Passive Investing Has Had a Major Impact on the Market: Here is What It Means for Your Portfolio

Dave disputes Rick Ferry's dispersion claim, stating that when examined on shorter time cycles and in options markets, dispersion has actually increased since the late 1980s, and index pinning effects (where options expiration forces index prices to pin while underlying stocks experience large variance) show that passive dynamics are changing market structure

“the there a couple things there first of all he leans hard on this idea we haven't had any more dispers the s&p&v 500 which means nothing could have happened he's actually just wrong here and I hate to say this cuz Rick I consider Rick a friend but if you look at pretty much any dispersion St as unless you're looking at like over onee return periods big long blocks of returns in fact we have seen dispersion in the market consistently clme slowly but definitely uphill uh since the late 80s um the bigger issue though is that when you get to shorter time Cycles we've seen huge dispersion and chem talks ch doesn't talk about this in the quote we're going to come up with but he talks about this quite frequently in the options Market where you end up with all these forces that pin the prices of the index itself”

The percentage of passive investing in markets is somewhere between 30-50%, with significant unmeasured passive in collective investment trusts and separately managed accounts that don't get reported to Bloomberg.

“what do you guys because I think it relates to this what do you guys think are the best estimates of the amount of like the percentage passive of the market right now is it like 40% is that right is do you think it's around there you know it's somewhere between 30 and 50 the challenge of course is that a lot of the money that's in passive strategies especially the truly mive never trade never move money is in vehicles that don't report right so like maybe we get a report out of the Saudi Sovereign fund or something like that um but Mo all of these institutions that are in Collective investment trusts and smas that are being managed by Black Rock for a basis point or two none of that money shows up in our in our markers right”

When the Russell index rebalances annually (typically in June), tactical traders try to front-run the known buying of stocks that will be moved into the Russell and short-selling of stocks that will be dropped, creating exploitable patterns for those who understand the mechanics.

“Rob mentioned this idea that if you like take the S&P 500 and you just delay the rebalancing you get like something like 20 or 30 basis points a year...there's an enormous amount of variance that shows up just by when you do the rebalance um now what he's talking about is specifically gaming a big well-known rebalance also known as the Russell trade which we used to do for decades I don't think those really work that much anymore more um scooping 20 to 30 basis points off a trade you lose so much opportunity for a beta move in there”

Active investing has chronically underperformed passive investing because it delivers 2% less return than the benchmark while charging for management, making it economically irrational for investors to pay for underperformance.

“I describe active investing as the equivalent of floods or as a plumbing company that if you call into your house because there's a leak leaves a flood and sends you a bill for it you'd never pay the guy right active investing bad performance is caught up with them”

Active investing has systematically underperformed passive indexing over the past 20 years, with approximately 95% of active managers underperforming their stated benchmarks on a 20-year basis according to S&P Dow Jones Index data.

“the best research on this has been done by S&P for years and years they published something called the index versus active scorecard we could quibble about the methodologies but at this point they've got I think 30 years of data really tracking with survivorship bias how active is compared versus their own stated benchmarks and the reality is the numbers are awful on a 20year basis something like 95% of active managers have underperformed their Benchmark”

The 2007-2020 anti-value cycle was significantly augmented by passive money flows into index funds, not driven by it, but substantially amplified in magnitude.

“so that's a long- winded way of saying this value cycle this anti-value cycle from 2007 to 2020 was undoubtedly augmented by the flow of money into index funds uh and augmented in a big way”

Passive flows have created a momentum effect that is now one of the primary drivers of market performance, suggesting passive itself has become a source of systematic risk.

“uh you know there is a natural momentum factor to passive investing uh and that passive investing has grown to such a scale that uh it is one of the primary drivers of momentum in this market now”

Stocks outside the index receive little analyst attention or fundamental review when they receive good news—they may pop briefly on positive developments but then collapse back down as the market attention fades, making value extraction difficult without sustained attention.

“a lot of these stocks that are not in the index nobody really cares about their fundamentals nobody's paying attention they might get good news and then they go up a little bit but then everybody just disappears again”

Dave counters Ferry's argument that index dispersion has been stable by noting that dispersion within the S&P 500 has actually climbed slowly but consistently since the late 1980s, and that Ferry ignores shorter time-cycle dispersion and options-market dynamics where index pinning occurs

“the there a couple things there first of all he leans hard on this idea we haven't had any more dispers the s&p v 500 which means nothing could have happened he's actually just wrong here and I hate to say this cuz Rick I consider Rick a friend but if you look at pretty much any dispersion St as unless you're looking at like over onee return periods big long blocks of returns in fact we have seen dispersion in the market consistently clme slowly but definitely uphill uh since the late 80s um the bigger issue though is that when you get to shorter time Cycles we've seen huge dispersion and chem talks ch doesn't talk about this in the quote we're going to come up with but he talks about this quite frequently in the options Market where you end up with all these forces that pin the prices of the index itself”

If passive investing continues to dominate, capital will not be allocated to create public companies or for companies to raise capital in markets because capital allocation via pricing becomes impossible.

