Transcript
Michael Green, the Portfolio Manager and Chief Strategist at Simplify Asset Management, joins Ben Nadelstein on The Gold Exchange Podcast to peel back the layers of passive investing and index funds. In this episode, Michael shares why low-cost index funds aren’t as “free” as they seem and how the huge flows of passive money can change market prices and squeeze out active managers. You’ll get real insights on what index funds mean for your portfolio, why hidden costs might be lurking, and how these trends could shape your financial future.
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Additional Resources
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How to Earn Passive Income in Gold and Silver
Transcript
Ben Nadelstein
Welcome back to the Gold Exchange podcast. My name is Ben Nadelstein. I am joined by Michael Green, who is the Portfolio Manager and Chief Strategist at Simplify Asset Management. Michael is one of the most insightful minds in the world when talking about problems of the passive investing strategies and is one of the best and brightest, in my opinion, to discuss financial markets with. Michael, welcome to the show.
Michael Green
Thank you for having me, Ben. It’s a pleasure to be here.
Ben Nadelstein
Let’s start with what you’re known for, primarily, which is passive investing. For people who don’t really know much about passive investing, can you, first of all, define what you mean by passive investing? Can you also make a steelman case for what some of the benefits are before we get to the potential problems?
Michael Green
Sure. The idea behind passive investing, I’d be surprised if your audience isn’t familiar with it, but in its simplest form, it’s the idea that you would buy effectively all stocks as compared to picking an individual stock. That exposure to the broad asset class should give you a return that approximates the return that is available to the overall investors in the class. The idea is very straightforward. Why pay a premium for trying to pick an active manager who’s going to select individual stocks or individual bonds when you could simply buy a replicating index that gives you all of the same underlying exposures. It was broadly introduced to the world by John Bogle in 1974, ’75. It actually slightly predates that the advent of the use of computers on Wall Street in the late 1960s really underpinned the growth of what was called index investing. It first started at Wells Fargo as a tool to be used by institutional investors that were looking to allocate pension funds or other assets. They had very few takers, just as did John Bogle for a period of time. But today, it has really grown quite explosively. My estimates, which are increasingly backed up by various academics that are working on this, academics at Harvard and Stanford and Chicago, et cetera, would suggest that we’re somewhere in the neighborhood of about 45% of the total market capitalization of US equity markets are now managed in various index forms like the Vanguard Total Market Index or the S&P 500 or the Nasdaq 100 would be prominent and common examples of this type of index investing.
Ben Nadelstein
One way I think about the problem in its simplest form is there’s an externality issue. It’s an individual investors’ interest to buy a low cost passive index fund. It matches the market return, very little to do. It’s almost completely passive for the investor. They go online, they click a button or two, very low fees. And next thing you know, they’re making market returns. But collectively, this causes a problem. There’s an external issue. It’s in our interest as investors to maybe go with the low cost, simple index funds. But what is the broader problem? Can you elaborate on what investors are maybe missing?
Michael Green
Well, the single biggest is actually in the underlying definition of passive from a theoretical framework. The insights that create the theory behind passive investing are built around the efficient market hypothesis and the idea that there’s all these worker bees like myself who are trying to figure out what is the right price for Chevron, what is the right price for Apple, and trying to steer the market towards those sorts of price levels. In the process of doing that, we’re doing research, we’re adding value to the market in terms of trying to to specify what the rank ordering is. Is this a better company or a worse company, et cetera? The idea behind passive is very simple. Well, let’s just mimic their behavior by buying stocks in proportion to the market capitalizations. That will reflect the overall work that people like myself and others are doing. You can free ride on that. The problem with that is that definition of passive requires a very particular implementation, which is that a passive investor always holds every security. That language hold is really important because it highlights that there’s no mechanism for getting in or getting out. The minute you actually try to buy into the market, you cease being a passive investor.
Michael Green
You become an active investor who’s choosing to allocate along a certain framework, I’m going to buy in proportion to the index. When the flows associated with those investors become larger and larger, and again, remember, we’re about 45% market share passive, but even more frightening is that more than 100% of the marginal capital that is coming into the market is now passive, meaning active managers are on net being fired in fairly sizable amounts bonds, and all the money is flowing into passive vehicles. That means that you’re continually investing, you’re making allocation choices that mimic the existing market structure, and those flows actually then influence the market itself, change the behavior of the market. That’s really what my research has been focused on is how would we expect those types of flows to influence markets? Unfortunately, the empirical evidence perfectly matches almost everything that I have suggested. The largest companies receive an additional impulse and get larger. The market becomes more concentrated. It’s not a function of the earnings performance. In fact, in many ways, the earnings performance is a byproduct of the outperformance because you’re able to compensate your employees through stock ownership plans or stock compensation, attracting higher quality employees at lower cost than your competitors are.
Michael Green
It’s a reflexive component to it, as George Soros might say. There’s also issues just associated with the scale. Once you get to the size of a Vanguard or a BlackRock at the $10, $15 trillion asset level, the size of your purchases and your sales when they occur and they’re rare that they that actually end up being selling because of the asset gathering that is behind this, it becomes the dominant force in the market, and it meaningfully changes the behavior and the utility of financial markets.
Ben Nadelstein
I have a question from my friend Stephen gray who is the Chief Investment Officer at gray Value Management. I told Steven I’d be interviewing you, and he had a question for you, which is, I don’t think extreme mispricings can indefinitely persist. And he said he thinks that you would agree. He He said, If so, it’s more of a matter of how extreme and how much longer these mispricings can persist. Have you or anyone else done a rigorous analysis of this question?
