STEVEN BREGMAN: Not just United States, but globally, we're in the biggest financial bubble ever. That includes stocks, include bonds, basically, it's the entire set of financial assets worldwide. In today's world, we have basically a bifurcated market in terms of clearing prices. You are in the indexation sphere of activity as a security or you're not. Now for the first time, you can buy companies that are deeply undervalued relative to some objective measure. If you have the license as an investment advisor to look below the ETF divide, you can find everything you want.
MIKE GREEN: Mike Green, I'm here for Real Vision at the Real Vision Studios in New York City. Today, we're going to sit down with another individual who is known for his work in the past of space, in particular, his work on ETFs. Steven Bregman has a been on Real Vision before with an extended series called, "The Dark Side of ETFs," where he sat down with Grant several years ago. We're going to revisit that, particularly in the context of some of the stuff I've talked about. I'm really interested in how Steven thinks about the endgame of the passive strategies and how to think about the influence in the market. Let's sit down and see how this goes.
Steven, you and I have not had the chance to talk for a couple of years, you've been one of the other voices in the wilderness shouting about the risks associated with passive investing. I'd love to pick into your brain and understand the approach that you're taking to some of these challenges and some of the opportunities that are created by the growth of passive investing. One of the places to start is one of the areas of difference. I focused primarily around the indexing component and you've spent a lot of time talking about ETFs.
STEVEN BREGMAN: Well, essentially, they're one of the same. Sometimes people use the terms interchangeably because they don't know the difference, and they're being casual about it, and I do the same actually, ideal primarily with direct individual clients. They're not institutions. They don't have an institutional mindset. They're unaware of real differences.
They're unaware of the fact that asset management companies, Wall Street is not really about investing. It's about asset gathering. They would be unaware, for instance, that how does an index come to be. An index comes to be because a certain asset management specialize in this might be under pressure from ever declining fees and you can't charge a premium fee for a commodity product. Once upon a time, I think the fees on S&P 500 index are like 50 basis points 60 basis points, now, they're down to zero.
What do you need to do to justify a higher fee? Create something that seems to have, at least has the fig leaf of differentiation. You can charge more for that, at least for a while. You invent a new index, you do some back testing, you find some bucket of 20 or 30 or 40 companies that fit some theme that back test well for the last five years. By definition in this industry in modern portfolio theory, as applied nowadays, that means, some positive rate of return with some relatively low comparative volatility, beta correlation, what have you, and then you can float a new index, and they're from offering ETF against it. You can't even get it off the ground unless it back test well. That's how that works.
Indexes don't just come about because they're good investments, they come about because it's an opportunity for a management company to gather assets through a new ETF for which at least initially, they can charge 45 or 55 or 65 basis points. They can keep that fee, except if they're lucky enough to gather enough assets, not 10 or 20, 30, or 40, 50 million, not even enough to break even, but if I gather some hundreds of millions of dollars, well, then somebody else would come and knock them off, like Vanguard and drag the fees down again. People don't even get these basic concepts and because my natural audience are individuals, who really are the victims of this asset gathering business that parades as an investment business, we study that.
MIKE GREEN: Well, you and I originally started in the same space. You come up from the classic stock picker, single stock focus, run a highly concentrated portfolio and by some measures, you found a few names that you think are truly extraordinary. We can talk about a few of them if you'd like, but your insight into ETFs that I know you from the Grants Conference discussions is largely around the dynamic of many different ETFs buying the same underlying products, and this tendency to overlap.
You'll see very high representation of Exxon Mobil, you'll see very high reputation representation of other stuff. The dynamic that you're talking about now, where effectively you offer a good back test to try to offer something that you can actually charge fees for and the potential for if that gets to scale, either you to lower your costs so that new entrants can't come in and replicate it or to be disintermediated by one of the giants in the industry.
STEVEN BREGMAN: They're very disinclined to do that, they need every penny.
MIKE GREEN: Yeah. How do you think about this dynamic of the difference between a Vanguard model and a BlackRock type model where they are charging rock bottom fees and the need within the industry for innovation in order to push forward how thought process is going?
STEVEN BREGMAN: The whole thing doesn't even make a difference. There's no differentiation. The whole thing, I'm going to say something, it sounds incendiary, I don't mean to be incendiary, but well, I shouldn't say it's a lie, but it's false. The whole thing is a false premise. Now, we actually have the evidence. The evidence is in.
We now have a couple things I'll mention. First of all, the great indexation passive investing ETF experiment, which took off for real, more or less yearend 1999. Slowly at first, but it was given a real boost in the wake of the 2007-2008 financial crisis and people got really scared. Now, they did everything that people do, which is act reflexively, which is not necessarily helpful, which is first of all, sell your securities and memorialize a perhaps temporary loss. Then when they get back in after there's confirmation that things are going up, which means they've lost much of the recovery. That's normal.