“now you can argue those are good you can argue those are bad but when you run through the models and you actually recognize what the long-term impact of this it it unfortunately is that we either have a total loss of utility in the markets because people can't get public because people can't get their comp use the markets to raise capital”

Index fund order flow is reported as only 5% of daily NYSE volume, but this statistic is misleading because large index orders are broken up into smaller pieces before they reach the market, so the actual index-driven portion of trading is much larger than 5%.

“I wasn't sure about Rick's idea that only 5% of the daily volume is index based I mean is that right or is that is that a valid argument against this he's talking about there is the amount of index trading the amount of orders that come in as like we are trading the whole Index right now the problem is that the market doesn't actually see it that way most of those orders are actually broken up long before they get to the market um so fundamentally I'm most think he's just wrong there”

Passive investors cannot absorb massive redemptions; even if passive underperforms for 3 years and active managers appear to be heroes due to coin-flip luck, they cannot absorb a trillion dollars in passive assets flowing out over 1-2 years, so they would become the market themselves.

“in that environment with markets down 3 or 5% guarantee you there will be a dozen managers will all look at like Heroes and they'll be on CNBC just coin flipping...the question is can they absorb a trillion dollars in passive assets over the course of a year or two of course not they then become the market”

Cory Hastin's research on 'rebalance timing luck' shows enormous variance in returns based on when rebalancing is done (monthly vs 15th vs 30th vs quarterly), suggesting timing can matter significantly.

“he did an amazing paper called rebalance timing luck which looks at historically like the impact of when you do these rebalances and how much variance in your potential return stream you have based on like doing it monthly or doing it monthly on the 15th or the 30th or quarterly um and the short answer is there's an enormous amount of variance that shows up just by when you do the rebalance”

Rebalancing timing (whether you rebalance on the 15th or 30th of the month, monthly vs quarterly) creates enormous variance in return outcomes, and this timing luck effect could be gamed by products that deliberately delay S&P 500 rebalancing

“he did an amazing paper called rebalance timing luck which looks at historically like the impact of when you do these rebalances and how much variance in your potential return stream you have based on like doing it monthly or doing it monthly on the 15th or the 30th or quarterly um and the short answer is there's an enormous amount of variance that shows up just by when you do the rebalance”

When passive flows go negative in periods of market stress, they create rapid repricing because price-setters must exit simultaneously, creating a 'pinning' effect that explodes into high dispersion once the index itself stops being pinned.

“when you get to shorter time Cycles we've seen huge dispersion and chem talks ch doesn't talk about this in the quote we're going to come up with but he talks about this quite frequently in the options Market where you end up with all these forces that pin the prices of the index itself because people are trading the index itself and then the underlying actually explodes with variance under underlying that when you get to these pinpoints when you get to options expirations”

A Stanford Bernstein paper by Denise Frasier Jenkins argued that if the market is purely indexed with no price discovery happening, then centrally planned allocation of capital would actually be better than indexation, making passive investing 'worse than Marxism' as a means of allocating capital to productive uses in society.

“I'm going to go with Rick Ferry more like Rick troll now I say that lovingly respect the hell that's from a great old piece though that's Stanford Bernstein's piece a guy named Deno Frasier Jenkins wrote that about a decade ago where we and I actually agree with argument if you're talking about the purpose of capitalism being allocating Capital to the things that are most important to society it purely indexed Market no longer does that at all so Central planning would actually be better that was his argument that's sort of what Rick's talking you I Rick's RI referencing there uh but no I don't think that capitalism is worse than Marxism what we're all on that page at least”

The percentage of passive assets in the market is estimated between 30% and 50%, though the true figure may be higher because many passive vehicles (collective investment trusts, separate managed accounts, sovereign funds) are held in non-reporting structures and do not appear in standard market data.

“you know it's somewhere between 30 and 50 the challenge of course is that a lot of the money that's in passive strategies especially the truly passive never trade never move money is in vehicles that don't report right so like maybe we get a report out of the Saudi Sovereign fund or something like that um but most all of these institutions that are in Collective investment trusts and smas that are being managed by Black Rock for a basis point or two none of that money shows up in our in our markers right”

Indexing does not set valuations because it buys everything proportionally and therefore cannot be overweighting large stocks relative to small stocks, and index fund trading represents only 5% of daily NYSE volume, so the impact on pricing is minimal.