Michael Green
I have done quite a bit of work on this. The work of Valentin Haddad at UCLA, Marco Sammon at Harvard, Xavier Gabay and Ralph Coyge, and these are all academics at Harvard in Chicago. They’ve all explored this question to a certain extent. I agree in extreme. Eventually, the system will correct. The question is, from what level? And since we’re on a multimedia display, I’ll actually pull up a chart here very quickly just to illustrate this. So this is a stylized model of what happens to valuations as passive gainshare. And the reason why this happens is actually pretty straightforward. Markets are not perfectly elastic as the market hypothesis presumed. The assumption under the efficient market hypothesis is that we’re all running around and collecting information, and that information then makes us varying degrees of confident in our views. That confidence is expressed through trades. And so as the question asked, if there’s an extreme mispricing, theoretically somebody should be able to go out and grab information, identify that mispricing, and then solve that mispricing by either shorting shares or buying shares to cause prices to move in the opposite direction. That works to a certain extent on the downside still.
Michael Green
If there’s a particularly neglected stock, you can still influence it higher by buying shares. The problem is when the scale of passive gets as large as it is, the money that is going in to buy that mispriced security has two features to it. If it is priced too high, the incremental dollar that coming in from passive is actually over weighting it on an incremental basis and putting more capital towards it. The second one becomes a question of just pure scale. And so that individual asset manager who says, Hey, I think this is really overvalued. I’m going to short the shares. And when you do that, what you’re really doing is temporarily increasing the supply of shares that’s available. Supply demand works. I increase the supply of shares that theoretically is pushing that down. But because I’m so small relative relative to these passive players that are behaving in the opposite fashion, I just get run over. I liken it to not running out in front of the steamroller and picking up nickels, but basically trying to push the steamroller. You’re trying to cause the steamroller to change direction, which I don’t know how powerful Steven is, but I know that I personally can’t come anywhere close to stopping a steamroller.
Michael Green
And this really is the crux of the problem with the Grossman-Stiglitz framework, which is what Steven is highlighting, this idea that the incentives get stronger and stronger and stronger to stand in front of the steamroller, the simple reality is, I don’t care how much money you pay me, standing in front of the steamroller is a suicide mission.
Ben Nadelstein
How different do you see this from the quote often attributed decains, which is that markets can stay irrational longer than you can stay solvent. Is this just a different flavor of that same problem?
Michael Green
It’s a great question, and it really is in a lot of ways. The difference is it’s not irrational from the perspective of the participants. What we’ve been told is that the S&P 500 or saving in a total market index is the safest, most secure way to do it. You’re obtaining diversification, you’re removing idiosyncratic risk. Everything that we’re being told says this is the rational way to invest. It’s gotten so far in that framework that actually that rationality has now been codified. In 2006, there was a very substantive change to the systems in the United States, where 401k systems shifted from being opt in, meaning I had to choose to participate, to opt out, meaning I had to choose not to participate. Today, if you get a job in the United States, the vast majority of employers are automatically going to be both matching your contributions and automatically withholding contributions, which means the flow of funds into these types of strategies is becoming effectively uninterrupted.
Ben Nadelstein
Someone like a Thaler and Sunsetstein, who wrote this book called Nudge, would say, Well, this is a benefit, right? We had people who weren’t investing in their 401(k)s. They were just completely missing the opportunity to invest in the market and having their assets compound over time. And this was a slight nudge that the government did to get more people into these 401(k)s and into these strategies. So do you think that there could be another simple nudge that simply said, Hey, pay attention to what you’re doing here, or is there something that actually has to happen that’s much larger than a nudge to fix this problem?
Michael Green
Well, unfortunately, Unfortunately, the entire principle behind nudge is that you can push people gently into doing things that are very low resistance, but getting them to do the opposite is actually quite hard. So forcing people to automatically participate in something, they don’t even see their paycheck. And they don’t see the withholdings from their paycheck. They just see it as effectively going into a savings account. That creates conditions under which they’re very happy to participate, getting them to change that and to provide attention to it and do something that they’re candidly poorly prepared for, which is identify value within the stock market or the bond market and make individual allocation choices is increasingly challenging. Unfortunately, this is part of the advice I give people, which is when everybody is doing something, we’re a social species. We recognize that there is value in staying with the herd. When everyone is doing something, it actually, as long as that action continues, you’re reinforcing that behavior, that money that is flowing into the index is causing prices to rise, as I showed in that chart. When it stops, it’s not that people suddenly woke up and said, Hey, I’m rational.
Michael Green
It’s that they said, Oh, I’m suddenly unemployed or I’m suddenly retired. And so my pattern of cash flows has now changed. Once again, there was no insight. I didn’t actually decide that Apple was overvalued or that Microsoft was particularly expensive. Instead, I my life circumstances. That now means that the dominant force in markets are things that are actually happening that may have absolutely nothing to do with the underlying fundamentals. They have much more to do with macroeconomic characteristics. Ironically, there’s a series of academic studies that look at this. They’re like, Hey, guess what? Stocks individually are getting less efficient. They are getting less capable of pricing the underlying fundamentals. But surprise, surprise, the market is becoming more macroefficient. It is becoming more reflective of of the underlying macroeconomic environment. Well, that’s not really a good thing. That is actually telling you that the markets have ceased to be a mechanism for pricing marginal capital for companies that need that capital. Instead, we’ve corrupted them to the point that we treat them as a retirement system. We think of saving in the S&P 500. It’s not a savings vehicle.
Ben Nadelstein
That’s a really great way to think about it, which is that the macro economy is one thing, but accurately pricing the capital for these companies should an entirely different thing. The fact that these are connected is slightly an issue. So I want to ask you about value investing. A value investor is hearing this and probably getting a stool and a news ready. What do you say to people who are value investors? Is this something where there is an opportunity to outperform in the future, but it’s just going to be a long future potentially? Or is value investing still something that makes sense during this market?
