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Transcript

00:01

MIKE GREEN: Mike Green, I’m here for Real Vision at the Real Vision Studios in New York

00:05

City.

00:06

Today, we’re going to sit down with another individual who is known for his work in the

00:10

past of space, in particular, his work on ETFs.

00:13

Steven Bregman has a been on Real Vision before with an extended series called, “The Dark

00:18

Side of ETFs,” where he sat down with Grant several years ago.

00:21

We’re going to revisit that, particularly in the context of some of the stuff I’ve talked

00:24

about.

00:25

I’m really interested in how Steven thinks about the endgame of the passive strategies

00:29

and how to think about the influence in the market.

00:32

Let’s sit down and see how this goes.

00:34

Steven, you and I have not had the chance to talk for a couple of years, you’ve been

00:40

one of the other voices in the wilderness shouting about the risks associated with passive

00:44

investing.

00:45

I’d love to pick into your brain and understand the approach that you’re taking to some of

00:50

these challenges and some of the opportunities that are created by the growth of passive

00:55

investing.

00:56

One of the places to start is one of the areas of difference.

00:59

I focused primarily around the indexing component and you’ve spent a lot of time talking about

01:03

ETFs.

01:04

STEVEN BREGMAN: Well, essentially, they’re one of the same.

01:07

Sometimes people use the terms interchangeably because they don’t know the difference, and

01:12

they’re being casual about it, and I do the same actually, ideal primarily with direct

01:18

individual clients.

01:19

They’re not institutions.

01:20

They don’t have an institutional mindset.

01:25

They’re unaware of real differences.

01:29

They’re unaware of the fact that asset management companies, Wall Street is not really about

01:36

investing.

01:37

It’s about asset gathering.

01:39

They would be unaware, for instance, that how does an index come to be.

01:44

An index comes to be because a certain asset management specialize in this might be under

01:53

pressure from ever declining fees and you can’t charge a premium fee for a commodity

02:00

product.

02:01

Once upon a time, I think the fees on S&P; 500 index are like 50 basis points 60 basis

02:07

points, now, they’re down to zero.

02:11

What do you need to do to justify a higher fee?

02:15

Create something that seems to have, at least has the fig leaf of differentiation.

02:20

You can charge more for that, at least for a while.

02:24

You invent a new index, you do some back testing, you find some bucket of 20 or 30 or 40 companies

02:32

that fit some theme that back test well for the last five years.

02:36

By definition in this industry in modern portfolio theory, as applied nowadays, that means, some

02:44

positive rate of return with some relatively low comparative volatility, beta correlation,

02:53

what have you, and then you can float a new index, and they’re from offering ETF against

03:03

it.

03:04

You can’t even get it off the ground unless it back test well.

03:08

That’s how that works.

03:09

Indexes don’t just come about because they’re good investments, they come about because

03:13

it’s an opportunity for a management company to gather assets through a new ETF for which

03:19

at least initially, they can charge 45 or 55 or 65 basis points.

03:23

They can keep that fee, except if they’re lucky enough to gather enough assets, not

03:28

10 or 20, 30, or 40, 50 million, not even enough to break even, but if I gather some

03:35

hundreds of millions of dollars, well, then somebody else would come and knock them off,

03:39

like Vanguard and drag the fees down again.

03:41

People don’t even get these basic concepts and because my natural audience are individuals,

03:46

who really are the victims of this asset gathering business that parades as an investment business,

03:56

we study that.

03:57

MIKE GREEN: Well, you and I originally started in the same space.

04:01

You come up from the classic stock picker, single stock focus, run a highly concentrated

04:06

portfolio and by some measures, you found a few names that you think are truly extraordinary.

04:11

We can talk about a few of them if you’d like, but your insight into ETFs that I know you

04:18

from the Grants Conference discussions is largely around the dynamic of many different

04:25

ETFs buying the same underlying products, and this tendency to overlap.

04:30

You’ll see very high representation of Exxon Mobil, you’ll see very high reputation representation

04:35

of other stuff.

04:36

The dynamic that you’re talking about now, where effectively you offer a good back test

04:41

to try to offer something that you can actually charge fees for and the potential for if that

04:48

gets to scale, either you to lower your costs so that new entrants can’t come in and replicate

04:52

it or to be disintermediated by one of the giants in the industry.

04:56

STEVEN BREGMAN: They’re very disinclined to do that, they need every penny.

05:00

MIKE GREEN: Yeah.

05:02

How do you think about this dynamic of the difference between a Vanguard model and a

05:08

BlackRock type model where they are charging rock bottom fees and the need within the industry

05:15

for innovation in order to push forward how thought process is going?

05:19

STEVEN BREGMAN: The whole thing doesn’t even make a difference.

05:22

There’s no differentiation.

05:24

The whole thing, I’m going to say something, it sounds incendiary, I don’t mean to be incendiary,

05:28

but well, I shouldn’t say it’s a lie, but it’s false.

05:33

The whole thing is a false premise.

05:34

Now, we actually have the evidence.

05:37

The evidence is in.

05:40

We now have a couple things I’ll mention.

05:43

First of all, the great indexation passive investing ETF experiment, which took off for

05:50

real, more or less yearend 1999.

05:53

Slowly at first, but it was given a real boost in the wake of the 2007-2008 financial crisis

06:00

and people got really scared.

06:02

Now, they did everything that people do, which is act reflexively, which is not necessarily

06:07

helpful, which is first of all, sell your securities and memorialize a perhaps temporary

06:14

loss.

06:15

Then when they get back in after there’s confirmation that things are going up, which means they’ve

06:19

lost much of the recovery.

06:23

That’s normal.