“well indexing doesn't set valuation I mean indexing just takes the market as it is and buys everything so with indexing it's the amount of money coming into the market through index funds let's call it a total stock market index fund you've got money coming into that fund they go out and buy everything so they're not over buying the big St stocks or under buying the small stocks they're buying uh the everything and same thing when they sell it's across the board they sell everything in in equal proportion so it's not indexing is not setting prices”

There is no clear inflection point or specific percentage at which passive investing becomes clearly destructive to market function; 100% passive is obviously broken but anywhere below that could be a continuum.

“now here's where I think the rise of passive can matter there is one number when let's ask the question what percent of the Market could actually be Jack Bogle style passive and still have some degree of an efficient market or not I don't know some you haven't hit inflection point where it gets really crazy well there's only one number we know for sure that can't be 100%”

Flows are everywhere in markets and always face resistance; understanding both the flow and its resistance is critical to understanding market behavior and any static flow analysis is incomplete.

“I'm fascinated by this idea too of you can never talk about flow without also talking about some form of resistance and what that other thing that gets in the way and this is such an obvious and intuitive point but it's everywhere in life like you want to go out for a run and Jack and I were talking before we started recording here like it's raining outside I don't want to my dog doesn't want to go for a wall we he can't achieve his Flow State if the act of resistance that it's wet outside keeps him from doing it so when we have in these markets we have to talk about the flows and the way they get into the system the way a dollar comes in the way a dollar comes out we have to never never never assume that there's just zero resistance”

When passive investing grows, price discovery shifts from fundamental analysis to other market participants; the real question is not whether passive investing impacts prices but where price discovery is now happening and who is performing that function.

“can't we can't forget that passive if we want to say passive doesn't determine valuation because it doesn't care we're also saying that we're moving that function we're moving the job evaluation elsewhere and we have to ask where are we moving that to because it's still an important question to ask and that's that's my Discovery happen”

Peter Madino's framework is that every dollar in an asset either gets gifted or consumed, and when it gets gifted the gift recipient must decide again whether to consume or gift, creating recursive risk uptake decisions through generations.

“one of my favorite interviews Jack you and I that we ever did was the Peter madino one where he's just like nope gifter it's a gifter consumption every single asset will either be gifted or consumed can't separate it any other way and when that gift happens the consumption question happens again and if it's not all going to be consumed then they're thinking about it as a gift and if they're thinking about it as a gift they're upping the risk”

Understanding passive flow mechanics serves as a framework for evaluating market anomalies and investor behavior, similar to how understanding price-to-earnings ratios provides a framework for stock valuation, even if it doesn't directly change investment recommendations.

“I think the main thing that I would like people to walk away from the active passive discussion thinking about is using it as a framework to evaluate the market right that's the important thing right just like if I if you'd never heard of price to earnings ratio and I was like hey you know here's an interesting way of looking at two different stocks right you take their price you divide them by their earning...thinking about passive Market thinking about flows particularly in the short term”

An S&P index error (temporarily adding a stock that shouldn't be in the dividend index) caused the stock to move from 84 to 90 before the error was corrected and the stock fell back to 84—a 7% move entirely attributable to passive index inclusion and exclusion mechanics with no fundamental change.

“S&P made a um uh a blunder they um reported a a uh a list of Holdings for a a narrow Niche dividend index that they maintain that didn't include one of the stocks that's supposed to be in the index and so the index trackers...uh actually it was the other way around added that they added a stock to the list that wasn't supposed to be there and then uh a couple days later they realized they're mistake and they took it out well the stock went from 84 to 90 and then back down to 84 that's a s plus% move for a little niche index strictly because the stock was added and then dropped”

Small cap active managers outperformed their benchmarks at an 87-90% rate in the first half of 2024, which is an unusual outlier compared to large cap where active underperformance is persistent.

“it works in some places so small cap Emerging Markets particularly things like Emerging Markets debt markets that I think we you know at least apocryphally always think of as inefficient the active managers tend to perform a little bit better in the first first half of this year for instance small cap managers 90% of them roughly 87% of them beat their Benchmark”

When S&P added a stock to a niche dividend index by mistake and then removed it days later, the stock moved from 84 to 90 and back to 84—a 7% move driven purely by index membership with no change in fundamentals.