Michael Green
Well, my core advice is, let me help you get that stool out. The problem with the value investing in particular is value investing is really that role of active managers. I’m supposed to increase the quantity of shares that are available if I think it’s overpriced. I’m supposed to decrease the quantity of free-flow shares that are available if it’s underpriced by selling or shorting and buying, respectively. When that starts to break down under the framework that I just articulated, it becomes a more challenging environment and the performance begins to deteriorate. We actually have seen this. The value investing framework has been a terrible performer for several years. Ironically, though, the reason that it’s been a terrible performer is not because the value stocks themselves have actually done particularly badly. It’s the stuff you’re supposed to be shorting that has done particularly well. This phenomenon, we all love watching GameStop soar and the hedge funds take it on the chin, et cetera. But what you really did was you destroyed a mechanism for price discovery in the market in that fashion. May have felt great from a schadenfreund standpoint, but this is a significant feature in the market today, is that shorting is increasingly viewed as a very dangerous activity.
Michael Green
And so fewer and fewer people are actively involved in trying to determine if securities are overvalued and try to change that marginal cost of capital. That in turn means that very marginal enterprises, firms like MicroStrategy, that simply as a Bitcoin holding vehicle operating incredibly unprofitably in their core business has no real mechanism to cause it to stop. You can create the perception that the world has become increasingly disassociated from the underlying fundamentals, which is true, but the next conclusion from that becomes one of nihilism. Nothing matters. It just doesn’t matter. Well, that’s a terrible societal message to carry through. Unfortunately, it’s one that I think is largely being created by the framework of markets that we now participate in.
Ben Nadelstein
So there are some criticisms of this passive discussion that we’re having. One is that, well, people retire and they might sell their stocks over time. That’s a demographic or a macro shift in some ways. But there’s also people buying. Young people putting into their 401k. In general, shouldn’t this basically balance out and there won’t be much of an issue for the passive investors? What are some things to look out for and are these criticisms valid?
Michael Green
Well, I think those criticisms are misplaced on a couple of fronts. One is recognizing that that has always been a feature. There have always been young people who are adding new capital and buying. There are always old people who are selling to fund their retirement in markets. The scale of the problem has changed radically. I’ll give a really simple one that I know off the top of my head, in 1929, prior to the crash of 1929, about 10% of the US populace owned equities. Today, that number is about 60%. It’s a much, much bigger pool of the population that is exposed to these components. In terms of the buying versus selling activity, there is a really critical distinction, which is remember, as valuations rise, each new dollar in buys less. So the younger generation, perversely, when they’re buying stocks at very high valuations, they’re putting their money to work, but they’re actually getting a very small share of the productive assets. The older people, on the other hand, are actually gaining an increasing component of wealth, and withdrawals are always going to be a function of wealth levels, not of income levels. So contributions are a function of income, withdrawals are a function of wealth, and as valuations rise higher and higher, eventually those wealth levels overwhelm the income levels, and the system has to actually run in reverse under that framework.
Michael Green
The question is, does it do so in an orderly fashion, or does it do so in a disorderly fashion? And unfortunately, all my models suggest the answer is disorderly.
Ben Nadelstein
So let’s talk about the system running in reverse. So obviously, there are some systems where running it forward has some issue, but running it back, it’s not the exact negative of that issue. It’s not plus 10, minus 10, right? So can you talk about an extreme scenario to a more conservative scenario When you say the system running in reverse, what should investors think about that?
Michael Green
Well, one of the easiest ways to think about it is, so let’s actually start with, let’s show passive gaming share and think about how that actually plays through. So we start with a market that’s 100 % collective managers. All of them are running around doing all sorts of calculations in their heads, some of which is now being put onto Excel, and they’re building various models to say, what do I think earnings are going to be? What do I think cash flows are going to be? What do I think the company looks like, etc. If So now we introduce passive players, and passive players just look at it and say they have the world’s simplest algorithm. Did you give me cash? If so, then buy. Did you ask for cash? If so, then sell. Because passive is gaining share, the answer is always, did you give me cash? Yes, I gave you cash. So now I’m going to go buy stuff. I have to buy it from somebody. So the first person I turn to is the active manager, and I say, Hey, you’ve got some shares in this company. I’d like to buy those from you.
Michael Green
And the active manager says, Great. I think the value is I think the value is $10 and it’s currently trading at $8. So I’m unwilling to actually sell it to you at $8. The passive manager has to buy it. So it has to find somebody to sell those shares, even if it has to bid up those shares in the process. Once it has those shares, the next dollar that comes in has to find somebody else to sell it. The next dollar comes in has to find somebody else to sell it. Now, ironically, if you’re a deep value manager, if you’re somebody who thrives off of things being deeply mispriced, you’re very quickly going to see your portfolio taken away from you. Because stocks are being bid up, you will end up having sold. And the marginal players that are left are basically people who less willing to sell their incremental shares. We call those people momentum investors, for example, or growth investors. They’re willing to hold for higher valuations. Perversely, that means value gets sold early, momentum and growth gets sold later, which means they actually benefit from more of the price increase. And this process continues where more and more, basically, the passive players have to find somebody other than the value managers or active managers to sell to them.
