When Passive Breaks the Market ft. Hari Krishnan & Cem Karsan

[00:00:01] Hari

I feel worried about all this though, because I don’t like an economy (putting my free market cap on), I don’t like an economy that is reliant on a small number of people to act as the watchdogs for a system that is bloated and fragile. They’re very well qualified to deal with this, but still, its dependence on a small number of people to support a global financial system that impinges upon everything in society.

[00:00:33] Intro

Welcome to Top Traders Unplugged. In markets success doesn’t come from predicting what happens next, it comes from being prepared for what you can’t predict.

In each episode we go deep with some of the world’s most thoughtful minds in investing, economics, and beyond to understand how they think, how they prepare, and how they decide, and the experiences that shaped how they see the world. No noise, no short-cuts, just real conversations to help you think better and invest with confidence.

[00:01:06] Niels

Hari, welcome back to the show. Cem and I have been looking forward to this conversation. It has been a few months since you were last on the show. How have you been?

[00:01:14] Hari

I’ve been well and it’s a pleasure to be back. I hope this will be the first of many occasions in the future.

[00:01:21] Niels

Yeah, so do we. Now, the reason why we’re here today is to talk about a new paper that you wrote with Mike Green, Stephan Sturm called A Model for Passive that Breaks the Market. And I actually think our conversation today is perfectly timed. As we’ve just witnessed, equity markets around the world have an exceptionally strong performance, the last month, with double digit gains in the S&P 500 and the NASDAQ. Whilst, at the same time, we have two wars going on, no clarity on where inflation is heading and what the next move from the Fed will be, as well as global alliances breaking down, which suggests that something other than fundamentals and logic is controlling the markets.

Now, you can correct me if I’m wrong, but your paper is not really about passive investing. It’s about what happens when markets lose enough active participants to maintain price discovery. And that is an important distinction, I think.

The three of you are essentially arguing that modern equity markets may be transforming from a value driven system or valuation driven system, I should say, to a flow driven system. And once flows dominate fundamentals, markets can become reflexive and unstable. But before we get into whether that’s a fair description, perhaps you can start and take us back to talking about the origins of the idea, how you got involved in the topic, and why you thought it was worth researching along with Mike and Stephan.

[00:03:00] Hari

Well, I have to give Mike a tip of the hat. He was kind of the driving force behind this. I think in 2018 he was one of several people, but a notable person who mapped out the Volmageddon where the VIX ETNs caused damage to the VIX futures markets very suddenly based on overcrowding effects.

Now, after that, he sort of turned his attention to where the next big overcrowding or structural risk might be. And so, he decided to tackle the big one, which is the rise of passive investing. And what we do know is that even though dollar flows in and out of passive vehicles have fluctuated over time, as the S&P has gone up and down, the share of dollars, in the US equity market in passive, has gone up pretty steadily, almost deterministically. So, passive share has increased in an almost surprisingly predictable way.

Now, he felt, and we felt that as passive share increases, the linkage between fundamental value (whatever that means) for the S&P and price would be broken. And the reason it would be broken can be sort of described in the singular limit (to use a fancy phrase), where if there were no active investors left, and everyone was passive, and whenever a dollar went into a retirement fund, it would go straight into the S&P, or some fraction of it would, then the S&P could go up indefinitely with no constraints. And by the same token, if there were outflows, the S&P could collapse and there would be no active bid to defend against that.

So, we felt that the process, which describes stock market dynamics, could easily move from one with significant mean reversion, and control, and stabilization, into one which is almost a purely diffusive process where volatility feeds back into itself and can engender really steep increases in risk. So, that was the idea.

Now, this was about two years ago that Mike came to us, or came to me, and as may not be surprising, I did nothing because I didn’t have a solution to the problem. But one day Stephan and I were chatting about something else and we figured out that we could come up with a very simplified, almost toy model of the impact of passive investing on the dollar value of the US equity market. And the model incorporates mean reversion and it also incorporates diffusion.

So, in other words, the larger the percentage of active investors in the market, the stronger the connection between prices and fundamentals. I should emphasize that fundamentals don’t need to be specified in any particular way. You can use any measure that you like. It could be Shiller CAPE, it could be price to book, it could be some discounted cash flow model, whatever.

But if the share of passive investors increased, then basically the mean reversion force between index prices and fair value would break, so that tethering would break, and the dynamics would become increasingly unpredictable. Now, what I think we did, and I don’t want to speak too long, is I think what we showed is that with a large enough share of passive investment, markets can become unstable even if there are no outflows from the US equity market. And that’s the critical point, that it’s not a flow driven argument for instability.

What it is, is a statement that high passive share drives market pricing from one where there is somewhat predictable mean reversion from prices to fundamentals into one where volatility dominates. And if you look at the standard options pricing models, at least for the S&P and other equity indices, what they say is that when prices go down, volatility should go up. So, given a random shock to the downside and no flows, you can get wild dynamics.

That was the main takeaway of the paper. It was a kind of a critical systems analysis, the sort you might do if you were in the military or something like that, showing that too high a passive share could drive wild dynamics in stock indices. That was the first part of the research, and I think I’ll stop there because that’s quite a lot to digest.

[00:08:04] Niels

Sure.

[00:08:05] Hari

And you can pick at that.

[00:08:08] Niels

And I’m sure we will, and I will bring in Cem very shortly and I’m sure we’re going to go down a few rabbit holes. But before we do that, I think what could be useful for the audience, when you bring out such kind of a paper, is maybe to understand some or all of the key assumptions you had to make in order to write the paper. So people can kind of get a feel for, yeah, we kind of agree with that, or no, that’s a bit radical. So, what were the assumptions you had to make to do this work?

[00:08:40] Hari

Yeah, the first assumption was that the fundamental value of the S&P index or the US equity markets rises over the long-term. Now, if it didn’t, nobody would buy equities, I presume. It doesn’t even have to rise as quickly as the risk-free rate, but it must rise.

The second one is that in aggregate, through their collective wisdom, so to speak, active investors push prices at least somewhat toward fundamental value. That’s debatable, but it is part of the academic canon, so we felt justified in including that.

