Lead-Lag Live

Mike Green on ETF Innovation, Passive Investing Risks, and the Future of Alternative Assets

• Michael A. Gayed, CFA

Share episode

What if the world's largest investment firms aren't giving you the full picture? Join us for an exclusive conversation with Mike Green, Chief Strategist and Portfolio Manager at Simplify Asset Management, as we traverse the fascinating landscape of ETF innovation and competition. Mike shares his extensive industry knowledge and Simplify's unique approach to crafting standout strategies amidst the dominance of passive giants like Vanguard and BlackRock. Learn how recent regulatory changes, such as the 2019 ETF rule and the derivative rule, have paved the way for sophisticated investment products, and why the allure of active management is on the rise.

Discover the profound effects of passive investing on the economy as we explore how continuous inflows into index funds might inflate market valuations and create potential risks, especially as baby boomers retire. Mike delves into whether small caps and non-market cap-weighted indices could offer a more accurate economic snapshot. Plus, we discuss the current state of the IPO market and the spectacular rise and fall of SPACs, providing you with invaluable insights into the market's future trajectory.

In our conversation, we also tackle the complexities of debt, deficits, and modern fiat systems, emphasizing the importance of strategic borrowing and spending. Mike offers a deep dive into global GDP dynamics, with a particular focus on China and trade tensions. We also explore the roles of gold and Bitcoin as alternative assets, the mechanics of dispersion trading, and the current market environment. Finally, celebrate our podcast's growth with us, and stay tuned for upcoming sessions with more industry leaders. Thank you for your continued support and for being part of our vibrant audience!

The content in this program is for informational purposes only. You should not construe any information or other material as investment, financial, tax, or other advice. The views expressed by the participants are solely their own. A participant may have taken or recommended any investment position discussed, but may close such position or alter its recommendation at any time without notice. Nothing contained in this program constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in any jurisdiction. Please consult your own investment or financial advisor for advice related to all investment decisions.

 Sign up to The Lead-Lag Report on Substack and get 30% off the annual subscription today by visiting http://theleadlag.report/leadlaglive.


Foodies unite…with HowUdish!

It’s social media with a secret sauce: FOOD! The world’s first network for food enthusiasts. HowUdish connects foodies across the world!

Share kitchen tips and recipe hacks. Discover hidden gem food joints and street food. Find foodies like you, connect, chat and organize meet-ups!

HowUdish makes it simple to connect through food anywhere in the world.

So, how do YOU dish? Download HowUdish on the Apple App Store today: Support the show

Speaker 1:

My name is Michael Guy, a publisher of the Lead Lag Report. Joining me for the rough hour is Mr Mike Green. Mike, I know a lot of people have seen you over the last year or so, but introduce yourself for those who don't know who you are. What's your background? If you've done throughout your career, what are you doing currently?

Speaker 2:

Sure. So I'm the Chief Strategist and Portfol portfolio manager for a firm called Simplify Asset Management. We're about $5.5 billion in assets under management in various forms of ETFs that are particularly targeted at alternative expressions of traditional betas. So, for example, I run a high yield fund that offers credit protection. As an overlay, we offer a modified mortgage fund that uses current mortgages, so offering significantly higher coupon than the traditional mortgages, etc. My background I've been doing this for about 30 years Originally got started in the industry on the corporate strategic planning side with valuation work. That transitioned into asset management in the late 1990s, and I've run everything from separate accounts to mutual funds to hedge funds. So today I'm running ETFs and primarily focusing as a spokesperson for the firm and helping to facilitate the creation of products that we think can add value to investors' portfolios.

Speaker 1:

So we had touched on this a little bit in person, but I don't know if that many people are aware of what happened to the ETF industry that has enabled all of these new products, because it seems like there's so many more interesting and unique strategies than we've ever seen before. Maybe talk through that a little bit, because I think it explains why we're in this interesting environment for product selection and development. Sure.

Speaker 2:

So there were two primary changes that occurred in the ETF industry in the last five years.

Speaker 2:

In 2019, this was called the ETF rule, which facilitated the creation of ETFs, shortening the comment period, making it easier to offer ETFs that it had been under the traditional 40-act fund. That lowered the cost and encouraged a lot of new entrants into the space. The second big change was what's called the derivative rule. These are all creatively named I'm pretty sure they hired advertising firms for them, but the derivative rule facilitated the inclusion of derivative strategies within ETFs, which opened up the opportunity for many hedge fund-like strategies to transition over to ETFs, particularly for high net worth or private investors who are investing in taxable accounts. That makes them dramatically more attractive than the traditional hedge fund structure, in addition to benefits around liquidity, et cetera. From the investor point of view, there are unique challenges associated with that, but those two primary rule changes that occurred in 2019 and 2020 have been kind of the nexus of a lot of the innovation that we've started to see in the ETF space over the last couple of years the ETF space over the last couple of years.

Speaker 1:

Has that innovation resulted in better access to alpha generating strategies, or does that dynamic not at all matter, given that we're still in this sort of passive large cap only world?

Speaker 2:

I mean, I think it matters less because of the second impact that you referred to right.