Michael Green
And ironically, we actually now know who is. What we know from a paper just released by Marco Sammon, one of the professors at Harvard, is who clears the market when passive trades, when passive buys, the answer is it’s corporate insiders. It’s actually stock-based compensation that’s now being converted to income. And it’s being bought by the passive investors who are bidding up valuations to very, very high levels. When the passive investors go to sell, when that wealth creation or that life event of retirement or or whatever else materializes, at what price do they expect to sell? They expect to sell near the current market price. But the only players that have the discretion to buy those shares actually stopped playing a long time ago. They’re only interested at much, much lower prices. And so you actually end up with this market that when you try to run it in reverse, instead of this climb upwards, it creates a downward cliff where I have to find that next marginal player who is willing to transact. This This is exactly what happened with the dot com collapse in March of 2000, where institutional investors who had allowed their portfolios to become overweight in technology and speculative technology names suddenly went to try to rebalance their portfolios and change their allocations and discovered that the next bid for those companies was dramatically lower.
Michael Green
We saw something very similar at the end of 2021 where speculative frenzies had bid up companies like Gamestop or AMC to levels that we now recognize in hindsight, and many of us saw it in advance, but we recognize in hindsight, like those were just silly prices. And so the question is, can that happen with the biggest companies, the companies like Microsoft or Apple or Nvidia? And unfortunately, my calculations say there is no difference between them.
Ben Nadelstein
Yeah. One way I try to think about this is that if you imagine the pool of buyers is completely zompified, right? They just hit by no matter what. And let’s say there’s 10 of them, right? And all the active managers or the value investors, there’s another 10 of those. Well, those guys left the party hours and hours and hours ago. Once the zombies all leave, they’re gone, right? There’s going to be a big delta, a big miss in terms of, well, the stocks aren’t going to go down 1% or 2%, because that’s right where the value investors were. The value investors left a long time ago. This is obviously a potentially large or one of the largest drawdowns that people could expect in these massive, massive companies, which on the one hand is beneficial because these companies are now being priced closer to something that a value investor would say is reasonable. But on the other hand, lots and lots of people in these 401k strategies, in these passive index fund strategies, don’t realize that they’re dealing with zombies on the other end. So what do you say to someone who hasn’t looked at their 401k, who does have a passive index fund?
Ben Nadelstein
What do you say to this person about this potential risk we just outlined?
Michael Green
Well, the quick answer is until the how flows actually stop. And again, remember, these flows have now been blessed by the US government in a regulatory framework. I give a presentation on this. I used to make a point of saying Einstein is wrong. The most powerful force in the universe is not compound interest. It’s actually liability avoidance. The simple answer is people don’t want to take risk. And for corporations, the Qualified Default Investment Alternative, which is designated with that 401(k) change in 2006, and is a Target Date Fund explains why when you open up your 401k at your employer, you’ll discover that the only assets that are really available to you are a series of target date funds or low cost index funds. That’s because that’s been given liability protection, that a qualified default investment alternative means you can’t sue your employer if that product underperforms. You’re basically given carte blanche. Well, no employer wants to get sued for the 401k assets underperforming, and they’re You’re not going to gain any benefit from picking better 401k assets. Not that there really are any. And as a result, you basically just have more and more people herded into this exact same approach.
Michael Green
Now, to your point, it’s not even that the zombies all have to leave. It’s just somebody has to turn at that zombie party and say, Hey, does anybody have any fresh meat? The answer is no. If it’s all zombies, then there is no fresh meat. It just takes one recognition of that to cause the party to end very quickly.
Ben Nadelstein
You’re someone who obviously thinks about this all the time. What are some of these indicators that you’re looking at to say, Oh, this is the person turning on the lights at the party. What’s an indicator investors should also be watching to realize, Hey, I think the flows are starting to turn around here.
Michael Green
Well, one thing you can watch is the flows. I will be very straightforward and say that it is extremely tricky for an individual investor or even a professional investor to accurately track all of this. It is amazing seeing how Wall Street has shifted. My My inbox used to be filled with earnings reports and companies, investment bankers telling me what I should buy on an individual basis or what things look like. Now, my inbox is largely filled with people reporting what is the flows that are coming in from ETFs or mutual funds or option trading, etc. There’s a growing awareness that markets are dynamic and that flows are really the underlying phenomenon. A good friend of mine actually runs a venture capital fund. He decided as an experiment to to use AI to review all the existing fourth quarter letters and figure out what the themes people are talking about. Basically, all anyone’s talking about at this point is flows, passive, and the MAG7, Magnificent Seven. The world has changed really remarkably in that framework. As an individual investor, the unfortunate answer is just keep on keeping on while being aware that you’re hanging out with flesh-eating zombies.
Michael Green
This is a problem that ultimately has to be addressed by regulators and removing things like QDIA shielding and stopping this process of guiding everybody into the same approach. We’ve just assumed that markets are robust. We don’t understand them, so we assume they’re robust. It’s a little bit like polluting the Hudson River, right? You can do it for centuries, but at some point you have to take remedial action and decide you’re going to incur the costs associated associated with the cleanup. The real question is, can we actually extricate ourselves from this process? And that’s where the uncertainty Let me come up with some strategies, and you’ll tell me where I’m wrong.
Ben Nadelstein
One way to potentially get out of this pickle that we’ve put ourselves into is that people start buying foreign stocks, right? Do foreign stocks have the same issue as these US stocks with passive? Then maybe one other opportunity would be for someone to say, Well, I’ll start buying alternative assets, right? Assets that aren’t associated with this index fund issue or this passive issue, and I’ll put more money into my house or gold or Bitcoin or a thousand other alternative assets. So what do you say to those alternative strategies?