The third one is that mean reversion decreases as passive share increases. Now, this was a thorny one that would have been harder to defend in the ivory tower until recently because there’s a well-known theorem that Mike has talked about a lot called the Grossman-Stiglitz Theorem. And what that says is that if there are price insensitive investors who come into the market and start buying or selling without regard to fair value or fundamental value, then the active managers will pick up the slack and they’ll use as much leverage as they need to drive prices back to some notion of fair value.

Now, that was academic orthodoxy until maybe two or three years ago. There were various papers. A notable one was by Haddad, Valentin Haddad and various co-authors that suggested that empirically active managers don’t have the ability to do that, or they don’t actually do that. They only correct for some fraction of the mispricing generated by price insensitive actors.

And once we saw that paper, even though it made no difference in our view of the world, because we’re pragmatists, we’re not academics, we felt more justified in stating that as an explicit assumption, namely that as passive share increases, and note that passive is kind of a price or value insensitive agent in the market, mean reversion should decrease. We made the simplest assumption that that decreasing function is linear. You’d have to defend anything harder. So as passive goes up, mean reversion strength goes down proportionally.

The final assumption we made is one for the quants, there are various models. The Cox-Ingersoll-Ross model, which goes way back and talks about interest rates, tries to describe interest rates and the constant elasticity of variance models in the modern day… it basically boils down to this (without using too much quant speak), as index values go down, volatility tends to go up.

That’s the whole reason why there’s a put skew in the S&P, or one of the main reasons, and so on. So, we made that assumption as well. But I would argue that all of those assumptions are, A, defensible, and, B, falsifiable.

So, what we hope we’ve done, what we think we’ve done, is put this problem on a sound footing where there can actually be a debate, where even in the no net flows case, we argue for instability and we challenge the audience to try and dispute that. Now, we could be wrong, but at least we put the problem in scientific and falsifiable realm.

[00:12:17] Niels

Okay, now just one more thing before I hand it over to Cem. So just staying on the passive side, you mentioned, I think it’s called the Pension Protection Act 2006. Is that where things start to change? Now we’re not noticing anything initially, I guess, but is that where things start to change? And maybe you can describe what that change was when that got approved or introduced.

[00:12:49] Hari

Okay, well, if I look at the dynamics of passive share, passive share was below 1% in the US around 1994. Now we have varying estimates where passive share may be 50%, 60%, or perhaps even higher if you think of the closet indexers in the market, but let’s say it’s around 50%, 55%.

Now, in 2006, there was a Pension Protection Act, I think in Australia, if I’m not mistaken, that set thresholds on performance, or lower bounds on performance and fees, more notably fees for active managers in Australia, that pushed pension funds or superannuation funds even more in the direction of allocating to passive. And so, that’s an example of a non-US important factor, related factor that’s driven an increase into passive investing across the board.

Passive investing has one of those great attractive features for an allocator. It’s easier to defend your position. If you did nothing else, you cut the fees. And if everyone else is doing it, that’s fine too.

I’ve often talked about this in other contexts, but maverick risk is tricky. As soon as passive gained significant force or significant share, it became an easy position to take. And so, our goal isn’t to say that the world is wrong, that passive is bad. It has many good features, it’s cheap, it’s transparent at some level. Even though it does involve active rebalancing, it’s somewhat cost efficient overall, it’s relatively cost efficient overall.

So, it has a lot of good features. But we would argue that when any agent becomes excessively large, and I point back to Mike’s analysis of the Volmageddon, it has the potential to cause harm. And that’s the position we’re taking.

Now, I can drill down further into what’s going on under the hood at the individual security level, but I’ll leave that for a moment.

[00:15:03] Niels

Let’s see where Cem wants to go.

[00:15:05] Hari

Yeah, we’ll let Cem riff on this because I think he can take the lead pretty effectively.

[00:15:11] Cem

I have 10 different angles I can go here and we will hit all of them, I’m sure. I’m just thinking about where to begin. Before I do, I have to note that Hari was the way this all started. Hari and I did an interview, I think it’s now five years ago, where you interviewed me as a co-host on Top Traders Unplugged. And that’s kind of what started this whole progression.

So, it’s fun to be here together, kind of on the other side of the table talking to you today. Tremendous respect for what you’ve done and all the stuff, you do to help teach people. So, just want to start there.

But before we dive in here, I want to kind of think about the big picture. I think it’s always great to start big and then drill down. One thing that I’ve been talking about, that you obviously been talking about, Mike Green has been talking about, before we could dive into just passive, is the overwhelming reality that the size and leverage of markets themselves have become so critical to both the economy and the whole system at large. This is no longer just about the market. The market is not just some reflection of the economy anymore.

And there was a time, I believe, much more than now, that the markets were more representation, more of a feed, a ticker of what the world and the realities of the world were expressing. The voting machine, the weighing machine were much more aligned. I think we have a world now where the voting machine and the weighing machine (Benjamin, anybody who’s followed us will know those terms, essentially the short-term buyers and sellers are the voting machine, the weighing machine is the fundamental realities and cash flows of the businesses and economy), we’re in a world where those two things have departed at such scale that to even look at the weighing machine in any period less than a year or so seems trivial. And I think that’s what we’re (just trying to put this in layman’s terms), what we’re really talking about; the gamification of the market, the fact that the market itself has become essentially in any reasonably short period of time, untethered from the fundamental basis of the economy.

I would take one more level up from that, that it’s not only become untethered but it’s reflexively become a primary driver as opposed to just a representation. I’d say its primary role (sorry, Hari, just to finish this thought), its primary role is no longer a representation. It is actually, its primary role is the liquidity and what it does to drive the economy and the outcomes of the economy, given the size of the financialization.

[00:18:18] Hari

One could argue that the S&P 500 is driving all sorts of social changes, whether it’s wealth inequality or any number of things, and that the markets are so untethered and unleashed that they’re basically driving everything else.

That politics are almost a byproduct of what markets do. And markets can almost forecast simply because of the belief system that’s in place, what will happen in the future. And this is worrisome about prediction markets, but we can shelve that for now.

