Podcast Summary
FIRE's Sustainability in Uncertain Market Conditions: The FIRE movement's assumption of historical stock and bond market returns may not hold true in the future, raising questions about its sustainability. Over-reliance on passive investing could have significant implications for market function.
The FIRE (Financial Independence Retire Early) movement, which encourages individuals to retire early through saving and investing, raises important questions about the sustainability of this approach, especially in relation to the bull market we've seen over the past decade. The FIRE movement's popularity is built on the assumption that historical returns in stock and bond markets will continue. However, this assumption may not hold true in the future, making it uncertain if the FIRE movement can continue to exist. Furthermore, the widespread advice to invest in passive ETFs and avoid market timing and individual stock picking has influenced not just the FIRE community, but also the general public, leading to a potential over-reliance on passive investments. This trend could have significant implications for the market function. It's essential to consider the potential downsides of passive investing and the importance of active management in various market conditions.
Passive investors are not truly passive: Despite the common belief, passive investors significantly impact the market and cannot be considered fully passive.
The popular belief that passive investing is truly passive and only matches the performance of active investors, while active managers underperform due to fees, is flawed. Mike Green, the chief strategist and portfolio manager at Logica Capital Investors, argues that passive investors, who manage trillions of dollars, cannot be passive as they are the largest transactors in the market. This misconception, fueled by the growth of passive investing and lobbying efforts, has led to a significant crowding effect, further boosting the performance of benchmarks. In reality, passive investors influence the market, and their actions should be considered when evaluating the passive versus active debate.
Index inclusion advantage for securities in indices: Passive investing creates a performance advantage for securities in indices, leading to a permanent shift in their valuation and potential 'virtuous' or 'vicious' cycle for passive investing.
The behavior of passive investors, who follow indices, creates a performance advantage for securities included in those indices. This phenomenon, known as index inclusion, results in a permanent shift in the valuation of affected securities. The academic literature focuses on one-off events, but the continued inclusion and flow of capital is a more complex problem. This dynamic can be compared to a carnival game where participants shoot water at horses, with the objective being to win by synchronously targeting the same horse. The increased capital flow towards benchmark securities, particularly larger ones, gives the perception of better performance, leading to active managers underperforming. This creates a potential "virtuous" or "vicious" cycle, where passive investing seems to outperform, further validating the passive approach and discouraging active management. This fundamental shift in the market means that historical market dynamics may no longer apply, as we have not experienced these passive flows before. To further investigate this theory, it's worth looking at the performance of benchmarks designed to model active manager strategies, which charge no fees, to assess if the underperformance of active managers is indeed due to passive investing or other factors.
Struggling with alpha in non-linear markets: Historical strategy of selling options on S&P 500 index has seen a decline in performance due to using linear equations in a non-linear market, which can lead to increasingly negative results.
The strategy of selling options on the S&P 500 index, while historically delivering alpha, has seen a decline in performance over the past 25 years. This is not due to interest rates or the relationship between implied and realized volatility, but rather the use of linear equations to measure performance in a non-linear market. The idea that the decline in alpha is due to the departure of "bad players" from the market, as suggested by Michael Moebison, is incorrect. Markets are not ergodic systems like poker, where the probability distribution remains constant. Instead, markets have an infinite number of combinations and a singular direction in time, making it impossible to predict future performance with certainty. As a result, the calculation of alpha using linear equations can lead to increasingly negative results. This highlights the need for new approaches to measuring performance in complex, non-linear markets.
Decrease in daily and weekly market volatility with passive investing: Passive investing's consistent inflow of funds decreases short-term volatility, but could lead to inflated valuations and increased risk due to structural market changes and regulatory frameworks.
The shift towards passive investing has led to a decrease in market volatility on a daily and weekly basis, as compared to monthly and annualized volatility. This is due to the consistent inflow of funds into the market, which passive investing algorithms facilitate, thereby providing liquidity. However, this trend could potentially lead to inflated valuations over time and increased risk. Another factor driving this trend is the regulatory framework, particularly the Department of Labor Fiduciary Rule, which has made passive investing the default option for many individuals saving for retirement through 401ks and IRAs. This has led to a significant increase in the amount of money being invested in passive assets, making it a structural change in the market that goes beyond a cyclical trend.