Speaker 2:

So, for all the hoopla around the growth of active ETFs and again I'm incredibly appreciative of an audience that has been receptive to our products, allowing us to grow very rapidly towards that $6 billion mark and we hope to hit significantly higher than that but the simple reality is is over the you know, the four years that we've done that really three and a half years at this point that we have had that growth Basically every single day.

Speaker 2:

Vanguard is taking in an equivalent amount, blackrock is taking in an equivalent amount, so the dominance of passive strategies continues to grow. Ultimately, that creates challenges for anyone trying to manage in a mechanism that is any different than that approach. But we think it's incredibly important to stake out this space and to make sure that people understand some of the challenges associated with traditional investment in the event that that's going to change, and I think we're starting to see the first signs that there are some limitations being placed around the potential growth of passive. We'll see if that continues to follow through, but this is among the most exciting times I've seen in the investment management space from an active manager perspective where there may actually be a check on some of the growth and passive strategies.

Speaker 1:

You always have to think through sort of the space that BlackRock and Vanguard will not touch right, which I think River will certainly allowed access from an innovation perspective to do. Is there a risk that BlackRock and Vanguard suddenly start going a little bit more rogue and start competing more in the simplify space, start trying to create products that play with that derivative rules so that they can take some of that lunch?

Speaker 2:

Well, I think that's absolutely a risk, and we've already seen components of that right. Much less vanguard than blackrock, obviously. Blackrock's launching of the bitcoin etfs, for example, gives you some idea how interested they are in continuing to attract capital, right? I can't blame them for that, the um. The flip side to that, though, is that they are very much fast followers, and, as Eric Bakunas of Bloomberg has pointed out, you know, things that make a meaningful impact on our scale won't make any impact on theirs, right? So that means some of the more niche strategies things like high yield, etc. Where you can grow to be a billion dollar or two billion dollar fund. Those are, you know, relevant, but still are not yet, you know, yet quite under the eye of Sauron, as I would put it.

Speaker 1:

Arabel Chounis also, I think correctly says that in order for somebody to succeed in the ETF industry or is sure to succeed, they have to have a strategy which can have the occasional shiny object moment where it really stands out. Is it fair to say that if somebody wants to get involved in the ETF industry, that they have to create something which maybe plays with the tails of the distribution just to have a chance at standing out?

Speaker 2:

I think that's unquestionably true.

Speaker 2:

I think this is actually, unfortunately, one of the challenges, right?

Speaker 2:

So if you continue to allow the vanguards and BlackRock rocks to dominate the center of the portfolio, it is just a matter of time before they begin hunting in the other spaces. The part that most people don't understand about passive is that it's largely a distribution story, and so when you think about the dynamics of somebody getting a job, getting a 401k, which they automatically opt into in most jobs in the United States today, they're automatically assigned to a passive index provider, typically through a target date fund. That makes it infinitely harder for anyone else to compete for that space. Right so you're automatically assigned off to a subset of the market, and that in turn, means that there is no real challenge to the allocation methodologies that are being used by the vanguards and black rocks of the world and heavily influencing not just the actual market price behavior but also the ability of companies to raise capital, to exit from a leveraged buyout, private equity type transaction to obtain liquidity. Those are all becoming bigger and bigger problems, even as markets basically sit at all-time highs.

Speaker 1:

It's actually a good transition to a question off of YouTube I'll share here. Question for Mike for an index fund sell-off what would make people sell? So you've got these automatic flows? You and I have talked about this before. I call it structural insanity. You just alluded to it before. What would cause some of that to reverse?

Speaker 2:

Well, that's one of the amazing things. It's actually built into the system that they will ultimately have to start liquidating. And this is part of what I flag for people. When you think about the behavior that is caused by money flowing into index funds, there's a ton of empirical and, at this point, academic research that demonstrates part of the implication. There is that prices and valuations rise over time as passive becomes larger and larger. That behavior actually sets up conditions under which, as valuations rise because withdrawals are always a function of asset value and contributions are always going to be a function of income levels You've got a condition under which the system has its own unwind embedded in it. Right, the most extreme version imagine PEs went to 10,000 times right. Each contribution would buy an infinitesimally small part. Each withdrawal would actually be significant relative to the contributions. Once those flows turn negative under that type of framework and it can simply be tied to the retirement of the baby boomers or, more accurately, it is likely to be tied to economic conditions that lower contributions and increase withdrawals Under that type of a framework once they begin to sell, it then becomes a question of is there anything that stops it in the opposite direction, other than valuations get low enough that that process begins to reverse.

Speaker 2:

This is one of these things that I think people tend to have underappreciated, because so many of the institutions that we take for granted things like 401ks or IRAs. They seem like they've been around forever. They really only emerged in the 1970s, at the start of the bull market that began in roughly 1982, they were each only about $100 billion in size. Today, iras, I believe, are about $17 trillion. 401ks are about $7 a half trillion. These are the two largest pools of assets on the planet and they are increasingly being managed in this systematic and formulaic method that unfortunately raises valuations as money flows in, gives the perception that everything is fantastic, and then, once withdrawals start, you begin a process of unwind in which it feels almost like the exact reverse. Right, but if we start to experience withdrawals, it will look like we can't do anything. Right, right, what could we get to get markets to go up? The answer becomes it becomes very, very hard.

