A new look at active vs passive (Michael Green)

about changing market structure so while I run a discretionary macro strategy and I'm not trying to raise money I'm not trying to meet allocators I'm doing this because I'm trying to put it out there and make sure that people are aware of what I think is happening and if you disagree or if you've seen something that says something else feel free I would love to hear the push backs two things are infinite the universe and human stupidity and I'm not sure about the universe so it's at Albert Einstein except he didn't really say that it's attributed to him the point that I'm gonna make us is that we do really stupid things all the time and we think that they're really really smart February 5th 2018 equity volatility exploded and took down a two billion dollar etn right so this is the xiv is you can now see it has been liquidated this was the target manager trade of 2017 and if you remember the Wall Street Journal this is up 650 percent people were making millions and millions of dollars was two billion dollars in total assets they were affiliated ETFs there is a product called the SV XY that was identical in structure it was inverse to the VIX measure of volatility performed in a very similar fashion and interestingly enough there were options that had been issued against this those options were fantastically mispriced for a very simple reason if you actually understood this product what you understood was the higher it went in price the higher the probability it would go to zero the options were priceless black Scholes so understanding that structure created the potential to trade around this and to be very long volatility and make a lot of money without taking the negative carry associated with it what was amazing about 2017 was that while the index of all was falling right which is the yellow line single stock ball had actually been rising for the entire time period for those of you that know how index volatility is calculated what that's telling you is that the unique story in 2017 was the epic collapse and correlation that occurred basically after brexit in 2016 it was just a monotonic decline and you can look at the sea you say well you know but that kind of makes sense I mean we're coming off of the elevated levels of volatility in late 2015 early 2016 with the Chinese devaluation and the concerns about Asia we're also coming off the levels of volatility that has been experienced in 2011 and 2012 in the euro crisis and even higher levels of volatility and correlation that had occurred in 2008 well it's not entirely true correlation actually hit its local peak in 2011 in 2012 the flash crash but in general we have this pattern of declining correlation this makes sense right one of the things that's so fascinating here is is that this is the entire data set that's available on correlation in Bloomberg goes back to 2011 correlation is is calculated from a calculation standpoint its intensive the longest data sets that you're gonna see on correlation will typically go back to about 2005 it requires if you think about the S&P 500 by 500 matrix showing the return of each individual security you have to draw a relationship between the two how explanatory are the returns of each individual component right however you can take this back over time so this is the exact same data series I just showed you and this is a mathematical construct that I call Co movement as you can see is functionally identical and does a very simple thing all it asks is did they move in the same direction right so if two stocks advance with each other on a continuous basis forget the amplitude then it is highly likely that they are correlated in terms of their behavior right and we can actually use that insight it's called Kendall's tau to extend back this data series pretty much as far as we want right and so what we see is actually since the mid-1990s the underlying trend in correlation has been one that has been rising and instead of being somewhat in line with the trend the period around February 2018 was extraordinarily extended relative to the trend so it became even easier to predict that something like this was going to occur um why was there this disconnect I apologize I'm gonna try to talk to both sides of the room why was there this disconnect well it's important to understand what correlation from a statistical standpoint is actually telling you and why you can have low correlation all right there are two reasons why correlation can be low one is the presumption that most people make that there's no relationship all right correlation is just telling you how much of the movement of variable Y can be explained by the movement of variable X which creates a second explanation you just didn't change X all right so we all remember our statistics 101 course where we're taught the relationship between crop yields and fertilizer application right fertilizer is applied in tonnes per acre if we changed it by pounds per acre then other variables would dominate right the amount of water fall the amount of Sun and fertilizer would appear to have no impact on crop yields that would obviously be a false assumption I will tell you a crazy story from my prior career even before I started managing money I used to work with General Motors and their service parts operations and when they were rebuilding their warehousing software in the late 1980s early 1990s they were looking for ability to reduce the computational intensity right and so these are warehouses and they said you know okay what is information that we can reduce in terms of the variables well the height of the product the width of the product the depth of the product that just gives us the volume of the product and so we can actually discard