A Powerful and Unappreciated Structural Force Driving Our Markets is About to Change
A summary of Mike Green's views on passive investing - Article #39
In this 12 min article, The X Project will answer these questions:
I. Why this article now?
II. Who is Mike Green?
III. Where is this perspective coming from?
IV-VIII. What are the top five takeaways from this perspective?
IX. What does The X Project Guy have to say?
X. Why should you care?
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I. Why this article now?
The current financial landscape is marked by historic levels of passive investment, influencing stock valuations and market movements in ways that are not fully understood or appreciated. Understanding these impacts is crucial for both individual investors and policymakers. As passive investing continues to dominate, the need to critically examine its long-term effects on market stability, asset pricing, and investment strategies becomes more pressing. Given the lack of recent market volatility and debates around the sustainability of passive investing during downturns, this article offers timely insights into potential risks and challenges that could shape future market behavior and investment practices.
Mike Green’s perspective on passive investing is multifaceted and deeply analytical, touching on the systemic risks and market dynamics influenced by the growth of passive investment strategies. He argues that the massive influx of funds into passive vehicles such as index funds and ETFs, driven by their rule-based buying and selling strategies, fundamentally alters market behaviors and price discovery mechanisms. Green points out that the theoretical foundation of passive investing assumes these investors never transact. In reality, transactions are constant through their regular inflows, challenging the definition of “passive” investing. Passive investing, he suggests, has led to distortions in market valuations, potentially making markets more vulnerable to shocks as passive investments’ market share grows but will likely reverse at some point soon.
II. Who is Mike Green?
Mike Green is a Portfolio Manager at Simplify Asset Management, and according to their website,
“Michael has been a student of markets and market structure, for nearly 30 years. His proprietary research into the shift from actively managed portfolios and investment funds to systematic passive investment strategies has been presented to the Federal Reserve, the BIS, the IMF and numerous other industry groups and associations.
Michael joined Simplify in April 2021 after serving as Chief Strategist and Portfolio Manager for Logica Capital Advisers, LLC. Prior to Logica, Michael managed macro strategies at Thiel Macro, LLC, an investment firm that manages the personal capital of Peter Thiel. Prior to Thiel, Michael founded Ice Farm Capital, a discretionary global macro hedge fund seeded by Soros Fund Management. From 2006-2014, Michael founded and managed the New York office of Canyon Capital Advisors, a $23B multi-strategy hedge fund based in Los Angeles, CA, where he established their global macro strategies, managing in excess of $5B of exposure across equity, credit, FX, commodity and derivative markets.
In addition to his work as a market theorist and portfolio manager, Michael has been noted for his work as a public speaker and financial media participant. He is a graduate of the Wharton School at the University of Pennsylvania and a CFA holder.”
Mike Green is active on X/Twitter and can be found @profplum99, and he is also on Substack:
III. Where is this perspective coming from?
Mike is a frequent guest on various YouTube Channels, and this article summarizes his views based primarily on the following recent interviews:
The Driving Force Behind Modern Market Dynamics with Michael Green
4,217 views, and published on October 17, 2023.
Simplify’s Mike Green Talks Powell, Geopolitics, & The Problems Posed by Passive Investing
1,506 views, premiered February 8, 2024
Passive Capital Flows Are Starting To Reverse - This Will Change Everything
71,603 views, premiered February 13, 2024
Has Passive Investing Broken the Market?
4,845 views, published February 22, 2024
Economic Time Bomb: The Silent Threat of Passive Investing Exposed
14,851 views, premiered February 28, 2024
IV. What is the top takeaway from his perspective?
Risk of Market Distortions
Mike Green emphasizes the significant market distortions that can arise from the disproportionate influence of passive investing. He argues that passive investment strategies, which operate on simple algorithms like “if you give me cash, then buy; if you ask for cash, then sell,” fundamentally alter the market’s natural behavior. This process lacks consideration for the underlying value of assets, leading to an inflationary dynamic within markets. Green highlights that passive investing’s market share growth creates distortions, not just through direct investments but also through mechanisms like securities lending operations, where the real money is made. This contributes to an environment where markets are increasingly disconnected from economic fundamentals, leading to potential systemic risks.
