Episode 332 - Randolph Cohen & Michael Green: How Concerned Should We Be About Index Funds?
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This is the rational reminder podcast. A weekly reality check on sensible investing and financial decision making from two canadians were hosed by me beneath felix and Cameron past more portfolio managers. p.

Welt, we have a very interesting grab your popcorn kind of episode. I really enjoyed IT. It's a very thought provoking IT goes back to the guess. We had, I think, what apple and I was three or two, I believe, with my Green the first time. It's a following to that. So ban, I mean, that's what I like an added as IT was really fascinating why IT was a back story and how you got these two guys to come on. So we have seen did the episode my dream, which helped us understand the difference between market efficiency, which is something that I had making content about saying there is no issue here with index funds.

And mike, I have said about that and was not shy about saying so ah he helps to understand the difference between market efficiency and pricy elasticity, which index funds may be having an impact on that was useful to understand my perspective on that and just gain an understanding of what he's worried about because the reason he gets upset as that people sort of mischaracterize argument and strong man against IT instead of understanding what is actually trying to say. So I think we took the time to understand we trying to say he appreciated that we learned a lots that was all great. After our episode of my Green came out a lot of a very smart people with the protests, people who were in academia, of people who are in practice, but may also hold P.

H, D. I'm not going to say who they were, but people like that reached out to me and said, listen, your episode, my Green is interesting. But we don't really think this is as much of an issue as mike does.

If we can give you someone who speaks well on these topics and can give a counter perspective, would you be opened doing an episode? And I was ago, sure. What do we do that with mike and just make IT a discussion.

So this is a bit of experiment. We've had ever ode these two people, but we never had episode two. People who disagree with each other will work on a hosting a discussion between them without you try, I thought, work great.

There was a great conversation. Is pretty easy for us. Yeah, we didn't have to say much. We did have a bunch of sort of key topics that we wanted to cover through out the discussion, and we didn't even have to moderate that. I think and Randy really covered the ground themselves.

Those really seen the point that mike was making about the structural shift and pension systems going from dv define benefit plans over to four one k auto deposit into target date funds is really interesting in that d risks. The system of the system has less risk. Did that increase Prices? Therefore, lower future expect to returns? Quite interesting.

Think to think about I don't know who's right wrong in this. That's one pauses argument. But just more generally, it's a pauses argument that if index funds make investing less risky for individual investors, the shift to index funds could closely reduce expected returns because stocks to become less risky, but IT also make the accompany less risky.

Does that not the company is not now liable for the fun in the case of the corporate pension plan? yeah. So the company like that, I didn't mention g as an example.

G, E, if is shifted away from A D, B to a four one gay plan structure, is a less resk company. I, S, I make sense. That's one of my arguments.

This is one of our longest episodes, if not the longest, when you include the information that we're recording right now. So there's plenty of new ones and with in pieces to pick up. I thought to Randy, point about and mike as well, is the rise of the megacity smart firms.

And they say there's no more fundamental and also is going as his mega firms of mega access to leverage super smart people running these quana firms that are really having a huge impact on the market. So this kind of side info aren't to believe nobody y's setting Prices this gotto be someone doing fundamental is somewhere at same point, do you not? I don't know.

We haven't yet said who the second justice, Randy cohen, from a harvard. He is the M. B, A class of thousand nine hundred seventy five senior lecture of entrepreneur basement in the finance unit at harvard business school.

He is a university chicago graduate. B, H, D, and he told us he was found as T. A.

For a while, while he was there. That was kind of cool, but he knows a lot of our best guess and stuff like that. He also serves on the board of the master of association for the blind and visually impaired.

And he's got up podcast dangerous visions. That's about those topics where he interviews passing people who in some way connected to the world of view. So so multiple friends, but very well spoken, very well informed perspectives on the topics that we talked about.

Mike can needs no introduction. Is that simplify as a management? Is the chief strategist and portfolio manager or sorry, he was pretty see the chief strategy import foo manager for a logic apple advisers.

He managed Peter teals family office for the teal maco. Anyway, k mike is lots of background on that T O experience. Specifically when he is on the podger bull stories there, the mikes, a partitioning with lots of experience.

This topic is really I mean, you can hear that when he talks about IT and when he writes about IT is very passionate about this concern that he has about how index funds and target date funds and required contributions and investments into certain types of products are affecting financial markets. So that's what this is the discussion with some light moderation for us with an overall intention of information that we wanted to get to. But it's a discussion really between ready coin from harvard and Michael about whether index funds are breaking markets or whether they are not doing much.

And I don't think we came to the conclusion. I think they both gave lots of arguments, but I don't think anybody came away. Sing, life changed my mind.

I agree with you completely. They said, keep discussing by email from here. Interesting conversation will leave IT at that and hope enjoy the large amounts of nuance and little bits and pieces of detail in this fairly long episode.

Alright, let's go. Rand, go on. And mike Green will welcome to the rational media podcast.

Thank you and mike welcoming .

you back to the podcast. This is your second time here. All right. So to kick us off, what is passive investing?

The definition of passive investing in the academic literature is somebody who holds but never transacts. That's really important because that provides no mechanism for how to get into a market or how to get out of a market that is presumed you're effectively born like affordable from the head of zoo into opposition of holder in the markets. That means you never transaction, you never influence Prices.

You are simply able to participate without any of the frictions that would be Normal for on code in transacting in a market that doesn't exist in the real world. And so for our practical standpoint, on your referred pass of investing, I would describe as as systematically investing into indexes, people will choose different industries to present. The most accurate would be something like a total market index.

In practical terms, the vast majority of that is simply invested into the S. P. Five hundred index.

I just want to say we're gonna have this kind of serious discussion. We gotta keep our fax trade. It's a thea who comes out of the forehead of south. Affordable is the one who's in the climb in the way you're right.

SHE comes from in the phone. You're correct. I appreciate IT uncomfortable .

with what you say about passive, but I do want to highlight one thing. I listen to some of your podcast about saying stop. And I talked a lot of my friends about this stop in the last couple weeks.

And sometimes the conversations get confused, and I think I figured out why, which is in a way, we're using phrases like the rise of passive to mean two different things. They're a little bit overlapping, but they are pretty different. One is you take a job, they put in a four one k plan.

More or less automatically, they put in in a target date front more or less automatically. And then every day, automatically here, every month ever, money goes into the stock market is all extremely passes. And so there are some concerns, does that push the market up too much? Doesn't make the market to value.

I don't think those are big worries, but I know you're concerned about those set one set of issues, then there's a separate set of issues that there's a whole bunch of money, some of which is that for one k target date money, but a lot of which isn't which is impressive, that people chose to put IT into the market. It's not going into the market passively. But what stocks they are buying are just based on percentages in the index is not still zus.

And so consequently, then you have across section worry might not be the case that microsoft is too high compared to delt airlines in an example for new use because of this proportional buying. 对， i'm not convinced that that's a concern either. But I could see, in other words on that when I think we don't have the evidence to say that, that's a problem. But it's worth talking about where is on the first one, I actually feel pretty confident is not a problem. So I just want to highly like that know what pass that is all about.

Just to be clear though, the first one you saying is automatic contributions to follow one case, the systematic investing process that emerge with the pension protection act and the Q D I S. You're saying they're not concerned about that.

I'm really not worried that for one case, lash target date funds, lash Q D I is making the market too high or too value. I think it's pretty clear that, if anything, they offset. Whereas the issue of is IT possible that have a huge percent of people put their money to pass the funds instead of active, that IT leads some surprising to reduce the eta that I think there's something to talk about.

Unfortunately, I see those who is inevitably late because of the existence of qualified default investment alternatives that force the vast majority of those investors who are now being automatically fit in exactly through the passive process that has the just sort of effects. In part two, if you're saying you're not concerned with .

i'm not overly concerned with either. But my point is just to say, I have a strong argument I want to make as to why the aggregate market issues or not concerned and that anything the things that have happened have probably alleviated problems with the aggregate market being either too higher, too volunteers. Then when we ask the question, hey, is possible that there are greatness pricing are not convinced that either. But i'm just saying that one seems more like something.

So here's one for you, how much of the market is currently held by passive investors? So my work .

several years ago suggested that we were in north of thirty five percent and climbing IT about three percent a year. I would around forty five percent. That stands at distant odds to what many would arrive at if they simply add up the holdings of banker blackrock sea.

Unfortunately, that approach actually misses what I would describe as effectively of the surface under the iceberg, or under the surface of the water on the iceberg, in which passive representation in the institutional space is far for greater accessing at everything through futures to the return swap collected investment trust and said that are not disclosed in that fashion. Recently, the work of Marks said in, and then independently validated through a different approach by valentine hedi, be right of some of his work, suggest that my numbers are very close to directly correct. Marico samon estimates, about thirty eight percent of the market is possibly held in just five induced, importantly, not including the total market induced valentine, a dot comes to the number around forty five percent.

I just ran in to marco in the hallway here at H. B. S.

And he says, hi, he said, you started to make that's great to my body. I don't have any particularly dispute with those numbers. All just point out a lot to find sort of what you can.

I was just reading one of marcos papers, the one with rob in Green wood, which i'm sure will talk about some point today. They did a thing where they looked at the index funds and they just set a cut off over ninety nine nine point five percent correlate with the index with the definition of an index on. And what that tells you is, man, there is a lot of money out there that is probably closet index that's at ninety eight or ninety nine percent.

Okay, that's not technical, an index fun, but that's pretty high. And I strongly expect there always has been. And then there's a question, well, if you have a sector index, is that an index that is that passive? Because obviously, if i'm saying, you know what, i'm selling all my oil sector stuff and i'm buying the tech sector, then that feels like an active bed. But I have just from one index fun to another uncomfortable to go with numbers in the thirties and forties, as you and mark are suggesting, for proposes of the discussion. But just highlighting that for different things that we talk about, different numbers may be the important numbers.

Just to be very, very clear, in my definition, passive. I exclude things like sector funds. I do not treat those as passive. I do not view them as passive. They are, as Randy said, simply treating a basket of starts to reflect and active.

But that's a good distinction to draw that we did do an episode with maro. If listeners want to hear him describe in detail how he came to the number, he does that in his episode. So why I know you explain this in detail when you did episode that people want to hear the detailed arguments. They continue to that. Just for this discussion at a high level, can you explain what your concerns are with the rise .

of passive investing, like any other type of investment strategy? Again, remember, passive is active in my terminal logy because there are flows, because there is purchasing and selling activity associated with IT. IT does influence the market. My concern is actually not with the need to get rid of passive, because the introduction of a new style of investing actually has had originally to a market IT makes IT more robust and less fragile in its construction.

As IT initially is introduced and as IT becomes a variable number of the environment, which IT exists no different than having a robust ecosystem, the problem is, is that we have advantage passive through a variety of tools. Most importantly, the pension protection act with the opt in component associated before one case and the liability production created by qualified to felt investment alternatives that pushed the share of passive to an extraordinary degree. Anytime you narrow down a ecosystem into a point in which anyone particular approach becomes dominant and introduces vigilio into the system.

And in my view, we are well past that going to in transit U. S. Equity markets. On my math, we crossed that someone around twenty five percent support of what i'm actually trying to do is raise the alarm in some ways to preserve access to these types of vehicles and effectively put the attack on those who should have the capacity to make allocation decisions in an active manner. He continued to do so.

That's part one, is effectively the risk that is created by a system that is overly dominated by one particular approach. Second IT is the mechanical properties of a market capitated approach in a world in which you have inelastic flaws. Ironically, the elasticity of the largest companies is smaller than the other components.

The process of making markets requires you put a capital, the profitability of that capitals determined by trading volumes, and the spread between the big as because the spread between the bid ask is narrow, and the volumes are large, but not that much larger in many of the large cap names. The influence of these types of strategies is overly large on those companies that has societal implications. The fantastic paper out by jane at the university of missionary talking about the impact on the rise of super forms in the component of the impact of passive IT is created disincentives for economic activity.