Michael Green
So I think those are all important strategies that people can choose. The foreign stock one does not solve the problem at all. The passive strategies are growing in foreign stocks. They’re particularly advanced in the United States, but they’re also very advanced in Australia. In fact, in Australia, there’s an interesting phenomenon in which the underlying securities have become incredibly bid up, and closed-end funds that hold those securities are actually being sold because nobody’s buying a closed-end fund anymore. So they are trading at deep discounts to their net asset value. This, in my analysis, is a direct indicator of a way of thinking about the scale of the issue. You have the closed-end funds trading somewhere around a 10% discount to their NAV at the same time and people showing no interest in buying these things at the same time that they’re bidding up the price of Commonwealth Bank, the largest publicly traded security in Australia, to to a point that even on a Western basis, it’s like this is just a silly price for a bank. Nobody should pay this. You’re not really solving the problem there. Then there’s a secondary issue associated with it, which is when you think about vehicles like the total market index, those presume that you are allowing the market to rebalance all of your allocations.
Michael Green
So you never have to make a decision. Do I want to buy energy stocks? Do I want to buy gold stocks? Do I want to buy small small caps, etc? It’s presumed all of that is being done for you automatically. Now, just as a quick thought exercise, imagine everybody on the planet decided that US small cap value was a really attractive asset class because we know it earns excess returns over time. No, air quotes, that it returns higher levels over time, and therefore we’re going to make it 10% of our portfolio. Well, if every single person decided that, by definition, small cap value would have to be 10% of all investible assets. When instead we decide we’re going to put it within an index and we never have to actually rebalance into that small cap, then you never get the event that looks like the march2000. Com collapse where there’s a reckoning between these different asset classes as they rebalance. And so this is hitting both US small cap stocks and international stocks, because what you’re never really seeing is this rebalancing phenomenon. If small caps get smaller, well, that’s just because they’re worse companies.
Michael Green
We assume there’s a narrative behind it. We come up with a conclusion that says we’re perfectly comfortable having small cap value be one and a half % of the market where it currently is down from about seven % as recently as 2006. That’s under performance. There’s no mechanism for it being changed. And perversely, it actually makes it harder and harder for new companies to become public. It makes it harder and harder for companies to raise capital in a differentiated fashion because there’s fewer discretionary investors that are looking at these environments. So you’re actually hollowing out the system of capitalism, even as people are perceiving that this is fantastic. There are a couple of other things that you mentioned that are worth highlighting. One is this idea that’s been expressed by David Einhorn, a friend of mine. I’m very flattered that he considers my ideas. He’s highlighted that he can invest in companies endogenously return enough cash to satisfy his objectives. And so he’s looking for companies that are experiencing neglect that are cheap enough but have actually an internal catalyst with the company buying back shares. That’s certainly an appropriate stance. It will likely lead to returns that are below that of the market, which feels like you’re doing an awful lot of work to underperform, but it also means you’re less exposed to that unique risk when it comes up.
Michael Green
The other alternative is one that you mentioned, which is identify alternative assets that could benefit from two fronts. One, they’re not directly associated with this phenomenon, so there is no passive equivalent in the same way. The second is that as people grow up and start recognizing this issue, there is pressure to include these types of alternative assets into strategies like 401(k), target date funds, et cetera. If you happen to get lucky and you capture that, then that’s easy street. That’s wonderful because now you’re basically picking an asset class that is going to become far more desirable to people. Another way of saying that is Bitcoin. Bitcoin is an asset that we have no discernible use for. We really don’t know whether it’ll work over a very long period of time. There’s an initial narrative and design of the white paper, which is it’s a peer-to-peer payment system. Now we talk about it as if it’s a store of value. My guess is that a big chunk, actually, it’s not a guess, I know this empirically, that a big chunk of what’s really going on is simply this marketing of number go up type framework where people presume that suggests something good is happening, even if there’s really no underlying economic information there other than people are trying to put money into it.
Ben Nadelstein
I want to end this passive discussion section with a question for you.
Michael Green
Oh, God, so do I. Oh, sorry, I misunderstood.
Ben Nadelstein
If you had unlimited data, unlimited money, what’s a question you would want to in this passive space? You had that conversation with Valentin Haddad, who I think is a very smart guy, but obviously, he only has so many numbers and so much money. So if you could get him onto something, what would you want answered in this passive space?
Michael Green
Well, first, you gave me an out here in saying, I have all the money I want. So my first question would be, where are we going on vacation? The question of what would I want answered? I’m not even so sure it’s a question of what I want answered at this point. I’d obviously love better transparency onto the flows and the way this is likely to develop because that would facilitate trading against it or with it, as the case may be. But I’m not sure that actually adds that much value at this point to the overall discussion. It sounds like you saw the conversation with Valentin. We pretty much know how this plays out at this point. While Valentin will acknowledge that there are models of the world in which this can be less impactful, they require those inattentive investors waking up and suddenly saying, Gosh, I really don’t want to buy Apple at 35 times earnings, even though I was perfectly comfortable buying it at 33 times earnings. I think the far more likely component is that Apple gets to 60 times earnings, and we all sit there going, Gosh, can you believe what a bargain it represented at 30 times earnings?
Michael Green
That corrupt disruption through the process is something that seems largely inevitable. Ironically, we don’t spend a lot of time thinking about the costs of overvalued companies, but I think we’re actually experiencing a component of it right now, which is palace building in Silicon Valley, incredible campuses that are being built, et cetera. Employees that think their jobs are basically to hang around by swimming pools and engage in TikToks. All of these are symptoms of a system of decadence that comes from a company that is being far too richly valued, providing capital for all sorts of whims and unnecessary things as compared to actually building a wonderful company. There was a paper written by Michael Jensen, who unfortunately has passed away at this point, but Michael Jensen wrote a paper called The Agency Costs of Overvalued Equities in 2003, in the aftermath of the dot com cycle, identifying exactly this phenomenon. You basically get management teams that think that their wealth and the performance that has been created as a statement is to their unique genius. When policy conduct, for example, is trying to drive a wedge between production in China and sales to the United States, corporate executives will often look at that and say, They don’t know what they’re talking about.
