Transcript: The Perils of Passive Indexation

Featuring: Mike Green

Published Date: December 11th, 2019

Length: 01:15:08

Synopsis: In his first appearance as a guest on Real Vision, Mike Green,

portfolio manager at Thiel Macro, joins Real Vision CEO, Raoul Pal, to
discuss the corporate credit cycle, the rise of passive indexing, and the
consequences of mass baby-boomer retirement. Green argues that the
simple algorithmic logic of passive vehicles causes irrational capital
allocation. He asserts that these passive strategies only make money in a
liquidity-enhanced environment, and he explains that stresses to the indices’
lack of cash reserves could create market volatility. Green and Pal examine
the shift to passive vehicles and how that shift is molding the fate of both
baby-boomer pensioners and millennials. Filmed on December 5, 2019 in
London.

Video Link:
https://www.realvision.com/rv/channel/realvision/videos/089b365a972c41e582fc7b63c6361afb
The content and use of this transcription is intended for the use of registered users only. The transcription represents the contributor’s personal
views and is for general information only. It is not intended to amount to specific investment advice on which you should rely. We will not be liable to any user
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 The Interview: The Perils of Passive Indexation

MIKE GREEN: It's extraordinarily hard because what we're describing on all of these are emergent
phenomenon. We've never had this stuff happened before. We can't subject it to a back test. We can't say
this is exactly what's going to happen. Those of us who've been in the market for a long time, we know
there's something wrong.

RAOUL PAL: Well, we love a bit of theatrics at Real Vision. Today, I'm in an old theater in London, the
London Palladium. You may hear a bit of sound as creaking old building with air conditioning units going
on and off, forgive me for that, but it's all going to be worth it because my special guest today is Mike
Green. Mike Greens has not been an interviewee on Real Vision for a couple of years now. You've all been
asking for this interview, so here it is.

Mike, finally get you back. We're in London this time, and you've not sat this side of the camera for two
years maybe.

MIKE GREEN: It's been actually slightly more than two years. Yeah.

RAOUL PAL: Everyone's been itching to hear what your thought process is and so I want to sit down and
grab your attention for a while.

MIKE GREEN: I can't imagine why they would want, but I'm very flattered.

RAOUL PAL: There's a lot to catch up on because you and I've been speaking frequently about what
you're thinking about. A lot of people who know you've Real Vision don't really know where your thinking
has evolved to. I think maybe the place to start is the big discussion about passive investment. I think that's
probably the top level part, then we can dig into a few other things.

MIKE GREEN: When we think about the dynamics of passive, like most people don't understand how big
this has gotten. You are forced to confront the very simple assumptions that are made behind it. If you go
back to the origins of the theoretical defenses, which are built on the ideas of efficient market hypothesis or
the work of modern portfolio theory, Bill Sharpe's original work, and the real defense of passive, the
outperformance of passive argument comes from the paper written by Bill Sharpe in 1991, called The
Arithmetic of Active Management. His point is, is that in a market that is complete, in which all assets are
owned simultaneously by passive investors and by active investors, by definition, they have to be functionally
the same, some active managers may own Apple and some may own IBM, but in aggregate, they have to
own them in the same proportion to what they represent in terms of market cap.

The ideas that are embedded in the arithmetic of active management, the assumptions, the simplifying
assumptions that make the model tractable so it can be solved include things like you never transact. That's
just absurd. Because we inhabit a world now, where almost 90% of the transactions that occur in the stock
market, in one form or another, involve a passive entity.

RAOUL PAL: What was that versus the past? If it's 90% now, what was it? How's it shifted?

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 The Interview: The Perils of Passive Indexation

MIKE GREEN: It was functionally zero. JP Morgan actually came out with some analysis a couple of years
ago that looks at this underlying dynamic. If we go back as recently as 2006, you would have seen the
market where 70% of the transactions involved the fundamental player in one form or another. Now, it's
90% involved passive, involve some form of an index representation. It's just been this really, really dramatic
change. It's occurred, US equities are the most advanced in this type of impact, but it's also morphed into
the rest of the world. We've seen this on a broad basis.

If you're an investor in the United States, it's almost certain that your exposure to the rest of the world is
captured in an index. Kyle Bass has talked an awful lot about the influence of players like MSCI in terms of
the ability to attract capital to countries like China. I would say that we're increasingly seeing the impact of
this in the bond markets as well, where more and more of the incremental capital that is going into the
market and fixed income is coming in the form of passive indices.

When you build a model, you have to make simplifying assumptions, I understand that. That's fine when
it's very small, but when you become the dominant player in the market, those simplifying assumptions, that
lack of representation of real world-ness, which is not really a phrase, but it fits it well-- those become critical
in terms of understanding the dynamics of what's going on.

Some of the stuff we've talked about in this framework is the underlying idea that the character of why
people transact changes or how they transact changes. You've seen some of my research on the underlying
dynamics of why markets have historically functioned as discounting mechanisms because the individual
players that have been in the market discount. If you talk to an active manager and you ask them why
they're buying something, they'll typically tell you because they think the expected return is in excess of their
cost of capital or in excess of what the rest of the market will do. They will have constructed some forecast
of future free cash flows, or some discounted cash flow methodology and it can be as simple as a PE ratio
versus history or they're all representations of the same underlying assumptions.