Speaker 1:

Isn't the implication of that that we've moved away from the market being a leading indicator to maybe much more coincidence, right, If it's just based on income and basically employment to that extent?

Speaker 2:

Yeah, no, I think the evidence for that is actually remarkably robust. I wrote a sub stack on exactly this topic, called leading lambs, in which I evaluated the leading nature of the market. Historically, you would be two-thirds of the way through a bear market associated with the declaration of a recession Starting in the mid 1990s. That simply ceased to be the case, right, and so we've actually seen what has been perceived as a leading indicator turn into a coincident or even lagging indicator, since it's often tied to the level of employment the level of employment.

Speaker 1:

I wonder if that means that maybe non-market cap weighted indexation ends up being a better true reflection of the future state of the economy. And really I'm talking more small caps there, because small caps are not a default option among the 401k plans. Is there something to the idea that maybe large caps are more coincident but the real leading part of the marketplace is actually the smaller end of things?

Speaker 2:

Well, we continue to see small caps behave as if there's a significant active manager presence and there is. They tend to overweight those names. The problem is, what we're seeing in small caps actually is also indicative of that type of behavior, where we've moved away from portfolios that would allocate, say, 10% to small cap value because of a history of outperformance. We've now moved to things like a total market fund that allows those small caps to change radically in terms of what their allocations are. Right. I mean just mechanically. If you were to think about what would happen if every single person agreed we're going to put a 10% allocation in small caps, mathematically they'd have to be 10% of the market. We used to be a lot closer to that. Today we're in an environment where we've shifted dramatically towards things like total market funds. That means there is no limit to how small these small caps can get relative to large caps.

Speaker 2:

Same thing, by the way, is true in international funds, where you'll often see a target aid fund will have an allocation to international versus a total market fund in the United States. In their use of passive strategies they will then allocate domestically X percent and internationally a much higher percentage than you'd see in the United States. Those allocations are typically a function of market capitalization. So again you remove the fixed component of allocations and say we're going to send 10 to 20 percent or 30 percent of our allocation to this different country. It actually perversely causes US markets to rise faster than international markets and this has been a contributing factor to the underperformance of international stocks, has been a contributing factor to the underperformance of emerging markets, etc.

Speaker 1:

Anything that you've seen that suggests it has implications on the IPO market, it seems like the incentive may not be as high as it used to be. If you are a small company and you want to go public, and if you're just at the mercy of the market cap weighted averages, maybe it's not really worth going public.

Speaker 2:

Well, I think there's two separate components, so it's actually quite interesting. Marco Salmon, who's a professor at Harvard who I collaborate with an awful lot, he actually just came out with a paper today that was just released, talking about IPOs and the impact of passive vehicles. In particular, he looked at the SPAC dynamic that occurred in the 2020 to 2022 time period, which SPACs which have been around forever, I think is the technical term for it suddenly caught fire. We saw an incredible amount of money raised through SPACs, a lot of it going to very dubious companies of very low quality, but this was the path for many venture entities to get public. It was the path for many private equity firms to try to list stuff in the past couple of years. Those rules were changed in 2022.

Speaker 2:

And since that point, we just have seen a complete disaster in terms of the IPO market. It has been very difficult for private equity funded vehicles or for venture funded vehicles to create liquidity events. That, in turn, is then being raised as an issue for the forward looking performance of financial markets in a variety of ways, but I would argue that most people are still not really paying attention to this. They struggle to connect the link between US equity markets at all-time highs and underperformance in IPO markets versus expectations. I actually put out a tweet on this in response to a Richie Handler who's the CEO of Jefferies tweet in which he highlighted the IPO market was open right, and it's most definitively not open. It's radically underperforming expectations, even as equity markets public equity markets have dramatically outperformed expectations.

Speaker 2:

The reason for that is to get a company public, you have to engage the active manager, right. The passive manager does not actually buy an IPO. They can't buy it under most index construction frameworks for six to 12 months after the IPO has occurred. In order to get the underwriting in the IPO out, you have to have the participation of active managers. Well, if you're firing all the active managers, by definition they're quite weak hands and, as a result, they have a very hard time deviating from their benchmarks. That means that there's really no support for the IPO market.

Speaker 1:

I want to switch gears a little bit to two of the panels that you and I were watching at Camp Butok, right? So the one on MMT and the other one which was on debt, deficits and defense. You got a little bit heated, I would say, maybe, in terms of some of the back and forth that was being said by the panelists. This point about debt mattering, deficits mattering or not mattering to me I think I didn't say it during the actual gathering, but it struck me that I think it missed an important discussion point, which is to say that if one way is to say that debt doesn't matter and deficits don't matter, that implies that a widening wealth gap does not matter. Wrong, that there is a link between debt, crony capitalism, widening wealth gap, and I'm pretty sure the history of human nature shows that the wider the wealth gap is, the more likely there is to be a revolution, Maybe a little bit dramatic, but I'm curious to hear your thoughts on the interaction of debt deficits and the societal framework.