We see recently the influence of the launch of a point four passive product into a microstrip gy or two times leverage version of that, that exploded the relative Price performance of microstrip gy. Again, that's not a passive component, but it's illustrative of an inelastic market that is actually changed economic history, a potentially facilitating ating, a transfer of tremendous amount of resources to a single individual othe wise wouldn't have been influence in that way. It's a micro causin picture of the broader micros story.

We have our economy in which a select group of individuals are being enriched by these dynamics, and the rest of us are somehow attributing IT to inside or performance. The third component is ultimately the outsourcing of retirement systems around the world, from systems of form, vote savings and investment in local communities to the concentration of those investments into U. S.

equities. This is happening around the globe. Again, this is leading to under investment in local areas and small businesses and over investment and IT imbaLances economy.

That's all prety compelling. Go honest. That's interesting or any .

you're not worried. It's a lot to respond to big picture level. Where can people put their equity investments? They can put IT with active managers who are picking socks and who have the ability is like like silent to keep some money in cash.

So a bit of the markets off, they could say, hey, to rich for my blood on putting more cash. They could put IT in hold school index funds, I would say the S M, P, I found of the total market and you write IT up and down. And then you can do target date funds where you have, let's say, sixty forty or seventy thirty or fifty fifty of your older props.

Allocation to sox and bonds and IT rebaLance ces might makes the point about fragility. What I want to say is that there are big differences between different products in terms of how much for gilty. They like a big success in the X, I, V.

Trade he talked about on this very disappearance that is a pro fragile ity type of product that is a dangerous kind of product. IT doesn't take that much money in X, I, V to potentially lead to explosive outcomes. A passed index on is a pretty solid like is not a big pusher of Virginia.

You need an enormous among the money in passive index funds to create for gile many things. We're online there and we can discuss that but are not convinced. But i'll tell you what is a fantastic anti ferrati's product and that is the target date fund.

And certainly, the biggest thing that I think I disagree with Michael this on of you, like her to express, I am understand, is that to me, target date funds are just what you want if you want an anti fragile market and economy. So what happens is you have coded and the market goes down a whole bunch, obviously coated given mates. Bad news for companies, but maybe there was an element of panic in there.

And what happens to at the end of the quarter, the targeted funds come in and they buy a whole underside to get back in baLance. And so they avoid they reduce the problem of markets over reacting to news. And then if you have good news and markets going on, pop up well, what is a targeted front every time is up.

That targeted front is selling stock and buying bonds with the money and putting things back into baLance and reducing the tendency that you might worry that a market would have. And by the way, that tendency is not in any way related to the placement. I mean, I understand there's this triple bank shot are given about big stocks being differently latics than small socks.

And maybe it's true, maybe it's not. People have written some theory papers, and history will be the judge on those papers twenty five years for now. But fundamental, if you say the old way, was people did the retirement savings to a pension fun.

They put the money in, and those managers put sixty percent in stocks and forty percent of bonds. And now the money goes into a target date fund, and they goes sixty percent in the hucks and forty percent bonds. Those seem like they should be pretty similar.

And if anything, by the way, I listed the three things at the top. And let's talk about active. The problem with active is IT seems like active could be a solution.

You have got these smart, reasonable people sitting around the conference table saying, hey, markets on so much, we're putting more into cash. That's just not what happens. You can look at the data.

I have the data of money held in cash and neutral funds through the coffee period before the crash. They were super low in cash because the markets had been doing well and they didn't want to miss the boat. And then the market crashed.

And then they put a whole bunch of money in cash, and then the market rockit IT back up. And they miss IT with a big chunk of their portfolio because they were sitting in case they got to exactly backwards. And there's a long history of human beings as the economy read the long way to say we're really fundamental, just over clock, east african plain ages.

And we have got reactions of things, you know, the economy inking fast and slow, the second brain, all that up. Humans tend to be tran chases. And so the passive eliminates the tran chasing, and the targeted goes the extra mile and says, let's do the opposite. And that's why when antil net shore was on the podcast russian reminder, and when wealth coach was on the podcast, both of enrol t to study target funds realf with studies, they both said this is not something to worry about. I think it's pretty clear, if anything, we done the right thing to push in the right direction against the potential problem.

And when that we did talk to her specifically about marketing latest city and targetted funds and SHE explained that her paper join Parker, which I know you've reference in some case, is mike. We find that mark latics is increased with the rise .

of target differenced. I right.

you mention one paper there. I know you have a free paper. If you want to give three pieces of evidence proving that your concerns are real.

what would they be before we do that? I actually just a very quickly address the key point. I don't think target date funds are a bad product.

I actually think the systematic rebalancing the bRandy is describing is overall a good thing for an individual, the actual abilities to do that. There are some really key assumptions behind target date funds. So I think there actually quite important and I would push back against any assertion that IT doesn't actually create trend like behavior and chase.

And in fact, what we actually see with passive investing insists that IT reinforces momentum trends. So in many ways, strengthens transferred in markets. The dynamics of brand is referring to our well written about by JoNathan park, much further explored by you is now the universe washington, I believe in work as he is.

P, H, D candidate underhand us to get stanford the process of influencing actually financial policy through target date funds and the rebalancing that is created. There is one of my concerns. The second concern, and you released the target address simply like any good idea, once they become increasingly crowded, they presume that the underline behavior continues.

So if you actually look at the assumptions of target date funds, but they have at their core is an assumption of a positive correlation or a negative correlation between certain asset mixes that allow me to say i'm going to be in ninety five percent and equity is a Young stages in my because I presume equity offer an embedded return of eggs and i'm going to become, with volatility, the desire. And I presume that bonds are gone to offer a return of why at some point in the future, the cross asset rebalancing or the cross asset allocation that would allow me to say something like, well, I think bonds yielding one percent are unattractive. Therefore, i'm going to increase my equity allocation simply does not exist.

Now as Randy points out, that can be an advantage. But where IT actually really becomes an advantage is when you are trading in a contrarian fashion to the rest of the market. If everybody figures this out, if everybody tries to trade in the same way, you ultimately eliminate the volatility, but you have a limited in terms of the Price component, you've lower the elasticity and effectively said, I don't care what's actually happening to i'm always going to add back to them.

I don't care what's actually happening to bonds. I'm always going to add back to them that process of not caring induces its own fragile ity into the process IT manifests itself at high share. And again, I agree with Randy that for most people, targeted funds are actually a positive components terms of their retirement portfolio.

But when everybody starts doing that and today, under qualified defauts investment alternatives, the U. S. Retirement system has effectively outsource itself to the target date fund industry with roughly ninety cents on every retirement dollar. Now flowing into these types of products and never really changing.

I wanted just really try so to keep focus on one thing at a time because if we jump from what's good for market failure to what's good for individual investors, to the regulatory environment, to what's good for local businesses, is can be hard to get to consensus on some of these points. The example you gave, I think, is exactly we're talking to sunshine.

If the boundary goes down to one percent, well, when bound yields go down, bond Prices go up. So rounds will go up, and then the targeted find will sell and bonds and shift tequila. Now IT is certainly true.

That is an individual. You could do your own research and you could say, hey, it's onna sell seven percent of my bones and put in decoration. But I think eleven percent is the right count to sell. What I say is the vast, vast majority of people probably aren't very well qualified to do that kind of analysis and come up with the great answer.

But to the extent that they are, they can move their money out of a targeted on anybody who sophisticated enough to be making those kind of decisions is sophisticated ough to not just stay in authority fund because that was the default t option on the program. Most people will stay with the default because most people don't want to do that calculation and figure out you will be fifty five percent. Equity is sexy.

I said on the investment committee of the school, we had a person on the team was a consultant in on investment consulting. There were all these top private equity people and heddon g people on the board, as you know, was a school with a lot of people who were in the finance business and kids there. He said, you know, I think we should go from sixty percent stocks to fifty five percent stocks because of this has been that what we're recommending to our lines and all these people are around.

We are all like, we don't know, we don't know which should be sixty or fifty five. That's a really hard stuff. And so i'm just saying automating that process and then giving people the flexibility to change that if they want to seems pretty good for individuals.

But more importantly, it's anti fragile. And so I feel like we should be able agreed that the target date fund people's four one came money going to for remember, people are going to save money. I will, in a little confused, listen to arguments across products.

Is mike saying that people should save less? Or is mike saying they should save a lot, but they shouldn't put as much into stocks or makes saying they should save a lot and put the same one up and put sixty percent on average into stocks? Bot, they should move IT around more based on their own study and instincts rather than based on a formula. Because none of those sound like the helpful situation. me.

So very quickly, a couple of key points. One is there is actually a very material difference between a pension and a four one cake, not just in terms of the process of money flowing in, but in terms of the underlying viability. What we've really done with the system, as we have said, we can't have any individual or entity responsible for your retirement.

I work at general electric for thirty years. They're not responsible for our retirement because we'll be showed in the ninety sixties into the one thousand nine seventies. The liability incurred under that process is something that anyone company couldn't bear.

We then turn around and we say, but collectively, the answer is for all of us to invest the stock market. If the stock market fails to perform, what if we actually done for future retirements impair them significantly across our entire society? That by definition, is far more fragile than the failure of anyone entity. The process of actually changing IT from something that has turned from, uh, responsibility for a small attim tic components in terms of a corporation to something that then turned into an admission component that he was an individual to something that is now become a collective societal risk is really the key points i'm highlighting over IT.

I don't buy that by the lovers. We had both those risks before. Before we have the rest. The G, E. Could go down and fail to pay its pension obligations or that the whole economy and market could perform poorly and then all the companies would struggle to pay their benefits. Your point is we didn't get rid.

The second one, if all the economies performing poorly, then people are gonna be hurt on the retirement, but they've got a chunky bonds. So if their stocks do me, but their bonds pay off because there are government bonds, it's going to be OK. It's not as good as you d like, but it's not terrible. So I feel like we went from two major concerns to one concern that we partly mitigate, and that sounds pretty good.

And again, when you look at that on a collective basis for an individual basis, I agree with you that there are some components of removing the fragile ity associated with the failure of in the individual company. When we allow the failure of an individual company, we actually are increasingly making a system robust company didn't deliver the products, he didn't deliver the outcomes, return IT into a societal and collective problem.

The process of transmitting that risk actually raises the valuation of everything in the process. Lower is the forward expected return because by definition, it's less risk. Y and yet, we've promised people that these underlying assets will offer the returns to allow them to secure the retirements that they desire. Those two are completely incompatible.

I don't understand the argument is to why we raise valuations or make things more rescue.

be very, very quaker. We have made the system less risky. But in the process of doing so, we raise valuations because anytime I make something less risky, by definition, IT is worth more. If IT, there is the same cash loss.

That's not true, of course. That is let's say there's a pile of stock worth a million dollars. One thing we could do is say we'll each take care a million.

The other thing we can do is say, well, tosa coin and if IT comes up heads, I get the whole million. If it's tails, you get the whole million. Well, the second one is risk you.

Or if we switch from the second to the first, we make things less risky, but we didn't change the valuation of that million dollars. By doing risk sharing, we will cause the stock market to be over inflated. I don't see that at all.

I completely disagree with the option theory would fly directly in the face of that.

I don't agree that look at my coin toss example. The were both the rist doesn't change the value.

The pipe let's actually sell the admission to the coin toss. There's three players if we flip a coin and IT comes up, heads or tails, two of them yet to actually split the million dollars. If under your game, only one person gets all of IT, how much would you pay for a ticket that pays out two winners of five hundred thousand versus one that pays out for a third chance in a million?