what we can discard the height width and depth components in terms of each individual project product what that suddenly meant was that the volume of a engine block which is a square was roughly the same as a bumper and they started trying to put them into the same bins right complete disaster this is very similar where what's actually happened behind door number two was the winner what occurred in 2017 all right so this is actually looking at the number of days with a fraction of days where the SP moves by a certain percentage between 0 and 25 basis points 25 to 50 50 to 100 100 and more and what you saw in 2017 was that the fraction of days in which X the SP moved was by less than 25 basis whence was the highest in history and so that low correlation was a product of they're not actually being any movement in a variable this creates another measure that we can use I call it conditional correlation and this is looking at the co movement of the S&P 500 on days where the S&P moves less than 25 basis points guess what it's basically zero what happens if we look to 25 to 50 oh it's rising 50 to 100 100 to 250 I don't go higher than that because the days are so infrequent and the impact is quite different but suddenly what was a very low level of correlation becomes a very firmly defined trend now why is this happening why are we seeing this big trend increase in correlation what are the implications of it first let's ask why they weren't moving so the reason they weren't moving is because of systemic volatility selling alright when you engage in a strategy or you invest in a strategy that involves something like a call over writing right or an iron condor or an accelerated share repurchase from a corporation where they are synthetically selling puts on their own stock to the street it leaves goldman sachs and other market makers in a position where they are what's called long gamma long theta it's effectively like being short the straddle alright and that's exactly what we saw if we looked at the market as of December 17th 2017 all right there was an underlying position where the market was currently in a position we're short a straddle okay no we have all done something like being short a straddle we're gonna try and play video here and I apologize if we run into any challenges but traditionally this was done by human being so you dealt a hedge you move your underlying futures position back and forth changing the position of your portfolio to reflect the increase or decrease in Delta of the option the short option position that you have so this is actually an experiment that was done at Carnegie Mellon University and this is showing a human being managing on a delta basis a two axis movement there's a sled and she's trying to manage an inverted pendulum alright trying to keep it up so when we play the video disruption it starts to go back and forth now just a little bit boring human beings have a tendency to forecast and to overreact alright becomes increasingly wild eventually she reaches the edge tips over its advanced to the next slide this is what it looks like when an algorithm does it and just to make this more fun instead of a single pendulum this is a triple-jointed pendulum alright a triple-jointed pendulum it is impossible for a human being to do anything like this we start this video and this is I believe happening at MIT okay now the video is still going I just stopped this is what was happening algorithmic management of short volatility positions continuously Delta hedging in small fractions right no that sounds great what's wrong with this well the problem is is that this became the dominant feature in the market right and it continues to be today we're seeing it right now we are back to this positioning where the short vol positions in the market are the highest they've ever been in history alright and so we're seeing this incredible decrease in the fraction of days in which the markets are moving but underlying it is this embedded correlation so that when the market does move it can explode right as I said we can actually extend co-movement back over time and we can start to see a bigger underlying trend alright this is not a period of low correlation as a matter of fact and this has the more recent data on it this is the period of highest correlation we've ever seen why do I think this was well there's the registered investment advisor Act of 1940 right basically place limitations on leverage that could be used by those who are managing public securities something else happens that almost nobody knows about in 1996 Vanguard discovered futures why did they do this they did it for a perfectly benign reason the inflows coming into index funds were high enough that they were beginning to develop tracking error they couldn't efficiently replicate the S&P 500 or other indices as new money was coming in without influencing the illiquid securities they again went to the bright backroom boys at the various Wall Street banks and said what can we do about this and they were told well why don't you just buy futures well we can't because the registered investment advisor Act of 1940 prevents us from establishing margin accounts you need a margin account to trade futures and the SEC said that's fine go ahead I believe that this is actually what kicked off the dot-com bubble and the period of irrational exuberance because there was another flaw at that point right in 1996 the structure of indices was that they were market cap weighted you're gonna say hey wait a second there's still market cap weighted no they're not they're float weighted and the unique feature of late-1990s market was that you had large cap low flow companies like Microsoft and so Vanguard was trying to buy Microsoft in proportion to its