[00:18:52] Cem

I think the word forecast is the wrong word. They drive.

[00:18:55] Hari

Drive is a better word.

[00:18:57] Cem

It’s not forecasting if it’s actually the thing causing the outcome. And I think that’s the part that people get so confused about.

[00:19:06] Hari

Yep.

[00:19:06] Cem

You know, CNBC is still out there talking about what drove, ex post facto, what drove an outcome based on fundamentals, when we all know that… I mean, all you have to do is look at the last six weeks of market outcomes to realize that kind of the fundamental big picture of news and the drivers that are changing the world, changing the outcomes, are no longer what’s driving.

And by the way, reflexively, you can see the narratives of peace and all these things that are clearly not true, coming out of that market outcome.

[00:19:42] Hari

Well, I was a slow believer in this because I used to read the stories as to why. And then I stopped asking the question why and I thought, well, the market has a random shock that may be fundamentally driven, and then the flows take over. And now I think the random shock is almost an afterthought. It’s the flows take over.

[00:20:02] Cem

Yeah, this wisdom of crowds piece is real, but I think it’s been meaningfully overcome by the crowd driving the price of these, that the crowd votes are driving the outcome at the end of the day.

So, I want to start there, and I think that’s an important place to start because the more you see this as the vehicle driving the outcomes, this has much greater implications than just reflexivity in the market. It now begins to be about reflexivity of society, reflexivity of global economic outcomes.

I talk, in passing, often of a very simple set of numbers, but I want to expound upon them a little bit today with you, Hari. This is, what I think everybody in markets should know, that very few people fully appreciate, which is there is about US$500 trillion of long global assets. Why do we need to know that? Because the size, and leverage, and amount of effect that these markets have is dramatic.

Global equities, public equities, are about US$150 trillion. Private equity, private businesses, everything else that would count in terms of business or equity or, like, think credit vehicles as well. Takes us to about US$300 trillion. US$200 trillion of this is more sovereign bonds, real estate, other things that clearly are highly affected, as well, by market outcomes. And when the market goes up 15%, like it did in two months, a month and a half, really, you could argue it’s somewhere between US$45 trillion and US$75 trillion of new collateral is created.

Like that.

Now let’s, let’s go back and compare that to like the power the Fed has or the Treasury for that matter. I mean, we think about the Fed is all powerful. Putin was, you know, don’t fight the Fed. How much, during COVID, how much actual liquidity did the Fed create?

[00:22:32] Hari

What, maybe a few percent of that, so, maybe US$1 trillion or so.

[00:22:36] Cem

Yeah, maybe US$5 [trillion] at max, depending on how you look at it with fiscal and all the other things involved. So, the point here is, it’s an order of magnitude plus, bigger than the Fed. We have to think about markets in that context. And I don’t want to go down this path too soon. We’ll come back around to it. But government officials are aware of this. The Fed is aware of this – hyper aware of this. The treasury is aware of this.

This is why we have hedge fund managers as the managers of these entities now. To live in this world where we think that markets themselves are not being managed is so naive. It goes against… It’s like saying the government officials don’t care about that source of liquidity that is 10 times bigger than the Fed.

This is why they have to voice and try and move markets ahead of time. This is why they have to get ahead of things more and more as opposed to play reactively. They have to be proactive.

[00:23:38] Hari

These are great points, but the one question I would ask is if, as I believe, and you probably believe as well, that the market is a complex system, can you really control a complex system over any appreciable length of time?

[00:23:54] Cem

The answer of control is in the grays. It’s just like anything we talk about. It’s not black and white. I mean, I guess there is a point of absolute control. What I would argue is absolutely not. There is no such thing as absolute control. And the more you absolutely control this is that Sumo market I talk about, the tectonic plates. Markets can be controlled. And underneath the hood, the amount of pressure… It’s like a balloon, you can control the air, but at some point it pops.

And so, what we’ve created, and I think this is what you’re touching on, is a system that is increasingly controlled, which leads to higher pressure under the hood, and nothing can be controlled forever.

[00:24:39] Hari

Yeah, this was kind of the thinking we had when we built the first model with Stephan, which is that a complex system cannot be described by any one model. You need a bunch of models, but let’s build a few, even if they’re toy-like. Let’s see what the consequences are of these models and see if we can link them together and make something out of it. And so, really, I put on the complex systems hat when we started with this.

[00:25:05] Cem

You can talk about these systems in the short-term, and they’re where we are now, and where the rise of passive has led us to, but I think there’s a much bigger story. For the last 40 years supply side economics has taken interest rates from 20 to 0, forcing the leverage, and the passive is a huge part of that. And honestly, it’s a reflexive recency bias effect, because if markets go up for 40 years, because interest rates go down for 40 years, the amount of leverage, and passive, and structural governmental structures, everything leads into this momentum effect.

[00:25:48] Hari

Yeah.

[00:25:49] Cem

Which then just gets, eventually, too big to handle. And, at the end, they try and control, and control, and control, as much as they can because the risks are too high. And that’s where we are in the story. And eventually things have to reverse. And this is complex systems, from a larger sense, but also what you’re talking about…

[00:26:09] Hari

Yeah, that’s right, I mean, the sort of Mach 2 of this analysis, which was spearheaded, again, by Mike, is that if you look under the hood, what you’re seeing is the Mega-caps growing even bigger because whenever the flows go in, the names that receive a large dollar allocation but aren’t that elastic, meaning that relatively speaking, equal percentage allocations to those names cause bigger price moves down or more notably up. What you get is greater and greater concentration in a few names over and above their importance in the economy.

And that gives them access to leverage, which creates even more concentration of the largest names in the economy and can be damaging to the health of the overall system.

[00:27:03] Cem

It has an ironically supporting effect for those businesses in the short-term.

[00:27:12] Hari

Absolutely.

[00:27:13] Cem

And a momentum effect for the earnings and growth of those businesses, which then reflexively creates better numbers, beating earnings. You know, all you have to know is that ‘99 till 2000, that last year, that tech earnings grew 30%.

[00:27:37] Niels

Yeah.