Speaker 2:

Okay, so a couple of points I would raise there. One debt is just a tool, right, it's an asset for somebody and it's a liability for somebody else, and so the idea that debt is good or bad is always going to be a function of the context. The concerns around this idea that deficits don't matter, of course they matter, right. It means that we are spending more than we are taking in and we are being forced to borrow to effectively soak up the liquidity right, to tie up the dollars that would otherwise be used for consumption purposes. We have to offer an attractive enough picture that a subset of the market has to decide. I'm going to defer my current consumption or investment plans in order to facilitate the government spending money as it sees fit, right. So you know, it's really important to understand that that's all debt really is is a liquidity maintenance tool that can be used by a sovereign government, at least under the framework of modern fiat systems, in which it's somewhat silly to think about the US defaulting in US dollar terms to steal from the Bitcoiners. One dollar is always one dollar, but this idea that somehow or another deficits don't matter is, I think, equally fallacious. Right, anytime that you're entering into a forward contract that says I have to return dollars at some point in the future with a set premium that we call the interest rate. You have to consider what are the investments that you're making that will facilitate the creation of wealth such that it's not dilutive going forward? I think that's a big chunk of what's missing from the discussion is how are we spending the money right? If we spend it on hip replacements for 95-year-olds, while that's certainly a positive benefit for the 95-year-old, it does almost nothing for society and, in fact, actually creates a call on resources that means they're not available for other purposes. I think that is often lost in the dialogue, right? The second component is if that money is spent on productive resources, right? So are we building infrastructure that allows more connection and allows people to, at lower cost, transit goods and services to other locations? And to emphasize that infrastructure can include things like communication networks, it can include ports, it can include roads, et cetera. All of those things ultimately add value to the overall economy in a way that transfer payments of income really don't. Right, and because we don't think in capital budgeting terms for our government, we often forget that right, we're dealing with a lot of immediacy. The money has to be spent now. Here's how we have to spend money to support X special interest group within our society.

Speaker 2:

Its matter and this was my frustration at Camp Kotak often fall down into these kind of dialogues of well, of course it matters, right, and this is just absurd and it's a caricature of what MMT is actually saying. I think, unfortunately, mmt is the framework for which money is created and debts are settled. In the United States and in most modern economies, it really becomes a question of do we trust representatives that we have elected to serve in government with how they choose to allocate those resources? And I think most of us would say we actually have a high degree of confidence that they're not doing the best job possible of allocating those resources. And I think the easiest example for me on that would be something as straightforward as a switch from transfer payments that supported the less well-off in our society, that supported those who needed to have additional resources put forward to the care of their children, whether that's in the form of daycare solutions or whether that's in the form of nutrition support, to an interest rate policy that is doing the exact same thing, but simply transferring it to people who already have resources Right.

Speaker 2:

So it becomes this kind of important discussion around how do we choose to spend the money, much more than can we actually spend the money, and I think that you know that a lot of times that gets lost in the kind of immediate dismissal of well, mmt is craziness, right? No, mmt is a factual description of how the system works, but it tells you nothing about how you should spend that money, and I wish we were spending a lot more time on discussions about how we want to spend that money rather than discussions around. Isn't this silly? Shouldn't we just go back to a system like the gold standard?

Speaker 1:

But I guess that's my point how we spend that money. There's always going to be misincentives in terms of where that money is spent and then who it enriches. And that goes back to the point about widening wealth gap. And at some point there's some breaking points. The wealth gap naturally widens in any capitalist system. The question is, how far can it go before there's real frustration and anger that actually results in actions?

Speaker 2:

I'm not sure that's entirely true. I mean again when you say naturally widens. It's just a function of how you've chosen to establish your taxation system. So if you run a regressive taxation system, as we often do in the United States, in which the majority of taxes that are collected are tied to something like unemployment rather than income in the corporate sector, which is where the majority of high net worth individuals are actually drawing their resources from, then absolutely you'll create conditions under which you concentrate. Well, if, instead, you acknowledge that what you're trying to achieve is not a quality of outcomes but as positive an environment for capitalizing on human capital, giving children the opportunity to have the resources so that they obtain the appropriate education, that they're given the right guidance, that they're given the skills that will enable them to succeed in a modern economy, that's going to have a very different impact than if I paid for paper placements for 95-year-olds.

Speaker 2:

And the lack of consideration of those two, when we actually have the information available on that, is extraordinarily frustrating to me. It's somehow perceived as responsible to hike interest rates, to the point that the US government is now spending more on interest rate policy than it is on servicing debts, than it is on almost any other form of spending Strikes me as just absurd, right? I mean, we radically underinvest in this country into young people. We don't think about our budgeting system in an appropriate way. I often, you know, highlight for people that the US has the world's greatest business model.

Speaker 2:

Lots of other countries will raise children, they will give them a you know, incentive to succeed, the tools that are necessary in education, nutrition, healthcare, et cetera, and when those people actually hit an age of maturity and they realize that they want to succeed at a much higher level, they pick up and move to the United States.

