising is in this really simple example, that the intersection between these two marginal propensity lines hit at almost exactly 50-50 at exactly the market's historical valuation average. What that's telling you is that if you, so in order to test this, I took these responses, I fed it into a agent-based simulation where I gave each agent basically randomly some fraction of the responses. And then I randomly gave them cash or took cash away. And what emerges from that is a mean reverting market pattern in which valuations rise, people become less willing to buy, more willing to sell. The incremental dollar buys fewer shares, et cetera, right? And that causes mean reversion. And this is why the market has historically vacillated around 16 times, rising during bullish periods, falling during bearish periods. But if I introduce a market participant that we call passive, and they have that super simple algorithm. It simply says, if you give me cash, then buy. If you ask for cash, then sell. That's 100% marginal propensity to buy and 100% marginal propensity to sell based on flows. There's no consideration of valuation.

Michael:
[17:24] And so what ends up happening is as passive gains share, it shifts the market from that mean reversion towards a mean expansionary mode, right? In In other words, valuations rise. And this is exactly what we are actually seeing in the markets.

Michael:
[17:40] Right now, you'll notice that I cut this off here. And the reason I do that is because it goes off the screen and then crashes to zero.

Ryan:
[17:49] Wait, explain that. It goes off the screen and crashes to zero.

Michael:
[17:53] So what ends up happening is that the quantity of value becomes so high relative to the discretionary buyer who steps in to buy for value that they simply can't step in front of it. And we've seen this happen before. So the trade that I did first when I began to do this analysis was actually the XIV, the Volmageddon event, in which the passive or systematic algorithm share had grown to about 70% of the market. In my models, this made roughly a 95% probability that this would encounter an event that would cause it to collapse to zero, even as the price went higher and higher and higher. And more money was attracted to it and more money was confident that this was a perfect money-making vehicle. The reason why this occurs is because the size of the passive seller overwhelms the liquidity that's in the market and it effectively goes to its lowest legal level, which is zero. All my models lead me to a very, very similar outcome in the S&P 500. And you can just simply think about this as like, where is the fundamental buyer for a company like Palantir on the basis of the cash flows that it can generate, right? It's dramatically lower than it is today. Okay.

Ryan:
[19:07] So what is your message then for those that are doing the passive investing algorithm? Is it basically like it's going to continue working probably as long as the market participants are shooting their guns together at the balloon and S&P is basically a shelling point. But at some point, this is going to stop working and your returns are going to be like abysmal, subpar. you're going to get like, I don't know, you keep talking about going to zero here. I don't think you actually mean the S&P is kind of going to zero, but some negative event happens and the passive investing strategy no longer

Ryan:
[19:48] works. Is that your basic forecast?

Michael:
[19:50] Especially you enter into a market non-clearing event, right? And so what would actually happen is the S&P would not go to zero. They'd simply shut the market. They've done it before, right? To your point of going to zero. I lived personally through an event in August of 2015 in which you walked in and ETFs could not trade. Johnson & Johnson had fallen from $80 to a penny. Those are the sorts of events that can occur if there is a lack of market clearing. It becomes easier and easier for the market to fail on those clearing attempts. The more you remove humans from the process, the more automated you make the process. You see it in crypto all the time.

Ryan:
[20:29] Yeah, but you're not, are you forecasting an actual Armageddon type of event like that? Or is there not the idea that, well, because everyone's doing it effectively, S&P, US equity markets have become too big to fail. This is basically baby boomer retirement accounts. The government can't let this fail. Surely they would bail out any situation that goes in an Armageddon type scenario. And so at worst, you're looking at like very poor returns. You're not looking at actual collapse to, you know, Great Depression types of events, are you?

Michael:
[21:02] I want to be very, very careful in that because I think there's a lot of truth to what you're saying, that ultimately it is becoming too big to fail. And the likelihood is that the government would actually step in. What I am actually trying to articulate is we should be prepared for that event. We should be aware of it. And we should also understand that we have created it. It's not a random event. And so more than anything else, what I'm trying to do is raise awareness ahead of what I think is a likely event that will precipitate the actions that you're describing so that we can build a better system on the other side of it instead of doing what we have largely done since 2000, which is throw our hands up at every event saying who could possibly have predicted this.

Ryan:
[21:46] Right?

Michael:
[21:46] And therefore, we just try to kick the can down the road.

Ryan:
[21:49] I see. So you're effectively saying that this massive dominance of passive investing is going to end badly. So for people that are unaware of basically the composition and how much it's changed since, say, 1995, you've got a chart in one of your recent substacks, Michael, the composition of trading has changed. 1995, we see 80% in this active management type category. 2022, I imagine it's probably similar numbers, maybe even less. It's 10%. And 36% passive market making now. So the market composition has completely changed over the past 30 years or so. How did we get here? How did this change occur?

Michael:
[22:32] Well, I would argue that it has largely occurred because we have tried to guide it in this direction, right? Right. So in 1994, something very substantive changed. We exempted passive index managers for the very first time from the 40 Act. We allowed them to start using margin accounts to trade futures to replicate the index as compared to having to buy each individual stock on their own or in a statistical sampling approach. That changed the process of index replication from a vanguard problem to a market problem and created the conditions of index arbitrage that we see. Now, perversely, this is actually what caused the dot-com cycle. And that sounds absurd to say, but the problem was when you had the indices in 1994 and you chose to make that change.

Michael:
[23:23] Which suddenly created a profit center for Wall Street to basically cause the index to be very closely replicated with futures. The index at the time was market cap weighted. Most people think it's still market cap weighted. It's not. It's float adjusted. And so what that meant is in the period from roughly 1994 until 2003, if you put money into an index fund, a future would be bought by that index fund. The futures broker in turn would try to replicate that position by buying the shares in proportion to its representation in the index. But because of the condition in the market in the mid-1990s, there were a large number of relatively large companies that had high market caps, but relatively low floats. Companies like Microsoft, Cisco, Dell, et cetera, that had relatively recently gone public. Walmart was another good example of this. When you tried to buy those in proportion to their market capitalization as compared to their float, you were effectively buying twice as many shares of Microsoft as actually were available to be traded. That causes Microsoft to outperform. That low float factor was the dominant feature in the market from roughly 1995 until late 1998.

Michael:
[24:36] That three-year track record effectively was enough to start driving flows in a very meaningful fashion. In the 1990s, we didn't have factor funds. We didn't have high insider ownership funds. What we had was sector funds. And the Venn diagram of the intersection between low float and relatively high market cap was very closely aligned with the technology sector or recent IPOs.

Michael:
[25:03] So the demand to flow into the technology funds, there was reaction of this outperformance of the low float factor is what drove that final stage of the dot-com.

Michael:
[25:14] We know this because we saw the exact same mechanics play out in 2014, 2015 in the Chinese stock market, in which almost identical considerations caused that stock market to rise 500% over the course of six months and then crash back in a 1929-style crash from which it still hasn't recovered.

Ryan:
[25:33] Can you help explain the difference between market cap and low float to some of our crypto listeners? The way we understand this is we have a metric called fully diluted valuation. Which is basically market cap, right? It's all outstanding supply that exists in the entire world multiplied by the price. And that gives you a fully diluted valuation. And then we have another kind of market cap, which is like market cap of existing supply that's out there in the market effectively. And, you know, there's been much attention to very low float tokens with very high market caps, the supply kind of locked up with insiders, that sort of thing. Is this a similar dynamic that you're speaking of?

