Active Vs. Passive Investing with Michael Green, CFA
Are you curious about the impact of passive investing on the market and the importance of active management?
Michael Green, Portfolio Manager, and Chief Strategist at Simplify Asset Management, explains the difference between active and passive investing and talks about the potential risks of the increasingly passive investment market. He also talks about the concentration of investment choices in 401(k) plans and the benefits of active investing, and how this can impact asset allocation and risk tolerance.
Michael discusses:
- The difference between passive and active investing in portfolio management
- The impact of passive investing on the market due to unthoughtful contributions
- Potential risks of an increasingly passive investment market driven by investment advisors for all investor types including high-net-worth individuals (HNW)
- The importance of active portfolio management and the potential negative impacts of everyone moving towards passive investing for diversification, risk management, equity strategies, and wealth preservation
Get ready for an engaging conversation filled with valuable wisdom and practical advice.
Wendy McConnell: Hello, and welcome to The MCM Podcast. I’m Wendy McConnell. Now, today we’re going to be talking with Michael Green, a CFA, and we’ll be talking about passive versus active investing. Hello Michael, thank you for joining us today.
Michael Green: Wendy. Thank you for having me. It’s a pleasure to be here.
Wendy McConnell: Well, I hear you’re in Northern California.
How is everything in Northern California? I’m jealous. I’m in New Jersey.
Michael Green: Well, the weather is slightly better than New Jersey, but it has been raining non stop, which we’re thrilled because it’s refilling the reservoirs, but I have to admit, we’re getting a little tired of it at this point.
Wendy McConnell: The drought is over.
Michael Green: At least on a temporary basis, yes.
Wendy McConnell: Well, we thank you for taking the time to spend with us today. So you are a CFA. Tell me, what does CFA stand for?
Michael Green: CFA stands for Chartered Financial Analyst. It’s basically a designation that you earn for passing a series of tests that indicates that you’ve studied and understood the dynamics of financial analysis, not dissimilar to getting an MBA, you just did a course of study that was prescribed by the Financial Analyst Society.
Wendy McConnell: Okay, so is this like a college? Degree, like an MBA degree?
Michael Green: No. It’s a mail-in diploma that you get by sending off to the Grenadines. No, it’s a relatively prestigious professional designation, not dissimilar to passing the bar exam, for example.
Wendy McConnell: Gotcha. Okay. So it means you’re super smart.
Michael Green: It means that I studied, yes.
Wendy McConnell: You’re not gonna go there with the super smart, you’re not falling for it. Right. All right, so let’s start with the basics, Michael, what is passive investing?
Michael Green: Passive investing is a term that is typically used to refer to index investing. In other words, you’re trying to buy into the stock market by buying every stock in the S&P 500 in a single basket, or every stock in a total market index in proportion to its market capitalization.
The idea is very straightforward. If you’re not a professional investor, you shouldn’t spend your time trying to select individual securities. You’re highly unlikely to outperform. Therefore, you just want to participate in every security in proportion to its representation in the market, right? You want to get the market return as compared to something that ostensibly represents your skill as a stock picker.
Wendy McConnell: So it’s more about getting a bunch of stocks than just focusing on one?
Michael Green: The theory is that what you want to do is capture the return of the market in total, okay? As compared to the return associated with any individual or selected basket of securities.
Wendy McConnell: So then you would just be watching the numbers of the market as opposed to, oh no, this company went down.
Oh, yay, this company went up.
Michael Green: Almost perfectly described. That is the benefit of the diversification. It allows you to spend less time worrying about your investments.
Wendy McConnell: Okay, so what is active investing?
Michael Green: So active investing almost by definition, is anything that is not passive, right? So it is somebody who is trying to choose the individual securities.
It’s somebody who’s trying to evaluate the individual prospects for the businesses and determine do they think they’re going to get better or worse, and invest accordingly..
Wendy McConnell: Okay, so this is something like you should have bought Apple back when it was at $75 a share
Michael Green: I feel comfortable giving that advice in hindsight.
Wendy McConnell: In hindsight, yes. Correct. So where has each gotten it right and wrong in their portfolio roles over time?