Speaker 2:

We don't capture those trade flows, right, we did in the 19th century, when it was unfortunately tied to human bondage, but we don't talk about those trade flows in terms of how that impacts the resources that are available to the United States. We do track things like imports and exports, which are actually quite minor. The United States population has exploded over years and years and years through the addition of skilled and unskilled immigrants immigrants that enhances the endowment of the United States while subtracting it from the endowment of everybody else around the world whose business model can basically be thought of. I create successful human beings and then they leave and stop paying taxes. To me, I would much rather have our business model, but I'd like us to actually be thoughtful about what we're trying to accomplish with it.

Speaker 1:

All this makes me think a little bit about Japan as well, right From how we spend capital, how they spend capital relative to how much debt that they have versus us. I'm curious to hear your thoughts on MMT as it relates to Japan in particular, because if Japan's volatility dynamic isn't done, there might be some things we can learn from what's gone on for many years there.

Speaker 2:

I think there are things that we can learn from them, but I think a lot of the lessons we're choosing to ignore, right? So you know I've been very active in highlighting for people that I'm not particularly concerned about the inflationary pressures that many people had highlighted no-transcript. You know my complaints about that is that it's just empirically untrue, right? The real lesson that we have from Japan and now from China is, anytime population growth and, more importantly, labor force growth slows dramatically, you're going to see disinflationary pressures that are simply a function of demand not being expanded because of the addition of people, right? Just mechanically, think about what happens to things like a labor capital ratio. When your labor force begins to decline, your capital ratio begins to rise. All else being equal, that means there's less demand for many of the products, particularly capital goods, that you might have otherwise had under a positive population pressure.

Speaker 2:

And this is one of the things I think people are really broadly ignoring is that the world has shifted from the 20th century model, which was explosive growth in labor forces relative to history, to a 21st century model in which there's very little labor force growth and, in fact, negative labor force growth across much of the developed world. All else equal. That is, a disinflationary and deflationary pressure on many of the things that we take for granted, that there's growing need for right, real estate, et cetera. All of those face conditions under which you would expect to see a much less inflationary environment in the 21st century than we saw in the 20th century, which was truly unique in world history switching gears just to bring up another youtube question here.

Speaker 1:

Uh, from for real, uh. Question for mike. Don't target date funds incrementally, sell stock and allocate the proceeds to purchase bonds the older the participant gets? Why haven't passive flows kept bonds as big as equities?

Speaker 2:

so that's a great question, and the answer actually boils down to part of the ipo statement that I was making before. Here in the united states, we've actually shrunk the quantity and the shares of equities that are outstanding, even as the demand has begun to taper off from things like target date funds tied to the aging of our population. On the flip side of that equation, we've actually seen a tremendous amount of issue and increase in the market capitalization of debt, and so when you have an entity like a target date fund that maintains a fixed allocation between those two, if I shrink the quantity of equities, I have to bid up the price of equities in order to keep their market capitalization consistent with that of bonds, and we've actually seen this. There's been a remarkable consistency in the relative market capitalizations of debt and equity. That's very consistent with this fixed allocation model.

Speaker 1:

I think that's very well articulated. I want to share the more recent substack on the screen, the dispersion diaspora, and I want to focus on this point about China for a bit, because there's a sentence in there which sounds a little dramatic, and I am usually the one that's known for being bombastic on writings and social media the rest of the world will not absorb China's domestic excess capacity, and the unwind has the potential for a Great Depression-style event centered in China. Let's talk about that. China certainly has been struggling for some time still the second largest economy and I myself think that there might be some hope that China's economy may have stabilized, or maybe we'll see not necessarily picking up, but at least the markets seem to be stabilizing.

Speaker 2:

Leo, your thesis on China here I mean China, like every other country in the world. Its GDP is a function of the number of workers it can bring and the quantity of goods and services that can be produced by those individual workers. We often talk about things like GDP per capita. That's actually an incorrect ratio, right? Because ultimately, gross domestic product can only be produced by workers, and so what you should be tracking is actually GDP per worker. When you do that on a global basis, you see a very consistent relationship. Certainly, in the United States it's been only really influenced by changes in the ways that we think about inflation, so changes in inflation methodology have influenced that, but throughout the 1960s, 1970s, 1980s, et cetera, we've seen fairly consistent growth in those numbers. Same thing is true for China, right.

Speaker 2:

China is ultimately limited in the potential growth of its economy by the number of people that it can actually bring to that table, and one of the things I think is actually very transparent at this point is how magnificently China's GDP is overstated, given the fact that it now has a negative labor force growth number. They continue to gain in productivity, but we've seen no element of that transferring to China in terms of increased consumption capacity. In fact, we see things like retail sales, et cetera, behaving much more like you would expect them to in that environment relative to the officially reported GDP, because they're using their labor to increasingly try to generate internal resources that can be used by the CCP. By exporting those for hard currency that can be used for the CCP, by exporting those for hard currency that can be used for purchasing everything from energy to investments in semiconductors, et cetera. They really have to be done in something that looks like a tradable security.