Michael:
[26:12] It's the exact same phenomenon, right? And so imagine a buyer suddenly shows up that is blessed by the government, you know, in a particular fashion that says, you know what, we buy all these tokens in proportion to their market capitalization. A token that is 99% held by a single individual, 1% float, if I try to buy it in proportion to its market capitalization, I am going to send that 1% float ballistic.

Ryan:
[26:41] Interesting. Yes.

Michael:
[26:42] That was the dot-com cycle. Wow.

Ryan:
[26:44] Okay. This is, by the way,

Michael:
[26:46] The same underlying reason why so many people in TradFi look at the crypto world and say, look, if you guys would simply talk to us, we can explain some of this stuff to you guys.

Ryan:
[26:57] That's what we're doing. That's what we're doing here.

Michael:
[26:59] Yeah. Right. But the general narrative is, okay, Boomer, right? We don't understand that stuff. No, we actually have lived through it. The problem is even in our own industry, most people have not taken the time to ask these questions and try to understand this stuff.

Ryan:
[27:13] Yeah. Okay. All right. So I see that. So what you're effectively saying is, the passive investing is causing these market distortions and the indices that we actually have, they aren't like high quality indices because they're skewed. They have biases in different directions. Systemically, things are biased in certain directions. Can we talk a little bit about the second order effects of this, of these types of distortions? One of them I think I've heard you talk about is this MAG7 monopoly. I've heard others talk about the rise of the mega firms. What is that phenomenon? In this type of environment, do the big companies just get bigger from the capital perspective?

Michael:
[27:52] Yes, to a certain extent. So there's a paper by Zhang, who's at Michigan State, called Passive Investing in the Rise of Mega Firms. So this is the paper by Zhang, came out in 2023.

Michael:
[28:04] And to zoom in on what they're saying, we study how passive investing affects asset prices, flows into passive funds, raise disproportionately the stock prices of the economy's largest firms, even when the indices tracked by the funds include all firms. Passive flows also raise the firm's return volatility the most, raise the aggregate stock market, even when they are entirely due to investors just switching from active to passive. Right now, why this is actually happening is quite interesting. So this is from a second paper. This is Valentin Haddad in 2021. And what he's looking at here is there's a theoretical relationship between what's called elasticity or inelasticity, which is really what this measure is.

Michael:
[28:51] Versus market capitalization. The larger a company is, the more an incremental buy, like if I buy 1% of Microsoft, that's an unfathomably large buy order that goes into the market somewhere in the neighborhood of $30 billion, right? A single attempt to buy $30 billion is a huge order into the market and will influence prices. The reason why in part is because market makers candidly can't put anywhere near that much capital up to facilitate efficient market making. And so that size order is going to shift. If I put up a 1% order for a $300 million market cap company.

Michael:
[29:32] Right? That's only $3 million. Nobody cares. That's easy to accommodate. And so the red line here is the theoretical relationship between elasticity, the change in price relative to changes in supply and demand versus market capitalization. What Haddad found is that that chart is much, much steeper. And the reason why turns out that it's tied to the indexing effect and the ability to substitute. So the largest companies, this is in log scale. So just to orient people, 12 and a half is about $3 trillion in market capitalization. The largest companies I simply can't replace. If you give me a buy order for an S&P ETF, can I ignore United Airlines? Yeah, it's like a $30 billion market cap company. It really has no impact on it. Maybe there's a news report that's out on United and it's behaving weirdly, so I'm not going to buy it that day. I'll buy it another day. It has no tangible impact on in my index replication. But do I have to buy Nvidia? Absolutely. Do I have to buy Microsoft? Do I have to buy Apple? Yes. At what price? Well, whatever price the market gives me is the right price, right? So I'm actually perfectly inelastic in my selection of those securities.

Michael:
[30:50] I will buy them at whatever price if you give me an order to buy an S&P index fund. The other thing that's happening is because we're actually typically firing active managers and replacing them with passive managers, perversely, that means there's net selling of many of the types of stocks that active managers are drawn to, right? Small caps, value stocks, et cetera, things that inevitably will have lower market capitalizations where theoretically my individual attention to the name could uncover something that other people have not yet found. So what we discover is that there is very high elasticity amongst the smaller stocks. And this is a function of the flow behavior. So as passive as gaining share, it's effectively pushing up these largest stocks and taking the market with it, even as it's having a much smaller effect on smaller companies.

Ryan:
[31:42] Okay, so we're skewed towards the large. And is your argument that that will result in decreased returns relative to a more balanced?

Michael:
[31:50] Eventually, right. And this is the other factor that has an air of inevitability to it, right?

Michael:
[31:55] Remember that contributions are always going to be a function of income levels. The most I can buy is what my income allows me to either finance or to buy directly out of my savings, right? What I can withdraw is always going to be a function of the value of the assets in total. And so again, you see this in crypto, right? When prices get too high for a meme token or for an altcoin or even for Bitcoin itself, it draws out secondary supply from whales who have accumulated huge holdings. That in turn pressures prices lower. Same phenomenon is playing out in the stock market.

Michael:
[32:35] When valuations get high enough, when market caps get large enough, natural sellers become the dominant flow as compared to natural buyers. And that's really what something like the Buffett indicator is telling you, right? When you relate stock market capitalization to GDP, what you're really doing is you're looking at a stock of wealth relative to income. GDP can be derived from an income approach, right? So that ratio between the two is effectively telling you how large that potential pool of whale sellers actually is. It's the same phenomenon you see in crypto. You see it all the time. The question is just like crypto, are we introducing an external forcing? This is again, the recognition of Jang. By shifting the market towards passive, we've introduced an external forcing. It's no different than BlackRock, including Bitcoin into its model portfolios or ETFs adopting Bitcoin, right? It's an external forcing of a new flood of capital that forces prices higher.

Ryan:
[33:35] Okay, so this overweight towards large cap companies, basically, we've given maybe one reason why this has worked so far. And that's just because everyone's doing it and everyone continues to do it and passive continues to increase. So we've talked about that. A second reason this might work, though, Michael, is just one observation, you know, a lot of that in the MAG-7, it's tech leaders, right? An observation about tech is there are network effects with tech. There are power law winners. The big do indeed continue to get bigger. Even something like AI, Peter Thiel has argued that's a, you know, a technology that really embraces centralization. I mean, more data, more economies of scale, more GPUs. So maybe there's actually a power law skew anyway in the actual value outcome dynamics of large companies that makes them superior, at least with this technology, this part of the market. And actually, it makes sense to be overweight large.

Michael:
[34:30] Again, that's a narrative, right? It's the same argument that value investing works. What's our definite? What's our evidence for it? Well, value investing works, right? Momentum investing works. What's our evidence for it? Momentum investing works, right? Large caps work. What's our evidence for it? Large caps outperform.

Michael:
[34:47] It becomes a question of why, right? Now I've offered you a mechanism that actually walks through and explains exactly why. And you're effectively saying, well, what if there's an alternate explanation? And you're a hundred percent correct. I can't dispute what is going to potentially happen in the future that could create that. The broader observation that you highlight though, which is this idea that large is beautiful, is actually itself a reversal of the narrative that we heard for years and years, right? That all the innovation and growth comes from small companies, right? Competition is what creates innovation. Instead, what you're effectively saying is, no, what we really need are national giants that can compete at scale. Effectively, let's create new countries, right? We'll call one country AI country, another country AWS country, another country Bitcoin mining country, right? And we're going to allow dominant participants to emerge. We actually know the implications of that. Yes, it raises corporate profitability, but it lowers agri-utility and benefits. Because what you're doing is creating monopolies that produce to average total cost as compared to marginal cost. And as a result, underproduce, creating scarcity in the economy where it doesn't have to exist.