“they um reported a a uh a list of Holdings for a a narrow Niche dividend index that they maintain that didn't include one of the stocks that's supposed to be in the index and so the index trackers for that strategy and these aren't big index trackers because it's a niche index um uh actually it was the other way around added that they added a stock to the list that wasn't supposed to be there and then uh a couple days later they realized they're mistake and they took it out well the stock went from 84 to 90 and then back down to 84 that's a s plus% move”

Even if active managers had positive returns during a downturn, they couldn't absorb the massive outflows from passive that would occur; a dozen managers performing well during a down market couldn't absorb a trillion dollars in redemptions from passive funds over a year or two

“in that environment with markets down 3 or 5% guarantee you there will be a dozen managers will'll all look at like Heroes and they'll be on CNBC just coin flipping we know that there will be people who just get it right whether they're smart or whether they're lucky is sort of irrelevant the question is can they absorb a trillion dollars in passive assets over the course of a year or two of course not they then become the market”

After a long period of passive underperformance relative to active (a 'lost decade'), younger generations will attempt to exploit that by shifting into whatever seems tangible—real estate, private markets, alternative assets—rather than continuing to chase passive equity index returns

“there is a desire for for tangible stuff in a periods like this so in periods of all like hope and promise and whatever else there is a return to a seeking of the tangible and when I think about his example of you know the birkshire haway of 66 to 82 or whatever else and you think about can tangible Investments return in a different way and I don't know if that just produces a new version of the cop Brothers down the road or something but it does say the attention will shift and it doesn't just mean it's going to shift into some type of broad-based insane speculation it could too like broad speculation is the new Act of investing when passive doesn't work new active investing maybe it is”

In non-index stocks, investors must buy at much lower valuations (possibly 5x lower) than index stocks to account for the wider valuation gap and uncertainty of price discovery.

“I probably you're referencing the Barry rol's Masters in Business he he did with um with David a while ago um he talks about you know if before I could buy a stock at 10 and know I could sell it at 20 eventually now I have to buy that stock at five right because the opport I need such a bigger window of confidence that I'm right in the Market's wrong”

Non-index stocks require much wider valuation margins of safety than index stocks because they must be bought at lower prices to compensate for the lack of ongoing capital flows and potential for negative rebalancing pressure (capital fleeing non-members to members).

“if before I could buy a stock at 10 and know I could sell it at 20 eventually now I have to buy that stock at five right because the opport I need such a bigger window of confidence that I'm right in the Market's wrong because there's so many things that the market can do against you that have nothing to do with the underlying stock”

Those criticizing passive investing are overstating its negative role by making it their life's work to be anti-passive; while passive has changed market behavior, the claim that it creates catastrophic inefficiency that eliminates free money opportunities is difficult to prove empirically.

“my instinct is those who are absolutely freaking out about it are overstating its role and have kind of made it their life's work to be kind of antipassive...I don't think I've proven they're inefficient to where you can drive a truck through and just as the rational investor make free money all the time uh I don't think it's that far gone”

Jack Bogle acknowledged that 100% of the market cannot be passive because markets would break down, but when asked what percentage could be passive before dysfunction, he admitted to simply making up the figure of 75% with no principled foundation.

“I said Jack so how much of the market can be passive before it starts to get weird um and he said 75% and I'm like oh that's really cool that's you know where'd you come to that Jack uh and he just looks and goes he gets a little twinkle in his eye and goes oh I completely made it up”

Passive investing became popular not due to innovation but due to interest rate decline from 20% to near-zero creating boom conditions that made 60/40 portfolios appear to be a natural, set-and-forget strategy when in reality passive had poor performance during the 1968-1982 period.

“passive investing as much as it's been sold to the world and the narrative is that passive investing is some new uh Innovation...in fact it is a it is the the new way to invest it's lowcost uh you know uh great just set it and forg it...indexing to be clear was was introduced about 150 years ago so this idea of passive investing is not a new idea the reason it's become popular is because interest rates went from 20% to zero and we saw a massive boom in in equity performance uh you know 6040 is the easy set it and forget it...1968 to 82 my period right before passive investing started there was a lot of passive investing you know why because it didn't work because 1968 to 82 you lost 70% of your money in the equity Market”

The liquidity structure for non-index stocks has changed such that there is no natural buyer for concentrated positions; successful active managers must take and consistently win big bets rather than many small mispricings.

“all it really means is active managers who are successful are going to be the ones that take and consistently win big bets”

Despite fundamental disagreement between Mike Green (passive creates systemic risk) and Rick Ferry (passive is benign), both arrive at the same practical recommendation: U.S. investors should maintain broad equity index exposure as a core portfolio holding.