What they did is they defaulted immediately to ETFs. They were there. They had time to become better known. They're a better mousetrap than a mutual fund and people had been really traumatized. Traumatized, by the way, not just individual investors, but their brokers, financial advisors, trustees of pension funds, [indiscernible] they all work. They were scared of risk, all kinds of risk; manager risk, security specific risk, everything.
The proposition of an index made a lot of sense. People had the experience, I could buy my favorite REIT. Maybe that's the one that goes to zero or I could buy an REIT sector index fund, and it might not do well but it's not going to zero. That started taking off. ETFs is supposed to be better, and indexations are better. People like me could talk about it and analyze it and start coming up with a very amusing and hopefully illuminating examples of how distorted it was becoming.
It was still subject to a lot of argumentation that passive investing, which is supposed to benefit from the free rider principle, we just want to participate in the wave of what active managers do when they contest in the open market and the set clearing prices and just participate without changing anything. We could argue that they're beginning to actually alter clearing prices but those are arguable.
We could argue that the only reasons they were outperforming active management then that came to be there are any innumerable articles about it, that active management has just been proven to underperform indexes. We could argue that simply because they were pushing up their own very limited number of securities in which they traffic people and understand that you have to elucidate that also why that is, but that was all arguable. Now, we've got some proof because now, we've got a 20-year track record for ETF -based index investing and history has spoken, and they all found one thing. The S&P 500 for the last 20 years has got roughly a 4.5% annualized return. If you go to the MSCI All Country World Index, less than that, maybe 3.5% or 4%. If you bought a 20-year Treasury note, and you're in 1999, you could have bought about a 6.3% or 4% yield.
MIKE GREEN: Remember it well, yes.
STEVEN BREGMAN: You could have done just fine. They didn't even perform as well as called a risk free Treasury but 20 years is a long time. Then if you take another look at what we think is the primary risk to investors, and the primary responsibility of an investment advisor is not comparable returns to some other manager or to some set of managers or some abstract index or an index with some abstract purpose or importance, but at the very least, to maintain someone's purchasing power over time, and hopefully to increase it. Well, the measure of monetary debasement over these last 20 years, M2 money supply expansion, has been more than 6% a year. In that sense, if you owned the iShares S&P 500 index over the last 20 years, you actually lose in purchasing power.
MIKE GREEN: How do you disaggregate that, though, between the outcome versus the process? Because if I were to point to active manager performance, almost by definition has to be worse, because we've seen in aggregate, active managers underperform the benchmarks.
STEVEN BREGMAN: What are the benchmarks? What if the benchmarks are rigged? What are we going to be talking about here?
MIKE GREEN: Yes, exactly.
STEVEN BREGMAN: By the way, I should preface this by saying I'm willing to try to defend it and I feel comfortable with that. I think this is the-- not just the United States but globally, we're in the biggest financial bubble ever that includes stock, include bonds. Basically, it's the entire set of financial assets worldwide. 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. What's $2 million times if you put it all into a 10-year US Treasury note in less than 2% and it's taxable, but even if it's not taxable, what do you get? You can hardly live on that. If you don't expect to spend your principal, you don't know when you'll die.
MIKE GREEN: Yeah, it's a pretty extraordinary statistic.
STEVEN BREGMAN: It's a crisis. I like to differentiate, there's a term statistic and then there's a place for interpreting for people, because it's really a crisis, it's a yield crisis, and people can't get yield. What does that do? There's a dynamic to bubbles, they build over time and people owned a series of bonds, municipal bonds or corporate bonds, or within a bond fund and little by little, their maturities calls and the yield goes down because the coupon goes down, or the average coupon goes down, because they replace it with lower coupon bonds and happens slowly. Little by little, people realize I've got a problem.
Wall Street is a unique industry. Among other respects, that is the only industry I know of, in which, if there's sufficient demand for a product, they can create effectively infinite supply almost instantaneously. If someone likes a certain GM truck, they have to retool, there's certain amount of capital you got to put in, but they'll sell you whatever you want. What happens? Some firms see, oh, there's a need for yield. Why don't we create-- it also helps the fee aspect. Let's create a dividend aristocrats ETF index.
You've got various kinds of companies like they collect the higher dividend yield and so people, they go with their lead there. You get less than 2% in the Treasury, if it's looking good, 3.5% in this REIT index or this dividend aristocrats index. They put more money into bonds than they really should, been into equities than they should. They're doing what they can.
Then you have the dividend aristocrats fund and so forth and so on, but it's important to understand the magnitude of asset flows into index funds. We're talking about several hundred billion dollars every single year for a decade, it's actually been climbing until this past year, and what happens is when you have trillion dollar asset managers, and they create a new fund, and it could be a $200 million fund, a $400 million fund, a $500 million fund and there's going to be a knockoff of one of the competitors, as a pure business proposition, you've got some really bright people in the back office, working up different packages of stocks, new indexes, and they tried to make it work.