06:26

What they did is they defaulted immediately to ETFs.

06:29

They were there.

06:31

They had time to become better known.

06:35

They’re a better mousetrap than a mutual fund and people had been really traumatized.

06:43

Traumatized, by the way, not just individual investors, but their brokers, financial advisors,

06:49

trustees of pension funds, [indiscernible] they all work.

06:53

They were scared of risk, all kinds of risk; manager risk, security specific risk, everything.

07:02

The proposition of an index made a lot of sense.

07:06

People had the experience, I could buy my favorite REIT.

07:10

Maybe that’s the one that goes to zero or I could buy an REIT sector index fund, and

07:17

it might not do well but it’s not going to zero.

07:21

That started taking off.

07:22

ETFs is supposed to be better, and indexations are better.

07:29

People like me could talk about it and analyze it and start coming up with a very amusing

07:34

and hopefully illuminating examples of how distorted it was becoming.

07:38

It was still subject to a lot of argumentation that passive investing, which is supposed

07:42

to benefit from the free rider principle, we just want to participate in the wave of

07:48

what active managers do when they contest in the open market and the set clearing prices

07:53

and just participate without changing anything.

07:55

We could argue that they’re beginning to actually alter clearing prices but those are arguable.

08:02

We could argue that the only reasons they were outperforming active management then

08:10

that came to be there are any innumerable articles about it, that active management

08:14

has just been proven to underperform indexes.

08:19

We could argue that simply because they were pushing up their own very limited number of

08:25

securities in which they traffic people and understand that you have to elucidate that

08:29

also why that is, but that was all arguable.

08:33

Now, we’ve got some proof because now, we’ve got a 20-year track record for ETF -based

08:42

index investing and history has spoken, and they all found one thing.

08:48

The S&P; 500 for the last 20 years has got roughly a 4.5% annualized return.

08:59

If you go to the MSCI All Country World Index, less than that, maybe 3.5% or 4%.

09:06

If you bought a 20-year Treasury note, and you’re in 1999, you could have bought about

09:10

a 6.3% or 4% yield.

09:12

MIKE GREEN: Remember it well, yes.

09:13

STEVEN BREGMAN: You could have done just fine.

09:15

They didn’t even perform as well as called a risk free Treasury but 20 years is a long

09:22

time.

09:23

Then if you take another look at what we think is the primary risk to investors, and the

09:31

primary responsibility of an investment advisor is not comparable returns to some other manager

09:38

or to some set of managers or some abstract index or an index with some abstract purpose

09:46

or importance, but at the very least, to maintain someone’s purchasing power over time, and

09:52

hopefully to increase it.

09:54

Well, the measure of monetary debasement over these last 20 years, M2 money supply expansion,

09:59

has been more than 6% a year.

10:01

In that sense, if you owned the iShares S&P; 500 index over the last 20 years, you actually

10:09

lose in purchasing power.

10:10

MIKE GREEN: How do you disaggregate that, though, between the outcome versus the process?

10:14

Because if I were to point to active manager performance, almost by definition has to be

10:20

worse, because we’ve seen in aggregate, active managers underperform the benchmarks.

10:24

STEVEN BREGMAN: What are the benchmarks?

10:28

What if the benchmarks are rigged?

10:29

What are we going to be talking about here?

10:31

MIKE GREEN: Yes, exactly.

10:33

STEVEN BREGMAN: By the way, I should preface this by saying I’m willing to try to defend

10:38

it and I feel comfortable with that.

10:41

I think this is the– not just the United States but globally, we’re in the biggest

10:45

financial bubble ever that includes stock, include bonds.

10:50

Basically, it’s the entire set of financial assets worldwide.

10:54

It doesn’t happen in a vacuum.

It happens because it’s unprecedented, but it follows on the heels of something whose

causality here, something else is unprecedented is there’s never before been a coordinated

global coordination by the world central banks to drive interest rates down to these artificially

low rates.

Now, people have caught on to this.

I have books at home that have the evidence, the lowest interest rates in 5000 years.

One of the things that’s happened is that it raises financial asset prices, makes people

feel good, but it’s actually very pernicious, because it transfers the risk and returns

between savers and borrowers.

If you’ve done everything you’re supposed to as an individual, you’re a retired accountant

or you’re an attorney or you’re a doctor, and you pay for your house and you’ve got

a million dollars, $2 million saved up.

11:52

What’s $2 million times if you put it all into a 10-year US Treasury note in less than

11:57

2% and it’s taxable, but even if it’s not taxable, what do you get?

12:01

You can hardly live on that.

12:03

If you don’t expect to spend your principal, you don’t know when you’ll die.

12:07

MIKE GREEN: Yeah, it’s a pretty extraordinary statistic.

12:09

STEVEN BREGMAN: It’s a crisis.

12:11

I like to differentiate, there’s a term statistic and then there’s a place for interpreting

12:15

for people, because it’s really a crisis, it’s a yield crisis, and people can’t get

12:23

yield.

12:24

What does that do?

12:25

There’s a dynamic to bubbles, they build over time and people owned a series of bonds, municipal

12:36

bonds or corporate bonds, or within a bond fund and little by little, their maturities

12:41

calls and the yield goes down because the coupon goes down, or the average coupon goes

12:46

down, because they replace it with lower coupon bonds and happens slowly.

12:52

Little by little, people realize I’ve got a problem.

12:55

Wall Street is a unique industry.

13:00

Among other respects, that is the only industry I know of, in which, if there’s sufficient

13:08

demand for a product, they can create effectively infinite supply almost instantaneously.