I can tell you that, elon, us would pay pretty much the same thing for us, right? I'm not rich enough to pay the same thing for both, but the way the stock market works is that people with deep pockets are the Price sectors.

No, that's actually not true. That's actually part of the point that I would make on this is that when you actually allow the participation of more people, you are actually changing that boy in line. Musk is not marginally setting the Price of the S. M. P. I found that I .

think we're getting all track before we have a thing worth. You work for G, E, your whole life, and then G, E went bankrupt. You lost your pension fun.

And now we've gotten rid of that. And your point is that makes G E overPriced. That doesn't fit. There's no connection there. What do you think it's over Price?

What I think is actually surprises the underlying asset. And by the way, I just won't be very clear. Over Price is not actually what i'm referring to.

You've lowered the risk ness of the investment. You've absolutely lowered the risk of my cortical pension by moving in from G, E. To stock markets. Dark market is less likely to fail in g years.

There's no Price or on my tension, right? I'm not selling my tensions anyone.

Of course, there is every financial of asset, whether it's a pension or whether IT is a portfolio. Stocks has a value that's .

the value of the underlying claim.

This is actually really important. It's not actually a true what you are describing with a pension on G, E is an annuity that is, this candidate, the value of G, E, cost of debt. If I change IT from G, E to a societal component, by definition, that now allows the cost of death to the U. S. government. I know IT is worth more.

I agree that I Better off as a pensioner if I know the money is coming that doesn't lead overvaluation the stock market or anything like IT. And I don't understand why the fact that my pension fund safer has somehow damaged anybody who's a hurt IT n i'm way that off, whose work off. I don't know what your concern is here.

The point that I actually making is that by making the process less risky, forgetting any implementation of by moving from something that was investing in by G, E, that then was a claim against G, E, against potential performance of that, that has a very different valuation. And if i'm saying i'm going to do the exact same thing in the stock market in total, refer to IT yourself. You said we've taken these risks out of the system. If I take risk out of the system, that annuity has to be worth more .

that just creating value. Your point is if you have an insurance company, you can make everyone Better off through risk sharing. And I agree with that.

But it's not like IT pushes the socked market up or pushes the value of socks off. Normally, I hear concerns for you that the value of stocks are being pushed up artificially. Maybe that's not the point you're making here.

That's the point i'm making here. So what are you worried about? What's the problem? So now everybody's Better off because we have some risk sharing. So that's a plus. There might be minus that way.

which to be clear, is exactly what I said. I think it's important to actually articulate. I'm not trying to take away pass of investing, not trying to take away people's four one kids. I'm recognizing that there are benefits of distributing this on a societal basis, ababa lute positive associated with that.

The chAllenges is that we then specify a particular form of investment that should be available to people and gave IT a liability advantaged component that has now forced everyone to believe what you started off with, which is, I have options for my savings. I can put IT in the S. M.

P. Five hundred to put IT into an active manager. No, actually, you could invest in into your own business. You could invest into your local community in a manner that is non public. These are all things that have taken a back seat at this point.

You're saying if people had no return, but I thought your concern was with the switch from defined benefit plans to four. One case. You're saying if we just got rid of all retirement savings, then people will do whatever they want.

Now obviously, we know from history that what a lot of people do is they consume IT now because people are always chAllenging getting through the day. And so what you see is very little savings. And then you have a problem because you have people who are old and hungry and they can't work because they are too older, too sq or to disable, and they consumed their self for perfectly good reasons.

Not criticizing those. People are saying they have kids who need to taking care of and they had lives they needed to lead, and they have unexpected things happen, and now they find themselves in their eighty two years years old and they can't work and they don't have any money. And then the question is, well, do we let them die or do we support them as society? And I think we are the kind of humane society that will support them. But then once you know that is society, you're going to support them, then you can need to set up something. You have a set of compatibility problems if you don't set up solutions to encourage people to make sure they say again.

I completely agree with that. I would point out the obvious contradiction which people used to save more prior to the introduction of these systems. They say less today.

They did before. But that is absolutely correct. Granted.

there's lots of ways of measuring these things and lots of other things in society in terms of how many children people have and what the children take care. Parents, you have this weird situation where you introduce social security and then you give benefits to people immediately, but they didn't pay into the city year. So is a complicated subject.

But fundamentally, yes, people will probably do. If you don't give people anything to rely on, then they'll have to do precautionary savings. But that's problematic to there is really vantage to giving people set up likes are so security and pension funds so that they know that they have something to rely on in retirement. But you're right that if you say, then hey, if you come up one penny, sure, then we're not onna treat your heart disease and you will die, then people will say why Better save enough to make sure I don't come up a panny sure.

just on the amount people are saving. We did ask internet sure about that because she's looked at in some other papers SHE sees no change in savings or read the quote. SHE said that actually, that's a very interesting question because you see they haven't necessarily, if I could, how much people put into retirement savings target date funds, according the research i've done, my colleague john Parker and page student S L. And coal, we actually see that they don't necessarily increase the many people save. But the way that people allocate the retirement savings, so SHE saying no change in savings, but different as allocation over the lifecycle with ark.

which is exactly the point that do .

you want people to put more in stocks or lesson stocks or do you think they have IT about, right? I means what i'm trying to figure out. I feel like what you're saying is they are putting too much in the socks and pushing the market too high. I can prove your own on that, so don't worry. I mean, in fact the answer, but is that your view the people being sixty forty and socks in the the age and seventy thirty the Younger, you feel like they should have a lot less than that in socks.

I an immovable in in terms of what percent they should put into the stock market verses anything else. But I am very much objecting to is the fact that we have created a form of investing that actually privatized is exactly spend points out scare savings as the saving seven increase. We're exclusively allocating that now to a small segment of the U.

S. Infrastructure and form of public equities and then around your component abroad. And because this is happening as such a concentrated fashion, IT is actually meaningfully affecting the structure of our economy and our society.

We think so. It's a concentrated fashion because it's in the three thousand publicly traded companies. Instead of you took your retirement savings and inducted in your neighbor store, something of that nature and people would be doing more of that.

You think? Yes, I see. interesting. We could reduce the amount that people put in their retirement ces and then hope that we'll take the extra money and put IT into things that are socially production instead of consuming.

And they might. It's not like I have studied the rules on forging case, say, hey, people are putting in three percent. And David, two point nine would be a horse. IT has to be three, you know, I don't know what the right number is.

And so if you think that number should be a little lower on open to that possibility, I can help I think is like there's a part of that want to say, gosh, have probably been in the last eighteen months, one hundred and fifty articles in the wall street journal about how people are saving too much in their over the opposite. All you have read in the financial press is crisis that people aren't saving, not after that. I understand your point is, well, if we die in force them to save so much theyd save just as much. But in other ways, and maybe it's true, I just don't know the answer. I think entry is referring to a change when we went from other kinds of investment vehicles into target date funds being so popular and that didn't really .

change savings at which he is actually referring to his Mandate and far contributions and the option verses opped out framer.

My guess is if you reduced the amount that people contribute, the overall savings would go down, but not by the full amount of the difference. You're actually right that they would save some. And no, maybe they would save just much. So my my deserve on you guys .

lost me a bit on the pension example. I don't really understand how eliminating proper attire pensions would affect market valuations. Thousand analogy of a little .

bit once there initially IT wouldn't really. But as you effectively take people who don't want to make these decisions and you provide them with an approved path, you are qualified default investment alternative and you tell them this is the way you have to say that collective decision is going to push the values of those entities higher.

Lowering their marginal cost capital versus every other company is out there and in turn facilitating a concentration, our economy that ultimately he adds dramatically to rise. It's really important to people understand this. All risk in all diversification as effective, A U shape to a vii, investing just one side risky, two stocks less risky, three stocks less risky.

If I invest in three thousand stocks, not appreciably less risky than investing in thirty five, as you know, from diversification benefits. But if everybody is invested in those exact same three thousand stocks in exactly the same proportions, actually, that's paradox. Much more risky.

I don't really find up. So he said, but the thirty five graph that we've all seen, an interview text is the number. If you have zero correlation among the socks, which is not the norm, I think there are substantial clarification benefits of having thousands of socks that are just a few dozen.

The notion that if people had half as much in the socks and then the other half they put into a building across the street triple deck, that they then ran out that, that somehow safer because now they're more diversified by adding that local investment. I don't find that person if I think a road based investment in thousands of companies plus low risk or safe bonds is pretty good. Now that's not to say we can find ways to make IT even more diversified.

Obviously, you see talk about adding other kinds of alternative investments to the next in retirement finance that's in the tour fix, boring on a finance professor. So i'm never going to tell you all let's have less diversification, but I don't think that you get more diversification. If people take a chunk of what's currently spread out among thousands of companies, close bonds and put IT into private local investments, I think those are going to tend to be pretty undiversified. Not can put five dollars each into one hundred different local buildings or whatever.

in part because we don't have the opportunity to do that because we now have been dated at this type of vehicle. There's nothing that would have prevented a local real fund from popping up to invest in cambridge real state, for example. That could be a component to the local community. IT would be a very important to tonic, particularly as IT released the things like large institutional accounts.

It's insein to me than an entity like harvard or an entity like casters in california allocate tes its capital on a fiduciary responsibility in which that fiduciary model is held against the performance of the s MPI funded instead of recognizing that as casters your members benefit from california flourishing and as a result, there are ancelles benefits associated with capital investment in your local markets on an individual basis. Randy, I completely agree with you. I am far more diversified because I have access to large scale financial assets.

That's a positive. And again, I can understand how you don't understand or don't see how that raises valuations by seeing that things have less risk associated about them. But at the same time, there is a societal cost is associated with the mind of that behavior.

That's what my complainant is against. I think that system mater passive investing is like any other form of investing. IT is a style of investing why IT receives priority and the implications of the rising to a certain scale is all I care about.

IT sounds like the difference between us is, you think you know what the right percentage is that people should have in simple low cost force savings vehicles? I'm saying to you, if there were saving three percent and you tell me I want to be two and half, my mind is open to, but is the reason you know the answer, because the answer is zero, if they shouldn't to put any on map? Or are you saying, no, no, they should have to put some in map, but the amount that companies are currently doing is too high.

I don't actually know what the right answer is and would argue that the tools that we have for trying to estimate that have been corrupted by this process of transition, we need to understand the impact of what happens when we increase the proportion of passive or systematic index investing on valuations and forward expected returns. Before you can come to that answer, you cannot use history and deriving that answer.

can we push on up? Because this, I think, is the biggest thing we disagree with. IT, i've heard you speak on the sub number time and IT seems very clear.

You said the last time, your own rational reminder that this money flowing into these four one keep plants instead of I mean, I soon you don't mean instead of the alternative where they just set up on fire. The alternative is that, lets say the old school defined them for pension plans, which we had for one hundred years. And in those plans they were pretty much investing sixty forty.

Now you have this money going to four one k plans and investing sixty forty. And your notion seems to be that that's gona make the market be five, six, seven times overvalue. Don't buy that at all.

And I guess I would like to understand your argument Better because a, it's about the same amount money going into socks either way. And b, the flows aren't nearly large enough to have a big impact. And I guess maybe you could start by saying how overvalue do you think the market is now as a result of this? We've had this stuff going since two thousand six. I forgot to look with the markets that today was like fifty, seven hundred or something like that. How much lower do you think IT would be if we just stop with to find benefit planting plants.

if we had not changed the process in? Otherwise we act out the component of passive? I ask somewhere in the of fifty percent reduction and value.

So that is super helpful. So how do you think, sister, when I got to grad school, the most famous paper in the field at that moment, this is early nineteen, was meron press ATS paper on the equity premium puzzle. And they said, if you look at the risky ess of stocks and bonds, stocks are risk here and they should have to pay a premium.

But if you do the analysis, that premium should be something in the neighbor od of half a percent year. But historically, stocks at out performing bonds by something like six percent a year. And I say these long bonds or whatever, currently stocks surprised to return something like bonds plus two, maybe three percent a year.