[00:27:38] Cem

Which is the highest growth they’ve ever had until they went bankrupt and then 95% of them went bankrupt. That’s about as black and white as you need to see. Reflexively, markets go up, everybody does… Well, not everybody. Those entities that are getting the capital do well. And that’s what we’re seeing the CapEx build out that comes from it.

If you give somebody infinite capital, what do you think the Anthropics and whatever the world are going to do? They’re going to go spend it to build more growth. They have it. So go build out the CapEx. Guess what? In ’99 we had a massive CapEx build-out of the Internet.

[00:28:12] Hari

Yep.

[00:28:13] Cem

And the numbers get better, and better, and better, and better. And everybody’s like, see, see, look, we were right, but they weren’t right. The numbers went up, so that they were right, and the number went down, and they were wrong. It’s not like the tech bubble burst, like the earnings just stopped, or in the Internet boom, it’s not like all of a sudden companies just started going bankrupt.

So, the bubble burst, the capital stopped flowing, so everybody went… So, the CapEx stopped, and the liquidation happened, and the leverage came down, and earnings imploded.

[00:28:52] Hari

And one of the notable things that you can see, sort of empirically, is that it used to be that there was a low volatility, maybe not premium, but low volatility baskets outperformed, not only on a risk adjusted basis, but they were pretty comparable or better in absolute return terms. Now, if you look at large caps, it’s the higher volatility names within the large cap bucket that may be outperforming. And that has really changed the dynamics under the hood, indicative of the power of leverage and the power of stock prices that get bid up to allow access to credit.

[00:29:32] Cem

I try and talk about this all the time, but I think very few people truly understand this. Which is the way the voting machine and weighing machine almost always come in line is through discontinuity, through a break, through risk, through a deleveraging effect. And there is not some smooth mechanism with which the voting machine and the weighing machine converge. They converge when liquidity dries up.

Because when liquidity drives up, fundamentals are all that matters. This is that plane flying fuel analogy I’ve given for many, many years. And the reality is, until that fuel stops, all that matters is the fuel, is the liquidity, is the position. And then to a second order effect. Now to get to what you wrote your paper about here, which I think is so critical, the primary driver of that fuel in the airplane, that keeps the trajectory in line of where it’s going, is actually positioning itself.

[00:30:44] Hari

Absolutely. I mean, one criticism that I’ve gotten, that maybe would be addressed sort of directed toward what you’ve said as well, is that oh no, it’s still a stock picker’s market because dispersion, equity dispersion is still high. Look here, the dispersion trade has been working pretty well. Now, I have my theories about this. I would say that dispersion can be high even if everything moves up or down together on the same day, simply based on the relative movements of the less elastic names. But I’d be curious to hear your take on that.

[00:31:22] Cem

Yeah, I mean I think most listeners here, and I know you, Hari, know that dispersion (I think it’s pretty hard to refute this point), we’ve seen a complete break of how dispersion works now, relative to how it used to work. And it lines up exactly with the beginning of this massive vol compression that was coming from vol selling products, structured products: iron condors in ‘17, and then an XIV. Right? That’s how it kind of started there.

But ever since then, the vol selling products, the non-correlated nature of those and that people are driving to them and whether it’s through ETFs, or structured products, or other things, have driven an index compression which is then pushing everything away underneath the hood. That is the biggest driver, not even a question for me, of what’s driven dispersion.

Now, what wins in dispersion? You can say there’s a magnet that’s forcing compression at the index level which clearly, if idiosyncratic risk still exists, drives things away from each other. So, it’s a kind of a reverse magnet on the single list which drives correlation breakdowns.

But what wins and what doesn’t, whether that’s fundamentals that’s driving that or not, that’s a whole other debate. And I feel very strongly that it’s not fundamentals. There is a ton of dispersion. It is long/short equity positioning, which has also dramatically increased, doubled, in the last two years.

And so, the positioning has actually gone up on long/short equity, which has driven, as we’ve seen during periods of illiquidity, dramatic pain both for the last two summers. And buckle up here, it’s May 11th, this summer is going to be the same.

The biggest indicator of what performs in the summer and what doesn’t isn’t fundamentals, it’s hedge fund positioning, it’s long/short equity hedge fund positioning. At the end of the day, we know certain things. One of the few things we actually know is that if people are long, max long, they can’t buy anymore and it’s selling in weight. And if they’re our max short, it’s the opposite.

And so, the whole positioning of the market, at any point where it’s concentrated, leveraged, ultimately is subject to being forced to buy back or sell out. The more liquid markets are, the worse that is. And that’s been the biggest driver, in my opinion.

[00:33:58] Hari

Well, I mean that raises the question how do you play that? How do you play these observations without giving away the shop, but in some broad strokes? I mean, we can talk about that quite a bit. Some things that, I would argue, would be that shorter-term momentum is probably higher. So, if the market is going up, it’s likely to continue going up. The bigger names are likely to continue getting bigger. The call skew is probably likely to be underpriced because the index will become more concentrated and look more like a single name or a small number of single names.

On the other side of the table probably downside hedges are more important because, A, you’re getting more bang for the buck being long, and, B, these breaks, that you speak of, can happen so suddenly that you’re not going to be able to rebalance your way out of trouble. So that would be the kind of broad stroke view I would take.

The one other comment I would make and I think shows sell better if we just disagree on everything but let me just throw this one out there.

[00:35:01] Cem

No disagreement is where all the growth happens. I’m always looking for people who disagree.

[00:35:05] Hari

So, I’m failing on two fronts. One is as soon as I introduce a formula or a quant symbol, I’m down. Secondly, I’m agreeing with pretty much everything you’re saying.

But how about trend following (this is almost a Neil’s question) on single names. I know it’s done, but if the single names are the ones that are attracting all the capital, and are less elastic in some way, they should have pretty good momentum properties going up and also real downside possibilities. So, you kind of want to have a floor on how much you can lose when you get in.

I know some CTAs do it, but I’m just curious as to whether that is a viable way to play the predominance of passive flows in the market today.