13:16

If someone likes a certain GM truck, they have to retool, there’s certain amount of

13:22

capital you got to put in, but they’ll sell you whatever you want.

13:28

What happens?

13:30

Some firms see, oh, there’s a need for yield.

13:31

Why don’t we create– it also helps the fee aspect.

13:35

Let’s create a dividend aristocrats ETF index.

13:40

You’ve got various kinds of companies like they collect the higher dividend yield and

13:45

so people, they go with their lead there.

13:51

You get less than 2% in the Treasury, if it’s looking good, 3.5% in this REIT index or this

13:57

dividend aristocrats index.

13:59

They put more money into bonds than they really should, been into equities than they should.

14:07

They’re doing what they can.

14:09

Then you have the dividend aristocrats fund and so forth and so on, but it’s important

14:13

to understand the magnitude of asset flows into index funds.

14:21

We’re talking about several hundred billion dollars every single year for a decade, it’s

14:27

actually been climbing until this past year, and what happens is when you have trillion

14:33

dollar asset managers, and they create a new fund, and it could be a $200 million fund,

14:39

a $400 million fund, a $500 million fund and there’s going to be a knockoff of one of the

14:45

competitors, as a pure business proposition, you’ve got some really bright people in the

14:51

back office, working up different packages of stocks, new indexes, and they tried to

15:00

make it work.

15:02

Let’s just say that they create a list that back test really well, that’s got a nice theme

15:07

to it and then they bring it to their managers, they managed it well, there’s a problem here,

15:15

is that you’ve got these hundred stocks, except in the nether regions of that list by market

15:21

weight, the ones at the bottom, they just don’t have the trading liquidity.

15:25

They’ve got so many shares per day of trading.

15:28

They’re an X percent, let’s say it’s equal weighted, and it’s X percent of your list

15:34

and we can’t go above certain liquidity limits that we set in place, we can only raise 100

15:40

million dollars for this.

15:41

It’s not even worth the time, barely pays for your salaries.

15:46

They go back to the drawing board and they fiddle with the rule set.

15:49

It’s a very simple rule set, and they simply drop out.

15:51

They find a way to drop those companies out.

15:53

It’s legitimate.

15:55

We’re only– we have this list, but only companies with above this much creativity or whatever.

16:00

Now, you drop those out and suddenly, you can raise $500 million.

16:04

That’s an example of why real practical purposes, the ETFs or their bond ETFs or stock ETFs

16:13

have trafficked substantially completely in large cap and mega cap stocks.

16:20

They really need basically industrial strength trading liquidity, which is why you find Exxon

16:26

Mobil everywhere they can put it and why you find technology stocks in funds where they

16:35

don’t belong, because Facebook’s really liquid, or Microsoft’s really liquid, to find a way

16:40

you can find individual stocks, like an Exxon Mobil or Microsoft or something else, and

16:46

you’ll find they’re in growth ETFs, they’re in value ETFs, they’re in momentum ETFs, they’re

16:50

in fundamental tilted ETFs, they’re in dividend ETFs, they’re everywhere.

16:53

If you actually look at it, it defies logic other than they need the trading liquidity.

17:01

There’s so many systemic risks in the market now.

17:03

What will happen is when something gets over done enough, when you get like a deep bear

17:09

market, you get a bubble, aside for the fact that they can go higher than you ever imagined,

17:13

more overvalued then you ever imagined, or lower, they become a variety of systemic risks.

17:20

One of them nowadays, systemic risk, set systemic risk meaning it’s going to affect substantially

17:26

most of the securities in the universe you’re talking about, a single variable and one of

17:32

those variables now– I know you’ve observed it and are concerned particularly, you study

17:39

it closely, is the concentration risk.

17:43

People are unaware of what the concentration risk now is.

17:46

They think they’re getting diversified.

17:49

Diversification semantically only just a name, because all the same stocks are being owned

17:54

by these ETFs.

17:56

The fund flows come in, the ETFs are– the indexes are price agnostic, there is no–

18:04

in their short list that makes up the rule set for inclusion or exclusion of ETF, market

18:12

cap, industry sector, PE, whatever it might be, those descriptive attributes, there is

18:17

no place for valuation.

18:20

It’s not on that list.

18:21

There are different ways to talk about the concentration risk.

18:25

Not too long ago, only a matter of weeks ago, I accounted up in the S&P; 500, the top 100

18:33

names, 20% of the names accounted, just happens that the numbers of this even 67% of the market

18:40

value of the index.

18:43

That’s real concentration.

18:44

Although we’ve never had concentration like that before.

18:47

They drive the market.

18:49

The asset allocation’s idea of shifting from one sector to another in terms of market capitalization,

18:55

it can’t happen anymore.

18:57

I think the figures for the Russell 2000, is it $2 billion and below?

19:02

MIKE GREEN: I think it’s a little higher than that actually now, but yeah, something like

19:06

that.

19:07

STEVEN BREGMAN: The sum, the complete market capitalization of all the Russell 2000 stocks,

19:12

it may only be several percent the value of the Russell 1000, S&P; 500.

19:19

Even if for the sake of argument, it were undervalued, let’s say it were undervalued

19:24

and people just wanted to shift some money there, they can’t.

19:27

You can’t have a thimble that’s a 5% or 6% size to accommodate that.

19:35

In one sense, people– they don’t know it, but they’re stuck.

19:37

They’re stuck in the dark, there’s nowhere to go.

19:40

They’re going to go to treasuries and earn a basically return that will [indiscernible].

19:46

I want to talk about that too, because the lie or the complete let’s say misapprehension

19:53

of indexation, talk about active managers you asked me before.

19:57

This is a long winded way of getting around to this response, which is that the indexes

20:03

have been buying automatic bid.