market cap putting $2 into Microsoft relative to every available share and guess what happens when the dominant flow is trying to buy twice as much of something the price goes up who are the people who are naturally overweight Microsoft geniuses who were assigned to manage a tech fund coming out of Harvard Business School they had no affinity for tech other than the fact that the fund that they ran was called a tech fund right so they were overweight Microsoft which meant that their performance was great which meant that they attracted additional capital what did they do with that did they go buy cheap home builders or trucking companies no they bought tech companies and Wall Street met their need to buy this stuff by producing IPOs right they bought those IPOs in the exact same way that in 2006 they would have created a synthetic mortgage for your demand for mortgage products February 2018 co-movement on February 5th 2018 co-movement the number of stocks in the S&P moving in the same direction hit a hundred percent first time in history that's not the best part it happened twice in December I genuinely believe that what's actually happening is that the influx of money into passive vehicles is driving this and it is being exacerbated by the dynamics of systemic volatility selling systemic volatility selling so when as an allocator you say you know what I'm just gonna buy cheap beta I don't see a reason to hire an active manager what are you actually doing you're hiring an algorithm that is the world simplist did you give me cash if so then by did you ask for cash if so then sell no discretion no value no cash on the balance sheet it's just a pure pass-through of your instruction that you may not even realize you're giving okay this now brings up another component why have markets historically functioned as discounting mechanisms so this is proprietary research they did a teal macro we did a survey of roughly 450 investors we presented them with a question you're a portfolio manager with 5% cash in your portfolio we're moving a cash constraint you receive a 1% new inflow or outflow what is your propensity to use that cash to either buy new securities or to hold it as additional cash contingent on valuation and what you see unfortunately not sure if I can get a arrow pointing this what you see is what you would expect the yellow line which is the propensity to sell rises as valuations get higher and falls as valuations get lower the gray line which is the propensity to buy is very high at low valuations and low at high valuations and interestingly enough the intersection between these two that occurs and this is totally random in terms of the survey construction etc and roughly 50% is exactly the historical p/e of the market at 16 and a half times and so what's actually happening in the market is that markets discount because the participants discount and we can actually see this so this is an agent-based model that we built to run through a simulation of what happens when inflows and outflows come in and on the left-hand side you can see the resulting p/e now this rises over time because we're showing net inflows and also because we're keeping earnings constant but effectively Pease become mean reverting in a response to inflows or outflows in the market I didn't ask a question about interest rates by the way I didn't ask any of that I didn't say what are the companies what's the quality of the companies what's their return on equity right this is embedded in the market that's telling you the valuation is an endogenous feature of the structure of the market when it was constructed of discretionary active managers when you introduce passive again remember passive is the world's simplest algorithm did you give me cash if so then by did you ask for cash if so themselves so their propensity to buy or sell is a hundred percent based on flows and so the implications of this is that you shift the market you move in terms of propensity to propensity to sell from the yellow line to the orange line I should do a better choice on color selection here I apologize in terms of the propensity to buy you've also increased it all right and so you've changed it from give or take 50 percent at sixteen and a half times to roughly eighty percent right now this doesn't actually seem like a big deal initially but if you run the same simulation what you discover is that the initial impact of passive is quite small all right the market seems somewhat indistinguishable you get a higher valuation than you've ever seen before as you go through the early stages of this and then you get a more dramatic decline in Pease than you pretty would have seen historically that seems an awful lot like what happened in the 2000 period right but then once you begin to approach 50% the system becomes totally unstable there's nobody to sell to you right and Pease can go infinite that's on inflows on outflows the solution set is the market goes to zero right there's literally nobody to buy from you this is a deep misunderstanding of the role of active management the current mantra propagated by boggle and others is the idea that active managers are paid to value securities you're not paid to value securities as an active manager you value securities so that you're prepared to provide liquidity if somebody wants to buy Apple from and an absolutely crazy price I'm willing to sell my shares of Apple because I've done valuation work that suggests they're paying too much for it if they're willing to pay way too much for it I'm going to synthetically create Apple shares by shorting them right that allows me to sell it to somebody even though I don't have the shares so I synthetically meet that demand when it begins to run wild on the other side of the equation if