Let's called to, based on the best theory that we have IT seems like socks still look cheat. And you're saying, no, no stock should cost half as much. Stock should be so cheap that they just crush, killing, destroy bonds every year, and then people shouldn't go out and race out to buy them any more than they currently do.

If stocks were away cheaper, everybody should buy a huge load of them until the equity premium is lower, and that would push the Price up back to where IT is today or arguably even higher. Why do you think that the equity premium needs to be so much tired than this? Why do you think people shouldn't buy stocks unless they get a gargano with premium?

And for so there's two separate components to the first press gotten mara Operator under an assumption of an argolic. First is non argotic system. And this is actually really critical to understand if I think about Normal distributions and standard deviation of returns and run money for our simulations on that basis, where I look at history, which as a survivor ship by a associated mira fact, and I will look back at history of stock market, implies a component of survival bias that doesn't exist in many regions around the world. So it's been very clear on that.

If I try to model business and I got a system, sex stocks are expected to return eight percent, a standard deviation of sixteen percent on either side of IT. Another is roughly mimicking history. I'm presume that the future is exactly like the past.

And secondly, i'm presuming that each individuals experience is actually distributed in a similar manner. And her gott system is one in which the time serious average is the same as the ensemble average. That works for many games of chance, or things like rolling two sets of die.

If I roll two sets of six sets a thousand times in a row, I mean, to get the same distribution is a thousand people rolling at one time for a very, very similar distribution. On the flip side of that of a thousand people invest for one year in the S M. P.

Five hundred. That's not going to have any ambuLance to my return. If one person invest over a thousand years in the S.

M. P. I fund was radically, radically different experiences.

what's the fair equity prime? I understand there is a question of my protest. Estimated the historical equity premium by history.

And obviously, if the market then doubles, the history gets higher, but the future gets lower. So fine, you and I might have a difference of opinion. The forward looking, I don't if we do. But what do you think the right equity premium is that should cept things in equal livery?

I think it's completely conditional. First, when you define equity repress um you're using evaluation assumption. You're simply reporting dividend yield versus treasurer yield or an earnings yield inclusive of stark by bags. You're making some assertion about the forward expected returns that i'm simply arguing you can't make.

I think you, serge, i'm asking you what forward expected returns would cause you to say the stock markets of the right press, you think the start markets should be half where IT is? Now if I was really clever, I could just translate that into afford looking expected return IT sounds like I found doing some quick back of the head calculation. You be saying, instead of stocks paying long gone plus two, you're saying you should pay long guns plus four, five or something like that. Is that the ball park?

You ask me actually a very different question. You said what would be the impact of this hadn't occurred? What was the impact of that terms evaluations? If we were to remove that, I think stock would percent lower.

Let's which to that, that I don't understand that at all. Raf oba have this wonderful paper. It's controversial.

So they say wo markets are way less elastic to people thought I think it's a terrific paper but this planet, people who think, no, no, no, it's not in last thing. They say let's take there as given. So they say a dollar goes into the market.

They move the market five dollars. If you take all the money that went into four one k plans last year, IT was about two percent of the size. The market I looked at up something like sixty percent of that went into stocks, sixty five percent.

So that's like one point two percent of the market. And then you apply five to IT, you say, okay, that should push the stock market of six percent. Then you have to ask yourself, or how long is the impact of that trade last and let's say at last, forever with a half life of one year.

So you make a trade, you put the market upper bunch. And then a year later, it's still half that effect is in the year later, half that. And super.

That's, I think, a pretty long half life. Most people think the half life should be a months or a quarter or a week, not a year. But let's make IT a year under that math, all the four one k contribution that have ever happened would make the market something like twelve percent higher. So how do you get fifty percent high? And by the way, I want to be clear that if zero of those dollars had gone into socks, in the words, if they gone to find one and then what, just as much that, but let's imagine that instead they lived all on fire, then I feel like the market would be twelve percent lower, not fifty percent lower.

That would be a great and absolutely if we were looking at a single period. But because this four one k flows are happening on a continue space, but I count for that. No, you didn't. What you actually did was you said if I put all the money in, that would have raise ed valuations by six percent .

and then last years would have been six percent then, which is three now because the tap that's nine, and the year before that would be six, which would be three, one and half. So i'm just using the easy now that one plus a half, plus a quarter, plus eight, plus sixteen people people to that's why double .

the six years now turn n IT into a time series and in which is a mult location as compared to an addition is one point or six times, one point or six times, one point or six times one point six?

No.

that's not true. Yes.

no. It's one point to six times, one point of three times, one point or one five. So maybe it's a tiny bit over twelve because the company is still going to be twelve. No, not at all.

In order to get the time doing, you have to assume that if somebody made a trade thirteen years ago and pushed up the market, every single bit of that thirteen year old trade is still pushing the market up. Do you actually believe that, that can be true? absolutely. Aren't saying there's a half life where the effect of that trade deteriorates a little at each year.

Walk through the math very simply. First year, one point or six, we agree on that.

right? But then three of you, you give back the next .

alone after one year and at one point or six now I have flow come in that has a similar impact. So that's actually one point to six times one point o six.

This is the heart, the net. I'm saying if to the end of the second years, one point of six times one point eight three, because the first years of fact, IT goes up one point at six percent when you've make those purchases, but then by a year later, you given some of that back, you can't just keep adding up forever. That would be crazy IT.

Does nobody .

thinks that the impact of every trade is a permanent impact? Of course, to ask that a half life.

I totally great.

So what do you think to have like this? I N C year, which I think is super long, do you want to use something?

One, let's use year. Let's stick with your number, but let's recognize that each year has a similar compounding effect run through the math.

Let's do buy here, and i'll tell you what I think. Can you tell me if you're right? The most recent year is a fact one point of six.

The year one back is one point or three, because I did one point two six half of IT been reverted over time, and the year before that is one point or one five. And the year before that is one point O, O seven, five. And the year before that is one point o three, seven, five.

So then you multiple those out basically it's like six plus plus one and half, which gets you twelve. It's a tiny behind than that for compounding in order to get giant and effects of the type are worried about if to be too crazy. Assumptions first, you after soon, none of those dollars would have gone into the stock market if IT warn four four one k plants.

But that's not true. We know that in the old days, they had to find benefit plans and those went into stocks in about the same proportion. So I would argue there should be no that.

But even if you make the super extreme assumption that if this have gone into or one k IT all would have been little on fire or buried in the backyard or something, then you still only get one point or six times, one point or three times, one point or one five. Europe, twelve percent. Even ten years from now, it's still only twelve percent because you always have the most recent years of six. And then a year that half is big and year that have is big. So you never get an explosive thing from this again, even with that first .

crazy assumption. Randy, again, the matter if you're doing is wrong. Stop for one second. Let's accept your proposition one point two six. The first year IT degrades to one point two three the second year.

Now I introducing another one point o six on to a market that is three percent more expensive. So that actually takes a tiny bit overnight. okay.

So now let's do IT again. So let's say that effective grades by fifty percent, that point nine one eight is now down to a four and a half. I multiply a four and a half, so one point o six times, one point eight, four, five, now ten and a half.

So now I take that number. I divided by two. I add you to one, and I take one point six times that five in .

a corner this next. Now you're in level in the corner. Do you see that you're closing in on a little over twelve? It's going up less every time. This is like a enos paradox. If you use no compounding, IT ends up exactly at one or with compounding, it'll be a little over twice.

okay. So after four years, I passed. Well, in that analysis.

do you agree that if we use simple instead of compounded would be exactly twelve after one hundred years or thousand years?

Yes, of course I do, but that's the problem.

I really that is compounded will pull out excel and you'll see i'm not saying I won't be fifteen instead of twelve IT, might be twelve of three quarters or might be fifteen, but it's not going to be fifty or anything. It's not going to go that much because you're adding these tiny little factors on the end, you're adding one point O O seven, five. There just isn't that much compounding anyway will do enough.

Randy, that seems to make sense. Like i'm missing why is wrong?

Let's run through this here very quickly.

We're doing this all right now.

I love that man as well, right?

Seven years, one point of six times, one point to three times, one point of one five. And you can do to us while you work on that.

make the follow question I have and really kind of eluted to IT finish this discussion will run the excel after I want to talk about, why is this different? We're talking about money going to target date funds or index funds. Why is that different flows going into active, which is kind of a different version of the D B pension plan? Why are flows going into this specific type of investment having a more concerning impact that flows going into active, managed unes, whatever anyway parked that I I want to hear what the excel is.

right? Because you can see by the tiny get to seven years, you're down to really tiny factors that you're adding on.

So unfortunate still trying to get the excel numbers in because i'm working off the single laptop.

You see how theory about sanga? What's one point or six times one point? O three times one point o one, five times one point o seven, five times one point o three, seven, five times one point O O two times one point, one times one point.

O, O, O five, four. I went a little high at the end because I couldn't do the dividing thirty seven and a half and half in my head fast in out. But I got us up to sixteen and set at twelve IT just doesn't go that high at first. To seven is not going to add much if batting those tiny factor. So it's probably between fifteen and sixteen person.

So I come to a similar conclusion again. IT just becomes a question of what is the degradation and what is the process of actually switching. And so then this is exactly the point is making.

And I want to get your point there, if the half life is five years, not one year, you could get to something big. So I leave IT to our listeners to ask themselves, do you think if you go into the market and buy ten thousand chairs of apple, that five years later, apple is still the full amount higher of your Price impact or even half as much hired? I feel like we all know that.

Is the great faster than that? What rolph's zi did is that they showed us, people thought, degraded in minutes for hours. And what they showed us is IT could be weeks or months, maybe I see in a couple quarters, and that's why I am granting a year, which I feel like it's kind of the outside, but I don't think it's flautist. But at five years, as I have life, I know that you prefer.

I think this ultimately, is what oils under the question. When I look at papers like jane or others, IT really does matter in a really big way what that degradation is, to your point, if that degradation is very temporary. And now you have to provide me with the mechanism that says why the Price falls by that amount.

Why does IT degrade by fifty percent? Who is the seller that is actually showing up and lowering those Prices? If your argument is, is that IT is active managers as they become a smaller and smaller share of the market, you have to believe that, that impact period is rising and creating the exponential features that I am describing.

The number one sell these days is probably target funds. If the point you to pushed up artificial artistic funds automatically self socks and five bonds, that's one sale that you know is in there in a big way, then there is a bunch of institutional investors who default to sixty, forty or fifty, fifty, some other number.

And that may be old school pension funds or who knows that maybe insurance funds that only allowed to have ten percent in stocks. And so every time stocks go up, they have to sell some in self word. You've got wealthy individuals who have an advisor who tells them, hey, we shouldn't over seventy percent stocks.

So you shall go over fifty percent stocks now they are older or what have you. And by the way, there's companies that can issue stock. And obviously, right now, companies are buying back more than they're issuing.

But I will argue that evidence that the markets not overvalue, the people who are in the best position to know what these companies are worth are buying back rather initially. And you see, they do IT when it's crazy. Look at game stop.

What happens is some person puts up some M O G on the web and then game stop goes up thirty eight percent. And then the guys who run game stop s say, hey, we're showing another billion dollars where they stopped. There are a lot of mechanism m out there to get things back under control.

And i'm granting IT might literally last forever. But by a year, half of its gone. And by two years, reporters of its gone. And so but i'm grancy the fundamental point that you are making in the rain of via making that this stuff takes longer than you think and that they are aren't as many natural fixers in the market as you would think. But i'm saying, boy, I can grant an awful lot of that and still not have an explosive problem.

And that's again, if we come back to our host point, what about this issue that people we're gona put money in stock market anyway? T, D, F is just one way of doing IT back with with old school pension funds. Why is this so different?