Michael Green: So I cheated a little bit in the definition there, right? So when I described what passive investing was, I described what it’s supposed to be. There’s actually a more technical definition of passive investing that refers back to the academic literature, and this is where the ridiculous amounts of studying ultimately comes in.
The idea behind passive investing is simply, if you yourself can’t do the work, then you can piggyback on others who have done the work and by definition, a passive index of all stocks is going to reflect the work that has been done by all the active managers, if you simply buy in proportion to the prices that they’ve already set, you’re replicating their work or piggybacking on their work.
Right? So that’s the idea behind it. Now, with that recognition that you didn’t have to put in the individual work. There was also a recognition that that meant that you could offer these products at lower cost to the investing public, right? So this is the Vanguard revolution of low fee funds without an individual portfolio manager analyst who’s trying to pick stocks, doing all the hard work associated with collecting that information, and theoretically being paid for how well they’re doing the job of doing that.
So by sidestepping that, we were able to offer low cost products to investors. That’s a win for investors. There’s no question about it. The asset management community in general has been overly greedy as it grew in scale, its cost did not grow in proportion to that scale, and as a result, it became a very, very profitable industry that was ripe for the type of disruption that we’ve seen on the passive side.
With this type of investing. The challenge is that the theory of passive actually says a passive investor is someone who always holds every security, right? So they don’t trade, they don’t transact, they don’t try to pick stocks. They don’t say, oh, Apple’s earnings are gonna be better, therefore I’m going to buy more Apple, et cetera.
They simply hold their position. and the same analysis, the same theoretical framework tells you then by definition, any active investor is simply someone who is not passive, right? Right. Now there’s a problem with that theory. If the description of a passive investor is someone who simply holds every security, how did they get into the market?
How did they get out of the market? How do they put their monthly or biweekly paycheck into the market as part of their retirement program? The definition of passive investing says that you can’t.
Wendy McConnell: Right. It sounds like a technicality, Michael.
Michael Green: Well, it’s a pretty important technicality though when you really think about it, right?
Because if you actually think about what a market is, and market is not a series of prices that reflects value. It’s a series of prices that reflect where transactions happened, and when you put more and more money into passive vehicles, and by definition they have to transact to put that money to work, the market is increasingly being determined not by the transactions of the thoughtful investors who are doing the work. Is this a good company? Is this a bad company? Do I want this company to have more access to capital or should I punish it by taking capital away?
Instead, the market is becoming increasingly determined by the very regular unthoughtful contributions that are coming through passive investing vehicles. Today in the market because of the growth of these types of strategies, more than a hundred percent of the money that is going into the market is now going in in these unthoughtful uncritical approaches. So that’s changing the structure of the market meaningfully, it’s changing the information that is contained within markets meaningfully.
Wendy McConnell: So what is the challenge behind that then?
It sounds a lot like what you’re describing is the average 401(k).
Michael Green: Oh, that’s exactly what I’m describing. Okay. And actually, 401(k)s now by regulatory framework automatically default you into passive vehicles. In particular, they’ll typically default you into what’s called a Qualified Default Investment Alternative.
In roughly 85% of the cases in 401(k)s around the country now, that default investment is referred to as a target date fund. Target Date Fund attempts to balance investments between equity and bonds, international and domestic, but it only asks one question when doing so, how old are you? That’s the only question it’s asking.
It’s not asking, how well is the economy doing? It’s not asking what is the level of interest rates? It’s not asking is the stock market richly priced, or is it inexpensive? Are dividend yields high or low? [00:10:00] It’s simply asking how old are you? And on the basis of the answer to that one question, it’s making allocations for everybody who’s invested.
Wendy McConnell: So does that mean you’re not a fan of passive investing?
Michael Green: So what I’m not a fan of is crowding into strategies in any form. And I’m also not a fan of regulatory environments that are designed to herd people into a particular area. And that’s what we’ve seen in this situation. When you have a regulatory framework like we have with 401(k)s today, that shields corporations offering 401(k)s from liability if they offer low cost passive vehicles or target date funds, right?