“if I listen to Rick Ferry's advice I should probably buy the S&P 500 if I listen to Mike Green who thinks the exact opposite of on this issue I should probably also buy the SSP 500 and then you guys were with me at the Epsilon KC conference there was a panel called markets are broken and the conclusion of that was I should buy the S&P 500”

Academic research on passive investing's impact has proliferated since 2019, with most recent work supporting the view that passive investing does create measurable market distortions.

“beginning in 2020 really 2019 academics began to start to really start to chew on this problem and unfortunately all their work at this point or at least the work that I have red is increasingly pointing in the direction that My Views are correct that ultimately we're creating a distortion in the market”

The core practical conclusion of the passive/active debate is that even those who disagree fundamentally (Ferry vs Green) arrive at the same practical recommendation: most investors should hold broad market index funds.

“if I listen to Rick Ferry's advice I should probably buy the S&P 500 if I listen to Mike Green who thinks the exact opposite of on this issue I should probably also buy the SSP 500 and then you guys were with me at the Epsilon KC conference there was a panel called markets are broken and the conclusion of that was I should buy the S&P 500”

Understanding passive/active dynamics is useful as a mental framework for evaluating market behavior, not because you should actively try to exploit it, but because it helps explain short-term noise.

“I think the main thing that I would like people to walk away from the active passive discussion thinking about is using it as a framework to evaluate the market right that's the important thing... thinking about passive Market thinking about flows particularly in the short term like the stuff that chem does I think doesn't get enough play in most average advisor or investor world not because you should be trying to do what he does but because so much of the shortterm stuff which I know is what a lot of advisers would have to deal with my client calls me if the Market's down 3% where Mark you know bitcoin's up 20% why am I not in it so much of that noise is driven by the kind of flows driven stuff”

The observation that 'broken clock' commentators get moments of vindication during market dislocations is important to remember when evaluating short-term predictions; just because someone is right for a few quarters doesn't mean their framework is correct

“these Broken Clock moments are so important to remember and that the next Broken Clock commentator moment is right around the corner”

Peter Madianos principle that every asset will either be gifted or consumed means that inherited wealth is not lost from the system; it either transfers to the next generation (who will make new allocation decisions) or gets consumed, but net capital doesn't disappear.

“there was one of my favorite interviews Jack you and I that we ever did was the Peter madino one where he's just like nope gifter it's a gifter consumption every single asset will either be gifted or consumed can't separate it any other way and when that gift happens the consumption question happens again”

A 'lattice work' of mental models (PE ratios, flow analysis, passive/active dynamics) applied across entire balance sheet and multiple asset classes creates a foundation for understanding complex market behavior better than any single framework.

“and back to that original point of like you can't talk about flow without understanding what those natural resistances are and you want to be able to argue it from the other direction so as a mental construct and I love the PE multiple example like these are first principles and foundational things that have have broader philosophical value to you you could be really smart in a narrow Niche you can have that that that Chim Carson knowledge of like one weird place but we want to be doing having this uh this lattice work of these things connected for ourselves to go how else can we apply them”

Flow and resistance are inseparable concepts in understanding market dynamics; you cannot analyze flow in isolation from the obstacles that impede it, and this principle applies universally across physical systems and human behavior.

“I'm fascinated by this idea too of you can never talk about flow without also talking about some form of resistance and what that other thing that gets in the way and this is such an obvious and intuitive point but it's everywhere in life like you want to go out for a run and Jack and I were talking before we started recording here like it's raining outside I don't want to my dog doesn't want to go for a wall we he can't achieve his Flow State if the act of resistance that it's wet outside keeps him from doing it”

Dispersion of returns among S&P 500 stocks has not increased over the past 50 years, which would be expected if passive investing were distorting relative prices. This constancy of dispersion suggests indexing has not fundamentally altered market structure.

“you look at the dispersion of S&P 500 stocks this is individual S&P 500 stocks you look at the dispersion of returns uh between S&P 500 stocks that hasn't changed to 50 years so indexing isn't doing anything to the market”

Small cap active managers had one of the best years ever, with 87% of them beating their benchmark in the first half of recent year, representing a rare outperformance window for active management.

“it works in some places so small cap Emerging Markets particularly things like Emerging Markets debt markets that I think we you know at least apocryphally always think of as inefficient the active managers tend to perform a little bit better in the first first half of this year for instance small cap managers 90% of them roughly 87% of them beat their Benchmark which is like KD bar the door you know win for active but that's a bit of an outlier right”

The 'Russell Trade' (exploiting index rebalancing at year-end) used to be profitable but has diminished in recent years because it is now well-known and has been competed away

“now what he's talking about is specifically gaming a big well-known rebalance also known as the Russell trade which we used to do for decades I don't think those really work that much anymore more um scooping 20 to 30 basis points off a trade you lose so much opportunity for a beta move in there I I think that's a little too clever by half”

Vanguard and passive fund managers are so entrenched and politically connected that 401k flows will continue to channel into passive vehicles even if markets enter a negative-return period, and passive investing will remain dominant despite its poor performance.