Michael:
[36:01] And so the correct answer is you're right. There are economies of scale, and those are particularly extreme at the multinational level where I can do things like tax arbitrage across different regimes, right? Or I could move my factory from Michigan to southern part of the United States to take advantage of low union wages. And then when the low union wages...

Michael:
[36:21] In the South are not enough, I can move that labor to China and I can then export goods from China under favorable terms. These are all ways that size benefits you, but the entire point of regulation is actually to reorient that system back towards maximizing wealth in society,

Michael:
[36:38] not for the individual companies and individuals. And so, you know, when you talk about the implications of this, part of the problem is if we decide that our retirement systems are going to invest in public equities. We're already creating a differential access to capital for these large companies, providing them with an advantage over the local mom and pop where true innovation may actually occur and where competition that is tailored to that local market could actually be allowed to flourish at the same time that you're developing a skill set inside the country. So perversely, I actually think one of the second order effects is the world that we inhabit today in which we're convinced that small is disadvantaged. It's true. It is disadvantaged because we've chosen to make it so.

Ryan:
[37:24] I completely agree with that. And you look well said. I mean, I agree this is not the world as it should be. And certainly the regulatory and the system itself should not be encouraging and giving advantage to the large of the small. I mean, dynamism is so important for U.S. capital markets and markets in general. And so we should, where possible, at least level the playing field, or in some cases, advantage the small. What are some other distortions, I guess, this overweighting towards passive investing have caused? So we've talked about the rise of these mega firms as well. Is there something about governance capture here? Or like, what are some other distortions that you find unhealthy about our current situation?

Michael:
[38:07] Well, I think the most important component is actually the negative impact that it has on innovation, right? So what is unfortunately happening is you are seeing all the symptoms of what you are describing. The United States is becoming less dynamic. Economic and social and even geographic mobility are falling as the barriers to executing those get higher and higher and higher from any of the dynamics that you're identifying.

Michael:
[38:32] Simple example, if rents are extremely high, it makes forming capital very difficult for young people. That in turn makes it very difficult for them to start families, to relocate for jobs, everything else, right?

Michael:
[38:44] The cost of moving is dramatically higher and the rewards associated with it are lower. We temporarily interrupted that with things like work from home that allowed people to execute arbitrage, taking Silicon Valley jobs or New York City jobs and doing them in places like Wyoming or Idaho, right, where you were able to capture a big city type income in a small city location.

Michael:
[39:09] Now the tides have turned and we've moved back towards work from home. And what are the areas that are benefiting from, we've moved away from work from home back to office. What are the areas that are starting to benefit from it? Well, rents are exploding in places like New York City. Young people are trying to flock to these cities to obtain increasingly scarce opportunities. You know, all of these things are a function of choices that we make on our policy stage. And, you know, to ignore that and to simply think that like, well, the market is just magic and it just kind of, you know, accumulates value over time. And I'm going to save for my retirement by doing no work whatsoever, other than showing the discipline to dollar cost average into the lowest cost alternative. Right. Again, it works until it doesn't. And the question is, what happens? What are the societal implications? We already saw a pretty serious event in the Volmageddon component. That was a $2.5 billion ETF. Now I'm talking about a $60 trillion market, basically the entirety of U.S. retirement savings. Right. I mean, the simple answer is it's a very precarious position.

Ryan:
[40:17] Can you talk about the Volmageddon incident for those who aren't aware of it? Is this, are you referring to the 2018? There have been many kind of volatility sort of events. And so describe that maybe, and then link that to what you think could happen. It sounds like there's some possibility in your mind of like a super Volmageddon

Ryan:
[40:37] type moment, like almost like a super volcano erupting at some point in the future. But talk about the Volmageddon incident in the context here.

Michael:
[40:44] Yeah, sure. So the Volmageddon incident is pretty straightforward. Prior to, so the Volmageddon incident itself refers to a couple of ETFs, XIV and SVXY that were inverse VIX ETFs. That meant that they behaved the opposite of the VIX fear index. Most people thought it was a directional component tied to the VIX. The reality is it was a carry trade. And so the primary source of return in volatility selling is selling uncertainty in, let's say, month two that's priced at 19 and buying it back as it rolls down to volatility priced for month one, which is only one month further out, one month out. And therefore, we have a little bit more certainty around it. That roll down is typically something like 19 to 16, right? Or more typically actually about 15 to 12. That's a very, very high return on a monthly basis. If I sell something at 15 and I buy it back at 12, I'm making somewhere in the neighborhood of 20% a month every single month. If I repeat that over and over and over again, I get a price pattern or a return pattern that looks absolutely phenomenal, right? That's the source of the return. Those strategies, which initially emerged to allow people to hedge their portfolios, Because capital is scarce on Wall Street, again, it goes back to that market making phenomenon. I've got to put up capital in order to make markets and that capital is by definition scarce.

Michael:
[42:09] Those sorts of returns were really, really attractive to people. And so, you know, we had to effectively create an inverse product in order to accommodate the demand for hedging. Then just like you saw in the RMBS in the big short, people went from using the volatility that was created by excess hedging demand, they flipped it around and began to create synthetic long exposures to equities through short volatility. Basically saying, why buy the equity when I can sell the insurance that the equity is going to collapse at much, much higher returns in aggregate over time? Hmm.

Michael:
[42:47] Perversely, the government actually blessed this. And so during the 2008 regulatory reforms under the Volcker rule, there was something introduced called CCAR, capital adequacy ratios, which basically told or dictated to investment banks how much they had to reserve against different types of trades, right? In the case of owning equities, so if my client owns equities and I'm holding that on my portfolio, right, on my book, where I've facilitated that by holding equity positions against that, I had to prepare myself for instantaneous volatility of a 30% drop. If I express that exact same trade in volatility terms, the equivalent risk metric was a 10-point jump in the VIX, right? Now, just to orient people, a 30% drop in the S&P 500 instantaneously translated to a VIX using the old methodology, which was less precise, somewhere in the neighborhood of about 120, jumping from give or take 20 to 120. So 100-point jump in the VIX associated with the crash in 1987. The difference between those two, because it was so much cheaper to put capital up against short volatility than it was to express it in long equities, which is very similar to the same trade, caused the street to crowd into short vol positions.

Michael:
[44:09] That crowding created the conditions that facilitated volmageddon, which was actually caused by a regulatory change on February 2nd, 2018. The Federal Reserve changed unexpectedly those CCAR provisions, raising the volatility risk from a 10-point jump in the VIX to a 30-point jump in the VIX. That's a dramatic increase in the quantity of capital that was required to be held against those positions. And as the street began to unwind those short vol positions, it created the conditions for selling of the XIV that ultimately overwhelmed the available liquidity. And on Monday, February 5th, 2018, in a single session, the XIV went from, I believe it was 115 to five. At that point, they shut the fund, liquidated it. We got paid out on our trades that we had taken around it. But that is a very simple model in a much less complex framework to what could happen to the S&P. Now, the simple reality is it can't actually happen because we have fire breaks or effectively points at which we stop trading. And we would stop trading. You would end up halting the markets. Where they clear after that is unknown.