Let's just say that they create a list that back test really well, that's got a nice theme to it and then they bring it to their managers, they managed it well, there's a problem here, is that you've got these hundred stocks, except in the nether regions of that list by market weight, the ones at the bottom, they just don't have the trading liquidity. They've got so many shares per day of trading. They're an X percent, let's say it's equal weighted, and it's X percent of your list and we can't go above certain liquidity limits that we set in place, we can only raise 100 million dollars for this. It's not even worth the time, barely pays for your salaries.
They go back to the drawing board and they fiddle with the rule set. It's a very simple rule set, and they simply drop out. They find a way to drop those companies out. It's legitimate. We're only-- we have this list, but only companies with above this much creativity or whatever. Now, you drop those out and suddenly, you can raise $500 million. That's an example of why real practical purposes, the ETFs or their bond ETFs or stock ETFs have trafficked substantially completely in large cap and mega cap stocks.
They really need basically industrial strength trading liquidity, which is why you find Exxon Mobil everywhere they can put it and why you find technology stocks in funds where they don't belong, because Facebook's really liquid, or Microsoft's really liquid, to find a way you can find individual stocks, like an Exxon Mobil or Microsoft or something else, and you'll find they're in growth ETFs, they're in value ETFs, they're in momentum ETFs, they're in fundamental tilted ETFs, they're in dividend ETFs, they're everywhere. If you actually look at it, it defies logic other than they need the trading liquidity.
There's so many systemic risks in the market now. What will happen is when something gets over done enough, when you get like a deep bear market, you get a bubble, aside for the fact that they can go higher than you ever imagined, more overvalued then you ever imagined, or lower, they become a variety of systemic risks. One of them nowadays, systemic risk, set systemic risk meaning it's going to affect substantially most of the securities in the universe you're talking about, a single variable and one of those variables now-- I know you've observed it and are concerned particularly, you study it closely, is the concentration risk.
People are unaware of what the concentration risk now is. They think they're getting diversified. Diversification semantically only just a name, because all the same stocks are being owned by these ETFs. The fund flows come in, the ETFs are-- the indexes are price agnostic, there is no-- in their short list that makes up the rule set for inclusion or exclusion of ETF, market cap, industry sector, PE, whatever it might be, those descriptive attributes, there is no place for valuation. It's not on that list.
There are different ways to talk about the concentration risk. Not too long ago, only a matter of weeks ago, I accounted up in the S&P 500, the top 100 names, 20% of the names accounted, just happens that the numbers of this even 67% of the market value of the index. That's real concentration. Although we've never had concentration like that before. They drive the market. The asset allocation's idea of shifting from one sector to another in terms of market capitalization, it can't happen anymore. I think the figures for the Russell 2000, is it $2 billion and below?
MIKE GREEN: I think it's a little higher than that actually now, but yeah, something like that.
STEVEN BREGMAN: The sum, the complete market capitalization of all the Russell 2000 stocks, it may only be several percent the value of the Russell 1000, S&P 500. Even if for the sake of argument, it were undervalued, let's say it were undervalued and people just wanted to shift some money there, they can't. You can't have a thimble that's a 5% or 6% size to accommodate that. In one sense, people-- they don't know it, but they're stuck. They're stuck in the dark, there's nowhere to go.
They're going to go to treasuries and earn a basically return that will [indiscernible]. I want to talk about that too, because the lie or the complete let's say misapprehension of indexation, talk about active managers you asked me before. This is a long winded way of getting around to this response, which is that the indexes have been buying automatic bid. Every time money comes in, they're required probably to buy and hold all the stocks they own in precise proportions. They've been buying their own book. It's arguable, pushing them up.
Therefore, this is not passive, if you're not participating in whatever the clearing price mechanism established by active managers. In fact, one of the reasons why active managers have done more poorly is they have been the bank of funds and you could-- there are places to look and you can see on a given year, a given quarter, so much money comes out of active managers, and pretty closely, that's the amount that goes into indexes. They've been the bank providing that, therefore, like [indiscernible]. You might like what he does, you might not like what he does, but give him this.
He sticks to his knitting. He hasn't bent. He's not going to do what he doesn't want to do in terms of his, let's say the integrity he has over the investment process. He loses money every quarter, but he's got to sell and you get redemptions. He's got to sell things that aren't in the indexes, there really is no buying interest.
He owns undervalued securities, and he's selling them, make them even less, more undervalued. The system is gamed, I don't think the conclusion on that basis that indexes have proven active managers to not be able to perform as well as index is false. There's another anecdotal bit of information I like. I made a list a year or so ago, of like a half a dozen really well respected value managers, value managers who had 20, 30 years of ongoing investment performance over obviously, over multiple cycles, superb performance, like reall