all hell is breaking loose and everybody wants to sell I'm prepared because I've done my valuation work to provide liquidity I'm willing to step in and give you my cash in exchange for your securities in order to functionally - in order for the market to work efficiently the active managers have to be large enough that in aggregate they can supply liquidity on those events and so the idea that we should be thinking about how much do we pay active managers so that they can be compensated for constructing DCs right and that we can think about let's lower active management fees to the idea to the point where they basically can survive and there's a few participants it's wrong it's just wrong if we get to 90% passive as John Bogle and others have speculated we can get to that means 10% of the market is going to providing all the liquidity think how much cash that 10% has to carry in order to fulfill those liquidity provisions it also has a really perverse impact and this is a little bit mind-bending but the current mantra in the market is the problem with active management is there's too many active managers they're competing away the profits bill sharps conservation of alpha they charge fees in excess of passive in aggregate their returns have to be the exact same as passive and therefore they're going to offer negative returns this is actually something very different is happening if my work is right what it's actually suggesting is that there's curvature in the return space if time becomes positively correlated with passive penetration and the features that I'm talking about what it creates is an upward curving it positively back surface alpha is a linear equation solution it's the be in a y equals MX plus B equation alright and again initially if we look at x 0 where there's no passive penetration your intercept is going to be against a horizontal line the historical returns are going to look just like the forward returns that's your hypothesis and therefore the Alpha that is created is value that is created by the active managers but if you create a positively convex surface over time that intercept is going to be forced lower and lower there's another feature that very few people realize when you look at this chart which is that your beta calculation is also incorrect alright because the beta is the instantaneous solution the derivative the first derivative of this curve not the slope of that linear line alright so what is happening is is that the beta of the market relative to its own history has increased dramatically there's empirical evidence that supports this this is the simplest form of looking at a hedge fund like return right so I'm what I'm looking at here is the rolling 5-year annualized alpha for call overwriting strategies by right strategies all right very similar to the return profile we have a very short history of the HF RI indices and their current incarnations you can see the red line down there this has been almost a monotonic decline right nobody thinks to look at buy-rite strategies and say what's the Alpha associated with them because this is crazy to think about it this way right you own the underlying security and you're selling optionality that has to deliver positive returns associated with it you're selling options against your portfolio that has to be positive but for this to turn negative what it has to tell you is that you're under pricing that beta all right the market has now introduced shape and convexity that means those options are all really cheap the exact same discussion we started with and we talked about the XIV Complex we're also seeing this in terms of the behavior of individual securities this is I love this chart because of the description on it right earnings day moves a 3.9 times as stock stock moving as an average day above the average of two and a half times over the past 20 years does that look like a chart that should be described as an average over that time period I think that's absurd what we're seeing here is a trend of rising volatility a rising fraction of volatility that occurs on fundamental events why is this happening please tell me who advantage art is paying attention to apples earnings report they don't exist on that day there's nothing in the instruction set for a passive investor that says reacts to apples earnings as a result roughly half the market liquidity disappears on those events right and you're seeing greater impact in terms of the volatility up why is this a problem well among other things as populations age as the baby boomers begin to hit retirement we should see lower equity allocations I'm gonna show you another slide this is actually from the San Francisco fed it's looking at the ratio of middle to old people it's basically saying who's buying versus who's selling what fraction of the population is buying and selling I don't think this is totally correct but the underlying feature is right we are going to see a wave of selling as the baby boomers and the pensions that were created around them begin to approach liquidation we're seeing this in many State and defined benefit plans that they've moved into liquidation 401ks are now moving into net liquidation that's a 14 trillion dollar asset pool that has grown from a hundred billion dollars in 1980 and today is now turning negative in terms of its net contributions there's more money coming out than going in this is why you're seeing the declaration that nobody's in this market flows are negative households aren't buying well they aren't buying their 75 right they're selling so they can buy cat food the crazy part is this is going to get even more systemic so this is actually from Vanguard they put out a report and again I apologize that it's difficult to see this the chart on the