Michael Green
They’re not as rich as I am. They don’t understand. It’s very similar to discussions that have happened in the past. But unfortunately, we enable a lot of it when we allow this mispricing to occur.
Ben Nadelstein
Let’s talk we’re talking about gold now. Someone listening to our conversation might go, Wow, this seems like a great opportunity for gold investors. First of all, it’s a physical asset, so there’s no counterparty risk, depending on how you hold it. It would definitely not be benefiting from this index flows, potentially. I can hold on to it and hope that if this index apocalypse does happen, that people will look for more valuable assets in terms of equities, but also in alternative assets like gold. Where do you see that being wrong and where do you see that being right?
Michael Green
One, I would highlight that actually this phenomenon already played out for gold. Part of what we saw in the early 2000s was the growing acceptance of commodities as an asset class. In 2005, a former professor of mine, Gary Gorton, released a paper called Facts and Fantasies of Commodity Futures, has created an environment that caused the commodity investing boom from an institutional framework. It’s why ETFs like GLD were created. We decided that gold was an asset class that people that are ignored and should be invested in. Not dissimilar to what we’re talking about with Bitcoin, etc. And that flow of capital into a very small asset class. Just remember how small commodities are. They’re only about 5% of the aggregate financial assets that’s inclusive of oil, that’s inclusive of gold, that’s inclusive of the food you put on your dinner plate, et cetera. We spend a tiny, tiny fraction of our day trying to figure out how to source commodities. And when institutions When the regional investors suddenly woke up and said, Oh, it’s a diversifying asset class. I should try to put 10 to 15 to 20% of my portfolio into this asset class, it caused prices to rise in an anomalous fashion that we then created all sorts of narratives around.
Michael Green
We’re running out of oil We’re running out of natural gas. We’re running out of all these things. And that still echoes in the minds of many of your investors or your listeners. I want to first put a foot down and just say, there is no shortage. And the idea that we are limited in some way in physical space, that we’re going to run out of rare earths. And your listeners are sophisticated enough that they know that rare earths are not actually rare. It just means unusual dirt. What is rare is populations that are willing to incur the pollution associated with the processing of tons of unusual dirt. But there’s no shortage. And we live in a universe is so vast in physical dimension relative to our existence that the idea of any form of physical shortage is actually really just a statement that you don’t believe in human ingenuity to apply energy to change the state of matter and obtain those resources for you. That’s all mining is, is energy application to relatively unusual dirt to extract materials. I don’t believe in any of the shortages component to that. With that said, they do play a very critical role gold.
Michael Green
It’s important to recognize that there’s a lot of information content in the pricing of commodities. One of the components that works really well is the use of gold, which has few industrial uses, but maintains a cultural affiliation as a store of value in telling you what’s happening with the fiat component, how much money has been printed. One of the natural outcomes from my work is that you cannot allow a a retirement system to fail. You can allow a market to fall, but you can’t allow a retirement system to fail. If you actually recognize that, then the obvious next step will be, well, when these events occur, the government will step in and simply buy equities, or they will step in to support markets in one way, shape, or form, increasing the quantity of fiat money relative to the supply of gold, and simultaneously scaring people into buying things like gold. It’s very hard to be to be very bearish on gold in that context, except to highlight for people what gold really is, which people are saying, I’m taking my ball and going home. I’m going to put my money into a non-productive asset because the rest of you have lost your minds.
Michael Green
I’m hoping that when that non when the time comes that you recognize that I’m able to sell you that non-productive asset in order to buy a much higher quantity of productive assets. That doesn’t feel like a terrible bet unless, of course, there is government action that We’re going to confiscate the gold, or We’re going to do all these sorts of things. I got to be honest with you, if that’s going to happen, you’ve got a much bigger set of problems you’re dealing with than listening to advice on a podcast on YouTube.
Ben Nadelstein
I feel the exact same way with the one caveat, if you are interested in earning a yield on gold paid in gold, you can check out monetary-metals. Com. Let’s do a lightning around here. I’m going to ask you all around different areas, different asset classes. We’ll start with a fun one. Eleven years ago, a young FX and rates trader asked Warren Mosler, who is the father of modern monetary theory, what he thought would be the likely outcomes of an unrestrained fiat currency like we’ve just been talking about. That man was none other than my guest, Mike Green. Now, I turn the question to you, what have been the behaviors, the outcomes of our modern fiat currency system, and do you think those have been net beneficial or not?
Michael Green
I don’t think there’s any question that they have been net beneficial. The really key thing to understand is that using gold as a currency or restricting the quantity of currency that is available is an artificial restriction. Currency is really more properly thought of as almost like the equity of a nation. If there is an attractive investment that can be made that will increase the aggregate wealth enough to offset the dilution associated with printing, you should take advantage of that. That can include things like children’s health, research and solutions for infectious diseases, education. These are all goods that actually raise the value of the human capital that already exists within our borders, and therefore makes a ton of sense to actually spend money on. Building infrastructure to connect disparate communities, whether that’s through telecommunications or physical connections in the form of roads, are other ways that you can raise the value of the human capital in a manner to offset the dilution associated with it. We’ve seen evidence for this throughout the past 100 years of basically the fiat system. We have had far greater wealth gains over that time period than we have at any time in history.
