This blog covers the general topic of financial markets.


Mike Green: Rise of Passive Investor and FED Policy

first posted: 2020-12-14 08:45:27.834289

Grant Williams hosted a thought-provoking podcast with guest Mike Green. Here are a few notes on this very long conversation. This is definitely alternative stuff, I found the podcast so thought-provoking that I had to summarize it and write down my comments.

End Game: Narrative vs Actual Float

  • The "end game" narrative is somehow gamifying reality. The world is not a game of chess, and it does not have an endgame. Still the title was chosen based on the back of two facts: the retirement of the boomers and the end of a debt cycle. It is an end game in the sense that some governments are getting out of road to kick the can down.
  • Mike Green sees the 90s as a turning point in terms of policy and markets
  • He had an epiphany in 2015, when he realized that the China market does not go up because of irrational retail investors, which was the prevalent narrative at the time.
  • His thesis is that the cap weighted Chinese index has substantial weight on many low float companies. Like only 5% of the company was afloat. Increasing volatility.
  • The 95 to 2000 boom was observed in tech, where low float companies saw money inflow.
  • He thinks that it is more important to get the big picture than try to do a very precise analysis. Essentially trying to understand macro-trends than get into details.
  • Since 2015, he has been mindful of the boomer withdrawals as their cohort retires

The Rise of Passive Indexing

  • Another point is passive indexing, which has grown to become 40% of all investment
  • Passive managers are overrepresented amongst the young, so that passive sees inflow and discretionary managers see outflow. This explains value underperformance.
  • He does not like the expression "cash on the sidelines" but it is a fact that discretionary managers keep 5% in cash, whereas passive is 99.95% invested.
  • Passive is dangerous because it requires price continuity. If a discretionary manager gets a liquidation order, he will liquidate the most liquid, least volatile assets first. If passive gets liquidation orders, it is mandated to sell at whatever price and the manager is big, the price can go to 0.
  • Discretionary managers will buy most when it makes fundamental sense. The problem is that their fund flows do not follow fundamentals. It is the same with passive, but the problem with liquidation at irrational price is not visible yet because of investing cohorts.
  • While Renaissance's Medallion fund is relatively small, it pays great attention to market impact. The passive heavyweights Vanguard and BlackRock seem to be doing the opposite. They are now systemic players but try to not be regulated as such.
  • Mike Green explains that every investor has scars, and that the next generation comes in and moves the market in a way that was not predicted by the old ones. He advises to read Leon Levy's book.

Fact check: while Mike Green seems to imply that there is a problem for low float companies being overrepresented in passive indexes because they are mkt cap weighted, the SP500, the MSCI and FTSE indexes are float adjusted.

Note that using market cap weights or float adjusted market cap weights both avoid ever having to rebalance the portfolio composition provided the stocks does not change, for this reason these indexes minimise trading and are called "passive".

Alternative Strategies: Volatility and Shorting Cigar-butts

  • He prefers to buy high quality, low volatility companies. He expects that lower volatility helps them reach a higher compound rate.
  • He met a young trader that was shorting bankrupt companies. He thought this was unsustainable because stocks are sometimes not available to borrow. The young trader could work because BlackRock and Vanguard do lend stocks to help reduce their fees.
  • Shorting stock is very dangerous now when short interest reaches 40%, which is when the stock becomes special and the lending rate goes to 100% or more, because the shorts use up all passively held securities.
  • He prefers to buy cheap vol, he made money using straddles. That strategy did ok in recent years. He advocates selling expensive vol on OTM puts and buying cheap vol on ATM straddles, and sees options as non-recourse leverage.
  • Retail has been going into options buying recently and did well. Of course, the volatility matters as you can't put on this trade when vix is 85%.
  • The 20% OTM are expensive because some are mandated to purchase OTM put as insurance. They see it as a cost of doing business, not as a profit center.
  • Call option delta hedging by option dealers for Chesapeake or Hertz may have caused prices to surge while the companies were worthless.
  • Debt equity arbitrage was another thing that was destroyed by the raising of these zombies: buying debt at 60% and selling the stock because it goes to 0 is a problem if stock goes x4. That's why Mike things shorting is too dangerous.
  • He suggests finding trades with small edges, and Kelly betting them.
  • For success, one needs to find an important issue and focus, succesful people such as Peter Thiel, the Paypal crowd or Bezos are focused.
  • Mike Green has a model saying that switching from holding 95% stock to 99.9% for funds is causing 50x increase.
  • Active to passive switch has been causing a big increase in stocks. This will last until redemptions
  • When redemptions occur, price goes to 0.