20:07

Every time money comes in, they’re required probably to buy and hold all the stocks they

20:12

own in precise proportions.

20:14

They’ve been buying their own book.

20:18

It’s arguable, pushing them up.

20:23

Therefore, this is not passive, if you’re not participating in whatever the clearing

20:30

price mechanism established by active managers.

20:33

In fact, one of the reasons why active managers have done more poorly is they have been the

20:39

bank of funds and you could– there are places to look and you can see on a given year, a

20:45

given quarter, so much money comes out of active managers, and pretty closely, that’s

20:50

the amount that goes into indexes.

20:52

They’ve been the bank providing that, therefore, like [indiscernible].

20:55

You might like what he does, you might not like what he does, but give him this.

21:00

He sticks to his knitting.

21:01

He hasn’t bent.

21:03

He’s not going to do what he doesn’t want to do in terms of his, let’s say the integrity

21:07

he has over the investment process.

21:09

He loses money every quarter, but he’s got to sell and you get redemptions.

21:13

He’s got to sell things that aren’t in the indexes, there really is no buying interest.

21:19

He owns undervalued securities, and he’s selling them, make them even less, more undervalued.

21:24

The system is gamed, I don’t think the conclusion on that basis that indexes have proven active

21:33

managers to not be able to perform as well as index is false.

21:38

There’s another anecdotal bit of information I like.

21:43

I made a list a year or so ago, of like a half a dozen really well respected value managers,

21:50

value managers who had 20, 30 years of ongoing investment performance over obviously, over

21:56

multiple cycles, superb performance, like really stellar, well respected, not anymore.

22:03

Why?

22:04

Because in the last five or 10 years, they’ve underperformed plus five years, the underperformance

22:10

year by year, and back to back.

22:13

Astounding.

22:14

We’re talking about not just five percentage points, 10 percentage points, 15 percentage

22:18

points a year.

22:20

If you take people like [indiscernible] and Chuck Royce and Sequoia Fund and so forth

22:25

and so on, even Carl Icahn, first of all, there’s information content in that.

22:33

How can you take, let’s say, half a dozen or 10 people like that, with proven serial

22:41

success, and suddenly in the last five years– and by the way, they all have different approaches.

22:49

They have an affinity or skill set for a different type portion of the markets, or style of investing

22:56

or method of doing it.

22:58

There’s very little overlap in their portfolios.

23:01

Suddenly, altogether, they got stupid or incompetent at the same time.

23:07

It just is quite improbable.

23:09

Therefore, there’s information content in that which is maybe something else is going

23:12

on, and I can talk about why the S&P; 500 underperform for 20 years the All Country World Index has

23:21

and get into that.

23:22

Before I give you this more specific, another more overarching observation, have you heard

23:27

of the or read the Bessembinder Study?

23:29

MIKE GREEN: No.

23:30

STEVEN BREGMAN: You’re going to like this.

23:32

I know if you’re going to read some point in the next week or month.

23:35

My business partner, [indiscernible], came across this and he wrote about it.

23:41

Let’s call it the academic invalidation of indexation as practiced.

23:46

This is a guy, Hendrik Bessembinder.

23:48

It sounds like someone from the 19th century, but– MIKE GREEN: This were in Germany but

23:53

yes.

23:54

STEVEN BREGMAN: He’s a professor at Arizona State University.

23:56

Two years ago, he published a study.

23:59

It’s a 90-year study of equity returns 1926 to 2016 but it’s entirely different than what

24:07

we’re used to.

24:08

It was called little insouciantly, do stocks outperform treasury bills?

24:13

I tell you, this is a seminal piece of scholarship.

24:16

It’s like a significant contribution to the field of study of finance, and essentially

24:23

it invalidates indexation.

24:26

What he did is the differences that– I used to wonder about this, the reliance as a standard,

24:35

this is the way it’s supposed to be when you measure performance returns for people.

24:40

It’s all based on this time weighted percentage rate of return.

24:45

That’s because it’s designed for institutions, how to compare managers, but individuals,

24:52

they need to measure their performance in dollars.

24:55

That’s not how it’s done.

24:56

All the studies are done that way.

25:01

The difference is that his study was based on dollars of wealth creation.

25:07

How much did each company over that period of time contributed in terms of dollars of

25:13

value increase as opposed to just percentage return?

25:17

Because that only– I say “only” advisedly, only compounds at 12% a year for 20 years,

25:23

which is actually really good and creates a lot more dollars of wealth for some small

25:28

company, in a percentage basis, it’s a rocket ship for 10 years but doesn’t really have

25:34

that much impact on the total index.

25:37

This study encompasses over 25,000 different stocks.

25:42

Of those 25,000 call it 700 stocks, only 1092 by 4% of the total were responsible for all

25:53

of the $34.8 trillion of wealth generated from the equity market between July 1926 and

26:00

December 2016.

26:02

96%, the other portion of all equity studied performed no better than treasury bills.

26:09

He can draw some very quick conclusions from that or propositions.

26:14

Indexation as practiced is purports to be a representation of market reality, but it

26:24

really doesn’t mirror market reality.

26:26

That’s not how the market works.

26:28

If 96% of the securities don’t provide a higher return in treasury bills, then when you trade

26:34

one stock for another, you only have a 4% chance, about 25 chance that the new position

26:42

will outperform cash.

26:44

That’s the best argument I’ve heard so far for buy and hold investing.

26:48

As that 4%, that’s why indexes ultimately undiversified themselves.

26:54

We wrote exercises about this a long, long time ago, that you just buy a list of stocks.

27:03

This has to be large enough to encompass a normal distribution.

