The Rational Reminder Podcast
Episode 332 - Randolph Cohen & Michael Green: How Concerned Should We Be About Index Funds?
Episode guests
Podcast summary created with Snipd AI
Quick takeaways
- The podcast discusses the complexities of passive investing, highlighting its actual impact on market dynamics beyond the perception of neutrality.
- Mike Green expresses concerns about systemic risks associated with the rise of index funds and their effects on stock market valuations.
- The debate on target date funds reveals their dual role in aiding retirement savings while potentially increasing market volatility.
- The dominance of mega firms in passive investing raises questions about market efficiency and the effectiveness of traditional fundamental analysis.
- Both participants emphasize the importance of understanding the risks and implications of an increasingly passive investment landscape for future returns.
Deep dives
Understanding Passive Investing
Passive investing is defined academically as holding a position without transactions, implying no influence over market prices. However, in reality, the concept is far more complex, as passive investors do engage in systematic investing into indices, primarily the S&P 500. This underlying activity means that passive investing is not as neutral as it appears; it can impact market dynamics and valuations. The discussion highlights a confusion where people often conflate the automatic contributions into passive funds, like 401(k) plans, with a lack of engagement in market transactions, which is not the case.
The Impact of Index Funds on Market Valuations
Concerns arise around the idea that as the volume of assets flowing into index funds increases, there may be unintended consequences on stock market valuations. If index funds make investing less risky, conventional wisdom suggests that this could potentially lower expected future returns, as risk and return are generally correlated. The transition from defined benefit (DB) pension plans to 401(k) plans, which typically invest in target date funds, complicates matters through reduced liabilities for companies. Consequently, companies become less risky, influencing overall market dynamics that may lead to higher valuations driven by passive investment structures.
Contrasting Perspectives on Passive Investment
The episode features a lively debate between Mike Green and Randy Cohen regarding the implications of passive investment strategies on market behavior. While Mike expresses concerns about the fragility and potential mispricing caused by excessive passive investing, Randy argues that these effects may be overstated and that the systems in place—such as target date funds—actually provide stability. The discussion emphasizes that both participants bring valuable insights, contributing to a broader understanding of passive investing's effects. Ultimately, neither party leaves with a definitive conclusion as to who is right, suggesting that much remains to be understood about the topic.
Market Efficiency and Fund Manager Behavior
Both participants acknowledge the shift in how markets operate with the rise of passive investing, especially concerning the behavior of fund managers. Traditional active managers are expected to make decisions based on fundamental analysis, but if passive strategies dominate, this can lead to decreased overall market efficiency. While Randy believes that active managers still possess the capacity to correct mispricings, Mike argues that the rise of passive diminishes their role. This stance raises questions about the long-term implications of a passive-dominated market on overall investment efficiency and price discovery.
The Influence of Mega Firms
A key point discussed in the episode is the role of mega firms that dominate market activity and their impact on price elasticity. Mike highlights that the largest companies have become less elastic to market changes, suggesting that passive investment strategies result in concentrated pricing power among these firms. This raises concerns about the diminishing effectiveness of fundamental analysis in the stock market, as the weight of mega firms overshadows the contributions of smaller companies. It creates a scenario in which the perceived value of equities may be inaccurately inflated, potentially exacerbating economic disparities.
Retirement Systems and Investment Strategies
The conversation touches upon the implications of current retirement structures, particularly the growth of target date funds and their effects on investing behavior. While these funds may help individuals save for retirement effectively, the concentration of capital into large equity positions can lead to systemic risks. Empirical studies suggest that the overwhelming shift from DB pensions to 401(k)s and target date funds may infuse equity markets with greater volatility as more dollars flow in without a proportional representation of underlying company performance. Thus, the transition reflects a broader societal trend where less capital is allocated toward local businesses and innovation, potentially hampering economic growth.
Expected Returns and Market Valuation
The analysis presented reflects on expected returns from passive investing and their implications on market valuations. Current forecasts highlight a potential disconnect between expected returns based on historical data and the substantial capital inflows into equity markets via passive strategies. As valuations rise alongside asset flows, we are faced with the possibility of future corrections should a divergence be observed in expected earnings and actual performance. Both Mike and Randy recognize the crucial importance of disaggregating inputs for more informed investment decisions but differ on the nature of expected returns going forward.
Risks and Future Considerations
The implications of the discussions are both practical and theoretical, raising awareness of potential valuation risks in a market increasingly shaped by passive investment strategies. On one hand, Mike advocates for a cautious approach to expectations based on historical performance, emphasizing that market corrections could be more severe due to current high valuations. Conversely, Randy sees the current market framework as feasible for future growth, viewing the ongoing adjustments from passive strategies as a stabilizing force rather than a destabilizing one. Moving forward, understanding the balance between these viewpoints will be crucial in navigating the complexities of modern investment environments.
Ongoing Dialogue and the Pursuit of Knowledge
The episode highlights the necessity for continuous dialogue within the investing community to better understand the implications of passive investing. As both Mike and Randy represent contrasting opinions on the subject, their engagement underscores the importance of examining diverse perspectives. Knowledge-sharing through research, data validation, and active engagement with evolving market conditions serves as a foundation for informed investing. Collectively, their insights emphasize the need for investors to remain vigilant in their understanding of arising market dynamics amid increasing reliance on passive investment approaches.