Speaker 2:

China's GDP is inherently becoming less and less focused on its domestic demand and in the domestic capability this is not dissimilar to Japan, by the way and increasingly focused on basically forcing the rest of the world to absorb the excess production that's coming through. That's not at all dissimilar to what transpired in the United States in the period leading up to the Great Depression, where our export numbers became so large relative to the rest of the world that the rest of the world was simply unwilling to absorb them. We introduced trade tariffs in an attempt to effectively choke off additional supply that was trying to come to the United States, particularly as the rest of the world began to rebuild from the aftermath of World War I. That set off the dynamics of the trade deterioration in the 1930s, and when you have that type of trade deterioration, people tend to think of it as inflationary and it can be in the importing countries, but on a global basis. You're now talking about robbing income from China, which means things like commodities et cetera are going to see downward pressures as well, as future productivity gains in China are likely to be transferred to the rest of the world in the form of lower prices, where they capture less of the tariffs than they otherwise might.

Speaker 2:

This environment of excess production is really what the 1930s were all about. We had an extraordinary explosion in productive capacity that did not match up against the world's capacity to buy it, because so much of it occurred in the 1920s on the basis of debt. That's not meaningfully different than what we've seen in terms of the increase in US indebtedness in response to our decline in productive capacity relative to China's. When we buy something from China, if we're not earning that income ourselves, we have to figure out ways of financing that. That's what debt on the consumer side really is, and we've seen a lot of evidence that that has begun to hit limits that are suggesting the demand for China's goods and services around the globe is going to face pressure from both tariffs and closed markets and, candidly, the decline in demand that's coming from China itself that's coming from China itself.

Speaker 1:

How self-aware do you suspect China is when it comes to all that? Because, yes, on commodities, sure there's not the demand, but China is a pretty big importer of gold and gold's been clearly acting very differently than copper, for example.

Speaker 2:

Well, I think the Chinese themselves are increasingly aware of this right. I mean, the only mechanisms that existed for them to invest were either through their domestic markets or through money laundering activities to get the money offshore things like sending your student to the United States for an educational purpose and buying a building so that they would have a place to quote unquote stay while they were here. You know, those markets are increasingly shut off to China. That really leaves things like gold I'm not convinced that it's coming as much from retail in China, although there's certainly some evidence of that as much as it is that the US behavior, particularly around Russia, in which we raised a very real risk associated with buying US treasuries, is forcing many of these countries to say we got to figure something else out.

Speaker 2:

Gold is effectively a non-investment right. It's a way to put money into something that theoretically, is nobody else's liability. Having it seized by the US government is far more problematic, and I think we just see a lot of evidence for this right that the world is basically trying to figure out. How does it operate in an environment in which the global hegemon, the United States, is not a munificent hegemon saying oh everybody, welcome on board. It's increasingly saying to a subset of the population you can't play at my basketball hoop or you can't play in my game. That causes the rest of the world to try to figure out places to put the capital that they're generating, because China continues to run record trade surpluses with the rest of the world as they do more and more, transferring of their domestic capacity to effectively try to raise hard currency to supplement the need for resources from the CCP. And that can be resources in terms of domestic. It can also be resources in terms of prosecuting a war going forward, which is the growing fear.

Speaker 1:

I thought that was supposed to benefit Bitcoin and not gold. Yeah.

Speaker 2:

I mean look, bitcoin is a mechanism or a tool that facilitates money laundering. I know half your audience is going to explode at me on that.

Speaker 1:

My audience thinks that Bitcoin is not a store of value as well.

Speaker 2:

Yeah, all right. So I mean, look, the simple reality is is that Bitcoin began as a payment system. It was adopted heavily by criminal elements because it allowed you to skirt the components of the banking system. The challenges of gaining on ramps and off ramps to the banking system was very. Challenges of gaining on-ramps and off-ramps to the banking system was very clear for Bitcoiners for an extended period of time, with lots of fraud around those types of dynamics. Now, in a kind of perverse way, you've seen more and more adoption of the potential to treat Bitcoin as a speculative asset and profit from it. That's removed some of the restrictions associated with it. But the real benefit to Bitcoin was that it allowed you to use subsidized energy production in China to create a global commodity that could be sold internationally with very little influence from governments on everything from KYC know your customer to various other money laundering attributes, and it's been unfortunate for me to see that we've adopted that within the public markets. I'm not all that surprised that people have tried to capitalize on the desire to speculate in that fashion. But it is very different.

Speaker 2:

Gold actually can work as a currency backing because gold does respond to human ingenuity If we see the price of gold go higher. That stimulates production of gold. It stimulates new technological innovations. That's really what a lot of the story of the late 19th century was. As we changed the technology around gold production, we dramatically increased the quantity of gold that could be produced. That actually allowed the gold standard to last longer than it otherwise would have in the presence of explosive population growth. Bitcoin doesn't have that capacity right dynamic and its adjustable hardness difficulty component effectively means that the issuance schedule of Bitcoin is perfectly fixed and remains perfectly fixed. That's actually very undesirable for a currency. Currencies need to have a flexible component that responds to increases in the price of the currency by encouraging production of additional backing for that currency. The gold standard has that. A Bitcoin standard does not and as a result, it's totally unworkable to think of it as a reserve asset.