[00:35:50] Niels

The odd thing, and I’m not an expert in single name trend following, but the odd thing is that when you look at returns for managers, and you go back say 25, 26 years and you look at the distribution of returns over the various sectors, people will think, well, equities have gone up so much in the last 25 years, and certainly in the last 15 years, that surely must be your best performing sector. But it’s not.

And I think that’s something to do with how equities move and the corrections that you get along the way, which can be very difficult to handle as a trend follower. These Vs, especially these V shaped recoveries we’ve seen, I don’t know about single stock equities, whether that’s the same you would get from that, but I don’t think we can just say that just because you have a certain strong momentum… Oh, clearly, yeah, if you bought Nvidia and did nothing, yeah, you would have made a lot of money. So, I don’t know about that.

What I do notice is that those managers out there who do trade single stocks, I don’t see that performance being better. Obviously, I don’t see the breakdown, but I don’t see it as being better. But it could have a different distribution, of course. But equities, as a sector, are not necessarily a great sector for trend followers.

[00:37:21] Hari

Especially on the short side.

[00:37:23] Niels

Exactly. Especially on the short side.

And I think it has to do something with, also, how human behavior, meaning tops tend to form, often taking more time than bottoms. We know, for example, a lot of these crises, they kind of turned on a dime and then they went straight up again. And that’s very difficult for managers to deal with.

But maybe, just for me not to be the one talking here, since you’re the guest here, Hari, I mean, I’d love to make sure we cover some of the topics from your paper that you want to cover and maybe what you find most interesting and telling from the paper, such as, for example, how do you… I mean, how do you link between the size of passive and the, say, the index level or something? You know, how have you gone about some of these more technical things?

And then, also, maybe the whole QIS world and how that plays in. I know Cem also has some thoughts on that. But let’s make sure we don’t stray too much away from your paper, since that’s why we’re here.

[00:38:26] Hari

Well, I get more excited listening to you guys than speaking, so I’d happily be a fly on the wall.

Okay, well, I’ll give you a little bit of history, which is that the CIR model for interest rates, the Cox Ingersoll Ross model for the spot rates, was widely criticized because it allowed for negative rates, or at least hitting the zero bound. I shouldn’t say negative rates. Rates could go to zero in the model before they reflected back up.

And people, when the model came out, which I think was in the ‘70s, and subsequently argued that rates can never go to zero, so they kind of threw it out. We found that model quite interesting to revive because that zero bound property is actually quite interesting and it arises naturally from our model.

Now, we would not argue that the S&P is going to go to zero in finite time. There are so many ways to prevent that from happening, both at the exchange level and at the government level. But we found that extreme Feller condition, as it’s called, pretty interesting. And I think the numbers we came up with, with our parameterization, were that at 91%, roughly, passive share. The market could go to zero in finite time. Strictly speaking, over any finite interval, but I won’t state it too strongly that way.

The more interesting case, for us, was that when the passive share gets to around 83%, volatility can increase uncontrollably at a cubic rate. A cubic rate means very quickly. And when we ran the simulations in the paper, we found lots of simulated paths going down very rapidly after about 12 years, and many paths going close to zero.

And so, the range of outcomes was much wider. The median outcome was lower, and the bad outcomes were much, much, much worse. They actually lost money.

And again, this was not to say that this will happen, but that it’s a natural consequence of a set of very humble assumptions that most people, at least quants, would agree with. And there was a lot of fight back there. Some people sort of were very angry at me because they said, well, the market will never get a zero. And my counter argument is, use the model, argue against the points in the model, and if you can do that, fine, but at least we have a basis for debate.

[00:41:04] Cem

Yeah, I love that. And I think you agree that this is a toy model, and it is meant as a vector or part of a much more complex system, and we should be exploring that as one important, meaningful piece of a much more complex system.

[00:41:33] Hari

And I should add there that my friend Mika Kastenholz has actually built a second order model that incorporates trend and mean reversion in the same model framework. And he actually gets lower values for criticality in his model.

[00:41:51] Cem

And I would actually… Part of why I started big, and now this is perfect, Niels, that you brought back in the specific: How does this paper, in my opinion, relate to all the other things that we’re talking about in terms of the big picture? And I think the problem is, as much as I agree with all of your findings, in terms of that those things matter, systems, naturally simple systems that are naturally more concentrated like this become more vulnerable to shock and more volatile.

I think we’d also both agree that this is not just a two-dimensional market of longs and shorts. And, if anything, the dramatic increase in all the volatility products, all the hedge fund products, the leverage in long/short. I mean, long/short equity has become US$3 trillion in terms of leveraged long/short and has an outsized effect when you start thinking about how active that is.

The other thing that people don’t really appreciate about markets, and I got to talk a lot about, and pat fly through and other people, we don’t really compound on is that, on average US$50 billion, US$50 to US$75 billion, give or take, is the incremental amount on a daily basis that moves.

This US$500 trillion dollar behemoth… Again US$50 billion is what’s on a day-to-day basis, moving US$500 trillion mind breaking reality. And so, these hedge funds and these entities that are trading quickly, the dealer flows, all these things, they seem small on some relative basis, but most of the world, again, is this big tanker.

And so, I think when we look at this system, and then we look at the size and scale of all the other things that are happening that are not just long the market, passive or active. And then add in, of course, the most important part which is the Fed, the Treasury, the government, which incrementally is much smaller than the collateral and everything of the big market. But their ability to put their thumb on the scale and drive market outcomes is incredibly powerful.

[00:44:24] Hari

I think commodity investors have known this for a long time. So, for example, in the electricity markets, if you flip your switch and there’s no electricity, prices can skyrocket and there’s no limit to what people will pay to keep their factory going in the absence of supply. And so, prices have always moved at the margin. That’s a very extreme case. And it’s increasingly, as you pointed out, it’s increasingly clear that that’s happening in oil markets.

[00:44:57] Niels

But can I ask both of you something? So, I’m going to be the uninformed vol guy asking two experts a question here. Okay, so, some people might sit at home listening to this and say, well, what is it that has really changed that we talk about? Yeah, maybe the market can drop 50%, 60%, because, if I’m not remembering incorrectly, the market did drop 85% in the NASDAQ in 2002.