“my view is that you know Mike Mike's view is and I think it's defensible to you like who knows let's see is that the the Powers at be at Vanguard are so entrenched um and politically connected that uh all the 41k flows and everything will continue to flow to all these passive Vehicles it's going to change”

Generational wealth transfer of $30 trillion from Baby Boomers to Millennials is unlikely to cause a sustained market decline because inherited portfolios are not 100% equities and heirs tend to uptake risk rather than downsize.

“the reason I don't think this is a problem is you have to ask yourself what's the actual like financial advisor pathway that happens here your 83 yearold client dies and leaves a $100 million estate they leave it to their Millennial children this is a classic financial advisor situation right you're dealing with a big inheritance and a wealthy family that money that $100 million sure a big chunk of that is probably in the S&P 500 on aggregate but actually what it probably looks like is the Last 5 Years of a Target date fund that's what the average person on their way out that's what their core Holdings tend to look like a lot of bonds little bit of real estate over here maybe some private Investments so then the question is when that when that retirement I mean when that that estate happens does the millennial all of a sudden drisk probably not they probably up risk right”

The XIV (volatility ETN) collapse serves as a cautionary example of how systematic investors with 'known response to close in price behavior' can create catastrophic losses when liquidity disappears.

“that's where I stumbled across the XIV which was a trade that you know kind of launched me into the public sphere um this is no different right what we're actually seeing is we're seeing a pattern of the traditional discretionary investor a professional investor who attempts to do a discounted cash flow type analysis to figure out what something is worth is being replaced by investors who presume that everybody else has done that work”

The biggest risk to US equity markets is not generational wealth transfer but geopolitical: if sovereign wealth funds from Nordic countries, Saudi Arabia, and other nations decide the US is in decline and reallocate away from US equities, that would trigger sustained outflows.

“the only the only place that I think there's legitimate concern is on the geopolitical front there's an enormous investment in the United States Equity markets from people who don't live in the United States surprising nobody right and if all of those Nordic Sovereign funds and the Saudi wealth fund and you know Retirement Systems in France and everywhere else they all decide that America is a declining star that that we're setting and they want to Reg globalize their portfolios and they start massively reducing their us Equity exposures because they don't believe in America okay I can create that scenario too but again as an investor I think you're going to know that's coming”

The fastest growing ETFs track leveraged and concentrated positions (e.g., 2x Micro Strategy, 3x leverage micro cap) suggesting that in periods of strong index returns, retail investors create their own active bets rather than hiring managers.

“we've had two boom years for index returns at least or for Passive returns something that always happens when we have multiple Boomers in a row is people might not be going out and hiring the active manager but people are like oh well I did really good on these like three stocks I had so maybe I'm not going to go hire the next active manager but I'm going to get extra overweight stock of choice XYZ that's gone up more than the Benchmark in those years and those variants are real well and we've seen this the entire ETF Market is now a washing products just to express those opinions of why why would I go hire you know clip ASAS to run my money I can go buy Triple leverage more micro strategy myself”

Baby Boomers transferring $30 trillion in wealth to Millennials is not a major risk for market disruption because inherited wealth typically comes as part of a diversified portfolio (bonds, real estate, some equities) and heirs will likely re-risk (increase equity allocation) rather than de-risk.

“your 83 yearold client dies and leaves a $100 million estate they leave it to their Millennial children this is a classic financial advisor situation right...that money that $100 million sure a big chunk of that is probably in the S&P 500 on aggregate but actually what it probably looks like is the Last 5 Years of a Target date fund that's what the average person on their way out that's what their core Holdings tend to look like a lot of bonds little bit of real estate over here maybe some private Investments so then the question is when that when that retirement I mean when that that estate happens does the millennial all of a sudden drisk probably not they probably up risk right”

People are unlikely to make portfolio de-risking decisions in response to a 3-5% market decline because the short-term nature of the move means most investors will wait it out, and those who do sell will immediately see better-performing active managers or leveraged vehicles and chase them instead

“so you have to imagine a world where say we have 3 years in a row of negative S&P 500 returns which would be a wild outlier in history but even if they're just small downturns you have to imagine that while that's going on there are enough managers with enough liquidity that could absorb the money that might come out of passive in that environment so in that environment with markets down 3 or 5% guarantee you there will be a dozen managers will'll all look at like Heroes and they'll be on CNBC just coin flipping we know that there will be people who just get it right whether they're smart or whether they're lucky is sort of irrelevant the question is can they absorb a trillion dollars in passive assets over the course of a year or two of course not they then become the market”

During lost decades like 2000-2010, active management did show periods of outperformance, but the capital that shifted from passive went into new asset classes (emerging markets, dividend stocks, real estate) rather than traditional stock-picking, showing that investors seek returns anywhere they can find them.