Michael Green
It’s not simply because people are smarter or better looking or whatever than they were years and years ago. It’s because we’ve placed fewer constraints on their behavior that frees them to be more innovative and to operate less from a position of stress. Many of your listeners will be familiar with the idea of market economies have failures. Well, one of the sources of failure is when people are forced to sell under duress. The exchange between Jacob and Esa in the Bible, where he sells his birthright in exchange for some soup. That was a distressed exchange that dramatically lowered the outcomes for Esa and created conditions in which Jacob ultimately fled, fearing the retribution of his brother and his father. Those types of events happen less when there is a safety net that is created, when we provide adequate nutrition for young people, et cetera. Those are all good things. What’s not a good thing is the belief that the money doesn’t matter, that we can spend it on whatever we want. And so military adventures and hip replacements for 107-year-olds and all sorts of things that make absolutely no sense in a realistic framework don’t don’t add to that wealth, and in many ways, they actually, by providing control to a subset of our population that is elected and considers itself beyond reproach, can create conditions under which we all lose.
Michael Green
I think there’s significant evidence for that as well. I think we’re better off because of it, but the key question that I was asking to Lauren at that time is, this is actually how the system works. What are the implications of us failing to appreciate that this is a trust that has been endowed to us as compared to, we just get to do whatever we want? It’s not that. You don’t get to do whatever you want. There are consequences associated with the choices, and we tend to make some pretty bad choices.
Ben Nadelstein
Tyler Cowen, at one point, said he’s not a gold standard guy, but some arguments for a gold standard in the current year would be that, Hey, how much do you really trust central bankers? Maybe they’ve had a good track record in the past, but how interested and incentivized will they be to remain politically neutral, for example, or do these positive expected value trades? What do you think about that? Saying, Hey, listen, the gold standard, although it may have flaws or costs associated, it’s maybe a lower volatility option than something like a Trump telling the Federal Reserve what to do.
Michael Green
I own gold. I think gold actually plays an interesting role. Again, it’s largely a barbarous relic in a Keynesian framework, but it does have an interesting property, which is that almost unlike any other commodity, its value is derived simply by its mass. We talk about the value of gold in grams, which is a measure of mass. We talk about the value of corn, not by mass, but by calorie content. So we can actually make corn more valuable by increasing its calorie content, larger kern, more robust, cellulose, etc. The same thing is true copper wiring. Do I actually care how many pounds of wiring or grams of wiring copper in a wire? No, I care about how much electricity it can transmit. And so I can introduce innovations in technology around copper wiring like shielding or multiple strands as compared to a single thick strand that actually improve the value associated with that while lowering the price on a weight basis. If you look at industrial commodities relative to gold over time, they are structurally deflationary. There are periods in which they go into high demand or relatively short supply, but the price of copper will almost always fall relative to the price of gold for that very simple reason.
Michael Green
I care about what the copper is used for, I don’t care about that same framework in gold. This is a great exercise that your listeners can do. Run a graph of the price of copper and gold. Actually, pull up some charts to show this stuff. Run a price of the copper versus gold. Run a price of oil in gold terms, et cetera. And you get that deflationary 19th century that was a function of us being on the gold standard as these human innovations are starting to occur. The discipline around gold is potentially its most valuable component. It’s the same thing that you would argue is occurring with Bitcoin if it were to become a strategic reserve asset. Now, the problem with it is twofold. One is it is not more stable. So unique events happen in history, like happened at the tail end of the 19th century, where we started to solve problems of infant mortality, female mortality during the giving of birth, during the sterilization of instruments, et cetera. That dynamic of the 19th century, where we were solving issues of human mortality, meant that the quantity of gold fell dramatically on a per capita basis.
Michael Green
That is too deflationary. It effectively translates to very high personal interest rates. It means you can’t obtain credit, can’t obtain capital early in your life that allows you to raise your human capital component, and it ultimately sowed the seeds of the gold standard’s own demise. Now, there can be arguments that you make that now that we’re through that population bubble, we reverse that, we go back to a more stable system, etc. I happen to think that there’s probably another innovation that’s out there that radically changes the calculus again, and so suggests that that’s not actually the right approach. I think it’s even more extreme when you talk about something like Bitcoin, where Bitcoin has a really unique property to it, which is it has enforced an algorithmic scarcity, meaning it doesn’t matter how innovative I get, I can’t increase the quantity of Bitcoin. That was not the case for gold. The solution for gold, what caused the gold standard to at least get another at bat was the development of the cyanide process at the beginning part of the 20th century that dramatically increased the production of gold, lowering the cost of money around the globe and allowing a lot of innovations to occur.
Michael Green
Unfortunately, a lot of those innovations took the form of military, but that is another statement in terms of benefits of controlling and limiting the power of governments. Bitcoin doesn’t even have that capability. It is actually an anti-innovation and anti-technology framework that suggests that humans are incapable of solving their problems and coming up with unique and interesting solutions. The fiat component, the one benefit the fiat component has there is it allows you to ask for grace. It allows you to effectively say, I made a mistake. That mistake has catastrophic implications on a change of control feature, which is really what credit is all about. We want to minimize the impact that that has the population in total, and so we’re going to increase the quantity of money to solve some of those problems. That puts more productive assets in play. It allows people to continue to participate. They don’t go to debtors prison, et cetera. And You laugh, but people underappreciate this. These are very real features that come out of an economy that is constructed with these elements to it and doesn’t exist under something like a Bitcoin standard or a gold standard.
Ben Nadelstein
Very interesting and insightful as always. What’s a question you would want me to ask Bob Murphy, who was debating war in Mosler 11 years ago, on this topic of MMT or any other topic, since I’ll be interviewing him in the coming weeks?