So, the question is here, has anything really changed? It might be a different… There may be some other things going on today. This is why I asked about the 2006 date, where the flow of passive maybe had started in some countries, and certainly also came to our part of the world. But markets have had these periods before.

Also, just maybe one more thing, we had the whole shutdown of the world in 2020. The market dropped quickly, a lot. But there were stabilizers that came in so that it didn’t go to 60% down. It stopped at, whatever it was, 35%, or whatever. So, I’m just trying to understand if something has fundamentally changed in the last few years and maybe we can…

[00:46:21] Hari

Sure, I’m going to just focus on 2022.

[00:46:26] Niels

Okay.

[00:46:26] Hari

So, when a lot of things that used to work didn’t work, 2022 had an equity market that went down maybe 22% if the S&P is a barometer. Rates went up, the 60/40 portfolio got obliterated as allocators rebalanced between equities and bonds. They had to sell some equities. The Mega-caps had a sharp reversal in performance. Long vol, which would have almost invariably worked, didn’t work in 2022 because vol was high going into the year. 2022 was a signal to me of significant structural change that (putting my global macro hat on) would be suggestive that, if we do have an increase in rates or any sustained increase in inflation over and above the oil price shock, most (this is too strong a phrase), many of the strategies that are currently being used by large institutional allocators will be turned on their heads.

And so, the only way to defend against that is, in my view, to have (I’m selling my book here) inflation sensitive assets such as commodities, short strategies of various types, trend following type strategies, and, perhaps not to lock into the greatest asset of the late 20th century and early 21st, namely bonds, treasury bonds, as a ballast plus a return generator, there has to be other stuff to go into.

[00:48:05] Cem

But I think the important part is that the world is waking up to that. Everybody in ‘22 started seeing that. And what have we seen since ‘22? In four years we’ve seen gold triple, precious metals on average more than triple. We have seen continuation, in waves, of crypto’s growth. Right?

And importantly things like vol products, structured products, ETFs, have 5x-ed from US$500 billion to US$2.5 trillion dollars and growing faster and faster each year. And hedge funds, which were at, by the way, US$ 2 trillion or so, US$2.25 trillion in assets, that literally flatline for 10 years, have gone to US$4.5 to US$5 trillion in the last four years.

[00:48:59] Hari

But again, a high concentration in names.

[00:49:03] Cem

Correct. And this is the part that I think is… completely you are right. That’s the part that’s important. It’s that people are trying to do, at a very basic level… Again, all of that, it went from US$7 trillion to call it US$22 trillion of assets in the context of US$500 trillion long. Right? So, it’s still a tiny percentage.

We’re talking about, you know, what is that? That’s you know, 5%. And so, the question is, is that really truly non-correlated enough? And how concentrated are those things? Very concentrated.

The options positioning is not like rich and complex. It’s very concentrated in certain types of strategies, at certain expirations, at certain places like the indexes or a couple of different names.

[00:49:54] Hari

Well, there are a lot of…

[00:49:55] Cem

Long/short equity is also very leveraged, and same type of names, very fundamental kind of driven.

[00:50:01] Hari

And there are a lot of interesting dynamics that make the situation worse. If you’re sitting in a seat at a large multi-strat, you have a downside exit or downside risk cut. So, you have to chase stuff that’s working.

You can’t go for the long-term contrarian bet unless you have other things going on. And so, you’re at the mercy of realized vol, as well as returns, on a given day. The whole market is at the mercy of realized vol, in some sense. And so, if markets are going up and realized vol, with the exception of the early phases of the Iran war, is low, people are just piling on the leverage. And so, vol doesn’t represent risk. In fact, it’s inversely related to risk.

[00:50:53] Cem

Yeah, and at the end of the day I think we have a situation where the people who are moving away from the passive kind of 60/40, which is still quite a small percentage trying to diversify… early adopters is what I would call them. They are having pretty great returns, relative to bonds at least, I would say, think about the gold performance, think about other things, and that’s driving more momentum there.

And I think when we start talking about this passive flow piece, I think that’s important because things work in passive. Reflexively, there’s a momentum effect that keeps it working longer than maybe fundamentals would dictate for certain business’ drive. But because it’s working, it also drives better outcomes. So, it naturally drives both.

But there is a point at which certain non-correlated assets, strategies, other things outperform.

[00:51:56] Hari

Absolutely.

[00:51:58] Cem

And as that happens, that builds momentum, in a sense, passive flows. I mean, when we talk about passive flows, by the way, it’s just recency bias. That’s what it is, that’s what drives… But the passive flows themselves drive good returns which drive better recency bias.

[00:52:14] Hari

Yeah, I mean, the techie way to say it is there’s a performance flow, feedback loop; good performance, more dollars chase it.

[00:52:23] Cem

I think we both know, if it doesn’t work for some point, if certain parts of the market don’t work, then that momentum machine will go into another part of the market, and that’s the real risk. Right? At some point something other than these flows, because these are not just the only things that matter, and then something new becomes the passive flow.

And what happens if non-correlated becomes the new passive flow because it worked while other things didn’t, or we’re doing a big non-correlated bucket but like let’s just say inflation assets like you said.

[00:52:58] Hari

Yeah, I mean, the obvious scenario where things could break down a bit is a spike in rates or a spike in inflation.

[00:53:06] Cem

Absolutely. This is, actually, you want something actionable. Everything that you’re telling me and everything we’re talking about has led me to one conclusion, which is these markets, from a government perspective, cannot go down too much for too long. It has too big of economic consequences.

And so, the only way out is some type of bigger, and bigger, and bigger, as we’ve seen, reaction from government. And at some point the only way out is monetization of valuation, not just debt, but valuation of leverage, of everything. Right? This nominal illusion world is the only way out politically and even that’s not… it’s the least of all evils. I think, by the way, they said it out loud with Hank Paulson just three weeks ago.

But I guess the big point here is that the passive machine is not only affecting the distribution of outcomes on its own, and driving more volatile outcomes, it is reflexively affecting the system. And the system has become so levered to it that, to not look at the players at the table to say, we’re playing a game of poker, the odds say X, Y and Z. Which I think is what the paper is probably mostly saying. Right? Which I agree with, that’s numbers.