FED policy caused anti-correlations

  • FED has been looking at markets for expectations in the 90s. They started print money when stocks tank. They created anti-correlation between bonds and stocks.
  • This has made the UST bond into the perfect hedge
  • This is become so conventional that Risk Parity funds suffered a lot in March when bonds went from 0.32% to 1.20% while equity went down.
  • Risk Parity deleveraging is causing Target Vol funds to sell as well.
  • Target Vol started to exist because people could invest in zero coupon and reinvest the proceeds in option like payoff. Vol targeting corresponds to selling each time the vol rises, and buying when vol is low. They are dependent on positive yield
  • FED does not know what it is doing, they still believe that propensity to consume increases when rates go down, whereas Mike and Mark Blythe believe that the opposite is observed.
  • Risk parity makes sense because of anti-correlation. Risk Parity is done with no leverage de-risk asset has negative yield, it is done with massive leverage with the UST yield more than short term borrowing rates. The positive 10Y vs 3M spread begets leverage.
  • The FED put has been hanging on markets too long. A crash is going to stop the markets.

Fact Check: The claim that anti-correlation is not always happening in the past is also made by Anti Ilmanen in Expected Returns. Schiller data allows to check the relationship over the long term. We see that 5Y rolling correlation quantiles became negative suddenly in 2002, meaning that correlation plumetted somewhere between 1998 and 2002, which gives us a period when the Greenspan put became effective. img

Dysfunctional Intervention, Politics and Escape Plan

  • In Germany, the Nazis decided for political reason that the stock market should never have down ticks. Prices increased with ever decreasing volume until nothing more was traded. When the rule was abolished after the war, the market collapsed 95%.
  • Evolution is not about progress, it is about fitness for a given situation. A FED governor that gets things done by pushing a button will keep pushing that button. There is danger of overfitting when there is no uncertainty.
  • Current world has too low uncertainty, this breeds fragility. Google can buy Waze for 2bn and give sufficient certainty to the founders that noone tries to innovate anymore.
  • Mike advocates greater tax on the rich (though he works for family offices). He is also talking about debt jubilee.
  • MMT is an appropriate description of a fiat monetary system. what happened in the last 10 years is that it became clearer as we see no inflation occurs with printing. He thinks elites will accept MMT because of the Cantillon effect.
  • Debt jubilee happens at the barrel of a gun. Meaning that it involves coercion by the state.
  • Outlook is bleak as people do not have a place to escape en masse as in the 19th century when swedes emigrated to Wisconsin and Sweden had to put in place social democracy to retain its population. New Zealand is too small country for US citizen to escape to.

Comments

The discussion goes into many nooks and crannies. The political views towards the end have been reproduced as they appear in the guest's exposition.

  • FED causing anti-correlation is consistent with the fact that rates correlation was not negative prior to that period. (Show Shiller correlation). The implication is that risk-parity are indeed overfitted but fragile strategies.
  • Stocks with low float causes rise can be tested.
  • Straddles are robust strategies, the question is whether they make money
  • Short interest above 40% is causing all kinds of surge effects.

Is the guest a prince of finance or an imposter? He worked with Peter Thiel whom he mentions repeatedly and resorts to name-dropping famous hedge fund manager Seth Klarman. He is using advanced scientific metaphors: comparing passive ETFs to massive objects bending the trajectory of light in general relativity, or comparing price signals to quantum states and energy emissions of particles which are a bit strained as he admits that financial practitioners' ability does not extend beyond linear equations. Rather than an imposter, this seems rather a person who enjoys to work at the limit of his abilities.

The role of float vs market cap pushing valuation and FED policy turning UST bond into the perfect hedge and setting up the conditions for the success of Risk Parity over the last 30 years provide us with an articulate vision of macro trends.

More white papers and blog articles can be found on Mike Green's firm logicafunds website.