The single biggest difference is that the e lastic ity of an active manager is much higher than a passive manager. Because individuals inside the fund, they are making the choices that bRandy is describing. If I remove that, i'm presuming that everybody is reacting, which is exactly that rand is talking about in this period of how long does IT take to take out that response?

If you actually look at gene case as evia give in rough questions word, they're are taking that five as an average. But if you look with what's actually happened is that average has gone from two, which is roughly the impact of an active manager. One point eighty is the number the value to come down to is your add passive. You're making the participants of the market less elastic and less capable of allowing that degradation. The Randy e is highlighting that's why illicit rises as passive share rises, the multiple er effect gets larger and larger.

Er so how we understand why the active guys have less impact. If that were the case that when the market goes up, they held more in cash, then they might be Better than passive, although still they probably wouldn't be as good as target date funds for the elasticity effects.

But the reality is that when the market goes up, they have lesson cash because they're terrified of missing the run up because it's so crucial that you have to be a five star fund when the markets doing well. So you have to be fully invested when the markets running because that's the only time inflows comment. It's very clear in the data and it's very clear logically that they don't even go the right direction in their track chases. And so if their train chasers and pass IT is flat and targeted funds are actually going against the trend, then why we going from active to targeted funds create illicit ity problem?

Again, IT is not a question of the target date fund vehicle purse, but highlighting the target date fund is something very different, that they are causing people to behave in mass. Absolutely agree. If you actually look at the importance of what you just said, IT could cause people to buy too much of any one asset as its Price goes up or down paradoxal.

If I look at something like what happened in twenty twenty two with the bond market, sala, I looked at the construction of the indexes, the bond indexes, they had become heavily overweight to long and low coup on insurance. why? Because those are the ones that rise most in value when interest strates are cut.

And that in turn means that they are most heavily waited in the index. So with in bond performance was far worse than anything that had ever come before because we had actually driven this inside the asset class. Again, i'm not disagreeing with you. Now the targeted funds are actually, let's say that they're sixty, forty. The reality is they're more like seventy, thirty.

And in terms of the aggregate dollar value that's been induced in them, they are not waiting bonds anymore today at four and a half percent years, then they were one percent or half percent yields that flies in the face across asset return expectations unless you somehow believe the equity expected returns have risen by an equivalent ent amount to bonds even as bonds have fAllen dramatically in Prices and equities have risen. And so what you end up doing is you end up creating a position in which you are correct. The aggregate impact of IT is actually a causes bonds and stark to become anti correlated in an individual portfolio. But IT doesn't do anything to address the underlying issues of each of those individual portfolio components, allowing them to go deeply off the rails, enforcing outcomes for a broader index like a dark market that could be far worse than you've had ever anticipated in your historical model. Exactly as VISA bonds in twenty twenty two.

three parts, one IT is the Normal assumption that the interest rate rise, expected returns on stocks are also higher for things to be an equilibrium. Now you may feel that you can outsmart the market. And you know, when the markets making a mistake in the market was an did IT off by the rise, given how much interest strates went up, you won't expected the stock market to go down.

And I didn't I think it's pretty obvious. The reason I didn't is people believe the technology change story, whether it's A I, whether it's the incredible health care breakthrough that are happening. People are saying we think cash flows are going to be a lot higher.

So even with this higher denominator in the the present value formula, we think this are so gonna that many people are wrong about that. But a lot of people who thought they could out more the market with timing like that have turned out to be wrong. The targeted funds absolutely took action when interest strates went way up, bonds went way down, and then they sold stocks and ball bonds.

And your point is, well, I know, but they just went back to sixty, forty or seventy thirty. But the point is they absolutely talking. They took money off the table in the stock market and poured into the bond market because of interest state.

surprising. So I think it's not right to think I didn't do anything because they just got back to sixty forty or seventy thirty. And the third point I wanted to make is real phin service thing looks like something that oh gosh, is scary for the market.

They are going to get way out of work. They're going to go too high. They're to be too volume.

But look how powerfully is that their result is so large in the target date fund context, let's say your seventy, thirty, seventy percent market goes up ten percent. Now you're seventy seven thirty. What's sagon didn't move to seventy seven and thirty.

Well, to get back to a seventy thirty proportion, you have to sell what on the three percent of your stocks and put IT in the bomb. Mark, maybe tup, what's its tip? So you sell two percent of the seventy seven, and now your seventy five, thirty two.

And that's probably pretty close to a seventy thirty mix I can have quite to the matter enough in my head. So you sell two, three percent well. And how do you say two or three percent? Ten, five? If targeted funds were a quarter of the market, then you're not have two percent. Ten five is ten times a quarter is you're not hit the market down two and eight percent, it's hugely impacted. I'm just saying that the result they have, which says, boy, you like to see potentially scary, is saying that these target funds, they're very powerful in helping rebaLance markets if they overreact to ips.

I would actually agree with that. I have no dispute around that. This is the critical component when I highly targeted date funds, my issue with target advance has nothing to do with the fact that we are using automatic systematic rebaLance C.

I completely agreed that actually changes behaviors of arts and makes portfolios, all dampening in that process. This is exactly Parker's point. If I sell equities and bay bonds to your earlier assertion, have been made an assertion about the forward expected returns to the market. Have I offered any insight in terms of the development of ai?

I'm not saying the targeted funding that well, what I am saying is your point is, boy IT seems like bonds are a Better deal than socks now because the interest went off, so the bombs are paying more, but the socks Price didn't go down. So IT doesn't seem like the yellow on the stock should be hired and the answer is where the yellow on the socks is higher if they're going to make a tony money.

Let's take a moment and talk about in video the forward multiple. The stock market is twenty two. Let's twenty.

Your feeling is, hey, if I weren't for this artificial forcing, you want to things that would be eleven, which I say, a boy, if you could buy socks for seven times learning, no same person would buy baLance. Everybody would bore all their money into socks. So I do not see that little moto is some kind of natural figure.

But okay, that's a disagreement with black in that. Markets are twenty two in video is forward. P. E is thirty three. Are you really worried that the videos is crazy high relative to the market, shouldn't be higher, shouted, have a higher most in the market? There were three big anomaly, as I learned about early and grassland.

One was the equity premium puzo, which we have talked about a second was the poster in announcement drift that says when there's news, the stock moves the right direction for the news, but IT doesn't move nearly far enough. And then the third was the quality anomaly of all the quantitative cross x ual anomalies. The one that is the biggest in Price terms is that high quality companies seemed to train way to cheap.

They don't seem like they are risk here. These are the quality companies and yet their returns were really high. And I feel like your argument amounts to, boy, because of the rise of passive, all three of these anomalies still exist, but they are not as biggest they were.

The equity premium is far out of lab. With what theory would suggest IT on to be the posters, y's announcement drift much more. In other words, firms come closer or to going up the right when there's news.

And then quality firms like inviting now trade more expensive instead of trading just a little bit higher multiple the market. They trade decently higher the market, although still probably in the noticias nation on a relative basis. So hasn't the rise of passive made the markets way more efficient and Better?

So yeah, a couple of quick points. One, I actually asserted start that the contribution of passive is positive up to a point. So I just want to be very, very clear on that.

The second component that I would I like this is when you talk about something like quality factor, part of the components of quality is effectively saying that there is lower vollar tilly associated with the underlying fundamentals that's creating less news on which people would either actively buy or sell the security in response to the information coming through a passive format effectively grants a special status onto that low volatility component. If a company is up ten percent, one learnings report and down ten percent, the next earnings report is snet down one percent. Company is up twenty percent, one next report down twenty percent, the next it's down four percent.

The first company under a passive framework is going to receive additional premium because is consistently being added to in size as compared to the more voluntier company. My point on this is not to actually say the quality component doesn't exist. In fact, I actually exploited many situations in portfolio construction. But with that said, we can't actually tell what quality factor is because we are simultaneously dealing with the rise of passage.

I point out the beginning this, these two kinds are passive. So this would a passive in the sense of these four one K I things where the money should slow an in the market every day without anybody thinking about IT. And I think that's a really good thing to look at another concern as you are about, but you actually right, hey, can we every once in a while while stop and think, is this a good idea to support? And without anybody pausing and checking, that's why.

And in the second passed is this projection of which we sort of gotten to know where we're sort of saying, hey, are the wrong companies getting purchase too much up? Are we sure the second kind of rise of passive has even occurred? Do we really think there aren't more smart people managing more dollars trying to beat the market now? I mean, the two pots in lively IT feels like there's way more smart people with way more dollars that can be impacted in markets then there were thirty years ago.

And second IT seems like if you ask any quite where does beating the market come from, they're say, well, one of two things have to feature at least one. Either there have to be bigger anomalies oh, posters and announcement drift is three percent, not one percent, or the anomalies have to last longer. That gets you three percent for three, you know, gets you one percent for four months in a row instead of three percent for a single month.

Every quite I know and I know a lot would tell you that both those things are very small, that the markets are way closer to fair Price. Wait more, of course, wci y things like things up. There were wci y things like let's stop calm in the old days, there's always been wci y things.

But fundamentally, IT seems like there's more smart people trying to get Prices right. And they find IT harder and harder every day because they are all so smart and they're all working so hard, they have so much money to use to get Prices right. Is there rise of passive at all?

Well, empirically, there has been a rise of passive. So we actually know that.

Are you sure count? right? That's what i'm asking you. Are you sure that we are accounting for all those family offices with trillions of dollars?

Do we know how much leverages they are using to make the big beats that they are making? Do we know what's really going on inside set of that all? And however, that farm is when I started studying the head fund business in the late nineties, a big head fund was like three billion dollars.

And now you've got all inspiring, not when you get they are all call themselves hetch ones. They go by all kinds of different names and they use tseu ever and they use the rid was that don't show up as leverage, but might fifty x their binding power? There were things I said you before.

I am like, i'm pretty sure i'm right about this. This i'm not sure i'm right about. I'm asking you to help me think throw because maybe i'm wrong, but my instinct is that if you counted the right way, it's not actually more tilted towards passive. And the fact that miss pricing seems to be much harder to come by, suggest that, that the case.

and I would actually reverse that and say, one, to argue that there hasn't been an increase in passive investing fields, completely counteracted. And that even something we can really entertain .

what i'm saying before that if you go back to the eighties, what you had was all the money in neutral funds that were basically closed and also on exactly course, they were, but eighty percent of them were close in x and twenty percent of them were three.

But when do we actually have data on this that shows the proportion of index hugging has actually risen dramatically? Proportional closet benchmark is risen dramatically.

but we don't know is about the real guys, the guys who actually have edge. Because because those guys in the eighties, it's not just that they hug the index, not when they weren't hugged the index, didn't know what they were doing. Do they have any end? We know they under perform consistently.

The point is where they actually fixing this pricing very effectively. I mean, i'm not saying they weren't doing anything in the eye. Dom, sure they were.

I feel like if you face smartness time dollars and you add IT up across everybody in the market where if you're fully passive, you don't count, the people then got very smart. But we're not counting not a smart is for this purpose of for smart is whatever who want to call IT. Is IT obvious that there is less markest time dollars now then there was back then.

I'm just not sure how people we are measure. I am sure i've seen the papers. So I know a couple people make effort, wealth made effort, other people made efforts. But I just not completely convinced that they really know what's going on inside sidell and all these other firms licit someone which you know what people haven't even heard, all just like meet people on people oh yeah, I wanted less. We've got twenty three billion and we forty x leveraged.

And like, i've never heard IT when I go yeah in sand tonia and that well, you still i'm saying i'm asking if you share my concern at all that is possible that we don't actually know if there's been a rise. The other kind of ized absolutely have all that money is. That's good.

I'm saying this kind is cross tional passive. I just don't know that the average dollar is dummer than I used to be. We took money out of the hands of retail people.