There are people playing this game at the table, and there are several big entities, with big stacks, who know the same things that you know, who are putting their finger on the scale every day, and have every incentive, and it’s all about reading that player and knowing their incentives to drive an outcome where that doesn’t fail.

[00:55:03] Hari

So, there’s no reset. There’s no reset unless there has to be.

[00:55:08] Cem

Inflation is a reset, in a sense. But my guess is that’s the most palatable reset. And I think if there’s a release valve, that’s it.

[00:55:17] Niels

So, what might the trigger be? Have any of you any thoughts about what might the trigger be other than we get to from whatever 55% or whatever percentage of passive we have now to 75% or 65%? But at some point we need the trigger.

[00:55:33] Hari

We do need a trigger even in the model that’s in the paper. The paper model assumes that if there’s a random shock it will feed forward into more volatility in a hard to control way. I think rates are basically what that Cem and I discussed. Higher rates force rebalancing out of equities for balanced portfolios. Higher rates put pressure on the economy. They increase the cost of financing.

They could break the private credit bubble (that’s a strong word), the private credit overhang, and that would almost certainly have an impact on other markets. I can see an exaggerated 2022 type scenario playing out.

[00:56:23] Cem

I agree, and I think the entities again, Fed Treasury, you know that… Again, you don’t trot Hank Paulson out to do a trial balloon on. We have a crisis coming in the long end of the curve and we must defend the treasury market proactively, which is essentially what he said.

There’s zero chance in my mind that Hank Paulson goes to Bloomberg and has a big speech about preparing for the Treasury market crisis without Treasury involved in that conversation.

[00:56:57] Hari

I feel worried about all this though, because I don’t like an economy (putting my free market cap on), I don’t like an economy that is reliant on a small number of people to act as the watchdogs for a system that is bloated and fragile. No offense to any individual in the chair. And I totally agree with you that they’re very well qualified to deal with this. But still, it’s dependence on a small number of people to support a global financial system that impinges upon everything in society.

[00:57:33] Cem

I 100% agree. And importantly, they don’t have the same level of control and theory that they may have had five years ago, and the world is a bit more fractured. And who has how much control matters in those decisions as well. I don’t like it either, Hari, but it’s not about whether I like it or not.

It’s about incentives. And for me the incentives are there. There is no other… What are we… Is the result to just do nothing and let markets rebalance? I think that’s a good idea, this town needs an enema, let’s have a catharsis and that’ll fix all kinds of problems and then we can more quickly move through a better allocator of capital, better system, but that’s not going to happen.

[00:58:28] Hari

I’m torn about that. I’m torn about that because I agree with you in principle, but I don’t know what the aftershocks would be in that scenario.

The other thing is that, from the standpoint of an investor, which both of us are, at some point you just have to say this is an event, this is the way the world is, this is the way it works and we have to deal with it as investors.

[00:58:50] Cem

Correct.

[00:58:51] Hari

We can’t say it’s wrong. So, we’re going to fight it with whatever dollars we have.

[00:58:55] Cem

Of course, yes. We have to trade the market in front of us. And so, my best guess is that the way out here, and I think I pretty strong conviction of this, eventually, it’s going to take time, is through kind of an inflationary monetization of the debt. And the way that plays out is a multi-year controlling of a long end of the curve in the US, which creates negative real rates and drives more inflation, which eventually becomes untenable and forces a reaction to let go of trying to control the long end of the curve.

There is an active process currently of controlling that back into the curve. It has been the focus of this administration from the day they started. Just look at when they react to what, and how they turn. When the 10 year goes above 4.4 and starts threatening 4.5, why? Because the equity yield is around 4. Right? You can’t have the 10-year go to 5 and not have market pain at some point.

So, that’s a problem if inflation keeps going higher. So, you said, Niels, you asked what’s the event? The event is an oil shock, is a move in Iran that forces higher inflation… a breakdown… inflationary pressures, which we’ve been talking about for five years, Niels, which we were way ahead of that. We are now seeing a second wave that drives a battle between… That puts the Fed in a greater box and ultimately forces a situation where negative real rates drive an inflation loop.

[01:00:51] Hari

Yeah, well, that’s very interesting because a lot of people would have said, well, Japan’s already successfully conducted that experiment many years ago.

[01:01:00] Cem

Stopped by the US which had ultimate power at the time and in very different demographic circumstances.

[01:01:05] Hari

Exactly, post Berlin Wall, we were in kind of a structurally deflationary environment. Change that, see how it works. It’s going to be tough.

[01:01:18] Cem

I talked about this. With Volker… you know, people talk about Volker being the hero. Volker did the same thing that William McChesney Martin did, you know, 15 years earlier. Nobody talks about William McChesney Martin. The difference was William McChesney Martin was at the wrong place at the wrong time.

And things had run their course in terms of politics, in terms of the rebalance in the system, that Volcker… What Volcker was trying to do worked. Same is true for Japan. Japan worked because of the situation, the circumstances of the time.

I think to simply take that, oh, it worked before, so it’ll work this way for us now, I think misses what’s happening structurally in the world, the structural populist impulses, the inflationary outcomes. It also takes a different system in the US relative to Japan at that time.

But they’re going to try, and they think that that is a data point that makes them believe that, well, we can probably do this, and they really don’t have a choice, candidly.

[01:02:26] Niels

I have a couple of questions that I want to ask before we wrap up. One is, I mean, this paper is obviously focused on the US, but do we see the same structural problem elsewhere, in other markets, that you’ve noticed?

[01:02:41] Hari

Less so directly. So, I gave a speech recently at an Indian conference and they pushed back and said, well, in India, passive is probably only high teens to 20% of the market. And I said, well, there are two ways to think about it. One is that locally it’s less of a problem. The other is that the US market is the market that drives all risk assets. So, it depends on your perspective there.

[01:03:08] Niels

Okay, the last question I had, we’ll see where Cem wants to go, but it’s just what kind of pushback have you had? I mean, this might not be very popular in the headquarters of some of these multi trillion dollar index houses. What kind of pushback have you had?