Ryan:
[45:30] But here's the thing about Volmageddon in 2018, right? So obviously some active investors, active managers play that very well. I mean, I think you talk about how Peter Thiel just on that trade, 250 million, something like that. For a lot of the people operating under the passive investing algorithm, they might not even remember what happened in 2018. I was like, Actually, coming to this conversation, kind of struggling to remember. It's like, oh, yeah, I remember when that happened. I just ignored it. I continued my dumb algorithm. I mean, mine is modified for crypto, of course, but just like by the market, dollar cost average in, and that was a blip on the radar. So what's the argument for why certainly passive investing creates conditions for these massive volatility spikes and these volmageddon type incidents, and possibly a future one could be even worse?

Ryan:
[46:19] But still, as a passive investor, can I just like ignore that noise? I'm not going to do anything when those events happen. I'll continue dollar cost averaging in and I'm fine over the long run or not.

Michael:
[46:32] Well, it depends, right? Are you a contributor or are you a net withdrawer? And so the characteristic of the market is ultimately that every buyer has to have a seller, right? The converse of that is, of course, every seller has to have a buyer. As the population ages and as passive investing becomes a more mature phenomenon, we're encountering more and more net selling activity as those who have the assets held in retirement ultimately need to start living off of those funds, right? So you end up in a situation in which it cannot go to an infinite level, right? Imagine the market is at an infinite level. Now, I as an asset holder am infinitely wealthy. How do I express that? I want to increase my consumption. That means I have to sell something. Well, how do I sell a share of infinity? Somebody has to come up with infinity, right? Like it's, you know, it is a process that breaks down in its extreme and just walking it back from that in slightly less extreme forms takes you to the same underlying conclusion, right? At the end of the day, withdrawals are always going to be a function of the asset value, right? If it's a market cap of $100 trillion and I'm taking withdrawals of 4%, that's $4 trillion a year.

Michael:
[47:47] I'm required to do that under things like 401ks. I'm also required under things like targeted funds to slowly sell down my equity exposure. So the outflows are ultimately baked into the cake. It then becomes a question of what are the contributions? And as I said, those are always going to be a function of income levels. And the income levels have not kept pace. This is one of the reasons it's a concern when we see compensation as a share of GDP falling. Ultimately, there are fewer buyers available for your product. In this case, product being financial assets.

Ryan:
[48:20] Right, right. Okay. So definitely on the kind of the baby boomer demographic aging and sort of starting to exit these markets, moving some of these assets to consumption and the ripple effect that that's going to have. Yeah.

Michael:
[48:32] I'll give you a really simple example. So when I started doing my work on this in 2015, 2016, one of the interesting pieces of research was what was the average age of a Morgan Stanley Brokerage client? What would you guess? 2016.

Ryan:
[48:46] 2016 average age, I'm going to say 45, 50?

Michael:
[48:53] 71.

Ryan:
[48:54] Okay. We're not starting the saving early, are we?

Michael:
[48:58] Well, no. To get to be a Morgan Stanley Brokerage client, you've saved a lot already, right? I see. Okay. So that's some of the self-selecting crew. This is a wealth threshold. The average age is about 71. What would you guess it is today?

Ryan:
[49:09] I'm going to say if we start at 71, I'm going to say it's much higher. It's higher than that, probably, you know, given kind of wealth accretion. Is that the case?

Michael:
[49:18] It's 72. Okay. It's gone up a little bit, mostly because Morgan Stanley has gotten very few new clients. Right. But there's a governing, there's a limiting factor. What comes after 72?

Ryan:
[49:30] To 73. Okay.

Michael:
[49:32] Right. And so like you are like, there are no 150 year old Morgan Stanley clients. Right. Right. It is a naturally limited series. When I started doing this research, what was the average age of a Vanguard client?

Ryan:
[49:45] Definitely skewing younger. I mean, I was kind of a candidate for being a Boglehead, you know, in my, you know, 20s and 30s. So I would imagine it's much younger, middle age.

Michael:
[49:55] 37. Okay. Right. What would you guess that is today?

Ryan:
[49:58] I think that that demographic has just aged up with Vanguard. So I bet it's higher. Give it 10 years higher.

Michael:
[50:05] Yeah, it's actually more than that, right? Because more and more people as they enter retirement are actually rotating into passive because they're also buying the narrative.

Ryan:
[50:14] Interesting.

Michael:
[50:15] The average age of a Vanguard client is now in the early 50s. 52, I think, is the actual number, right? So in that 10-year period, we've seen a 15-year aging of the Vanguard universe. That means that the passive investor is getting closer and closer to the point at which they start to reduce their equity allocations, start to actually process retirements. One of the key things that is ultimately we're actually seeing is we're starting to see a slowing of the net flows into passive that reflects this aging out. Effectively, more people are taking distributions. We particularly see this in the mutual fund complex, which is unquestionably negative in terms of its flows at this point. All of the growth at this stage is hitting the ETF space as compared to the mutual fund space. And so the writing is on the wall here, right? Whether it happens next Tuesday or whether it happens five years from next Tuesday is what we truly don't know yet. And it's contingent, right? There's a stochastic framework to it. If unemployment rises sharply, contributions will fall. It will pull forward that date. If market volatility increases, people will be less incentivized to hold, right.

Michael:
[51:23] Paradoxically, if interest rates get cut, suddenly that reduces the income that people are receiving from their fixed income portfolios that actually raises the proportion of assets that they need to sell in order to meet their retirement objectives. So all of these factors will ultimately matter. You know, as I said, the writing is on the wall. We just don't know whether that writing is next Tuesday or five years from next Tuesday.

Ryan:
[51:46] That's fascinating. And I'd love to dig into that a bit more because I do agree with you. If the, you know, the squirt gun stops squirting the balloon, right? And the passive, like investing, the flows stop increasing and start going

Michael:
[51:59] The other direction.

Ryan:
[52:00] That could spell an entirely new dynamic for everything that underlies all markets. And that's what you're basically forecasting. Let me ask you a question, Michael. So for someone who wants to passive doom proof their portfolio a little bit, what kind of assets do you encourage them looking at? So I don't think you're against the S&P necessarily, but you like more, I guess, better weighted indices of S&P, for instance. But why don't you tell us? So how do I, if I've got a typical portfolio, we'll ignore crypto. Believe me, we'll come to crypto in a minute here, but ignore crypto. What is the Michael Green passive doom proof portfolio? How does that look? What modifications would you make on a standard portfolio?

Michael:
[52:49] Yeah. So first I want to be very clear that no portfolio is doom proof, right? At the end of the day, if an asteroid hits the earth, your government T-bills are going to be just as worthless as, you know, your gold or Bitcoin. Fair enough. So, you know, one, let's dimensionalize this by specifying that nothing is doom proof. What I'm forced to do is effectively look for assets that perversely are negatively impacted by this dynamic. So that means, as my good friend David Einhorn has pointed out, that you're looking for things that have endogenous liquidity to them. In other words, instead of relying on what the next person is going to pay you, you're actually looking for the cash flows that are generated within the asset to be valid. In other words, you're able to generate your target returns simply by looking at cash flows that are effectively guaranteed to you. David's approach has been to focus on smaller cap companies, to focus on companies with high buyback potential, et cetera. Even that has gotten really expensive. And he is admittedly noting that he really can't find much in that area. And again, part of that is a byproduct of passive investing raises all boats in valuation. It just raises some more than others. And so, you know, a lot of people think small caps are really cheap. They are cheap on a relative basis. They are absolutely expensive. And so on a relative basis, I understand that argument, even as I would argue that you're not really getting away from the problem.