The rise of passive investing through target date funds in 401ks: Desire for ease and employee satisfaction drove passive investing trend, amplified by DOL Fiduciary Rule and low-interest-rate environment, resulting in yield enhancement strategies and new investment opportunities.
The shift towards passive investing through target date funds in 401ks, which began around 2012 and has become the dominant investment vehicle in the US, has been driven by a desire to quickly and easily dispense benefits to employees and keep them happy. This accelerated trend would have been further amplified by the DOL Fiduciary Rule if it hadn't been stopped in 2018. Additionally, the low-interest-rate environment created by central banks has led to a desperate search for yield, resulting in the rise of yield enhancement strategies that dampen market volatility. While some active managers complain about central bank liquidity distorting the markets, it's important to note that this has given rise to new investment opportunities. Ultimately, the choice between passive and active investing depends on one's investment objectives.
Distorted Capital Allocation in Financial Markets: Ultra-low interest rates and passive investing fuel a distorted environment where bad companies receive capital, increasing risks for investors using high leverage, with trillions involved in yield enhancement strategies.
The role of financial markets is to allocate capital efficiently, but the increasing prevalence of passive investing and yield enhancement strategies, fueled by ultra-low interest rates and central bank influence, is creating a distorted environment where bad companies receive capital at the expense of good ones. This distortion, often referred to as the "greater fool theory," can lead to significant risks for investors, particularly those using high levels of leverage. The use of yield enhancement strategies, which involve selling options or taking on increased risk to generate higher returns, is pervasive but hard to track, with estimates suggesting trillions of dollars are involved. Central banks' actions, intended to stabilize asset prices, have instead expanded the demand for financial assets and increased the need for these strategies, creating a vicious cycle. The limits to this trend are uncertain, but the underlying behavior of investment dynamics and the availability of dollars for investment will eventually face limits.
Buyer beware market: Despite current economic growth, market instability is a concern due to unsustainable trends and potential for discontinuous pricing. Investors should consider alternative strategies and be prepared for market volatility.
The current economic conditions, characterized by low unemployment and high corporate earnings, have led to significant market growth and investment strategies like share buybacks and retirement funds' required withdrawals. However, these trends are not sustainable, and when the outflows begin to outweigh the inflows, market prices could become discontinuous, potentially leading to a market crash. It's essential for investors to be aware of this dynamic and consider alternative strategies that allow for both participation and protection. At Logica, they are exploring ways to obtain nonrecourse leverage in both directions to capitalize on market volatility. Ultimately, it's a buyer beware market, and investors must be prepared for potential market instability. Whether the market deflates quietly or pops is uncertain, but being prepared for either scenario is crucial.
Trend of Early Retirement and Its Economic Consequences: Mike Green from Logica Capital Advisors discussed concerns over early retirement trend's impact on labor force and economy, emphasized importance of financial literacy, and highlighted regulatory changes leading to market influx.
The ongoing bull market and the debate between active and passive management were key topics in a recent conversation with Mike Green from Logica Capital Advisors. Mike expressed concern about the trend of early retirement and the potential economic consequences of removing human capital from the labor force at a young age. He also highlighted the importance of understanding financial tools and their true purpose, such as the use of deep out-of-the-money puts. Additionally, he emphasized the significant regulatory changes that have occurred since the 1980s, leading to a consistent influx of cash into the market. The conversation touched on themes of market valuations and the role of human capital in the economy. Overall, the discussion provided valuable insights into the current financial landscape and the importance of active management and a thoughtful approach to retirement planning.
Shift in Perspective: Market Regulation and Fiduciary Responsibilities: Following the market irresponsibility of the late 1990s, there's a more cautious approach to discussing the market, emphasizing regulation and fiduciary responsibilities. Michael Green emphasized the importance of considering incentives and their impact on market behavior, challenging the notion that passive investment vehicles don't influence the market.
The financial media and industry have undergone a significant shift in perspective following the market irresponsibility of the late 1990s. This correction has led to a more cautious approach to discussing the market and a greater emphasis on regulation and fiduciary responsibilities. Michael Green highlighted the importance of considering incentives and their impact on market behavior, challenging the notion that passive investment vehicles like ETFs don't influence the market. The hosts suggested exploring future episodes on the fiduciary role and a deeper discussion on passive versus active investing with Michael Mauboussin. Overall, the conversation underscored the importance of understanding the real-world implications of economic models and market practices.