left says is age based equity allocations among Vanguard retail investors there's a report that they put out in May of 2018 and their point was some fraction of Millennials don't trust the stock market and don't buy enough right and so they're showing in the step function line the dark gray line this is the allocation that you would expect to see based on their target date formulations what they neglect to point out is is that the right side of this equation which looks at the average and median allocations for older people relative to their target date funds is literally a hundred percent too high right 70 percent of the assets are held by baby boomers so we are massively over allocated and then there's another chart to the right that shows you an even scarier thing Vanguard manages 1.8 trillion dollars in corporate pension plans and external sourcing fidelity has a roughly 5 trillion dollar platform doing the exact same thing this is a point of pride for Vanguard roughly 53 percent of the assets in Vanguard 401ks or I'm sorry 53 percent of the fund holders in Vanguard 401ks have a single investment their target date fund 53 percent and their goal is to get to 77 percent by 2023 right this is crazy we know exactly what these people are going to buy we know exactly what these people are going to sell we know exactly what their end holding allocation levels are going to be before they do it how is this an efficient market this is bananas up December 2018 the largest equity outflows in history two and a half times the levels that we saw in 2008 now the story in the street was this is tax loss harvesting right this is you know an efficient management what it really was was active managers being redeemed we didn't see outflows from passive managers in any meaningful construct and the four in the last quarter of 2018 what were we actually seeing we were seeing the first taste that the baby boomers retiring at the age of seventy point five you're required to take distributions from your 401k for tax purposes to tax deferred assets right we now have three years worth of baby boomers who are now 70.5 and they have begun to sell this year-to-date basis what do we hear if we look at positioning reports households our net sellers alright this is the retirement the baby boomers it was off in the future it's here now and the scary thing is is that they're increasingly holding these same passive vehicles that when they give the instruction to sell so far it's coming out of active and active has discretion I'll try to meet your redemptions with the cash I have available on hand selling the Securities is my second choice because I know it adversely affects my performance if I send that instruction set to Vanguard they don't Oh we'll conclude with another quote from Voltaire those who can make you believe absurdities can make you commit atrocities right the stories that we're told about passive are not true bill sharps conservation of alpha as assumptions behind it that are not true simplest one being there's no transaction in which your passive you don't need to buy or sell to get in and out of the market you just happen to be there alright well we've seen in the period from 1996 so I would argue roughly 2017 was them buying now I'm concerned that we're going to start to see what happens when they sell what's it any questions on flows you know it becomes difficult right you said because you're not really looking at valuations and what would be the type of sector for the next ten years when does that inflection point happen I think it's nothing we're already in it you think we're ready in it yeah if we go back to that so then what other milestones are we looking for well the for the theory to be correct right you would expect to see this sort of pattern of a somewhat linear decline in alpha you would expect to see this pattern of the markets behaving in a manner that is more correlated right so stocks that seem to have no underlying economic relationship with each other begin trading together right because they happen to be in the S&P 500 we're seeing all of this and now in the last six months we've seen one of the biggest declines on record on almost no fundamental news and one of the biggest rallies on record on no fundamental news right I mean we can decide that it's raw I mean I'm perfectly happy for the theory wrong and I agree that it can't be proven until it occurs in the exact same way that you know buying puts on the XIV or s vxy to be more accurate literally the stereos like what the hell are you doing this is completely insane all this thing does is go off right but the structure is rotten and those flows are gonna come out so what do you think about the copper bye bye bye because we see the buried hillside people continent selling what I wanted to go up or go down they are net setters but the huge amount of high back so maybe they the pool is shrinking in essence the question may not be is as much what they think about the fact of buybacks so I think that's absolutely right I think that there's two impacts of buybacks one is is that or three to be totally fair one is this that it's currently favourable to argue that buyback should influence valuation that you should be thinking about the combined return of cash in the form of buybacks and dividends and therefore that combined yield is quite high theoretically that's totally flawed right because dividends are actually very different their distribution to all shareholders buybacks are a distribution to a favored few those who are selling their shares cynically I would argue those are primarily corporate insiders right because what you've largely done in many of these companies is offset the float increase that's been created by grants to management but on a less cynical