Michael:
[54:17] Areas where I think you actually have genuine cheapness are created by index arbitrage or exploitation in the opposite direction? What are the areas that are not subject to those components and actually suffering from significant neglect? And there it gets really interesting because if you think about what is actually happening in the bond market, I just want to, I'm going to take you through some of my much more recent stuff. Okay. So first, I just want to be very clear. These are theoretical models. They're very simple ways of explaining what ultimately is happening in two different types of securities. And equity is a quote unquote Ponzi asset. And I want to be very clear on what I mean by that. I don't mean literally Charles Ponzi, it's all made up, et cetera, but it is an asset that ultimately derives the vast majority of the value that you receive from what the next person is willing to pay you for it. Yep. And so there are two paths, effectively a cone of possibilities that exists in equities. I can pay a thousand for it and somebody pays me 200 for it 30 years from now, or I can pay $1,000 for it and somebody pays me $100,000 plus for it in 30 years. And everything in between is kind of fair game, right? This is why options models effectively model geometric browning in motion in an expanding cone of possibilities over time, right?

Michael:
[55:34] Another version of option pricing is the Cox-Rubinstein binomial pricing tree, which simply says, you know, it gets easier to go from here to here from here than it was from here, right? And so it just is expanding that cone of possibilities over time. But at the end of the day, my return is largely determined by what somebody else is willing to pay for it unless I get valuations so low that like dividends and share buybacks can generate that value for me. As valuations get higher and higher, it gets harder and harder to get that sort of fundamental return. Bonds, high quality bonds have a very different distribution pattern that looks much more like a American football in flight.

Michael:
[56:19] So if you think about a high quality bond, the things I absolutely know about it are that it was issued at par and it is going to mature at par and I'm going to receive the coupons associated with it over time. Yeah. And so the return profile is obviously much lower in terms of its possible outcomes. But more importantly, there is a defined path that it can possibly take. There's a low interest rate environment in which the price goes higher and then barely rises at all. And there's a high interest rate environment in which the price falls. And then I earn a portion of my return through capital appreciation. All right. But at the end of the day, there is no scenario in which a super high quality bond is worth anything other than its terminal value.

Ryan:
[57:06] Okay.

Michael:
[57:07] Right? Now, what that means is that passive, which is at whatever price I will buy, is inherently unbound in equities, but bonds eventually have to pull towards par. So the influence wanes over time as you get closer and closer to maturity in a passive bond index, right? This has given a rise to a phenomenon that I think is super interesting. The Bank of Canada is just starting to wake up to this. Others are starting to wake up to it as well. But if I look at something like the total bond market index and I compare its weightings relative to the nominal quantity of bonds that are outstanding or the notional quantity of bonds that are outstanding in each of these, what I discover is duration is fundamentally underweighted at this point. And the reason for that is really straightforward. If I build a market cap weighted bond index and I issue securities at 1% coupons and I then raise interest rates to 5%, those 1% long duration bonds fall in price to roughly 60 cents. So a bond that was issued in 2020 or 2021 as a 30-year bond with a coupon below 1% is now trading basically 50% down.

Michael:
[58:27] That means it's underweight in the indices. And so as new money comes into the index, think back to that inelasticity framework, it effectively underweights those, creating the type of trading behavior we're seeing. Even if I go to buy bonds, I'm buying less duration. This is creating that narrative that the bond markets are fundamentally broken, that bonds are uninvestable, et cetera.

Michael:
[58:50] This is where I'm drawn to, right? I think there is just a fundamental mistake in terms of what people think is actually driving the behavior in the bond market. So if you are buying BND, for example, you are structurally underweighting duration at this point. Okay.

Ryan:
[59:07] And so are you making the case that the passive is underweighting duration? Therefore, if you were to kind of passive adjust your portfolio, you should somewhat overweight or over allocate to long duration bonds. That's an asset that you would modify in the individual's portfolio.

Michael:
[59:27] Yes. And I would go a step further and say, even within that, there's a couple of categories that are totally underrepresented here.

Michael:
[59:34] Municipal bonds, which are tax advantaged, don't have any representation in these indices at all. So there is no buying of many municipal bonds in most of these portfolios. They're ignored. We see that in their spreads. The second area that I would emphasize is tips. Tips are fantastically underweighted. And so if your concern on long duration bonds is the inflation risk. And by the way, I share some of that because of the response functions that we talked about with the government ultimately stepping in to bail out retirement systems. I'm super aware that that is a potential issue, but look at what a 30-year tip is yielding right now. It's 2.6%, right? A 2.6% inflation guaranteed zero risk piece of paper is incredibly valuable, particularly in an environment in which Vanguard themselves are looking at equities and saying, These returns are going to be really terrible going forward. How about we're going to continue to pile you into these strategies because we have no alternative. This is fascinating.

Ryan:
[1:00:36] Let me give you an insight into the typical bankless lister and allow you to maybe respond, right? They're probably a bit more towards what we call the crypto barbell, which is basically like a whole bunch of their portfolio is super high risky, highly volatile crypto assets, right? On one side of the barbell, the other side is basically something very safe, treasuries, let's say. And maybe in that portion, they're hearing you and like treasuries, maybe there's room for some long duration bonds and tips, that kind of thing. But the typical bankless listener is weighted towards that portfolio because they don't ultimately trust long duration bonds in particular or any bonds. Because when you were talking about equity as being sort of a Ponzi scheme type structure or like pyramid scheme type structure, depending on the, you know, kind of the next buyer, they also see the fundamental bond system and the fiat system subject to a massive debasement in the coming years. Big, beautiful bill, all of these things, you know, money printing from the Fed, fiscal policy, can't stop this train, Len Alden, all of the things. And so they fundamentally see fiat and bonds as a Ponzi-like instrument as well. So how do you address the case for bonds to someone listening who's like, Michael, man, I'll hold bonds in order to buy crypto or on the dip, basically. Otherwise, I don't want to hold anything like bonds, municipal or otherwise, for any long duration here. What do you say to that?

Michael:
[1:02:05] Yeah, I find it fascinating that people are simultaneously predicting runaway inflation, hyperinflation, a collapse of the currency system, etc. Thank you. And instead of actually taking steps to fix that, they're basically cheerleading it. The simple reality is that if the US experiment fails, if we end up discovering that our bonds are truly Ponzi, it doesn't matter what else you do. We will devolve into a civil war. We've seen what these look like. This is not an outcome that anyone should want, nor remotely anticipate that their crypto wealth is going to protect them in any meaningful way. The second is it's just, it's without evidence, right? So the claim was that we were going to experience cycles of accelerating inflation that was going to look like the 1940s, et cetera. First, inflation never came anywhere close to the levels. And that's not me saying this, right? This is using tools that were embraced by the crypto community, tools like Truflation, et cetera, that are now telling you that inflation is running below 2%, but nobody wants to believe that now, right? The second is that we actually have market-derived pricing of inflation expectations. There's something called an inflation swap.

Michael:
[1:03:21] Inflation swaps have all the profit incentive in the world for you to turn around and say, gosh, if I think there's going to be a lot of inflation, I'm going to bid it. But the reality is that those inflation swaps actually are telling you inflation is going to fall going forward. We've normalized on those. There is no sign of any uncertainty in anything that actually requires people to put up capital. You know, I love the speculation, but that's exactly what it is. And so the idea of a barbell portfolio where you are effectively saying, look, I want to be long call options on chaos and distress and the next great thing, right, through crypto. What is your offset to that position? Is it crypto-based stablecoins? Is it US treasuries? Is it the S&P 500? Right? And the point that I would just emphasize is, my gosh, guys, if you're actually worried about inflation, and you're actually worried about that barbell in your portfolio, why wouldn't you lock in extraordinarily high real returns?