V. What is another top takeaway?
Impact on Price Discovery
The dominance of passive investing impairs the market’s price discovery mechanism. Green points out that the theoretical foundation of passive investing relies on investors never transacting, which is far from reality. Every paycheck invested through a passive vehicle results in a transaction, contradicting the notion of passivity. This process, driven by constant fund inflows to passive vehicles, divorces the buying and selling of stocks from their intrinsic values and market fundamentals. It leads to a situation where market prices are more a reflection of capital flows into passive funds than an accurate measure of companies’ worth, undermining the market’s ability to signal economic health accurately.
VI. What is a third takeaway?
Vulnerability to Large Withdrawals
Green discusses how the market’s increasing reliance on passive investments heightens its vulnerability to large withdrawals. With passive investments constituting a significant market share, any substantial shift in investor behavior, such as mass redemptions to fund retirements, could lead to dramatic market downturns. He parallels historical bear markets in other countries, suggesting that similar prolonged downturns could occur in the U.S. if negative flows dominate. This scenario underscores the systemic risk posed by the sheer scale of passive investments in the market.
VII. What is a fourth takeaway?
Challenge to Active Management
The growth of passive investing presents a formidable challenge to traditional active management. Green argues that the efficiency and simplicity of passive investing, which often results in lower fees and better performance relative to a large portion of actively managed funds, have led to a significant shift in capital towards passive vehicles. This shift reduces the diversity of investment strategies and puts pressure on active managers to justify their existence. The homogenization of investment strategies, driven by the dominance of passive investing, could amplify market movements during periods of stress, further exacerbating volatility and systemic risks.
VIII. What is a fifth takeaway?
Demographic Pressures and Outflows
Finally, Green delves into the potential impact of demographic shifts, particularly the retirement of Baby Boomers, on passive investments. He warns that as this demographic begins to withdraw investments to fund retirements, the balance of inflows and outflows could shift negatively, applying downward pressure on markets. This situation is exacerbated by the structure of passive investing, which necessitates selling assets to meet redemption requests, potentially leading to a self-reinforcing cycle of market declines.
IX. What does The X Project Guy have to say?
First, I have known of and followed Mike Green and his work for years. Demographics is one of the ten subjects The X Project studies. Mike Green identified a direct link between U.S. demographics and the U.S. financial markets via the baby-boomer demographic bulge and passive investing. And so it was the third interview above that prompted this article. If you are going to listen and watch just one of the YouTube videos, watch the third one listed above, which is Adam Taggart’s interview on his Thoughtful Money channel. And if you don’t have time to watch the entire 1 hour 18 minute interview, skip ahead 53 minutes and 45 seconds and start watching there. Green starts by talking about the problem with the poor quality of the employment data coming out of the Bureau of Labor Statistics and how misleading initial releases of monthly reports are when they are eventually revised and end up being much lower than initially thought.
However, he then goes on to his most important point, which is that the passive investment flows are starting to slow and turn negative. He shares this chart:
He points out that 401(k) plans almost entirely flow through mutual funds, and those flows are starting to turn negative due to baby boomers retiring. Instead of contributing to their plans (and adding to the passive flows), retirees have now stopped contributing to their plans and are starting to take withdrawals. He also indicates that, up until recently, mutual funds outflows have been offset by ETF inflows, which are not usually part of 401(k) plans.
And then, he shows this chart, which combines the mutual funds with ETFs:
He states that unlike in early 2020, due to the pandemic, the slowing and decline we now see is the structural change occurring demographically, which reverses the positive passive flows. Changing one of the significant tailwinds supporting the market into a substantial headwind can be catastrophic in the future.
That said, Green points out that policymakers are aware and references 2018 when we started seeing the same phenomenon. What happened? Policymakers increased the amounts that could be contributed and extended the age at which distributions must begin. These changes just delayed the inevitable, but it showed that policymakers will try to avert the disastrous decline in the stock market that might otherwise occur. (Note: if you have not read Why Rate Cuts, a lower U.S. Dollar, and Inflation will All be Returning Soon: Revisiting Fiscal Dominance and the U.S. Policymaker’s Only Choice - Article #37, you should do so as Sective VI in that article explains why U.S. policymakers need higher stock markets.)
Don’t policymakers realize the inevitable has been delayed? Probably, and that is why Green suggests we will likely hear proposals soon or at least lobbying by Vanguard, Blackrock, and other major players providing passive investment vehicles for proposals like the U.S. Government should hand out $10,000 to every person to invest and save in the stock market.
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