basis it's viewed as a tax efficient way to return cash to investors all right what it's really doing is influencing the market in terms of there is a ready and willing buyer to take those securities from you as you attempt to sell all right that's great for management pay packages by the way right but it is a return of cash the real concern is twofold one is that the structure of these buybacks are increasingly taking on a form whether it's in the form of accelerated share repurchase programs or in the form of automated ten b51 plans where the instructions are set up so that they behave as synthetic puts right it's very common for a 10 B 5 1 plan to have language that says something along the lines of if the stock falls below its 200-day moving average accelerate the purchases right well if I have to outlay cash when prices fall I'm sure to put and that's the supply of synthetic volatility and so if you go to goldman sachs and i don't mean to pick on goldman sachs they're just ubiquitous if I go to goldman sachs and i do we all like to pick on goldman sachs too but if i go to them and i say i'm going to have a corporate share buyback program what they actually do is they treat that as if you have sold them a synthetic foot and then they realize that because they're running a diversified platform of corporate share buybacks they've spread so much that actually gives them an inventory of all that they can go out and sell index of all right and so this is exactly what's happening this is the supply of all that is actually occurring into the market a sizeable fraction of it's coming from the corporate share buybacks but we need to be really concerned is eventually those are going to stop we will encounter a cyclical event in which corporate profitability deteriorates or credit event in which many companies are unable to buy back their shares excuse me and when that occurs we're gonna discover that this was a very Pro cyclical phenomenon I think it exacerbates the underlying dynamics there were a couple of questions here in what's the house we'll be over here just recently worlds of washing cash u.s. is two-and-a-half percent rates with a pretty decent currency and yeah its next biggest more in the world's China where you have a lot of restrictions of buying and selling and I mean it seems like how do you make sure that this form okay data matters because money keeps flooding here from all over the world and it doesn't feel like it's abating it doesn't feel like money's coming out of the market does it you tell me well so there is net money coming out of the market we actually do know that for a fact the question is how do we think about what is the dominant flow components right as it relates to the S&P 500 the dominant flow component right now is absolutely corporate share buybacks that's by far the largest share component this year it looks like it's gonna be somewhere in the neighbourhood of 900 billion dollars in terms of corporate share buybacks and talked about that a little bit in terms of money coming in from other areas around the world on net they're actually now selling from US securities so I'm a little bit less focused on on that dynamic 401ks as I indicated or selling pensions in aggregate or rebalancing away with one other interesting feature because of the feds reaction function we've introduced the idea that you can own bonds and own stocks and the bonds will hedge your equity position all right there's created another synthetic instrument which is that there's an embedded put in the ownership of Treasury bonds all right when you have a positive return vehicle like a Treasury bond that has a hedging feature associated with it you now have a positive expected return foot and your calculus changes in terms of your portfolio construction instead of owning 40% bonds 60% in equities you own a hundred percent bonds and a hundred percent equities you were on a levered portfolio on a Modern Portfolio Theory construction all right that's been an additional source of buying power and so I don't dispute that all of these factors have conspired to drive this type of dynamic what I'm most concerned about is that that leverage has actually taken the form primarily of just buying beta buying the S&P 500 right and has done so through either Total Return swaps or index instructions or futures right so we're all piling into the same thing it's actually an aggravation of the underlying feature yep yeah your phone this is Blackrock by the way right so the quick answer is we don't know exactly right if I flip back to this slide one of the things you'll notice is that baby boomers and older people have held more equities than we would expect them otherwise to hold right I actually think this is I think one of the things that worries me most is it the institutionalization of protocol professional asset allocation is going to encourage them to sell more than they otherwise might sell right so a target date fund is going to lead to net reductions and equity is relative to what we would otherwise have seen there's a variety of reasons why that is mostly in attention right you can also argue that there's a sizable fixed income allocation associated with things like Social Security that is not typically captured in the analysis right so in general if you're thinking about your own personal retirement you're using a target date fund to remember that it's not capturing the other fixed income components of your life whether that's a pension or Social Security if we begin to behave similar to target date funds all right it would suggest that as those baby boomers retire the quantity of net selling from the household sector is going to begin to rise precipitously last year is about a hundred billion dollars in net redemptions that