27:06

However, that’s 20 stocks or 10, or whatever it is, 30.

27:09

Most people say 35, statistically is a good number.

27:12

You just don’t touch it.

27:15

Then the two smart ones, now you don’t know which one is smarter then, they will outperform

27:22

over time.

27:24

Over time, the performance of the account will converge upon the performance of those

27:27

two stocks.

27:30

The account will get more and more volatile but it’ll also outperform.

27:35

The thing about indexation, though, is for a variety of reasons, it will never permit–

27:42

it can’t permit that to happen.

27:43

Number one, they’ve placed caps or limits on what a position size can be.

27:48

Number two, there are constantly new entrants, Uber comes along, IPO, they have to make shelf

27:54

space for it, they have to reduce so they get diluted over time just in a natural way.

28:00

Anyway, as practice, one can see why ultimately the indexes can do as well as for variety

28:10

of reasons, the historical returns suggest.

28:11

MIKE GREEN: Yeah, I think there’s definitely some truth to that.

28:15

I think the underlying dynamic of survivorship bias, the inability to fully participate,

28:22

the other component, of course, is that the participation of the individual is not reflective

28:27

of the performance of the index.

28:29

Particularly if you’re buying in an ETF where you’re paying bid versus ask, which can be

28:33

quite narrow, but accumulates over time.

28:35

To me, the most interesting thing that’s happened with the index space, though, is actually

28:41

almost the exact opposite.

28:44

Because we have functionally locked in a group of stocks that money gets continually piled

28:52

into.

28:53

The most popular mutual fund is the Vanguard total market index, where functionally every

28:59

stock, there are some that are excluded for sampling and liquidity purposes exactly as

29:02

you’re describing, which get excluded and then continue to underperform which naturally

29:07

draws the eye of astute value investors such as yourself, which locks in potentially underperformance

29:13

even as you’re accumulating a greater ownership of an undervalued asset relative to an index

29:18

that’s playing off of momentum.

29:22

That type of dynamic perversely actually ends up really damaging the capitalist system.

29:30

Because companies participate, regardless of their underlying fundamentals.

29:34

STEVEN BREGMAN: Yes.

29:37

Now, I’ve changed the way I talk to clients about the market and the bubble and so forth.

29:44

What I do find people can readily assess our bonds.

29:50

Bonds have many fewer variables.

29:52

You’ve got a coupon, you got a maturity date, and if it’s money good, you’re getting 100

29:58

cents on the dollar at the end period.

30:01

If you’re not sure it’s money good, that’s usually pretty determinable.

30:04

That’s not such a mystery usually.

30:06

I now can use this to talk about the falsity of the way modern portfolio theory and efficient

30:18

markets and blah, blah, blah, the way that portfolio management is practiced in an institutional

30:25

basis, which filters into these asset allocation models, which induces people or their investment

30:30

counselors to put them into certain asset classes and certain indexes and so forth,

30:37

the basic false premise of it.

30:41

You mentioned the most popular ETF by size, which is the Vanguard total market.

30:46

Well, in the bond realm, the fifth largest ETF is the iShares 20-year plus Treasury ETF,

31:02

TLT is the ticker.

31:07

Last year, actually through November, it got $7 billion of new assets which increases assets

31:13

by 65%.

31:15

Spectacular.

31:16

The problem is that the average investor who owns TLT probably thinks they did pretty well

31:23

last year, and they’re very pleased with it.

31:25

They think it’s a high return low risk investment.

31:28

Why?

31:29

Well, first of all, it’s up 14% last year, what they don’t look at necessarily and know

31:33

to look at is that the average coupon is not even 3%, 2.99%, which means that 80% of their

31:41

term came from appreciation and that that appreciation only happened because the government

31:45

lowered interest rates or interest rates were lowered, got lowered.

31:49

Well, what if they say, what if it keeps getting repeated?

31:54

Well, there’s obviously a limit to that.

31:56

Even so, the majority is still only 2.29%.

32:00

You hold that for 20 years, the same more or less, you can expect that’s what you’re

32:03

going to get and that is below the rate of inflation.

32:10

The government is telling you that you are guaranteed for 20 years to this purchasing

32:15

power every single year.

32:17

If M2 money supply, which in the last 20 years has been 6.2% or so, last year, it was more

32:27

like 7%, the last six months, it’s more like 9% on an annualized basis.

32:35

That’s monetary debasement.

32:36

If you’re going to lose 4% in terms of purchasing power every year, that means in 10 years,

32:46

the hundred thousand dollars, the million dollars you put in those 10-year treasuries,

32:51

those 10-year treasuries will be worth half as much in terms of purchasing power, you

32:55

could be in real trouble.

32:56

If the amount of income you’re able to get off, it was just enough for you in year one.

33:00

That’s an existential crisis for people and they sense it, but they don’t know how to

33:05

evaluate in terms of what they’re buying.

33:07

The other problem is how Wall Street describes risk to them.

33:12

If you go to the TLT website, right on the main page, I’ll tell you, it’s got this duration,

33:18

it’s got this convexity.

33:20

I don’t know what that is.

33:21

MIKE GREEN: You can know what it is, but yeah.

33:25

STEVEN BREGMAN: Investors aren’t conversant with that.

33:29

What they don’t know, in terms of risk is that if 20-year interest rates, just for the

33:37

sake of argument, next year, go from 2.29% which is what is about the [indiscernible]

33:43

and that is, to five, that they’re going to lose 30% of their investment.

33:49

They don’t know that.

33:50

MIKE GREEN: Perversely, though, if that happens because of the higher coupon, they’ll actually

33:54

end up with a higher total return over that 10-year period.