Ryan:
[1:04:21] And how do you do that? What's the best mechanism for doing that?

Michael:
[1:04:24] Just buy tips.

Ryan:
[1:04:25] Just buy tips.

Michael:
[1:04:26] Okay. Is that what, by the way, your ETF is? The Simplify CDX ETF?

Michael:
[1:04:32] So we actually do not offer, believe it or not, an ETF that has tips. My ETF is actually in the high yield space. It's an area where I can add value through a couple of areas of market structure, which is always, as you've probably figured out by now, what I'm looking for.

Michael:
[1:04:48] HYG, the ETF, is used by many credit funds to short market exposure in the high yield space that allows them to amplify their single security picks, but it also places pressure on dealer balance sheets. And so those dealers are actually willing to share those returns with me if I access it through what's called a total return swap, effectively taking those shorted shares off of the dealer balance sheets. I pick up between 50 and 150 basis points, typically over and above the HYG, which more than pays for the asset management fee on my product. And then further augmenting that using various hedging techniques, most importantly, using a derived proprietary overlay that mimics credit spreads and allows my fund to outperform in periods in which credit risk is rising. With credit spreads really, really tight, currently they're at, you know, give or take the second percentile level in history. That actually feels like a fairly safe bet that I'm willing to basically pay almost nothing for that hedging protection at the same time that I benefit from a potential spread widening in the category. And that fund has done very well. It started to attract significant assets. And that type of modification to what's called a beta exposure is fairly common across simplified products.

Ryan:
[1:06:06] Michael, it's part of this portfolio as well. I think I've heard you talk before that you actually like gold as part of the portfolio. Is that correct?

Michael:
[1:06:13] So I think that gold has interesting features to it, not unlike Bitcoin in some ways, right? So I just want to lay that out there. The problem with gold is largely the disinformation campaign. There is nothing magic about gold. It is not money. It is an element on the periodic table. I think it's number 71, right?

Michael:
[1:06:31] Every single, and I've shown these presentations over and over and over again, happy to show it again, but basically every single metal that is in that quadrant of metallic elements has been used at money for one point in time, whether it's platinum, aluminum, tin, nickel, et cetera, copper. They've all been used in coinage for the very simple reason that they have elemental properties molecular properties that make them very suitable for coinage gold is among the rarest of those right the next level down is i forget what i think it's called rosingentium or something which has identical properties by the way to gold except it has a half-life i think 60 minutes and so basically your money would disappear half your money would disappear every 60 minutes if you decided to use that as your coinage, a very deflationary currency, to say the least.

Michael:
[1:07:21] But we've chosen not to use it for exactly those reasons, right? But so gold has nothing magical to it. It's just an element. Now, interestingly enough, the reason why gold worked is because the only way it could be manufactured is in supernovas. And the way that we extracted it is through human ingenuity. And so if you think about the supply demand framework for gold, if you choose it as your base currency, right, if the price of money goes too high, society will devote resources to obtaining more quote-unquote money, mining gold, extracting it, applying technology to it, et cetera. The supply of gold becomes elastic to the price of money. That actually creates a very stable system in which human ingenuity can address shortages of money.

Michael:
[1:08:08] Likewise, a credit function, this is the source of JP Morgan's observation that gold is money, everything else is credit. That's not actually an assertion as to the elemental properties of gold. It's simply a reflection that anything that comes out of the private sector in terms of credit creation references back to that payment in gold.

Michael:
[1:08:26] And the only way that you cancel out credit is with money. That's really what money is. It is that which cancels debt. Okay, so where this ultimately brings us to in gold is gold worked really, really well as long as it wasn't a byproduct of anything significant. Now, literally yesterday, we actually just found something out, which is that some of the new approaches to nuclear power have actually recognized that they can make gold production as a byproduct of nuclear power regeneration. And the way that you do this is by adding a radioactive form of mercury to the actual process, inundating it with neutrons in the nuclear process and accelerating that particle decay to the stable isotope of gold, which is right below mercury. In other words, alchemy has suddenly become real.

Michael:
[1:09:18] Now, if that's the case, I'm no longer favorable towards gold for the very simple reason that becomes a byproduct. It's being manufactured in an industrial process in which its value can collapse. Where else have we seen this happen? Well, I don't know if you know anything about uranium, but uranium used to be a byproduct of vanadium mining. Now, vanadium is a byproduct of uranium mining. We pay far more attention to the uranium.

Michael:
[1:09:45] Silver mining used to produce various types of metals, including copper, right? Now, silver is largely the byproduct to that process. And as a result, its supply can be affected by significant changes. If something like gold became a byproduct to nuclear power production, the price of gold would collapse. I have no emotional attachment to it. Now, with that said, I do think that gold as it has existed historically, and I think the emergence of this is fascinating to see, by the way. But I think gold as it's functioned historically was that nice balance. It rewarded human ingenuity. If the price of money went up, we devoted more resources to obtaining more quote unquote money. If the price of money fell, we would devote less resources to it. And the system was capable of providing some balance under the framework of human ingenuity. This is one of my primary objections to Bitcoin, unfortunately, which is because it is such a hard standard, right? With the difficulty adjustment, which is designed to mimic effectively the purity or concentration of mining activity in the real world, right? So we used to start out mining deposits that were 30% copper. Now we're down to 0.6% copper.

Michael:
[1:10:55] That mining difficulty is the idea behind the Bitcoin adjustment. But perversely, what that means is if money in a Bitcoin framework gets too expensive, there is no mechanism for adjustment. And so ironically, Bitcoin is actually anti-human ingenuity. In a scenario in which the price of money is going up, it cuts off access to many forms of capital, especially debt, which is a very useful way of creating exactly that optionality that you described in your barbell portfolio. Debt as a capital instrument is effectively just selling a put. I am willing to take all the downside in exchange for limited upside. You as an equity issuer in that framework have suddenly, or a debt issuer in that framework, have suddenly turned your asset into a call option. If things go really well, I get all the upside. If things go badly, it's his. And so that type of capital structure framework gets cut off in a Bitcoin world because of the risks of deflationary outcomes. And that unfortunately means that it is less productive than the system we currently have.

Ryan:
[1:12:06] This is similar to an argument that Ben Hunt has given when he's come on Bankless, basically that the Bitcoinization of the world would be just systemically bad. It's kind of like rooting for everything else to fall. But I think there's two discussions here. One is whether that's systemically bad or not, some world of hyper-Bitcoinization, hyper-crypto everything, versus what you kind of expect to happen, right? So the extreme Bitcoin maximalist is there's the Bitcoin standard and everything is based on Bitcoin and it replaces the gold standard, etc. But there's also just the question of whether it replaces gold as a society, a store of value, an alternative. It's not necessarily going to take over the world, but it can be used to port value across time. And it's basically the same principle that we were talking about at the beginning of this conversation, which is it becomes a shelling point asset. More and more people are squirting their squirt guns into the balloon. The balloon's getting larger and larger. What about the case for even if you don't think it's systemically good, it could still go up and will still go up as a store of value asset because people are looking at alternatives and they're thinking, well, I want to store my value in something that can't be inflated. It's basically the gold use case.