came out some inflows at the start of the year lots of outflows at the end of the year on year to day basis we are negative somewhere around eighty billion dollars in terms of household selling I would expect that this year that rises to somewhere around two hundred and fifty billion dollars in total if you believe the demographic dynamics and they start managing in a more aggressive fashion and again the penetration of these target-date funds rise so each retiring cohort has higher penetration of these types of strategies the numbers exceed a trillion dollars by the time we get to 2023 right and at that point even if we're buying back 800 to 900 billion dollars and shares we're talking about net redemptions right now it's not positive because of the corporate share buybacks in the household sector yes a phrase a household and actually the foreign sector as well but I'm sorry what no that it's absolutely not true what if you so let's pretend we own stock eh all right it's currently priced in 100 bucks all right you sell it to me at a hundred bucks I agree with you you try to sell it and there's nobody to buy it from say you know what I'll bid 70 is there the same amount of money in the stock market that's the answer no no it's done the opposite for the reasons that I'm talking about it's gone the other way the convexity in the positive direction has raised the amount of money in the stock market relative to what we would expect under normal conditions I just thought I just wanted to ask you a little bit more about December yeah because we definitely got a lot of questions about December yep and from what what I've understood from your discussion December was sort of the tip of the iceberg in the sense of some sort of sense of us starting to see this type of behavior occurring how can you explain what's happened post then sort of with that the sort of reinforcement of passive rebuy as sort of regaining its strength after no and that's why the markets been going up so much since the beginning a year or what's your thoughts so some people have talked about some of the dynamics right I describe it as there's two different types of flows there's endogenous flows and there's eggs on Janus flows exogenous flows are money coming in and out of the market right endogenous flows are risk-taking within the market and what we saw in the four quarter was a combination of outflows particularly from active managers that by and large has exceeded their expectations and as a result they were forced to endogenously within their portfolio Steve risk right which created both eggs honest and endogenous negative flows and so the market sold off quite sharply post December 24th 2007 right what you've actually seen has been a significant re risking within the market and so others will track this quite well número does a good job of that Goldman does a reasonable job of that there's independent parties you can subscribe to their research that will track the behavior of things like CTA flows and so we've seen as we've seen a net re risking within things like the CTA a space of almost six hundred billion dollars off of the December lows and that's occurring in the context of what they buy or futures all right they're buying the Russell futures of the S&P futures or you know any number of other things that behave exactly like these index vehicles and so that's happened in the context the very creased liquidity and at the same time corporate share buybacks have been off the charts so I would argue the increased volatility that we're seeing around this is indicative of the features that I'm talking about but yes unfortunately I think the fourth quarter was the open it was a warning shot that great to start off warning this way I mean so it seemed that the implication is that for a lot of strategies for a lot of managers that used to be playing a valuation game but now markets are a flows correct game is that fair to say yes I think that's absolutely correct presentation why why didn't you address interest rates the Fed in some of the behavior the stock market in December and here today that's an entirely different presentation long story short interest rates if you correctly define what equities are right so equities are a long call position a short foot position a dividend receiving position in a secured rate position all right if you think about the two halves of that the call - the put right the interest rate relationship there is actually negative higher interest rates go the more valuable that portion becomes because the put has declined in value the call has risen and value the Delta between the two it goes up we're used to thinking about the right-hand side of the equation which is the discounting of the dividends right and so that goes down in a higher interest rate environment the reason why I don't specify interest rates is because it doesn't actually matter the relationship with interest rates and equity prices particularly risk-free rates is I would argue deeply misunderstood and we see this in the market they don't behave on the basis of interest rate so anything they actually trade in the opposite direction of interest rates that you would expect on a discounting basis for the past 20 years I think people under appreciate the fact that the only time interest rates become super relative relevant is if they get high enough that people say screw it there's no reason I'm going to take any form of equity risk it's a substitute asset asset as compared to a complementary asset so that's why I didn't just I don't think in this range interest rates matter at all anybody else okay thank you very much Michael thank you you

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Length: 46min 57sec (2817 seconds)

Published: Thu Jan 02 2020