And exposes them to liability if they try to offer allocations to the individual managers who are theoretically being thoughtful and helping to set the price of the cost of capital, the incremental reward or penalty associated with choices being made by management teams. If you flip that system so that it penalizes people trying to do that thoughtful job of capital allocation, you’re going to get exactly what we have, which is a market that feels increasingly disassociated from the underlying fundamentals. And that’s what a lot of my research and work actually focuses on, mechanically we can show that to be the case.
Wendy McConnell: Okay. So would you say that’s a misconception then with passive investing?
Michael Green: Hundred percent. That’s exactly what it is. It is a misunderstanding and a flawed framework for evaluating the process that is unfortunately leading to potentially catastrophic outcomes.
Wendy McConnell: Wow. Okay. So what is the biggest misconception with active investing then?
Michael Green: So the biggest misconception with active investing is that it suddenly has gotten very bad, right?
The people can’t beat the S&P 500, or they can’t beat the total market index. Part of the challenge there is the actual just definition, right? So most managers are not trying to beat the S&P 500. Most managers are trying to meet beat a much narrower focus. My portfolios that I manage, for example, will have benchmarks ranging from a bond equity mixed portfolio to strategies tied to volatility indices to fixed income portfolios, et cetera, right?
So I don’t care about the S&P 500 per se, I’m trying to exceed performance in a much narrower slice. The second issue though, that grows out of this is as more and more people crowd into one particular type of investing strategy, perversely, that has an exponential impact, that basically pulls it away from the pack on a short-term basis, right?
Imagine, we’ve all played that game. At the carnival where you try to shoot water into the mouth of a clown, that blows up a balloon or causes a horse to race across right? right. Imagine everybody focused, everybody playing the game, focused on one clown, what’s going to happen? It’s going to inflate very quickly and it’s going to look like all the other clowns don’t work properly.
Right. Okay. But what you’re actually seeing is everybody crowding into the exact same thing. It has nothing to do with the skill or capability of the individual managers. It has everything to do with the capital that is being allocated, and at this point we actually have a bizarre dynamic, where again, more than a hundred percent of the money that’s coming into the market is flowing in through these passive vehicles.
That means that all of the money is basically going in proportion to how things are represented within the S&P 500. There’s negative capital. In other words, money is being taken away from the thoughtful individuals who are trying to decide who are the next great companies? What are the overvalued companies, what are the undervalued companies, et cetera.
And the point of the market is actually to try to establish that cost of capital to try to reward or penalize companies that are making good choices or bad choices when you take that capability away, and actually what we’re doing now almost runs it in reverse, you get very perverse signals in terms of capital allocation, economic expectations, et cetera, and all of that becomes increasingly important because also in the last 15 to 20 years, we’ve seen policy makers like the Federal Reserve increasingly rely upon market-based signals for policy choices, right?
So if the S&P 500 is going up, theoretically that means the economy is going well. I think it’s pretty straightforward to look at what’s happening within the S&P 500 of markets fairly recently, you know, going into 2021, for example, and flip that around and say, Hey, wait a second. They weren’t signaling that at all.
That’s not what they were telling us.
Wendy McConnell: Okay, so what, how much active investing is there then compared to passive investing? You’re saying that it’s predominantly passive at this point?
Michael Green: So we now have more than 50% of the managed funds, the money that is actually being actively managed and excluding components like what is held by the internal founders of companies, et cetera.
I’m also excluding components that would be captured in some other sub-segments of the market. But all indications are at this point that well over half of the capital that is being managed in fund form is now being managed on a passive framework. What that fails to consider as well though, is the flow dynamics, right?
So because passive is quote unquote newer, it’s gaining share as it gains share, that means that more than a hundred percent of the new money that’s coming into the market is going into these strategies. Markets are set on the margin. It doesn’t care what happened in the past, it cares what’s happening today.
And so the behavior of markets is increasingly being determined in a purely autopilot framework, that’s changing the structure of the market, it’s exposing investors to risks that they’re unaware of, and it’s changing our policy decisions where we’re assuming that companies that are outperforming or that have done very well in the past are presumed to do so in the future.
Wendy McConnell: Interesting. What is the right proportion of technological analytics and human analytics in making investment decisions?