Michael:
[1:13:21] No, that's not the gold use case. That is actually a misunderstanding of the gold use case, right? So the entire point behind gold was actually nations adopting it as the gold standard, right? That facilitated trade on an international basis because if I'm executing a trade in Spain in U.S. Dollars that are convertible to gold, or I'm executing a trade in the United States in Spanish pieces of eight that are convertible to gold. I'm actually crossing my currencies and facilitating trade.

Ryan:
[1:13:52] And you don't think that can happen with a Bitcoin, basically, that nation states adopt it, for instance?

Michael:
[1:13:58] The point would be that because it is inherently scarce, there is no potential for us to then use debt in that system. I'm cutting off an avenue of financing that I understand a lot of people think debt is bad, but that's just a tool. It's a little like you're basically saying, you know, look, I'm really into gardening. I'm going to do all my gardening with a rake. Okay, well, that makes trimming bushes really hard. Can it be done? Sure, you can probably stand back and with a lot of practice, you can swing that rake just right to, you know, scrape away some of the branches. But God, it's a terribly inefficient way to do it.

Ryan:
[1:14:33] What do you make of arguments from people like Ray Dalio, who just talk about sort of these debt cycles, basically these great debt cycles every, you know, 80 years or so, sort of, there's a great deleveraging. Right now, the World Reserve asset, let's call it, is basically treasuries, basically some of the bonds that you've been talking about. And every 80 years or so, that gets over levered and it needs to bleed out somewhere to some sort of a new, more credibly neutral monetary system. Maybe that becomes a Bitcoin or an Ethereum or gold even for some period of time while nation states figure it out and kind of reset. So it's just part of a cycle here that we ebb and flow.

Michael:
[1:15:13] Yeah, I think when you frame it in that way, one, you're presenting these cycles as if they are, you know, mere oddities to observe, right? And those cycles tend to involve extraordinary societal disruption. And your place in that society is inherently shaken up in an extraordinary way. If you happen to be in the wrong building during one of those periods, the odds are you get blown to pieces. You know, it's a nice erudition of what we've seen in the past, and it's nothing unique, right? Polybius was writing about political cycles and economic cycles in 800 BC. So there's a long history of talking heads that engage in these various forms of pontification, including myself, right? I'm just one of them. A long series of people who will probably not be remembered in various ways. But the simple reality is that to characterize it as such is to fail to consider the actions that are likely to emerge that prohibit you from effectively getting ahead of this, right?

Michael:
[1:16:16] Candidly, I think that a lot of what Ray says is nonsense, right? It's very high-level stuff. Yes, there's cycles. It's very being there. And the movie referencing the idiot gardener, Chauncey Phillips, right?

Michael:
[1:16:31] Who opines on various things. People are like, oh, the depth of his thought is amazing. In the spring, there will be flowers. Oh, okay. We're going to project onto that, right? I just, I think there's a huge component of that. And I'm as guilty of it as anyone. I just try to base things in numbers. The simple reality is the idea that debt is debt at the sovereign level is not accurate. What it really is, is equity, right? You can't go, I can't go bankrupt printing my own currency for debt against my own currency. I can always print more Mike bucks. What I can destroy is the value of Mike bucks. Right. So you're unwilling to take those for real assets, right? That is the hyperinflation that people ultimately describe. And it is possible. But if you instead reframe sovereign debt as simply a liquidity management tool that basically says, I'm going to soak up the excess quantity of currency that I've printed. And I'm going to offer to pay people something, right? We'll call that a secondary market of interest to allow them to defer their consumption on that. there's really no evidence that anyone cares. And in fact, what we're actually seeing is evidence that inflation expectations are lower, not higher.

Michael:
[1:17:44] And the dollar has actually strengthened over this time period, not weakened. It certainly is weakened against something like gold, but gold has a very particular catalyst that's driving it right now, which is the US government in June of 22 decided to take the treasury assets of the Russian Federation.

Michael:
[1:18:02] Right? What was the signal that was sent. If you are trading with the United States and accumulating resources in treasuries, they can take that away from you. So what did that force China to do? It forced China to redirect into gold. That's where gold started to outperform. And it is a forcing just like Bitcoin into ETFs, right? If BlackRock tells you that it's going to be 1% of portfolios and their advisors follow that guidance, that is money that is going to flow into Bitcoin, it should create a price response. Same thing is true if governments send a signal, It's not safe for foreign entities to hold U.S. Treasuries because we can take them away from them. They're going to redirect into things like gold.

Ryan:
[1:18:40] I'm wondering what you think, because there are sort of two faces within crypto of, you know, just there's one side, certainly in the side that I think you've talked about being critical of, which is the.

Michael:
[1:18:50] Fiat system is crumbling.

Ryan:
[1:18:53] Basically burn it down type of system that in crypto assets like Bitcoin are the things that are going to replace it. There's certainly that side, the debasement side. There's another side though, that's just about rebuilding the existing financial system. Things like tokenization, things like stable coins, things like decentralized finance. And that's less of the burn down the existing system and more, hey, we're rebuilding a brand new system. I was trying to make a wire the other day, Michael, and the pain of just like moving money from one of my bank accounts to another ended up getting right in the wrong place. They couldn't find it. It had a Fed wire number. It was so stupid and inefficient. Must have been five people I had to talk to in order to get this money transmitted versus stable coins where it can just be gone in seconds and I can get it to another location. It seems like there's a whole building type of aspect to crypto. And I'm wondering if you're less critical of that, if you've checked into that and what you think of that side.

Michael:
[1:19:49] Yeah, actually, I gave a presentation at the Solana conference on exactly this topic. I have, you know, this is one of the, you know, kind of frustrating points is that, you know, you end up in this weird place, you know, where people are simultaneously on the edge of an incredible breakthrough and at the same time terrified to actually execute it. You know, I gave a slide in which I used the analogy to Emily Dickens' poem, you know, about a grandmother who's, you know, alive in the attic, but should have been buried 15 years ago, right? Effectively dead.

Michael:
[1:20:26] That's where we are in much of traditional finance, right? What's happening in ETF land is not innovation, it's adding leverage, right? There is very little interesting that's actually happening there. What's happening in equities themselves is that we're seeing fewer and fewer equities and less and less diversity of equities. What used to be a very rich toolbox has now basically fallen apart and become corporate debt and corporate equities. because those are blessed by passive indices, that's where nearly all the capital activity is occurring. Unless you enter into weird setups like microstrategy, et cetera, where they're basically exploiting a somewhat captive audience to obtain their own distribution. But there used to be a very rich world in TradFi of preferred equities and convertible equities and convertible subordinated debt and secured debt and unsecured debt, et cetera. All of those have largely disappeared.

Michael:
[1:21:24] And it's because of this enforced conformity of QSIP labels and designation in index investing. So we're weirdly dying in TradFi at the same time that you guys are running around using languages you don't fully understand, but facing a very interesting universe of digitally native tokens that allow you to do things that simply can't be done in the analog world. Right and so like while we all think about stocks as digital assets the reality is they're paper based assets there's a little literal stock certificate that's sitting at dtcc that says this is a valid share right it's an nft for all intents and purposes that because it's a paper document and again its focus is on cryptography it's got all sorts of interesting watermarks and designs on it to make sure that it's the original right but because that's a paper document its actual executable code has to sit separately in something like an S1 prospectus or the filings at Edgar and the SEC, et cetera. There is no link between the two. A smart contract actually allows me to take that same security and embed the logic and execution in the security itself so that it's auditable. I can understand exactly what it's done. It allows me to do things like create structured products at fantastically lower costs than I can do in TradFi, right? So think back to the residential mortgage-backed securities of the GFC.