“we we we did it what what did we see we saw the Advent of like three different Emerging Market ETFs and then of like you know crappy Bank lending funds and all the things that come out of people look elsewhere and a lot of people moving to a new AET class like a lot of the big Capital moving towards real estate”

Return stacking strategies and leveraged micro-cap ETFs (like the 2x micro strategy ETF) have grown to massive asset bases despite poor expected returns because they offer expression of retail opinion about which stocks will outperform.

“it's funny Cory H had a tweet the other day about like this idea that he he they built an amazing thing with return stacking but he's like I looked at the you know the two times micro strategy ETF and it has way more assets than our own at a higher fpr it probably doesn't end well for the people that are in the uh two-time micro strategy uh ETF”

Closed-end funds with permanent capital and no arbitrage closure mechanism (like interval funds) will see a resurgence because they offer portfolio strategies without the daily liquidity pressure that ETFs and mutual funds create.

“I feel like an older conversation I used to hear way too often so 10 plus years ago and it was just talking about the difference between the um you know like the closed end funds where there's no ARB opportunity and the ETF where there is an ARB opportunity and you have to understand how what closes the Gap and a closed end fund what's going to close the premium discount Gap it's not there there's there's nobody to do it so you're either waiting to shut the thing down or...they're just about to go on and it's just who's going to close that gap for you...and that's it's a very different methodology”

When people experience multiple boom years for passive returns, they don't hire active managers, but instead often become overweight on individual stocks that outperformed the benchmark during those periods, taking on concentrated idiosyncratic risk.

“I'm sure I'm curious if you're seeing this in your own your own circles we've had two boom years for index returns at least or for Passive returns something that always happens when we have multiple Boomers in a row is people might not be going out and hiring the active manager but people are like oh well I did really good on these like three stocks I had so maybe I'm not going to go hire the next active manager but I'm going to get extra overweight stock of choice XYZ that's gone up more than the Benchmark in those years”

When selecting between active and passive strategies, financial advisors increasingly frame the decision around whether the client wants exposure to a specific market segment; if they want broad beta exposure, passive is fine, but any attempt to paint a 'style box' results in active being 'really freaking hard' to justify.

“if I listen to Rick Ferry's advice I should probably buy the S&P 500 if I listen to Mike Green who thinks the exact opposite of on this issue I should probably also buy the SSP 500...I think this goes back to the point that Dave made earlier about know where you want to be active so there's lots of stuff where you just go passive is fine...but when you get into some of the other areas there's lots of reasons to uh choose active but often times that means going either out of public markets and into private or it includes going into a weird corner of the investment Universe”

Value investors need a 7-10 year time horizon to prove their thesis, but most investors are not psychologically or institutionally equipped to wait that long, making value investing difficult to execute even if it's theoretically superior

“I'm a value investor at least in part and that's that's the tough thing with value investing is the time frame you probably need and me faers talked about about this to judge value investing is probably a decade but nobody's going to sit around for a decade so it makes value investing a very tough strategy for people to follow”

When presented with higher potential for upside returns, conversations between advisors and wealthy clients increasingly shift toward exploring private equity or private markets rather than trying to pick among large-cap public stocks.

“increasingly that conversation comes down to I want more growth why do you want more growth well I want more potential for upside okay are you willing to accept more potential for upside more potential for downside yes or no yes I am okay great let's look at some private vehicles to do that well why because can I pick if Nvidia is going to do better than Microsoft next year realistically because all these managers can't so let's go look at something else”

The key question is not whether passive investing has changed markets, but rather how to understand and navigate those changes as an investor; rather than assuming weirdness indicates an arbitrage opportunity, recognize that strange behavior likely has structural explanations.

“so I think that's probably the healthy attitude for like a financial adviser or investor to have this rise of passive does not mean everything is going to come crashing down in a quick hurry and you better you know hedge yourself into Zero Performance right what it means is market dynamics have changed and therefore when you see things that seem weird don't just assume that means aha I found something I can Arbitrage they probably good reasons for it”

Stock dispersion in the S&P 500 has not changed over 50 years, proving that indexing has not distorted markets or made stocks move together; the absence of dispersion change is evidence against passive-driven market distortion.