I don't know that they were doing that much to fit this pricing. We took money out of the hands of some mutual al fund folks who are not sure how great they were a fixing this Prices. And we put a lot of IT into pure pass IT, which obviously isn't doing anything to make this Prices that right away. And then we put a chunk e of IT into big higher level, exceptionally smart institutions.

And I just wonder. So the quick answer to that is you are absolutely correct, is rise of mega firms within would traditionally be described as a hedge fn space. The role, though, is actually radically different.

So cinda do is a hedge fund and a market maker. Its role is a market maker, warf said of its roles, a hedge fund and the type of trading behavior that theyve engaged. Completely agree with you, but what we didn't track previously and when we are thinking about that type of behavior was behavior.

The specialist for who also ran heavily levered, had order books that provided transparency at such a what city l and others have largely done this. Synthetically recreate order books. They pay for order flow to calibrate those models, and they trade accordingly.

That's just replacing a separate role. We actually do have data in terms of proportion trading that is going traditionally through those who Operate off a fundamental as compared to Price of volatility in sights. And we know that, that's fAllen from around eighty percent of market activity to around ten percent of market activity today.

Think about we were found, not marco Simon, his work and he wrote this paper and good with that out now he shows that this index inclusion effect, which was git, was what the main things that smart mark makers and quan folks made money off of. It's totally on now. We put enough smartness on that problem that that thing doesn't exist in all anymore.

And so we don't have the firms inside the index trading higher Prices in the firms outside the index. And you don't even have any meaningful movement. I think they find the point six percent or something you go up when you yet in the index. It's an astonishing result, but i'm just sing if the post is an ounce ment drift is gone and if the quality effect is very small way than IT was and if the index inclusion is gone, I would not expect a true rise of passive to make anomalies go away. And so I want to propose that maybe the anomalies went away because the world just moves towards lessons pricing and that either there was no eyes of pass IT at all, or if IT happened, IT wasn't a big enough effect to make you either pushed in the right direction, like with the quality effect in the post dance of announcement trip, or in other cases, IT didn't do too much harm.

So again, this is a question of what is the actual mechanism is IT because effectively the market to become more efficient or is our definition of market efficiency is good in that direction? Those earnings announcement draft has been replaced by dramatically increased volatility on the earnings itself.

As I needed to be, I used argue with my dad about that. My dad has been training stocks for seventy five years, is in a easy started. When was twelve years old? The bristol mies is person still, but he would call me, and he say, can you believe these crazy Marks they missed by a penny in the stocks, down nine percent.

And this is in the nineties ago, learn in the and I like, yet, didn't drop enough. Dad is like, what do you mean? I like, look, obviously, I don't know about the specific thought, but i'm telling you that generally, they only drop between like a half and two thirds as much as they ought to.

IT needs to move a lot more. And the reason IT doesn't is because of guys like do dad, in other words, he's the guy who goes, is IT drop too much? I'm gonna the dip, but in fact, IT needed to drop further and people like my jumping in there.

And now we have enough institutions that IT falls. The full fourteen percent IT should have fall. And instead of only falling nine again, all numbers made up money back.

That can be true. That can be a stage of efficiency that the question is, the mechanism is IT occurring because of greater efficiency or is IT occurring because of greater illiquidity that is being created?

But if that were the second one, then we see the quality printing money, but we know there not we know how tough IT is.

What we actually know is that the only business left is quana that are arbitraging down. In other words, the returns to fundamental analysis with the returns to the type of arbitrage that you're describing would increase. And that's exactly what we've seen.

I don't think we've seen people making more money on things like getting on what happens right after earnings granting. We wouldn't nessy call post strings and element or maybe now it's an overreact postings there. But the people who do that kind of try, you buy, you hold me for a day a week among not the midst second guys, which obvious ly is a little bit of a different thing.

You can read all the academic papers that their stuff is based on. And you see all this once five percent year and this one seven percent a year and this one three percent, and you've got two dozen of them. And then you look at the performance, even if you only look at the survivor to save out before and by a few percent a year, it's pretty tough out there.

And that's because a friend of mine once said to be said, yeah, sometime around two thousand, somebody turned on the big computer and they just started pushing all the Prices to the right places a lot faster than they used to. I talk to a lot of quant because a lot of people I went to grad school with really, really talk points, former students and so on. And so before they are four thousand former students. Now, nobody thinks it's gotten easier.

Easier relative to what? Easier to what I used to be. No, easier relative to actually trying to project the fundamentals. absolutely.

What do you think of fundamental analysis these days?

I don't think anyone does that anymore. I don't think anyone really cares. In all seriousness.

couldn't create opportunity if you did. Is your point that if someone did that would be great, but they don't do IT?

This is the second point of IT, which is if you actually think about the parameters around, the assumptions behind all the academic models on this, things like growth and stick lus, which is really what you are referring to, when you talk about these types parameters will IT be easier for people to make money.

Is there an incentive for them to make money off of fundamental analysis? Roseman stillest is just a reformulation of the wisdom of the crowds. If everybody votes, we're going to get something that looks pretty close to the front, the wising, the crowds.

And the gross for stimulus has its own assumption not to similar to sharps that pass IT never transacts or as simulate assume that the market has roughly equal in downing. Every protestant ant basically gets one vote. That's how the wisdom of crowds works.

But we've actually done is substituted in which basically forty five percent of people get one vote of radical size, and everybody else gets a tiny vote. That means that the listening crowds breaks down under those simulations. You end up with the answer that forty five come to, not that the fifty five come to.

So golden came up with this report the other day that I feel like was end of you. Don't you think I mean, that you didn't put your name IT seemed like they were ready yet to address you. Would you agree?

yes. Do you think that's correct?

I thought they had a couple of good point since other points that worn as copeland. So I feel like you deserve a chance to respond to that.

absolutely. The golbin socks came over the report headline by David costs and head of strategy in which they attempted to isolated onor of passive. And they pointed out that passive effectively had a very small impact relative to other controllable.

there. Also, this study, like almost every study that has been done, but notable exceptions of some of the academic work that has been done, relies on a definition of passive that is derived simply from something like facts, indicators. And so everything in an industry fund, everything in a sector fund, everything in X, Y, Z, is included in there.

The most passively held stock according to golden sex, but something like forty two percent with NASA, N, D, A, Q of the ticker that some third, the next came to the conclusion that the most possibly held stocks with the rate at set a. And bloomberg did the same analysis earlier in the year. You end up with the conclusion that the least passively health socks are actually the largest socks.

As a result, all parts of the analysis are just all of that because what we actually know is the most passively socks are the largest socks. Active managers can hold apple in proportion to its market cap in their portfolios. At least not the vast majority of active managers or individuals can hold IT at a waiting that is consistent with what is held in passive vehicles, among other things.

The before you act prevents them from a diversified basis in holding many products that there is concentrated as the induced are currently. That tells you that the analysis was completely wrong in its specification. And this is that simple.

I think you have a good place when they said, oh, the average stock is twenty five percent passed in videos, only twenty two and then they said they ran a aggression and they show they, the lower passive ran out more. I thought, twenty five verses twenty two. And that, before we forget, to your point about, is that really properly measured? So even though in the end I read similar conclusions to them about there is a passive, I think you have some good points and responsible 都是 i .

do you want to reach up a couple things。 We have talked about aggregate valuations and we talked about how flows into pass of funds drive up valuation at the area area level. How much depends on how quickly we think the effect the case that's kind of where we landed on that cross section ally, maybe markets aren't as possible as they seem because they are growth and hedge und and things like that, that we don't have much visibility on.

Hetch funds have not grown since two thousand and twelve other than the underlying asset values. So flows have been negative into hetch funds for extended period of time. What Randy is describing is a component of hedge funds effectively within hedge funds itself, its transition from fundamental analysis. To increasingly high speed quantitative trading, to arbitrage out exactly the components, the ratios and universe .

and other kinds of things that wouldn't call themselves a heads fun but are working to make market is more efficient.

We talk about that, but I don't know we talk about where might do you think the cross section impact is on stock valuations from index investing?

I did. So I think the process sectional impact is to raise evaluation. The key question becomes exactly what Randy highlighted, which is effective. What's the degradation factor associated with that? What are the mechanisms by which that degradation occurs .

that's agreed market though cross sexually, how is that affect large cap stocks .

or a small cap talks on across section basis? This difference in multiple are effectively with the inelastic ticket component. So this is work i've actually been working with valentine aod.

To derive some of the components of IT. And if you actually look at the elasticity or the elasticity, the smaller socks are far more elastic than the largest socks because they have readily available substitutes. I can choose to buy delt earlies.

I can choice about united dallies. I have no substitute for apple or a video or anything else. The second is the smaller share of the market that is actually held by active managers, the greater that decrease in analyticity.

If you got to a market that was a hundred percent passive, the market, by definition, would be perfectly elastic. There would be no original buyer or seller. Take IT back to ninety nine. Market is still highly elastic.

The point that i'm making is, at a certain point, the market moves from benefiting from the contribution of this new city to being degraded by the size, gain and determination of the capacity of the other players in the system. This is exactly what valentine's paper is written about the strategic response component. Perversely, as passive gets larger and larger, this strategic response becomes exactly what brand is describing.

IT effectively becomes around arbitrary ging the behavior of passive as compared to trying to make an articulation about the underlying fundamentals and the future cash lows associated with the firm because in any realistic form, those play a very small role in determining the valuations in anyone period, when we talk about a stock jumping or falling by twenty percent because earnings in a single period, that is irrational, as rand's father pointed out. If it's a complete one off, but if it's a look forward, if you're effectively saying, well, all future cash list are going to be affected by that one penny miss, this causes me to degrade my model, then that would be something different. But those are two very different mechanisms to have people simply arbitrating a Price behavior versus having people make a attempted understanding what the forward fundamental outlook, kids, a market that is shifted from that forward fundamental outlook becomes increasingly disassociated with those forward fundamentals in lasting mechanism for increased strategic response rises.

Talentless point is that strategic response is a fraction of what people have. historic. I thought I was. And IT is falling as passive is larger and larger. Larger sometimes .

works really interesting in very high quality, where first question ask is, how much more passive are we than before? You know, we have these fun. They don't call themselves head funds, their institutional long only.

But they have one hundred, two hundred, three hundred billion dollars and unbelievably, insanely smart people at them, you know, including friends of mine and friends, are there is what i've gotten to know. Sometimes they're able to use leveraged and drives and other things. And so there are some big players and there, so OK, we've done that to that. That's the first.

How much rise of passes is there in the cross section? Unnatural at that much IT might even be negative. But let's say there is. So so then odd does the strategic response paper is a quality piece AR. But there is a lot of papers that estimate things a lot ways.

And right theory, I don't think we should take any one of these and annoyed IT IT takes a long time before you can really have confidence in that kind of if you have very solid method gy like Green wooden salmon, where using standard approaches to estimate time, series effects and so forth, you can have a lot more confidence in that. That's the second thing is okay. Are we sure it's right? Maybe is right.

The third thing is what he finds is the strategy response knocks out two thirds of the effect and there's only one third left. Now I think it's your believe my with the higher levels of passive that you believe in, maybe you will get a higher answer than a third problem saying, is your story or something I think is either small and on existing? Then you have to put in some kind of fudge factor for how sure you are.

The this paper, the right answer. We all know, look, i'm an academic. We know we like to get meaningful effects, and we tweet our models and we tweet our miracle work to yet something that's interesting.

We don't do anything crazy. And I certainly accusing to a not doing anything lazy. If you build your mother one way, you build to get some more interesting result. That's the one time to get.