33:58

While the immediate impact would be negative, and I spent a bunch of time digging into exactly

34:04

this topic, post the global financial crisis because I was trying to understand what are

34:10

the real risks in bonds.

34:11

The real risks and bonds are exactly as you’re describing that the rates go low and stay

low forever.

STEVEN BREGMAN: They could stay low.

Well, I’m convinced, and this is completely unscientific, this is completely non-technical.

I’m a big believer in incentive systems, and basically, behavioral psychology and behavioral

finance, is that interest rates will stay very low if the government can help it for

a very, very long time.

If it can help it, simply because it can’t afford for them to go up.

34:46

MIKE GREEN: I agree with that.

34:47

STEVEN BREGMAN: They’ll do whatever they have to.

34:49

Eventually, they create a real crisis of one sort or another.

34:54

MIKE GREEN: I think the interesting challenge is thinking about it from the standpoint not

34:57

of a valuation system which most people tend to focus on the idea that low interest rates

35:02

translates to higher valuation, but you’ve referenced them to a couple of times in this.

We live in a collateral based credit system.

What happens when the government cuts interest rates?

The price of the bond goes up.

What does that do?

It provides you with additional collateral to then go and buy stuff.

It’s theoretically worth more even though it’s going to depreciate towards par.

I think that is actually one of the key underlying dynamics.

We’ve effectively built a system predicated on collateral.

It’s not that the interest rate is really what’s driving it, it’s the bond price.

35:38

What do you see as the alternatives?

35:39

STEVEN BREGMAN: In today’s world, we have basically a bifurcated market in terms of

35:45

clearing prices, and how those clearing prices are developed.

35:50

That is either you’re in the indexation.

35:52

Above the ETF divide, you’re in the indexation sphere of activity as a security or you’re

35:57

not, and even excluded by the relatively simple rule sets of the ETF universe because you

36:06

don’t have the– you might be a large cap company, I’ll name a company, I’m not recommending

36:12

it or not.

36:13

AP Moller Maersk.

36:14

I forget the market cap, could be 30 billion.

36:17

It’s the largest shipping container company in the world.

36:19

Aside from the fact that it’s not a US based company, but even if they were, the thing

36:25

is the Moller family, I don’t remember, but they owned 45%, 55% of shares.

36:32

Therefore, the effective market cap is way, way lower, it doesn’t suit.

36:37

It also doesn’t have the volatility return characteristics you might want because the

36:44

shipping industry has been in depression for years.

36:47

That’s not going to be in an index.

36:48

What will happen is, if you’re below what I call below the ETF divide, there is no institutional–

36:56

for the original purposes, virtually no institutional interest in you.

37:01

There aren’t any analysts covering you because they can’t get paid to cover you.

37:05

Therefore, for the first time in my career, which only goes back to 1982, you can have

37:13

companies, you can get a free lunch– now, there is no free lunch, you have to figure

37:17

out like why it seems free, otherwise, you’re on thin ice.

37:23

You can get a free lunch in all sorts of ways because the excesses in the indexation centric

37:30

securities market has created deficits, in clearing prices and valuations in below the

37:38

ETF divide.

37:39

What will happen is that there are companies now that are undervalued not for any fundamental

37:45

reason, meaning fundamental adding to their balance sheet or their income statement or

37:50

competition or technological displacement or regulatory problems or management issues.

38:00

How can you find a decent company trading at a low enough price that you think you’re

38:06

getting some discount or margin safety?

38:08

Very, very difficult.

38:10

You really couldn’t.

38:11

What you needed to do traditionally is find some company with a blemish, the CEO absconded,

38:17

they lost a big contract, whatever it might be, stock drops.

38:21

Then our job is to try to evaluate that and find out whether that insult is transitory

38:27

or permanent.

38:29

Whether it’s structural or it’s superficial.

38:32

I say you know what, in two years or three years or four years, somewhere beyond the

38:38

standard institutional investment time horizon, I can’t take the time risk, I’m willing to

38:41

take the time risk.

38:42

That’s what I think my advantages is, is it’ll be fine.

38:48

In which case, what’s the normalized earnings on this and what’s some a normalized perfectly

38:52

average valuation?

38:53

Oh, I’ll do pretty well.

38:54

I’ll buy it and wait.

38:56

That’s what you have to do.

38:58

Now for the first time, you can buy companies that are deeply undervalued relative to some

39:03

objective measure, their assets and their assets are profitable, or their earnings or

39:09

their free cashflow, whatever it might be, good balance sheets, there’s no blemish on

39:13

them.

39:14

The only reason they’re cheap is that they’ve been excluded from the indexes, probably either

39:22

one of two reasons.

39:23

They don’t have sufficient trading liquidity.

39:25

Large companies, small or they don’t fit the shape parameters, meaning it might be a trust,

39:36

or it might be some odd– it might be a multi-industry company.

39:42

It’s not exactly– it might even be a real estate company, but it’s not a REIT, they

39:47

want REITs, they don’t lend to development companies.

39:50

What’s happening now is that if you’re willing to look– if you have the license as an investment

39:57

advisor, to look below the ETF divide, you can find everything you want.

40:02

It’s possible.

40:03

It’s really possible.

40:05

You can create for somebody, you can create a portfolio with bonds and other income securities

40:11

or equity series that’s got, let’s say, I’ll give an example, let’s say a 4% gross yield,

40:19

dividend and interest, some of which is tax exempt, that has strategic, important strategic

40:27

flexibility, let’s say 20% in cash reserves, that also has both bonds and equities in there

40:34

that have plenty of optionality of a high order continued to force or modest but steady

40:45

state internally generated growth in shareholders equity overtime and therefore income production.