“you look at the dispersion of S&P 500 stocks this is individual S&P 500 stocks you look at the dispersion of returns uh between S&P 500 stocks that hasn't changed to 50 years so indexing isn't doing anything to the market”

Government policy intervention (direct government investment in markets, junk bonds, and stock market support) has become so important that policymakers will likely prevent sustained bear markets in the future, making Jeremy's lost-decade scenario unlikely

“the government uh investing directly in junk bonds which they did during the crisis and you know what Japan does and who are directly investing in their own stock market those strike me as extremely likely reactions from a populist government over the next 4 to 12 years uh so I don't I literally don't think the government will allow the market to have a sustained bare Market uh even if it's only on a relative you know on a real basis”

Those claiming passive investing is the devil and overstating its negative role have made it their life's work to be antipassive, but this does not mean passive has zero impact.

“I think and I admit this is all is still in the realm of hard to prove that putting a magnitude on it is difficult and my instinct is those who are absolutely freaking out about it are overstating its role and have kind of made it their life's work to be kind of antipassive”

Rick Feri seems to believe that academic research on passive investing's market impact is wrong and that markets are perfectly efficient with no inelasticity, but he refuses to actually read or engage with the academic papers that challenge his position.

“and the other thing is I honestly don't know why I can't get r to actually read any the academic papers because he actually just seems to think that all of the academic research here is wrong and that the market is perfectly efficient and there's no anelasticity at all”

Index fund order volume is broken up into smaller orders before reaching the market, so Rick Ferry's claim that index funds represent only 5% of daily volume significantly underestimates their actual market impact.

“I wasn't sure about Rick's idea that only 5% of the daily volume is index based I mean is that right or is that is that a valid argument against this he's talking about there is the amount of index trading the amount of orders that come in as like we are trading the whole Index right now the problem is that the market doesn't actually see it that way most of those orders are actually broken up long before they get to the market um so fundamentally I'm most think he's just wrong there”

Mike Green's insight about flows was to recognize that index trackers execute a 'known' strategy based on predictable flows, making their behavior systematically analyzable and distinct from truly passive behavior.

“that Insight effectively that the the key story was about transactions or the actual flows as compared to the stock is kind of the only unique thing that I've brought to this process the really key insights around um what's actually happening with passive have been fleshed out by a lot of academics”

Active management will continue to exist and thrive in market pockets where passive dominance is lower: small cap, emerging markets, emerging market debt, and other 'weird corners' where managers can actually demonstrate edge.

“so there's lots of stuff where you just go passive is fine or an index approach is fine on the approach to get my Beta get my exposure like us large cab growth or something like that if you even paint a style box around anything or attempt to at this point in time you're probably going to go it's actually really freaking hard we've got this the speed report cards to prove it but then when you get into some of the other areas there's lots of reasons to uh choose active but often times that means going either out of public markets and into private or it includes going into a weird corner of the investment Universe where somebody might actually be able to demonstrate that edge over time”

The phrase 'worse than Marxism' attributed to passive investing originates from a Stanford Bernstein research piece by Denise Frasier Jenkins about a decade ago, arguing that purely indexed markets fail to allocate capital to socially important uses and that central planning would theoretically be better at capital allocation.

“that's from a great old piece though that's Stanford Bernstein's piece a guy named Deno Frasier Jenkins wrote that about a decade ago where we and I actually agree with argument if you're talking about the purpose of capitalism being allocating Capital to the things that are most important to society it purely indexed Market no longer does that at all so Central planning would actually be better that was his argument”

Rob Arnott has built an investment fund based on the theory that stocks ejected from the index over time have higher future returns because they had to be depressed in valuation to be removed, and he has deployed significant personal capital into this fund

“the thing I love about Rob is that he always puts his money where his mouth is he never makes a bet that he doesn't actually mean and so he did some academic research with his very sharp team and came up with with this theory that turns out it plays out in back test that if you invest in things that have been ejected from the index over the long term you actually do better and the theory here is that there's a premium associated with being in the index and if you pay a premium to get into something by definition your long-term expective returns are lower right I mean that's just math um and the portfolio that he's built here actually does have that quality as we said earlier the challenge is is anybody going to really hang out for the 3 to seven years it takes takes for that fundamental outperformance to show up but he's put I mean he put his own money in it right he launched the fund made it available to everybody and plow a m of his own cash into it which is the robar not way”

The Fidelity headquarters in Boston has two-thirds empty office floors because the active asset management business is shrinking due to passive dominance, and this job loss will likely continue

“all those floors in Boston that Fidelity has 2third of them they don't need it's a it's um it's not great if you're in the act of investing business because the business is going to get smaller”