And then the third thing is even taking a resolve to face, you got ta take a third or so it's like a piece of a piece of a piece. And so that's why not worry on the latest ity. It's not that couldn't be something there, but I not convinced, ed, or something there and there. Something there are not convinced that would be big, but my mind is open IT could be either something there and I could be big so I supposed to in the aggregate or i'm like really pretty sure there's not a problem on this side. My mind is, mart.

i'm not entirely sure how to respond to that because, among other things, to serve that there has not been arrived in passive index investing when indexes were not even created until one thousand nine fifty seven. With the exception of to doll induces, it's about .

whether the average dollar is smarter, more important because as we know, a lot of those old visual funds were eighty percent passive. There were ninety percent passive, whatever. In europe, the virtual funds with those same names maybe even more passive than the word.

I don't know if the things says that the average is more passive, that may include the index, but i'm not sure that the average actives on is more passive, but maybe even is. But then there's just all these other folks out they are doing. So I understand we disagree on that.

And just highlighting, i've got two pots. One is, if you think about all the smart people you know who are doing this of how much money they control, including leverage in everything, and then you think about the person in your six, thirty years ago, how many smart and how much they would have controlled. These are the highest paying jobs in the world, other than starting a tech company.

Think about how much talent there is from abroad, how many people from europe and asia and amErica where they are sitting in the dosh chairs with one eighty I Q thirty fifty years ago now with zillions of them. I just feel like there's so much more talent being sure about that. My intuitive wer the outcome that we know in terms of IT being harder find this pricing, the mispricing should different from the elasticity issue, but they are related in the words if things were just way more passive, the market was more kind of sloppy than I think that would show up in this pricing as well as in elasticity.

Absolutely granting. You might be right. Have a strong opinion on this. I say my strong opinion, but is loosely held six months now I might call you be like, you know what you you're right on that point.

As I often say on this, I hope i'm wrong, but I think i'm right. So effectively, i'm just on the flip side of Randy on this. The evidence in terms of what is actually happening in markets in the behavior is best explained by models of analyticity and the rise of passage .

on valentine's paper. We had him on the parks. I think you listen that episode. Maybe my question wasn't, well, form actually, Cameron ask a question, but we asked him if his research findings support the idea of a bubble in large stocks due to flow index funds. And he said, I have mixed feelings about IT. I'm going to give you the research answer, which is that we don't really know. So valentine done the work, and I agree that seems to support what you're saying, but I don't know valentine interprets .

at the same way I don't want to speak for him, but as you could infer from that answer, the research answers is not the same as his individual .

conclusion at this point. Fair, he said his feelings are mixed.

I will tell you that I spoke of valentine's earlier this week and many of the things that I raise as concerns candidly, he did not considered and his reaction to a was not only do I think that you are directly correct and those are laughable, but IT actually raises the importance of what we're doing from the .

stuff that we have talked about. What do you guys think from each perspectives? What are the implications for and investors.

I continue to stand by line point, which is that as long as this process continues, you should expect rising valuations, which will be too higher equity returns then should otherwise be realized if the process stops or reverses, which could be due to a combination of rising Prices, because with those are always a function for the asset level, all contributions are always a function of income levels, or because of a regulatory change in any way, shape reform, the process of reversing that could cause the system to go into reverse with much sharper for actions, evaluations and wealth levels. And people are currently anticipating.

My thought is we have a clean the coal mine on this stuff, and that is motors. If the video was trading at a forward earning multiple of eighty, then we have real worry there. If the market as a whole was trading at a forward any multiple of fifty, we'd have all worry there.

As IT is IT seems like the market has a yield of four percent real. You can do IT off dividends. You do IT off, and you are going to get four percent real.

And long bonds are paying two percent real. And so IT looks to me like that's a pretty reasonable Price for the market to be add. And if the market gets to an unreasonable Price, then we have to worry about IT, whether it's caused by rising passive or anything else.

We have to get scared. But I just don't see that. If I had conversation with bob shiller once after his book in mali, rational exeo berts, I said more or less what I said.

T makers said, the equity premium pulsing says Prices need to be this high. So shouldn't a book be called rational example? Ines with socks are finally getting to a Price that sort of that makes sense logically.

And he said, no, he thinks there are two mistakes going on that on the one hand, people don't want hold socks unless they have a five percent premium or more from them. And on the other hand, the people were mistakenly expecting that they were gonna, that very high premium BBS, one of the smartest st people in the world. So that's the great answer and he absolutely might be right.

So i'm sort of looking and saying the number seem pretty reasonable. And he saying that because people are making two counteracting mistakes and that could be. And so you can get a crash without socks eating to Prices that seem irrational from a theoretical point of view.

And that may have the number we've always had crashes and will probably continue to have them. But if Prices get five, six, seven times higher than where we are today without earnings multiplied by similar amounts, then we're going up to get very concerned about. I think right now, we're in OK place.

But I think what's great is that you're looking to wind work and asking the questions so that the things start to seem scary. We can go and say, look at all mix analysis, look at all this thing. If he was right all along, we probably should have acted a little sooner, but hopefully it's not too late to act. But if you were not talking about these issues, that we wouldn't be positioned 来。

I do think that there are a couple of really critical things to remember. The one is that four during estimator twenty two times presumes twenty percent earnings growth into this year. Secondly, IT stated all of non gavericks perata names system to get earnings trAiling gaverick around two hundred.

When we talk about historical market multiplies and the equity risk of the bRandy is referring to the average to deliver that number was tied to do something around at thirteen times on gap trAiling not forward at twenty two times on any metric where extraordinary ily extended versus those historical averages. Now part of that could be, as rand points out, a realization that we should have a lower equity with premium, but IT would be unrealistic than to forward project higher expectations, which is the second error that sheller is highlighting. Ting, and as i've pointed out to you, and we're actually seeing this, we're seeing the backyard investor surveys.

They're actually expecting higher and hier returns even as the four word potential is getting lower. So I disagree with Randy in terms of whether were in a good place right now. The real question that I have is what's gonna en to the flows that's gna determine whether this gets realize in a short term period or over a longer term .

period than I expected I S ChatGPT for the foreign illy or and then I double checked on google to make sure was no hole stinson so clearly on the world's expert. Now you follow harder about how we should interpret these multiples to me. So I have asked IT on that and off the court about its first one.

What do you guys think the typical retail investors listen? This podcast or financial advisor is helping get their clients list. This podcast should be doing with this information. If anything.

there is a problem. If you've got an equity premium, you're onna get something like a four percent yld on and that four percent you're going to add to inflation, obviously, because these are real asset, you're an inflation plus four. And so you do have to decide, well, you've got clients and theyve got socks that you're going to give you inflation plus four and you've got bones that are going to give you inflation plus two.

And it's pretty hard to argue that you shouldn't have a pretty solid chunk of that. And stocks is IT possible that there's going to come a day when the world says, hey, we demand inflation of five from socks and then they crash nonetheless is possible to only certain we've seen I mean, cheese without crashes seems like now we get them every four years yourself. But the problem is you kind of go not that one more quick.

Bob hellar story. Bob came to Richard failures class when I was in grand school. He did a seven r and then Richard got to come to the class, which was wonderful. Bob told us that he thought the market was ludicrous, overvalued. And he made his case based on so quick, adjust the Price, earnings and all these other of the things that he's made his fortune and off.

I said to him because I was a Young wise, as how long have you have been saying that the markets massively overvalued and is likely to crash because, you know, we have a lot the last few years and then deller said, yeah, oh, that's a good point. You've been saying this since eight, so this was in ninety four, but this conversation happened. So in ninety four there are said you've been saying this since eighty nine now then barber's book in around two thousand and then the market crash.

And then obviously, timing is everything none of the journalists said. But haven't you've been saying this since nineteen? United, not the first ate about amazing.

It's just to say that you can be grown for a long time before you write crash. And I know you're always very careful about this. My, I not unshaded you either. I know that you're very aware of this problem and how hard that is.

So i'm just saying if all my financial advice or i'm looking saying if you buy and hope for every gun inflation plus four here in sox I an inflation plus two in bonds, something like sixty percent and sox y is not unreasonable. And when that crashes will be painful for you will probably be we were pretty quick like you you write that. So i'm interested in your thoughts giving those chances. And I know you're team aware that we're never going to be able time the crash.

I think these two several components to that. First, I think your expectation for four returns in terms of inflation plus four, to your point, will there be a point in which that goes to inflation plus five and therefore, stock valuations meaningful that, that would actually not be a for correction because you're talking about going effectively from A P E of six to seven or seven to eight type dynamic talking about at twelve and a half percent or crash. That's not what i'm actually sorted though.

We can go to six and it's a twenty, twenty, twenty five percent crash and that is a Normal crash.

correct? So that is a opponent of the expectation path, which is if you actually think that, that is correct, then you are talking about wiping out a significant fraction of returns over a holding period, which you're going to receive much greater returns from investing in fixed income, positioning you to be there. I'm not trying to suggest that, that means everybody should go all in into fixed income.

It's simply saying actually that the mechanism by which you're proposing, which that decision making is done, has largely been sourced out to a rigid model of diversion ation. IT doesn't allow you to change those based on evaluation components that actually a critical components that lowers those feedback mechanisms, that strategic response exactly as you are describing. The second thing that I would say around that is it's a very different thing to say that the stock market has historically returned to eight percent a year.

And my expectations over the next ten years are the stark marketable return. Eight percent year. Nobody invest for a hundred years except a very few select people.

And as a result, that terminal risk is actually a really, really big deal. Stocks have a very different behavior set to fix income. You can dollar cost averaging to both, but when you're taking money out, the volatility of equity just simply to your disadvantage, you'd have to sell more.

When Prices are low, you have to sell less. When Prices are high, that whole process reverses itself. You're not into fixed income versus equities.

Further, the return characteristics, you get older. The reason why you switch into fixed income is because of the certainty of the payout component to IT. IT causes that dollar cost averaging toward in your favor relative to simply holding equities.

This is the case for the target date funds.

exactly hundred percent of the case for target funds, except if you actually look at an aging america, IT owns more equities and has ever owned in its history.

you thought is maybe the kids are all right, but there is too many sixty eight year olds who are sell seventy percent equities or something like that, that my picture hundred percent. So let's say we agree, not only could we get a Normal fifteen and twenty seven, twenty five percent crash, which is horrible, but there is a chance of fifty percent crash out there in the next decade.

I have a lot of smart friends who say, did you notice that the debt is over one hundred percent G. P. And that the deficit is giggling ic, the newly elected president doesn't seem like some who is afraid to cut taxes or afraid to spend a lot of money if they will make him popular. And when you put all that together, might there be a day when the ball market say, you know what, we're just not sure these long term bonds are gonna pay off to the words, isn't a fifty percent bond crash about as likely as a fifty percent star crash or more likely? And shouldn't we be scared of a bigger bang crash one night once?

Have already crash significantly for fifty percent, crash from the levels of two thousand and twenty. sure. If I look at tips or anything else, or give me an extreme example, the austrian centric.

what about a real debt crisis? Okay, that is a great point. Let me solute you. But i'm talking about a real debt crisis where people said where nobody wants those freaky bonds and they go not four percent of the twelve percent of the eighty eight. Couldn't that happen here?

I think highly unlikely. But this certainly not as likely as a fifty percent correction in equities. The second point, though that I would emphasize on that is if the U. S. Government loses control of its economic system in that matter, do you honestly think that microsoft is going to retain control of its I P?

Is the fastest question is to how I would get all .

with the guest, Scott ster beri, of this research. This approach a little bit conventional, because using bootstrap simulations with global data, and not just U. S.

Bond data, but he finds for retiree's bonds are actually quite risky. History, ally, if you sample from around the world, not just the U. S, because in real terms, bonds are actually extremely risky.

Long horizons, even in the U. S. There have been serious born drawdowns recent history, not so much. But if you go back a little bit further, the real returns on bones are pretty scary for long term. But anyway, it's just a bit of a side point.