Speaker 1:

I'm going to go back to that substack, the dispersion diaspora, and talk about the second part of that, which was the big spike of 65. And you and I were actually. You were talking about it with somebody else and I was intrigued by what you were saying at the time, so I want you to expand on it From that sub stack. However, the big spike was unlikely to be a precipitating event. This was the unwind of the crowded in quotes. Dispersion trade, a basis trade like any other. The discussion covers the implications of rising implied correlation of all the US markets. First of all, explain what the dispersion trade is and let's talk through the mechanics of what happened on August 5th.

Speaker 2:

Sure, I'm trying to remember if August 5th was the actual date, but Monday I think it was. Yeah, okay, so the dispersion trade is a form of index arbitrage. Right, it's a basis trade. That basically says I can buy a call option on the S&P 500, or I could buy a call option on a market cap weighted recreation of the S&P with each of the individual components. Now there is actually a substantive difference when you think in option terms, because if I buy call options on every single name, option terms, because if I buy call options on every single name, I can have a single name that gives me a hundred times return. That justifies everything else that I invested, while if I did that in an index, that could happen on a small company and have very little impact on the index itself. And so the relationship between the pricing of the replicating pool of options on the individual names and the price of the index option is what's called implied correlation. The higher that implied correlation, the closer the pricing of the index is to the underlying, the lower the pricing of that implied correlation Effectively, the greater the diversification benefits and the less likely it is that the behavior of that index option mimics the behavior of the individual pieces that are built, it typically would have much lower volatility.

Speaker 2:

What we saw in the last couple of years was the growth of the dispersion trade in which people said, hey, wait a second, why would I want to own every name in the index when I can simply own Nvidia, apple, microsoft, et cetera? I can buy call options on those names and sell index volatility and I'm protected because there really is no mechanism for the index to advance in a meaningful fashion if these names don't move forward. So that created conditions under which it was very attractive for people to sell index volatility and buy the volatility on the single names. That trade became very crowded and we saw that trade alongside the equivalent, what's called Delta one, the cash equivalent position, where many hedge funds were long MAG7 type names and short, small caps, to quote unquote neutralize their market exposure while giving them access to the outperformance of the single names. The dispersion trade is just another variant of that, using derivatives to express the same trade. When you express it through derivatives, you have an additional variable, which is the relative pricing of volatility amongst those two components. Remember, I'm long single name, typically call options and I'm short the index against that.

Speaker 2:

When you have an event like the unwind of the Japanese yen's carry trade that causes implied volatility to begin to rise and for people to seek protection against a drawdown that causes index volatility to rise relative to the single names that implied correlation pricing went from, I believe, going into the event. We were about 25% implied correlation. At one point I believe it was around 8.25 AM on August 5th the implied correlation of deep out of the money S&P puts rose to 240%. Now, remember, correlation can't go over 100%. So all this is telling you is that there was forced buying of the index volatility positions and, to a much lesser extent, likely selling unwinding of positions in single names. Right, that implied correlation was the footprint that basically says here's the guilty party.

Speaker 1:

So the reverse character was a catalyst for that unwind and usually when you have a VIX spike like that, the immediate thought is it's over and we're not going to see something like that for some time. And we've seen the VIX obviously collapse since then. But if this was more of a it's called a structural type of dynamic because of the dispersion trade, do you think that holds true, that that was it, that we should treat that VIX spike like any other, where it was the buying up theory, or is there something unique to the way that that played out?

Speaker 2:

No, I actually wrote about this and that's part of what I was saying that this is unlikely to be the precipitating event. Right, this was very isolated to the volatility space and it was tied to an unwind of a particular trade, with lots of market participants heartened by the behavior that emerged after that. Right, once those positions are covered, there's no more losses. Right, and this is again one of the features that we have in a market that is increasingly focused on short-dated options. One of the key differences going into the global financial crisis is that you had a ton of activity around long dated derivatives. Right, and you can understand both aspects of that.

Speaker 2:

Theoretically, long dated derivatives behave much more like the underlying. If I looked at an environment in 2006 or 2007, you saw lots of 10-year variance trades where people would be selling long-dated protection on the S&P 500, arguing that that was going to behave over time very similarly to the S&P itself. A big chunk of what transpired in 2007 and 2008 was the unwind of those trades. But when you enter into a 10-year derivative contract, you're running a risk that there's a very fundamental reappraisal of what the risks are over the life of that contract. If you sell a one-day option, you can get absolutely hammered on the delta move, but it's unlikely that you're going to get hammered on the volatility move.

Speaker 2:

Right, it's a very different component. A single day option has very low vega component to it. It has an exceptionally high gamma component to it, which means the change in delta of the option for the change in the underlying. That's a very different trade than what we had going into the global financial crisis. And again, if you think about the global financial crisis, it really was about long dated instruments going awry. You could make the same argument, by the way, around Silicon Valley Bank right, long dated instruments going awry. Those are much more traditional sources of market corrections and unwinds and kind of the short dated component. I like to refer to zero data, to expiry options as playing Russian roulette. Right, you can't have a mass shooting with Russian roulette.