Michael Green: So it’s a great question, and the answer is there is no right proportion, right? There are just choices that you make along the way. Now, the analysis that I’ve done suggests that there’s actually value associated with passive investment that it introduces, if you think about it in terms of like a predator prey ecosystem, right?
Where there’s rabbits and there’s wolves, you wanna have a level of interaction that keeps both populations honest, right? If we wipe out all the rabbits, then the wolves will eventually die off. If we wipe out all the wolves, then we’ll be overrun by rabbits, right? What you want to do is you want to introduce limits on these types of behaviors.
My analysis would suggest that somewhere around 20 to 25% passive actually creates tremendous value in the market. It introduces players in the market that operate off of very simple algorithms, which is really the right way to think about a passive investment. A passive investment thought of in an algorithmic fashion, which means a rule-based fashion is simply saying, if you give me cash, then buy. If you ask for cash, then sell. Do I care about did the company reports great earnings? No, I don’t. Do I care if they reported terrible earnings? No, I don’t. Right? And so introducing that diversification into the universe can actually be very helpful and healthy in terms of lowering volatility, improving transaction efficiency, et cetera.
We’ve benefited from that for the most part , but now we’re crowding into an environment where effectively there’s too many rabbits, right? The ecosystem is being overrun, we’re not getting logical conclusions out of this. You’ll see this in the behavior of meme stocks, for example, which I’m sure will touch on, which were heavily influenced by the behavior of passive, right?
So when we think about a stock like a AMC or a GameStop, and we ask ourselves, who are the largest buyers of those? It wasn’t Roaring Kitty on Wall Street Bets, or in Reddit Wall Street Bets. It was actually Vanguard, right? For a brief period of time, AMC and GameStop each individually became the largest stocks in their small cap indices.
And as average Americans were simply contributing to their [00:19:00] 401(k)s, et cetera, those vehicles were buying those shares even as they soared in price, driving them even higher. That was a key example of the sort of behavior that we’re increasingly seeing in markets, and it’s a real risk that’s created by the dynamics of passive, right?
There’s also this question though, of how do we place these limits around it? How do we decide to do this? And part of what I would actually argue is that passive should in some ways be reserved for those individuals who, for no reason, you know, who are invested in markets with no insight whatsoever, don’t have the capability, don’t have the funds to do so, etc.
So should there be pension plans or should there be individual savings accounts that allow people to do that? Sure. Should there also be penalties associated with institutions that offer these types of products from growing too large and becoming systemically important in the same way that we think about too big to fail banks? In my opinion, absolutely.
And this is a key risk. Neither Vanguard nor BlackRock nor Fidelity North State Street, which are all now majority passive investing. None of them has been labeled as a systemically important financial institution. Even though when we talk about the assets that they manage, when we look at an entity like Silicon Valley Bank that just failed, that was roughly 200 billion in assets, BlackRock is 9 trillion, Vanguard is 8 trillion.
We’re talking about institutions that have become so large that they alone can meaningfully impact markets. through simple mistakes, simple allocation, choices, et cetera.
Wendy McConnell: So I’m trying to understand, because, you know, we’re encouraged now to contribute to a 401(k) in lieu of companies handing out pensions.
So what you’re saying is, it’s structured in a way that could make things dangerous in the future or are you saying that the fact that it’s being encouraged by governmental factors, uh, the reason that it’s so overcrowded? I don’t know if that’s the right word.
Michael Green: Hmm. So, unfortunately the answer is both.
Mm-hmm. Right? Mm-hmm. . So yes, this is being driven in part by the regulatory framework. Most people, when they get a job and they now get a 401(k), they typically won’t even spend a significant amount of time evaluating the investment choices for them. The 401(k) will be offered by the corporation. The corporation will offer a menu of choices, most of which are typically going to be target date fund exposures from a company like Vanguard, which has roughly 65% marginal market share, in other words, of each dollar that’s now going into the retirement accounts in America, Vanguard is capturing about 65 cents of every dollar that is now going in.
That’s extraordinary. That’s an extraordinary level of concentration on next dollar in. The second thing that’s happening in that framework is because of these types of strategies, because they’re all doing the same thing, it is leading to this overcrowdedness, and unfortunately that exposes us to significant risks when they change their allocations.