40:56

You can get a yield that’s twice the 10-year Treasury rate.

40:59

You can have a purchasing power protection.

41:04

You can get everything you’re supposed to have.

41:07

Now, is it going to track what’s happening in the marketplace?

41:10

No, but that’s not my goal.

41:11

I have a different objective.

41:13

You can do that, but you can’t find it in the– same with bonds, I heard you discussing

41:21

this is that you find a bond that’s sure valuation, perfectly good.

41:28

It’s money good for the next four or five years till it matures but it’s not an index.

41:33

It might not be a large enough issue, you can buy a 7% yield and it’s not a junk bond.

41:40

MIKE GREEN: Interesting.

41:42

Well, I think that’s going to be the interesting question.

41:46

A lot of the dynamics that you’re discussing, we both experienced in ’99 to 2000.

41:51

Similar components I’ve talked about, homebuilders right before the big housing bubble being

41:55

priced at half bulk value.

41:57

The challenge in my mind, and we referenced it a little bit before in the discussion,

42:02

it says that we have actually created such a fundamental flaw in the structure of how

42:07

assets are collected and how money comes into the system.

42:10

It’s not clear to me that we’re going to be able to capture those means reverting characteristics

42:15

that you’re highlighting.

42:17

If 95% of the money that comes in, if millennials who are going to be the millennials, and those

42:22

who come after them are fundamentally forced into passive investing styles because of regulatory

42:30

systems, and gain no experience whatsoever, are we setting up the conditions in which

42:37

we destroy those mean reverting characteristics?

42:39

I would highlight is a good example, the travails of FedEx relative to Amazon.

42:44

Amazon functionally has a zero cost of capital because of the dynamics of inclusion that

42:52

you’re highlighting.

42:54

They’re able to make investments that would be uneconomic for almost any company to make

42:59

certainly a large scale logistics company like a FedEx, they’ve been able to build a

43:04

second FedEx, something we would have thought of was having a giant significant moat for

43:09

an extended period of time.

43:11

They’ve been able to replicate it in the period of roughly three years.

43:14

The real fear that I have is that we’ve broken that characteristic and I think it’s going

43:18

to be fascinating to see if it reverses itself.

43:22

STEVEN BREGMAN: You bring up two points which I think spark some responses.

43:27

One is you’re pointing to something that people forget generationally.

43:31

Every generation, there are some companies that for 20 years, 30 years, grow and grow

43:39

and grow and they become recognized.

43:42

In the course of someone’s life, their personal experience, they’ve been there forever.

43:46

They’re stable.

43:47

That’s not how business works.

43:50

They’re not stable.

43:51

What’ll happen is that’s another reason why indexes have trouble doing well, which is

43:58

that one of the reasons why– another reason why they get this 4.5% annualized return since

44:03

’99 in the S&P; 500, is because if you look at the largest 10 companies in the S&P; 500

44:06

at the end of 1999, most of them have suffered displacement by competitors.

44:14

IBM was displaced by cloud computing.

44:20

Dell was displaced by the emergence of the iPad, and so forth and so on.

44:29

That’s natural, because the largest companies represent the easiest largest targets for

44:36

a national competitor to secure customers and revenues, and people think that an Amazon

44:46

or a Facebook or a Google are somehow impervious to technological displacement.

44:54

If you take a look, there are a whole variety of companies and technologies or just plain

45:01

old competition that is beginning to make inroads.

45:06

We don’t know which will work or not, but to give you a nontechnological form of what

45:13

can happen, the margins, the returns on equity of the modern Information Technology slash

45:21

technology companies like Facebook, Google, Twitter, are simply enormous.

45:27

The stated ROEs might be 30%, or something like that, depending on, but really, it takes

45:33

all the cash and marketable securities and the market securities in the balance sheet,

45:37

which are nonproductive, they don’t need them to do the business.

45:39

You take that away, the returns in equity could be 50%, 60%, 100%.

45:44

It’s simply like unheard of.

45:46

It’s not really sustainable.

45:48

Someone’s going to come after that.

45:49

Now, how can they come after it?

45:51

Well, Dell, which displaced all sorts of other companies in manufacturing PCs by doing a

46:01

direct to consumer approach, and they were willing to sustain a lower profit margin to

46:07

get there.

46:10

Dell is now getting into cloud computing.

46:16

What does that mean?

46:18

It sets you off up a warehouse, and you buy all the equipment and you do it.

46:26

Now they’re going to compete.

46:28

By the way, there’s a food fight going on now.

46:32

Amazon and IBM, IBM needs to succeed in cloud computing to protect itself now.

46:39

Dell’s getting involved.

46:41

Amazon at some point, there’s going to be margin compression.

46:47

One of those players is going to be willing to take a lower margin just like in ETFs.

46:53

Here’s why I don’t think it can keep going on.

46:58

We talked earlier, the bank of funds for suctioning out of active management into the passive

47:11

management, that’s finite.

47:13

As of a year ago, I think there’s a Fortune magazine article, they did a study.

47:20

They thought that we passed the 50% dividing line, very significant one, of all passive

47:30

assets as a percentage of all investment assets in public markets.

47:39

That has all sorts of implications.

47:40

You’ve looked into them yourself.

47:42

There’s a law of large numbers.

47:44

Now, there’s 50% float available to them.

47:48

Now, it’s less, now it’s 49.

47:49

If that was a correct number, 48.

47:52

Every year, in order to maintain the same constant pressure on the automatic bid on

47:59

all the stocks owned by old ETFs and bonds, they need larger inflows each year, like it

48:06

was $350 billion last year, whatever the number was, now it’s going to be more but the pool

48:12

from which they’re drawing is getting smaller.