[01:03:24] Hari

One is the notion that this is anti-American, in some way, for me to say that the stock market can collapse. And that’s by no means my goal. My goal is just to give an objective assessment of the positioning risk in the US market. I’m far from the sort of person who would take a politically motivated stand on this. So, I might do things for business reasons, but I’d never do them for something like that.

The view of the large entity, such as who you would know, has been to ignore this, frankly. Why stir any problem by attempting to attack what we wrote? It would just bring more attention to it. So, I think they’ve largely tried to ignore it.

Now there are two possible reasons. One is that it’s not a big enough thing, but I think it is probably, at some level, a good enough critique of passive share that it should warrant some attention. But it doesn’t incentivize them to draw any attention to it because, whether we’re ultimately right or wrong, I think what we’ve come up with is a defensible argument that things could become very unstable in the near future. And who would want to sacrifice their revenue stream by taking even someone as soft spoken, as people have said, as me, on for this?

[01:04:58] Cem

Yeah, I mean what is the potential reaction at the end of the day? It’s to stop people putting money into their 401Ks, having people stop putting money into the equity market. At the end of the day, the administration, part of what’s driven the last 20 years, actually, probably the biggest driver of the last 20 years is massive capital allocation.

And the reason we’re having this AI boom is interest rates went to zero, is that the passive flow continued to support those growth companies. The momentum machine is the greatest tool that America has to achieve these outcomes.

It is not a coincidence, by the way. There’s zero chance it’s a coincidence we’re having this populist wave at the same time the machines have come to eat human jobs. Right? The populous wave is a function of interest rates going to zero and inequality going infinitely higher because money’s being allocated to capital. And the more that we dive into that, the technological boom that’s come out of it, then it’s reflexively continuing to eat human output.

So, we are reaching a point where the passive momentum effects in the system, that lead to more and more, and more, and more, and the concentration of wealth and the power that it benefits, to your point exactly, you know, they don’t want to hurt their income. Everybody’s clinging to it while the system itself and the people within it are doing everything they can to keep fighting and push for a different outcome. And it happens that the capital owners are not the same people as the people getting hurt.

And this is the important part. Demographically, those capital owners are dying and the people who got hurt the most by this generationally are coming to power. And that’s what breaks this, and that’s what’s breaking the global coordination. It’s the protectionism to protect those people, the political will. It’s a political reality that breaks this whole cycle. And my opinion is, when that happens, this passive flow part, which is the biggest, the tip of the spear on it, breaks as well.

[01:07:28] Hari

Absolutely.

[01:07:31] Cem

But it is a function of demographics. It doesn’t live… I guess my biggest pushback is (and I know you know this, so it’s not really even pushback) that this toy model doesn’t live in a toy world. It lives in a world with people, and political dynamics, a governmental system that is incentivized, and those that are empowered are incentivized to keep things going as long and as much as they can.

And when you solve for that, the least painful outcome is inflation, even though that is incredibly painful for the poor as well.

[01:08:05] Hari

I strongly agree with that. The one thing I would say is that while I would freely admit that our model is a toy model, one could argue that Black-Scholes is a toy model. All models are toy models.

[01:08:16] Cem

Absolutely, and very valuable, nonetheless. I didn’t mean to make it sound…

[01:08:19] Hari

No, no, no, I wouldn’t disagree with that.

The other thing I’d like to point out, from kind of a philosophical perspective, which hopefully will wrap a few things up, is that that subtle violation of Goodhart’s law has driven a lot of this. When volatility ceased to be something you measured but became something you targeted (I hope I haven’t paraphrased it poorly.) So, vol targeting means low vol, more risk, better performance. Lower vol means more risk, better performance. And the thing keeps perpetuating itself until it stops, and before you know it, it’s leaked into all aspects of the economy.

And, I think, that’s the main reason why you and I, especially you, have been banging on about positioning risk for so long, because that basic violation of Goodhart’s law has been a cause for many of the problems that we find today in financial markets.

[01:09:17] Niels

That’s a good place to wrap up. Maybe. There’s one thing I should ask Hari and that is, there are so many ways we could have taken on your paper. Is there anything you want to mention before we wrap up completely that we missed, because it was pretty wide-ranging and maybe not as structured.

[01:09:40] Hari

The main takeaways I would give are that, as the passive engine continues to roll, so to speak, being long is probably quite attractive, being long equities, and accepting that this may persist for a long time. But also hedging and looking at inflation protection as well as crash protection, I think is very attractive.

Barring that, I think buying upside tail risk is quite a good thing to think about because that’s a way where you don’t have to take on additional risk in your long portfolio and you can still potentially participate from an underpriced index call skew if markets do rip higher based on all of the reflexive arguments we’ve given today.

So, stay long, perhaps, buy upside convexity if you don’t want to increase your longs, buy protection, and find a way to get long inflation sensitive assets.

[01:10:44] Niels

And of course, none of that is financial advice. I should just add.

[01:10:48] Hari

Oh, by no means, by no means.

[01:10:50] Niels

But having said that, just one final, final thing I thought of was you mentioned this was one of two papers. Do you want to say anything about what’s coming?

[01:11:00] Hari

Well, the first paper was designed to just model fragility in the S&P, as a stock index. That was written jointly with Mike and Stephan. The second one is really Mike’s domain. So, I’ll let Mike speak about this at another time, but I’ll just summarize. It’s basically arguing in favor of outperformance of higher volatility stocks in the large cap sector, the Mega-caps, until the system breaks. So, stay long, or go long the large caps, but buy some protection underneath.

[01:11:33] Niels

Cool, great. Well, I mean, both Cem and Hari, this was really tremendous and wonderful conversation. Thanks to both of you for doing this today.

By the way, just to make sure that you go and follow and subscribe to Hari’s and Cem’s work because, as you can tell from today’s conversation, we are living in a truly flow driven world now, and perhaps it is not being covered so much in mainstream media, so you definitely need to go and follow both of these gentlemen from Hari, Cem and me. Thanks ever so much for listening. We look forward to being back with you as we continue our conversations. And in the meantime, as usual, take care of yourself and take care of each other.

[01:12:13] Ending

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