To me, one of the scariest statements that was made in March, as actually made in April of 2020, associated with the Covid crash and pandemic and fear in the market, was a statement that came from Vanguard that less than 1% of their clients tried to sell. Right now that sounds like a very thoughtful, conservative and important statement about consistency of investing and staying invested in markets.
My problem with that is, oh my god, what if it had been two? What if 2% of Vanguard’s clients had tried to sell? Because these vehicles have no capacity to provide their own liquidity, it’s exactly like Silicon Valley Bank, which when depositors tried to take their money out, they simply lacked the liquidity, the largest fund on the planet is a fund called the Vanguard Total Market Index. It’s roughly 1.6 trillion in assets across various types of investments. It has less than a hundred million in cash in liquidity, right? If they were to try to deal with a large redemption or a series of redemptions or retiring baby boomers withdrawing their capital from the markets, they’re simply incapable of meeting those liquidity needs.
Wendy McConnell: Isn’t that why they make it so it’s not easy to withdraw these funds?
Michael Green: That’s exactly, I mean, well that’s not exactly, but that certainly is true. Right? So 401(k)s have penalties for early withdrawals, et cetera. Simply in the time that I’ve been spending talking about these dynamics, they’ve also changed the withdrawal characteristics, so that you used to have to start making withdrawals at the age of 70.5. So 70 and a half years old, they’ve moved that to 72. Now they’re trying to move it to never, right? Basically protecting those who do not need their retirement assets, those who are extraordinarily wealthy, preventing them from ever taking their money out or from having to take their money out.
One that’s just a violation of the spirit of 401(k)s, which is you’re supposed to save for retirement, we defer the taxes associated with it, and then you withdraw it and pay the taxes as you go forward on that, right? Mm-hmm. If it becomes a vehicle for effectively shielding wealth for the 1%, which it increasingly is, that really wasn’t the spirit behind which we created the 401(k).
The second component that I would highlight on this is, is that the origination of the 401(k) was all about liability avoidance. In the 1970s, corporations had offered defined benefit plans and pensions in the traditional sense, suddenly discovered that they had under reserved for those liabilities that providing those pensions created their own risks, right? For the corporation itself.
We decided instead of the corporation being exposed to that risk and a professional manager of a corporate pension plan having to take responsibility for guiding the investment choices for employees, we decided to take individuals and say, that’s now all on you, right?
You’re responsible for picking out your investments. Well, unsurprisingly, most people are poorly prepared to make those decisions. And even those who are extremely well prepared are looking for ways out of the consequences of their own decision making, right? We’d all prefer to avoid liability if we can, and again, it leads us back to the same thing, everyone crowding into the same strategies, which is leading to markets increasingly not reflecting fundamentals, but instead reflecting the pressures of buying and selling in markets increasingly by people who are simply trying to mimic other people.
We’ve all seen these sort of crazy behaviors that happen in a social framework where people don’t even know why they’re doing what they’re doing anymore. They’re simply doing what everybody else is doing. That is a pretty accurate description of our financial system today.
Wendy McConnell: Okay. Wow. You are giving me a lot to think about and I don’t know if I like it, Michael.
Michael Green: Unfortunately, that’s part of the message that I’m trying to convey to people is that we should feel uncomfortable with these choices, because we know they’re untrue, right? We’d all love to pretend that there is a magic market ferry that delivers a certain amount of return regardless of the effort we all individually put into allocating capital.
But the historical returns of those types of indices, when we look at an S&P 500, et cetera, reflect an index that incorporated that thoughtful decision making and the choices that people were making along that. As we move away from that, we can’t expect that to continue to be true.
Wendy McConnell: So you are more with backing the active manager.
Michael Green: I think that it’s important for people to understand, one, what active management is actually attempting to do. We’re not trying to, per se, generate returns to pay for retirement, we’re trying to allocate capital to companies that are indicating that they’re likely to have good results going forward and take capital away from businesses that are incapable of generating attractive returns on an operating basis.
It’s presumed that those actions in turn, will drive prices as other thoughtful players make similar choices. We can have disagreements about them. I can make a choice that’s very wrong. Somebody else can make the right choice. The combination of the two of us is ultimately going to arrive, and what Warren Buffet has described as the weighing machine as compared to the voting machine of the market, right?