We talk to find anything is truly safe.

particularly in the world the brand is describing. If you have A U. S.

Dollar crisis in which suddenly the U. S. Dollar is no longer except to around the globe. What you're really talking about is a radical determination on the purchasing power of the american public, and in turn, a broad collapse and economic conditions.

IT is a scenario that nobody wants, and they got a lot of people fear IT farm more than they think. And unfortunately, I think that many of the discussions were having today, people's behaviors aren't part influence by these narratives. It's safer to invest in the equity of microsoft and the debt of the united states. And that's a very strong statement.

I Better teaching expert ones who told me that five years after taking an entire course, students only remember one thing from the course. So as a professor, you should make sure you know what you want to teach. And so i've took to asking students, when I ran in the years later, what they remember and very consistently to think they remember from my course, is that one percent a year for life doubles your month.

The natural log two is about point seven, so one point. No one to the, the seventy of power is about two. And so a lifetime, one percent. So two percent a year for life, quite rupees your money. So i'm saying is, if you're even asking the question about the relativity, ss boy, maybe take the extra two percent because four x is a lot.

And I read highlighted the more people to believe that, the less the possibility of that excess return stock varieties .

are too high because people think .

they're too safe. What do you hear? You hear people say i'm saving through my four one kid.

What are you saving? And i'm saving in the s MPI under you're not saving, you're investing. And investing is an inherently whisky activity. That's why you receiving the compensation. The land is a risk.

has to be the idea about this. So I know some of thoughts, but what do you think black rock vanguard, but also academia like rov coin. When he was on a podcast, he wasn't worried about this.

I dad, when I talked, wasn't worry about IT. Maybe you've talked recent is and so that sure doesn't seem to worry about IT thinks targeted funds are good thing. What do you think more people who should know Better if we take your perspective, why don't they .

share your level of concern on this? So again, I think IT really depends on how you ask the question. So I wash your the how you form I so is actually in which he says i'm not particularly concerned about that is he's actually anticipating the strategic response.

I actually agree with that. I do think that there will ultimately be a strategic response, but strategic response comes at what level and what form does a strategic response take? Those are the key questions out. Just be very straight forward with you in conversations with both roles. And valentine IT becomes a question of them, understanding either how far we are in the process or how favored we have actually made the process of passive investing in our legal framework that is driving the growth and preventing candidly response unction.

Mike, what evidence would you need to be presented with? I we talk, you don't want this to be a problem you think IT is, but you don't want to be. What evidence would you need to see to be like.

you know, what does no wish you here? What I love to see is actually non confirmation. In other words, the hypothesis that I formulate, i'd actually like to see that is proven in any one form. But more frightening thing for me is, at every seven, this process that I go through, and i'll give a really simple example, I just ran through an analysis of the impact of introducing IT levered etf to trade monster stock, which is the perfect example of the mean stock type phenomenon. The grandie highlighted the introduction of a two times levered etf into monster man at five hundred million dollars, created fourteen billion dollars of additional market cap.

So twenty eight times multiplayer on a roughly fifty billion dollars start IT is far above what you expect now because IT was two times lever meant that is actually four teen times the amount of money that went in. But five hundred million dollars was able to create a twenty eight times multiple. Er and that particular start is subsequently his knowledge to the announcement of issuance of forty two billion dollars of equity and that the impact of these things in terms of the misallocation of capital and resources and behaviors in our economy, allocating more capital to the largest firms that don't need IT and simply refers chasing stock, which ironically in richer they are executives but does nothing to invest in society.

Now that i'm suggested, they have some great brand responsibility, ie s to society, but IT is an important impact. Understand means that they have lower costs of employment because they have lower costs of capital is that are which further advantage is the relative to small businesses where innovation and entrepreneurship typically happens in our economy, created a system as negative feedback loops for both our society and our potential retirements. That's what I care about.

Ready you start about you're not worried about this stuff after hearing mikes, are you yesterday and going to this discussion .

where deal and now i'm still not very concerned to me. I just what I say is on the cross section, my view, if microsoft trading ten percent too high and delt trading ten percent too low because elasticity issues with large companies, obviously, we want Prices to be as perfect as possible, but I think Prices are closer perfect now. And they were in past, and we move through the society in the past.

Of course, there are these wake game stop type situations. Maybe those become a huge issue in the future. I think for knowledge.

Unfortunate that was going to people who lose a lot of money on those. So i'd like to see less of that. I think it's a society while crisis. It's something that's always been very confessions of a stock Operator and all that third day. And the one that would scare me is the aggregate.

If I came to believe that the market was either way, way too high or had become way more valuable or was going to, as a result, passing investing on that score from an evidence perspective, well, yeah, you know the multiples get high enough. I'll start to worry that what necessarily mean because of the rise are passive. But i'll certainly be open to that as one possible explanation for why multiple is so high.

But mostly, I would say you would be more about understanding, less about evidence and more about really trying to understand why IT would matter if people are saving through defined benefit. Pension plans, sixty percent. Stocks, forty percent.

And then on the other hand, you put in the target date fund that is similar. It's not that clear to me why I should make a be there and and obviously, I read the paper to betray and pushing. We've got interesting argument.

We put those things in the bucket of this might be a thing that's important. Let's do lots more research and maybe over time will discover there's a reason why doing IT in the passive way creates problems. Even when that money came out of pension funds, they had a pretty small percentage.

And large dogs to what people have now mean. In the end, the passed in the active have to add up to the whole market. And if the passive is represented of the market, that when you attract the acid from the market, the active part looks just like the active part.

And I know obviously, again, if you count is active on something like a sector from then that doesn't have a perfectly hole. But the fundamental idea, which I use, sharks idea IT, seems pretty solid. So IT shouldn't really matter the format very much. It's a second or third order effect.

Would my matter enough to care about? But I don't see IT as a scary thing because the second, third effect, when I multiple out the numbers on the flows, I don't feel like even if somehow active didn't count and pass that did, I don't feel like I should be that problems. So also card about all the stuff discuss and may not be like oh, on certain. But as of now, I still kind of feel like logically IT shouldn't matter. And then empirically, I don't think the Price increases we've seen are of around that .

looks scary to me. My media reaction to that is, is that to look at current valuations at twenty two times forward and compare them to the past IT is not an appropriate approach if I look at everything ranging from dividend yield to sales. Yld, the underlying expectations invented in the market today are higher than we've ever seen in the past.

Not sure. I just think this all Prices were too luck and will be clear. I thought ted, in nineteen and ninety three, when I got to grab before I came, grad go, and I learned about the research and I said, oh, the stock markets way too cheap. And I feel like it's center last thirty years.

right? And unfortunately, I didn't even have to go to grad school to get that because I learned that an undergrad. And what roughly the same is the point that I would make that is motion. Everyone knows the problem is, is that as you've already agreed to the transition from under valuation to even if we say fair valuation as embedded in an expected return that is now built into asset allocation models, that higher expected return, regardless whether this can be realized over five years, fifteen years or thirty years or never realized, is going to cause those asset allocations to change a very slow fashion. If we add to that the impulse association sive, I think even you would agree this positive.

There is no data that suggested that is negative if you add those two components and the risk that actually had very high valuations with very high equity allocations at exactly the time that we're going to begin to need those asset levels in order to fund the retirements that in front of is extraordinary ly high, to your point, that is all the same. It's not I go back to one thousand and twenty and nine and a peak in activity in the star market, ten percent of american households on deviations. I go to the one thousand nine hundred and sixty, which you are referring, pensions.

Almost nobody owned equities, but they actually had to exclaiming inst their employer. Today, sixty two percent of american households owned equities there for one kids, and that is their requirement for retirement. So as a society, we have ramages ally increased our participation ent in our exposure to levels that we've never seen before to argue that, that didn't contribute to the return profile that went out relying on seems completely specious. Even before I be in the process of the value, the impact to pass of there .

is interesting paper on. I think it's a theoretical paper. I've got equal library model by miles.

You read that one. I may have not early sure of the authors.

Small in the aim, I think, is the coats not published. But they talk about how basically we are saying that are shift away from individual starcus dings from households into index funds. Increase market wide valuations because it's getting less risky to invest, which increases equity participation.

Basically exactly were saying anyway, it's implausible. One of the things that talk with me last talk, mike, was that we ask you when we asked a question, what should people do, what individual investors do and your answer this not much you can do. You've got to hold on and hope things are OK. And it's more about advocacy and trying to change the way things are structured as opposed to changing your s allocation decisions.

Do you still all of you? I do unfortunately, because I have to actually Carry forward my beliefs and say that if that of investing is causing valuations surprise, then I should expect higher expected forward returns in equities. And outperforming, actually, is i've shown you through presentations, becomes a harder and harder chAllenge regardless of the scale level of managers that's very straight forward.

Now with that, sad. Are we getting closer and closer to a point, both through evaluated reasons and through aging of society at the process of which this begins to potentially reverse itself? absolutely. And so those are key concerns. The last component that I was just highlight is policymakers increasingly rely on markets to tell them how the economy is going and what policies are appropriate.

But now on our third consecutive presidential election, in which a key focus of how well is the economy doing is measured by the stock market, one of the reasons I would argue that malaria is message was so roundly rejected because the vast majority of americans experiencing a vote, vote to steal in the language of the day lived experience that is radically different than that implied by N. S. N, P, approaching all time minds.

awesome. And this has been an incredible appreciate the generosity with your time both now and in preparing for this conversation. So thanks again for coming on. Take care of thanks. Great to see you.

This is a quick addendum for the end of the episode based on male conversations between Michael Randy. I just thought I IT under the end of the episode, so it's all here as opposed to having a and follow up episode.

A big sticking point during the discussion was how quickly into what extent evaluation increases from flows degrade back to Normal? How long do those valuation effects last if the effect degrades, say, within a year, the impact on valuations is limited to the effect of flows in each year because IT goes away after that. At the other extreme, if IT is not degrade at all, the effect is exponential, since valuation effects from the previous year are compounded by the following year by flows from the following year.

So we did discuss this or micon Randy discuss this at quite a bit length in the podcast, but mike followed up by email saying that the disagreement on the Price impact of flows really comes down to these strategic response from active managers. How quickly into what extent our active managers trading to resolve Prices that are too high in quotation Marks due to flows. And we know from valentine hadj's work that IT seems that as indexing increases, these strategic response from active managers decreases.

So mike is arguing that this creates an exponential effect and valuations because they don't return to their initial level because active managers don't have the capacity to execute. The false strategic response to the rand replied and disagree that he was making any assumptions about strategic response, but that we need to take a stand on the half life of the impulse response to a trade. The andy says that there is no publish literary on this topic and he kind of describes in the email how you would do that study.

But it's in practical to do however practitioners that he is spoken. We have have run these studies internally, but they don't release the data. And based most conversations, he thinks that something like half of the effect remaining after a year could be reasonable as a conservative assumption, and then the valuation effect degrades by another half, the follow year and so on and so forth.

And at that level of degradation, the effects of flows into passive on market. Violet would be pretty modest. Rand also makes the point that I think is pretty interesting that this is the math. The math we're talking about is the math. If we assume the zero of the dollars flowing into four one k plans would have otherwise gone in the stocks in the absence of the post two thousand regulatory changes.

But we know that in the previous world, and if they were to find benefit pension plans, for example, that money once still fall into stocks like there were sixty, forty portfolios roughly, which is not a whole a different from targeted funds. At interesting point that there were flows in the stocks previously, just as there are now. And then microwave that.

No, this is really all about the strategic response from active, which as again, how does work shows as decreasing as indexing grows. So we can assume that the valuation effect degrades the way that Randy is describing. I mean, that really becomes the point of discussion.

So this follow didn't bring any resolution. There's still not agree with each other, but IT does kind of give us the research question that would need to be answer to come to a resolution. Hope that dinner was useful.