Speaker 1:

Is there any evidence to suggest that that dispersion trade is suddenly crowded yet again? I mean, it seems like we've kind of gone back to the prior spread trade large outperforming small.

Speaker 2:

I mean anything that suggests that we're back to where we were pre-July, I had actually heard that around 75% of the dispersion trade was unwound. However, we've seen the exact same behavior that presaged its arrival. In particular, if I look at things like low delta call options, we've seen single names significantly outperformed the index. The implied correlation on that 10 delta call option has now fallen to kind of the sixth percentile overall history and the first percentile in terms of the last several years. That tells me that people crowded right back into the trade.

Speaker 1:

That seems a little ominous, that seems a little ominous.

Speaker 2:

Well, again, you know like if a bunch of kids are playing Russian roulette like it's a bad thing, let's just be really clear but it is unlikely to have the same implications as a foreign invasion.

Speaker 1:

Right, when you think through markets here, do you get a sense that we're maybe still in a higher risk environment than most people realize? I've used that joke before. That seems like everyone's on the same side of the boat holding an anvil yet again, in terms of just everybody suddenly being optimistic, recency bias hitting like never before, I think, in history. Anything like that that makes you concerned. I don't know if it impacts the products at all, but anything that makes you concerned here.

Speaker 2:

Well, I mean, this is unfortunately the byproduct of a lot of the focus that I have around things like passive investing, right? So if you move from a market that is predictive, a market that is a leading indicator, to a market that is a contemporary or even a lagging indicator, and you set your policy around that, right, you're trying to explain why the S&P is hitting new all-time highs, even as the relevant point is not that the S&P is hitting new all-time highs, because that can be tied to everything from valuation increases to the mechanics that I was referring to for market behavior, much rather than the fundamentals and at the end of the day, fundamentals really do matter, right. If people don't have jobs, they can't make purchases. That, in turn, creates less capacity for corporations to buy back their shares. It creates additional need for capital to float businesses over difficult business periods, as we saw during COVID, for example, and I think, unfortunately, that's where we are right.

Speaker 2:

So I draw people's attention to the analog of the XIV and the components that led up to Balmageddon. If you had used an analysis of higher prices means everything's okay on the XIV, it would have led you to exactly the wrong conclusion, right? What we were creating was a bimodal distribution, meaning a distribution that is not continuous in its construction. Instead, it has two potential outcomes. One is prices go higher, the other is prices go to zero. I think something very similar is building in the S&P 500.

Speaker 1:

For the last few minutes here. Mike, how do people find more of your work and maybe talk through what type of content you put out on the Substack? Oh my God, why would they want to do that? That's absurd. Yeah, especially if they're watching this whole thing. We just gave them everything I know.

Speaker 2:

Yeah, easiest place to find me is at simplifyus. We put out a ton of material there. I can be found on Twitter wasting everyone's time at profplum99. And then my sub stack is available at a subsidized rate for the clients of Simplify and, candidly, a very subsidized rate overall. I'm just trying. I only charge $99 a year for it, even though it's going to provide you with some of the more detailed analysis like what we just walked through as well.

Speaker 2:

As you know, I would argue somewhat different thinking around how markets function and work tied to the work that I have around passive. There's a lot of components around that and also a lot of social commentary tied to it. You know we live in a world in which I think it's harder to get away from information and people who are publicly available, and so you know I'm thrilled anyone anytime someone checks out my sub stack at yes, I give a figcom or signs up to follow me on Twitter, but I do caution you that I write for myself. That often means that it can be very arcane topics or a different perspective on thinking about things that you might find just as offensive as useful. So be thoughtful about whether you actually want to sign up for the pain associated with that Most important question for me.

Speaker 1:

Mike, Can you email me exactly how you made that drink?

Speaker 2:

Michael's referring to a Boulevardier. So when we were up in Camp Kotak, I brought up a bunch of whiskey that's associated with the distillery I have a link to and instead of serving wine like everybody else did, I served Boulevardiers, which is simply a one-part whiskey, one-part Aperol or Campari I prefer Aperol and one-part sweet vermouth and you shake the equal parts with ice, strain it over a large ice cube If you have it available put a twist of orange on there and it's one of the best drinks you'll ever have. It was exquisite.

Speaker 1:

I'm really glad you enjoyed it. Thank you everybody for joining us. We had a nice audience, around 6,000 people watching live. I have another one of these with Andrea Stenelarsen coming up at 2 pm Eastern. This Stenna Larson coming up at 2 pm Eastern. This will be on Lead Lag Live as an edited podcast. Please help me keep the momentum going as far as the number of downloads 1.2 million and counting and make sure you follow Mr Mike Green. Thank you, mike. Thank you, mike. Thank you very much, michael. Cheers everybody.

Speaker 2:

Thank you.

People on this episode

Head Shot

Michael A. Gayed, CFA

Host