When everybody moves into passive, it simply becomes a voting machine. There is no weighing component to it.
Wendy McConnell: So how would you rate the impact of a manager’s selection methodology versus the selling methodology in long-term performance?
Michael Green: Well, again, I can’t speak to any one individual manager, but let’s go back to that carnival example, right?
What would you expect to happen to the individual who decides to deviate from the group and train their water gun on a different horse or a different clown balloon? They’re going to lose, right? By definition, because they’re not providing anywhere near the water pressure that everybody else is in concert, on that index, right?
That collective group. And as a result, that manager who’s trying to do something different, who’s trying to do what you’re expected to do or what markets are really about, ends up getting fired and their capital flows into the group, right? And that’s how this process is working. It’s very rare that somebody is making a super conscious choice that says, you know, gosh, this is the way I really want to invest.
My problem with it, I think it’s fine if you as an individual make that choice as long as you go into it recognizing some of the risks that you’re taking and the collective, you know, what’s referred to as the tragedy of the commons if everybody decides to do the same thing. When we go a step further and say that it’s increasingly being regulated into existence, the governments are providing liability relief for those who choose to go with passive vehicles as compared to exposing you to liability.
If you choose to go with active managers, then you’re putting your thumb on the scale to an extent that really becomes damaging to the system in total.
Wendy McConnell: So as we wrap up here, I’d like to ask you, what are your thoughts then on moving forward? What is the best direction for people to keep in mind?
Michael Green: Well, I think the most important thing is for people to be aware of these dynamics, right?
To understand that increasingly their retirement options and their retirement security is being outsourced to a market that is no longer functioning in the way that it has historically. Awareness of the problem is, you know, the lion share of the solution in many situations. The second thing to be aware of is that you’re being pushed into these strategies by the regulatory framework.
Look at your 401(k) choices. Ask your HR manager how these were selected, verify everything that I’m saying to you, and understand the consequences of the group think [00:31:00] type dynamics around this stuff and I assure you that all of these changes are being funded by lobbying expenditures by BlackRock and Vanguard and others that are involved in this space.
So, you know, the first part of it is be aware. The second part of it is to understand that we’re making a very significant mistake by relying effectively on the cudgel of liability to force people to make these choices. We need to remove those barriers from allowing people to make the choices that they think are appropriate for them as individuals, and we need to put taxes and penalties on firms that have become so large that they individually represent risks to the system. Vanguard, BlackRock, others have become so large that they individually represent risks to the system. If they try to tap into liquidity, if they face withdrawals from clients, you’re looking at a much bigger issue than what we saw with Silicon Valley Bank or a very similar dynamic of concentrated deposits trying to withdraw, created the crisis that we’re currently experiencing.
Wendy McConnell: Do you think that it’s smarter than to contribute less to say an organized program and go more into active investing?
Michael Green: I think that there are benefits associated with that, but I also recognize that I’m asking people to pivot away from the winning clown to a group of clowns that are underperforming, and I use the word clown intentionally there, right? I’m not suggesting that we should all break out the world’s smallest violin to play for managers who are struggling to make it in the market versus the S&P 500. I understand those dynamics. I encourage people to look up other speeches that I’ve given where I walk through the mechanics of this process and understand that much of what you’re seeing in markets today is a mirage about actual performance.
Wendy McConnell: Okay. Where do we go to get more information to hear more about what you’re talking about Michael?
Michael Green: So, the easiest place to go is to our website at www.simplify.us. We offer ETFs to individual investors that allow them to gain exposure to markets with some modifications that may reduce the risks associated with these types of events.
You can also look for me on YouTube. I’ve given many speeches on this sort of stuff. And you can find me on Twitter at profplum 99, which doesn’t look anything like me. Obviously this audience is not seeing that. But at P R O F P L U M 99, totally random and unintended that I have any sort of social media presence, but it is a place where you can find a lot of the stuff that I write.
Wendy McConnell: All right. Well, thank you so much for taking the time to spend with us today, Michael Green.
Michael Green: Thank you very much, Wendy. I appreciate you inviting me.