Michael:
[1:22:52] What is an RMBS? An RMBS is literally a collection of wet signature mortgages that are stored in a physical location as an aggregated security, right? So the barrier to entry among other things is in order to issue an RMBS, I have to source and obtain 3 million pieces of paper that have wet signatures on them and store them in an Iron Mountain facility while I've digitized the paper so that it's easily searchable, et cetera. All of the executions actually require that physical analog piece of paper. That's the primary barrier to entry. In contrast, if I truly make all of those mortgages digitally native, that entire process, what does it mean to store it? It means I have a thumb drive, right? I can put it in anyone's storage facility anywhere. It's instantaneously active. And by the way, it can also become executable, right? It automatically makes payments for me. It automatically separates out cash flows. I can combine two mortgages or a thousand mortgages or 50,000 mortgages or two different RMBS to create an entirely new product in digital space at a fraction of the cost that I can do in analog space. And so all that innovation is actually sitting out there waiting to be taken.

Michael:
[1:24:12] My identification is that the primary issue is actually coming from the crypto space. They are resisting the security designation because they're terrified of being regulated. Everything I see says you should be doing the exact opposite. You should recognize that digitally native tokens and tokenized security is actually enhanced compliance. They can turn compliance on its head, changing it from a penalty-based system into a rewards-based system. And so that's actually stuff I'm actively working on right now.

Ryan:
[1:24:41] That's really fascinating, Michael. I guess it's maybe hard for people at this point in the conversation to bucket you in one group. You're not a crypto hater. Maybe you are more bearish on the store of value narrative around crypto assets, but it sounds like you're very bullish on tokenization, smart contracts, that kind of thing. Maybe allow me to make a case for why crypto has some phobia around tokenization and security. And I don't know if you've been following the previous chair of the SEC, Gary Gensler. There was not a path to doing what you just said under previous securities administrations. And in fact, there was a lot of persecution, I would say, of incredible companies in the area. We just couldn't do anything like what you're talking about. Now under chair Paul Atkins, I think that could be different.

Ryan:
[1:25:29] So maybe crypto is turning a page, getting into tokenized securities in the way that you're mentioning. This has been great. We could have touched on so many things. In fact, I feel like I want to get you back on the podcast and talk politics, your thoughts on industrial policy, all of these things. But I'm wondering if we could maybe leave folks with two messages. So I think there are a number of people in the bankless audience that have some aspect of their portfolio managed using the passive investing algorithm. I want you to give maybe them, what are the takeaways for someone listening who's on that passive investing in algorithm? Drop a takeaway from them, what they should learn from today's episode. And then maybe another takeaway for the crypto barbell type investor. I don't know if you're going to convince them to not do crypto barbell, but maybe you can modify them in some direction. So first give a message, ending message to the passive algo investor and then to the a crypto barbell investor. I think that'll cover about 80% of our audience today.

Michael:
[1:26:28] Yeah, exactly. So look, to the passive investor, the first thing I would say is the line from Goodwill Hunting, it's not your fault. I just want to be very, very clear. Both the benefits that you're receiving from the system and the abuse that the system will ultimately mete out is not because of something you did. It's actually because of the regulatory framework, that same regulatory framework that has prevented the growth of digitally native tokens for all the reasons that Ryan highlighted.

Michael:
[1:26:54] Is also forcing you and people like you into a system that is preferentially advantaging the largest companies, facilitating much of the behavior that you see and detest in our society, and that is actually driving you towards having crypto in another portion of it. And so just recognize that you are working against your own interests as you do that, even as I can't offer you a meaningfully better alternative. The second point that I would emphasize on this is that you as an investor should be looking within your opportunity set for areas that are not subject to this. The same process that led me to emphasize bonds and tips. You actually want to identify areas that are being negatively impacted by this because it does appear we are headed towards a transition point at which this process could begin to reverse. If that's the case, perversely, many of the features that we take for granted in the market, the outperformance of large caps, the underperformance of small caps could very easily flip themselves quite meaningfully. The narrative, the U.S. large caps and technology are the only place to be could just as easily be replaced as it was in the aftermath of the dot-com. We'll do it again. I absolutely promise you. And so, you know, when it is a mechanical system.

Michael:
[1:28:11] Understanding that those are the outputs from it and that they are societally disadvantaged should reduce your willingness to actually present to either your

Michael:
[1:28:20] elected leaders or to others that, hey, maybe we should actually make some changes here. In terms of the barbell portfolio, again, I just want to emphasize what you are trying to do with a barbell portfolio is a capital structure trade. You're trying to create a call option in your portfolio and you're trying to create a put option in your portfolio. The ultimate put option is effectively that all of the narrative that you are buying into in the crypto space, that dollars are going to become more plentiful, that they are going to become instantaneously available and therefore worthless.

Michael:
[1:28:53] The opposite of that is actually, wait a second, I think dollars could become more valuable and all the other alternatives out there are mere speculation about how this could break. And I just want to emphasize that Like if you go back and you look in history, cycles of debt accumulation don't end in inflation, right? Unless they're tied to a war that destroys productive capacity in a meaningful way, they inevitably are associated with cycles of deflation. And so what is the far more likely outcome is that we wake up at some point two years from now and suddenly discover that we're struggling to meet the obligations that exist, whether those are real world obligations, like, can I pay my rent or can I pay my car payment or can I pay my mortgage, right? Or whether they are synthetic ones that are created because the government suddenly raises taxes or because the price level changes radically and my groceries are now much more than I could have afforded. Any scenario that you run through with that, you discover that basically we're creating a debt trap for people. That's really what we're engaged in. And in that framework, deflation is the far more likely outcome rather than inflation. Inflation comes after, it's the response, but the immediate impulse is going to be deflation. Michael Green, thank you so much for sharing your contrarian perspectives today on Bankless. We really appreciate it. This has been great. Thank you very much. Got to give a shout out.

Ryan:
[1:30:15] Some action items for you, Bankless Nation. So go follow Michael, ProfPlum99 on Twitter. Okay, get into some TradFi Twitter if you're into that kind of thing. Also, yesigiveafig.com. That is Michael's substack. And actually, I just found this out. The first year is free, completely free of charge. At least it seems so right now. Mike, I don't know if you plan on changing that, but that's great to get folks plugged in here.

Michael:
[1:30:38] Actually, it was a temporary decision, but I'm happy to give you a code that gives your users a period of free participation. There we go. I'll shoot that to you right afterwards.

Ryan:
[1:30:48] There we go. That'll be in the show notes. We got deals are happening right on the show today. There you go. Got to let you know.

Michael:
[1:30:55] The only reason I charge for it is I want people to actually value something that they're reading. Right? So it's not about the money. I'm happy to offer discounts. So if you request a free subscription, I'm always happy to give it. But I do think that people should value what they're reading. There you go.

Ryan:
[1:31:09] You got to have some proof of stake, some skin in the game here.

Ryan:
[1:31:12] So got to let you know, of course, none of this has been financial advice. You guys know crypto markets, they're all risky. You could lose what you put in, but we are headed west. This is the frontier, not for everyone. But we're glad you're with us on the bankless journey. Thanks a lot.

Music:
[1:31:35] Music