48:16

That can start to accelerate real fast.

48:19

When the flow of funds into indexation slows, or stops, or turns negative, there’s no more

48:27

automatic bid and the marginal trade which is effectively indexation has been for the

48:33

last 10 years and increasingly in recent years.

48:37

The marginal trade, like the baton is handed over to the active manager and the active

48:43

manager, I just referred [indiscernible] because it occurs to me.

48:48

He’s not buying a blue chip.

48:50

He’s not into technology, but he’s not buying a day now mature trending into cyclical blue

48:57

chip, like Coca Cola, or McDonald’s or Procter and Gamble, which actually had sales declines

49:04

in recent years, at 25 times earnings, just not doing it.

49:07

Where’s the bid going to be?

49:08

This is before we get to other dynamics.

49:10

MIKE GREEN: The pushback that I would make to that is that the old people, for lack of

49:16

a more descriptive term, are the ones who own active managers.

49:20

The young people who continue to have inflows are those who own passive vehicles.

49:24

There’s nothing that actually says that active manager ever gets to bid again, there’s no

49:29

rule of the universe, there’s no law that says that has to happen.

49:32

It’s unfortunately catastrophic, but there is no law that requires that.

49:38

That I think is going to be the really interesting question is, if the system can’t find itself

49:43

self-regulatory.

49:44

Sure.

49:45

STEVEN BREGMAN: The rules again, when you get extremes, you get other possibilities.

49:51

Since it’s fully disclosed, the precise percentage positions in every single ETF, you know exactly

50:01

what they own, you know how many total dollars of assets are every in single ETF.

50:06

At a certain point, if the inflows get small enough, even with a lower age demographic

50:18

making contributions, it’s going to start to peter out.

50:22

We don’t know, I’ve never worked with these kinds of numbers the way you have but at a

50:27

certain point, if it looks like it’s tipping, you can have short sellers who know if there

50:33

are going to be any redemptions, net redemptions.

50:36

They’ll know exactly how much is being sold of every single security.

50:42

They have almost unlimited quantities of assets that they can front run.

50:49

That’s a different scenario.

50:50

MIKE GREEN: Yeah.

50:51

I worked through the numbers, and I think it’s going to be interesting to see how it

50:54

plays out.

50:55

I don’t think– STEVEN BREGMAN: It’s more dynamic than that.

50:56

MIKE GREEN: It’s more dynamic than that.

50:58

I think the real risk is that we’ve seen short sellers already eviscerated by the inflation

51:03

that I think is caused by the passive investment process.

51:05

STEVEN BREGMAN: But the passive investment process has still– that’s why those short

51:09

sellers are missing an important element.

51:15

Money’s flowing in, to the tune of hundreds of billions of dollars a year.

51:18

You can’t get in front of that.

51:19

MIKE GREEN: Well, to your point, though, that money is coming out of the active managers,

51:23

are flowing into the passive, ironically, if you have that inflation, the supply of

51:28

assets that’s available to the active managers goes on much longer.

51:32

We’ve probably seen this, there’s very few stocks, you highlight it yourself, unless

51:36

they’re outside of the indices, which Vanguard total market index had very few stocks that

51:42

actually are outside of that unless they fail to meet float dynamics or ownership dynamics.

51:46

STEVEN BREGMAN: Yeah, but if they’re, 100th of 1%, they’re in de facto in a de facto sense,

51:53

but it’s meaningless, statistically meaningless.

51:55

MIKE GREEN: Yeah.

51:56

No, I think that’s right, but that’s exactly the point that I’m making, which is the assets

52:00

that are owned by the active managers who by and large, buy stuff with similar characteristics

52:05

to the passive indices, you being one of the notable exceptions, they can experience that

52:10

same inflation and so one of the big push backs I have is the idea that value stocks

52:13

are cheap as they were ’99.

52:15

I don’t see that at all.

52:16

I think there’s elements exactly as you’re describing.

52:19

I think we’re going to run out of time, but one of the things that I think is going to

52:23

be so interesting, and I’d love to come back and sit down with you in another year is this

underlying question of, is there a selflimiting feature?

Can this actually wrap back around?

STEVEN BREGMAN: I think what’s going to happen is there are going to be some serious social

problems.

MIKE GREEN: I agree.

STEVEN BREGMAN: When you see serious tumult in nations, social tumult, it really often

follows when there’s been currency debasement, loss of purchasing power, inability to live

on your investments or your income, people get desperate, then things change, desperation,

and we’re heading that direction just a lot more slowly than Greece or Venezuela.

MIKE GREEN: I share those sentiments exactly.

STEVEN BREGMAN: As I mentioned one term, it’s necessary for anybody I talked to, to hear

whether they are willing to let me work with them on it or not, is the ultimate hedge against

currency debasement.

It might never work, it might never be necessary, but it can save your financial future and

it can be done in such a small amount that will never harm you if it doesn’t work, which

is a fixed issuance meaning nondebasable cryptocurrency.

If the time ever comes that people in various parts of the world feel they need a non-debasable

currency, the returns can be on the order of hundreds of times your money.

MIKE GREEN: I share those sentiments.

54:06

Historically, it would be gold.

54:08

We don’t know if going forward, it’s going to be a crypto asset but I agree with you

54:12

that those types of nonlinear properties will become an important part of any asset allocation

54:17

framework.

54:18

I really look forward to sitting down with you again and sharing these thoughts.

54:23

STEVEN BREGMAN: I actually enjoyed listening to you more than talk with you.

54:27

Thank you.