Michael Green
I’ve had the chance to talk to Bob. Obviously, I sat and asked questions of Bob as well in that framework. Look, Bob is a died in the wool Austrian and believes that money is the most marketable good, right? That there’s a signal associated with that, and that gold has that unique property to it. I just don’t actually believe that. And so I would probably ask Bob some question along the lines of, well, let’s take the 5,000 years of history out. If you were picking the most marketable commodity, why would you choose gold today? What are the properties of it that you think are unique? Because I don’t think there actually are a lot of unique properties to gold. I’ve given speeches on this and I’ve shared this, but if you look at gold, it’s just a a metallic element on the periodic table, every single metallic element that has the properties of gold in terms of non-reactivity, it’s not poisonous, it is a solid that is malleable at temperatures that could the approach during the period of coinage as compared to digital assets. All of those metals were used as money. We made pennies out of copper and tin, we made nickels out of nickel.
Michael Green
We made dimes out of initially tin in silver, and then we made dollars out of silver, et cetera. We used them all. There was nothing unique about gold in this process. They happen to fill a particular niche in terms of their reactivity. And because they are elements on the periodic table, they’re very hard to counterfeit. Actually, impossible to counterfeit for the most part. There were mechanisms for controlling counterfeiting, et cetera, that existed through the use of these simple metals. We alloyed them for robustness and wearability. But it was very easy to audit those things. There’s nothing unique in gold in that framework. The only thing that was unique about gold was this relative scarcity and the fact that it largely existed in the vaults of kings, and most people never got to see it. As we, as a population, have become so wealthy that as an individual, you now own significantly more individual goods than King Henry VIII probably had. It’s not surprising that you look at gold and you’re like, Man, I’m a king. I’m a king in my own castle. I can own some gold and feel safe. Like I said, I think there are positive attributes associated with that, but I think it’s largely mythology.
Ben Nadelstein
One final question on gold. How do you think of the stock to flow ratio in gold? Obviously, it’s quite unique compared to other commodities or other metals. Do you think the fact that we’ve had an incredible amount of gold mining in mainly South Africa in the recent decades, do you think that matters at all to the gold question going forward or as a monetary medium or not as much?
Michael Green
I think it matters far less than people think. Again, gold is not money anymore. J. P. Morgan made that quote, Everything else is credit. He actually was just telling you, Hey, this is modern monetary theory. He was highlighting that everything in the monetary system that you don’t see as physical coinage is effectively a form of horizontal money that’s been created by the banking system. That was an insightful observation that has been unfortunately misused by many in the metallic community. The production of gold, the ability to bring a traditional gold into being, et cetera, I don’t think matters nearly as much as people would think. The stock per capita, if it’s used as a monetary asset, matters a lot. Again, that’s why I highlight the developments of the late 19th century. Now, it’s really just a question of what is the relative supply and demand? The more enthusiastic viewers you get, the more demand there is for gold relative to its supply, the higher the price goes, it has Veblan good asset component to it. The higher the price goes, more people get excited about it and want to buy more of it because they think it’s effectively making money.
Michael Green
Again, there’s some truth to that. There’s a collective psychosis that can take hold in those environments, and that collective psychosis, by the way, can play in reverse where a government decides it’s capable of doing anything and it’s going to print money willy-nilly, and as a result, the price of gold rises in that local currency. So I’m not as sure the stock-to-flow component matters in the way that people think as much as it matters. That stock to flow will be radically different for a consumed industrial commodity than it will for a monetary asset. What really ultimately matters if it’s a monetary asset is how achievable and attainable is it for individuals not just that were born 50 years ago, but are potentially born 50 years hence.
Ben Nadelstein
Mike, it’s been a fascinating conversation. I want people who want more Mike Green to be able to find you. So first of all, where can they read more of your work? And as well, tell us what you’re doing at Simplify Asset Management.
Michael Green
Well, at Simplify Asset Management, we are an ETF firm that is a byproduct of a regulatory change that allowed the transition of hedge fund-like strategies into ETFs. We focus in the alternative space products. So I run products, for example, a credit fund that offers credit enhancement, protecting against credit spread widening or a traditional credit event type framework. We have other products in the commodity space. We have two products in particular that might be very interesting to your… Three products, actually, that might be very interesting to your listener base. One is CTA, which is our Managed Futures Trend Following strategy. That’s managed by my friend Charlie Magara. It’s a really powerful way to think about the question of what happens next by saying, Man, I don’t know. And so you actually follow the trends. You allow the market to dictate where you want to invest. Charlie has adapted that to invest more directly in commodities in hard, which is a commodity ETF that takes advantage of the ability to be both long and short commodities on trend, as well as benefit from the components associated with carry. And then the third product that might be interesting to your investors is why GLD Why gold, as we like to joke about it, is actually an income-enhanced version of gold that monetizes some of the volatility in gold to create income associated with those gold holdings.
Michael Green
I know you do something very similar in terms of returning it, not in terribly debased fiat dollars, but in actual metal content. If you’re looking for something to spend, however, I’ll put my fiat up against your gold and suggest that for those later in life, it might be more appropriate to think about an income-generating asset than a capital accumulation asset. If you want to read my work, and I haven’t discouraged you from doing that with my droning voice and belaboring points, you can find my sub stack at yesigiveafig. Com, and you can follow me on Twitter @profplum99, P-R-O-F-P-L-U-M 99. Confusingly, my avatar is Vasini from the Princess Bride. We can have a discussion about that in the future. And then, of course, I encourage people to check out Simplify. Our website is www. Simplify. Us. And that’s pretty much it. Thank you very much. I appreciate it, Ben.
Ben Nadelstein
Mike, thank you so much for joining us. We’ll have to have you back on soon.
Michael Green
Thank you.