Are index funds a silent disruptor? Or are the concerns overblown? In this grab-your-popcorn episode, Michael Green returns to the show after his previous appearance elicited a wave of compelling feedback from listeners. These included very smart individuals in academia and practice who were interested in hearing a counter perspective. Joining Michael today for a lively debate is Randolph Cohen, Senior Lecturer of Entrepreneurial Management in the Finance Unit at Harvard Business School. In our conversation, Michael shares his deep concerns about how index funds and target-date funds might be distorting financial markets, honing in on the tension between market efficiency and price elasticity. Randolph counters with an academically grounded perspective, drawing on his PhD and years of research and teaching at one of the world’s leading business schools. With Ben and Cameron moderating, the discussion explores both sides without reaching a definitive conclusion. Tune in to witness this spirited, nuanced exchange and decide where you stand!
Key Points From This Episode:
(0:00:14) Introducing Michael Green, Randolph Cohen, and today’s topics of debate.
(0:06:00) Defining passive investing, distinguishing between the two different meanings of “the rise of passive investing”, and how much of the market is currently held by passive investors.
(0:12:53) Michael’s concerns with the high levels of passive investing and Randy’s response.
(0:20:55) Addressing the proliferation of target-date funds and their use in different scenarios.
(0:28:48) Debating risk in the market, raised valuations, and retirement savings diversification.
(0:42:22) A breakdown of the biggest thing Michael and Randy disagree on: how passive investing is impacting stock market valuations.
(0:57:06) Answering the question: does inelasticity rise with passive, and how does it shape the impact of active managers?
(01:06:14) Unpacking whether the rise of passive has made the markets more efficient; an accompanying refresher on the two types of passive.
(01:09:27) Reasons to doubt whether there really is a rise in both types of passive and the effect of the rise in mega firms.
(01:19:16) The state of fundamental analysis in the current market and Michael’s response to a recent paper by Goldman Sachs attempting to isolate the component of passive.
(01:23:30) Unpacking the cross-sectional impact on stock valuations from index investing and insights on the work of Valentine Haddad.
(01:31:28) The implications of today’s subject matter for investors and what they should be doing with this information.
(01:44:22) Reflection on why more experts don’t share Michael’s level of concern.
(01:47:42) Randy’s takeaways from today’s conversation, why he still does not share Michael’s level of concern, and what he might be worried about.
Links From Today’s Episode: Meet with PWL Capital: https://calendly.com/d/3vm-t2j-h3p
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582. Rational Reminder Website — https://rationalreminder.ca/
Rational Reminder on Instagram — https://www.instagram.com/rationalreminder/
Rational Reminder on X — https://x.com/RationalRemindRational Reminder on TikTok — www.tiktok.com/@rationalreminder
Rational Reminder on YouTube — https://www.youtube.com/channel/
Rational Reminder Email — info@rationalreminder.caBenjamin Felix — https://pwlcapital.com/our-team/
Benjamin on X — https://x.com/benjaminwfelix
Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/
Cameron Passmore — https://pwlcapital.com/our-team/
Cameron on X — https://x.com/CameronPassmore
Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/ Michael Green on Substack — https://substack.com/@michaelwgreen Michael Green on LinkedIn — https://www.linkedin.com/in/michael-green-9a15142/ Michael Green on X — https://twitter.com/profplum99 ‘Yes, I give a fig… Thoughts on markets from Michael Green’ — https://www.yesigiveafig.com/ Randolph Cohen — https://www.hbs.edu/faculty/Pages/profile.aspx?facId=6597
Randolph Cohen on LinkedIn — https://www.linkedin.com/in/randy-cohen/
Dangerous Visions Podcast — https://podcasts.apple.com/us/podcast/dangerous-vision-with-randy-cohen/id1477519445
Episode 302: Michael Green — https://rationalreminder.ca/podcast/302 Episode 322: Marco Sammon — https://rationalreminder.ca/podcast/322 Episode 310: Antoinette Schoar — https://rationalreminder.ca/podcast/310 Episode 212: Ralph Koijen — https://rationalreminder.ca/podcast/212 Episode 314: Valentine Haddad — https://rationalreminder.ca/podcast/314 Episode 224: Scott Cederburg — https://rationalreminder.ca/podcast/224 Episode 284: Scott Cederburg — https://rationalreminder.ca/podcast/284 The Grossman - Stiglitz Paradox (feat. The Plain Bagel) — https://www.youtube.com/watch?v=zoXMZxe8crI
Books From Today’s Episode:
Irrational Exuberance — https://www.amazon.com/Irrational-Exuberance-3rd-Robert-Shiller/dp/0691166269
Papers From Today’s Episode:
‘The Disappearing Index Effect’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4294297
‘Passive Investing and the Rise of Mega-Firms’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4851266
‘Retail Financial Innovation and Stock Market Dynamics: The Case of Target Date Funds’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3723265
Valentine Haddad on Google Scholar — https://scholar.google.com/citations?user=PlPjP48AAAAJ
‘How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing’ — https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=3821263
‘Household Portfolios and Retirement Saving Over the Life Cycle’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4068063
‘The equity premium: A puzzle’ — https://www.sciencedirect.com/science/article/abs/pii/0304393285900613 ‘In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3686935
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