They'll use that so that they're prepared to offer the market liquidity in the event that liquidity is demanded.
That liquidity can be demanded in the form of I want dollars. If you've done a discounted cash flow analysis
of Apple, and you decide that Apple is worth $200 a share, and suddenly, the market is trying to sell it at
100 bucks, you'll put capital up and you'll risk it because you're prepared and you've done your analysis.
That's what a DCF is for. We're not actually--

RAOUL PAL: Yeah, it gives you a fair value, whatever that is.

MIKE GREEN: It gives you your personal estimate or fair value. We all accept that my forecast for Apple's
earnings is going to be different than your forecast for Apple's earnings--

RAOUL PAL: Or how you value them.

MIKE GREEN: Or how you value it, what the discount rate is, etc. Each individual active manager prepares
themselves for opportunity that is created by the market where the market is demanding liquidity in the form
of the price is too low.

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 The Interview: The Perils of Passive Indexation

RAOUL PAL: That's how people think about free markets.

MIKE GREEN: That's how they should.

RAOUL PAL: When that's what free markets are based on, everybody else has their buying and selling
rationale based on their own hypotheses, let's say.

MIKE GREEN: This, to me, sits at the core of the error behind the thought process of what passive actually
is. Because the writings and speeches of John Bogle and others who talked about this to say, well, how
much do we actually have to pay people to set these prices? The prices that are being set by DCF on Apple
has no bearing on where Apple should be trading. Unless the price conditions around Apple in the market,
the behavior of those prices, creates an opportunity for me to actually risk my capital.

I've got capital that's available to me, if you decided that you desperately want to get rid of your Apple
shares and sell them 100 bucks, I think it's worth $200 therefore, I'm willing to risk some of my cash for the
prospect of future return because I think you're selling the Apple too cheaply. On the other side of the
equation, if Apple goes to $400 a share, I may decide I'm going to give you my Apple shares in exchange
for the cash that you apparently no longer want.

It's those transactions that actually cause prices to be set. Prices don't exist until the transaction occurs. At
the extreme end of that, and this goes back to the experience of somebody like Julian Robertson and the
dot-com cycle, if prices get so crazy, I can synthetically create Apple shares by shorting to give them to you
or JDS Unifies, or priceline.com or whatever I want to pick on, E-toys. In that environment, I can say, I'm
going to synthetically create this by borrowing the shares from somebody else and handing them over, but
that's historically described how the market behaved.

Passive behaves very differently. Passive, what we think of it as these sophisticated algorithms that are being
run at shops like BlackRock or Vanguard. It's literally the world's simplest algorithm. Did you give me cash?
If so, then buy? Do I care what the valuation is? Do I care what the forward expected return is? I don't care
about any of that. All I know is, you've given me cash, which gives me an instruction to buy. Likewise, if
you ask for cash, I'm going to sell and I don't care where the price is.

That's a very different feature to introduce into the market. If it takes the form of money flowing into passive
strategies as it has for basically the last 20 years, that process of shifting from investors who are discounting
to investors who don't actually care about that discounting is going to prove inflationary devaluations and
this is exactly what we've seen.

RAOUL PAL: The active managers who still may think prices have risen too high sell out. They then
disappear from the market, and over time, it just becomes more and more and more indexed, I guess.

MIKE GREEN: Well, there's that component which, in part, if you have this inflationary return feature
where returns are being facilitated by rising valuations, and most people will focus on something like a PE

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 The Interview: The Perils of Passive Indexation

ratio. Well, PE ratios have high degrees of cyclicality to them. We're currently, particularly for the S&P,
near peak margins and so each dollar of sales is producing more earnings. There's a variety of reasons
why that has a mean reverting characteristic to it but a better way to think about valuations in that type of
framework, at least on my point of view, is to think about what's the median price to sales in the S&P 500.

What that means is I'm looking at the stock that is in the middle of the S&P 500 on a price to sales basis. It
has its own modulating characteristics as you're grabbing the median, it's not overly inflated by the
extremes, the super high valued stuff, nor is it being overly penalized by the stuff that is very poorly valued.
It also has the characteristic of not capturing extreme profitable companies, so most people will think well,
price to sales should go up when you're switching from companies like General Motors to Microsoft, which
is a super, super valid point.

If I look at the median stock in the S&P, right now, the median stock in the S&P is VF Corp. It's a shirt
manufacturer. Its profit margins haven't changed. Its growth rates haven't changed. Its return on equity
hasn't changed. Almost nothing has changed about VF Corp in the past 20 years. Its valuation has gone
up 5x. In the last 20 years, its valuation has-- 25 years, its valuation has gone up five times. That's a huge
contributor to the return profile that we're looking at.

To your point, if I'm an active manager, and I decided that these valuations are ridiculous, and I take myself
out of the game, I hold cash because I expect valuations to revert. That valuation inflation is being caused
by a secular shift. This move to managers who don't care what the valuation is, or simply responding to the
flows, then I actually begin to incur an increasing penalty associated with holding that cash, you increasingly
get fired, that's exactly right. It creates a feedback loop.

Part of that feedback loop is created by the performance characteristics which is in very mathematical terms
is being created by this increasing curvature or convexity in the return space. Part of it is also is just being
created by the narrative and I would toss in the demographic components. When we talk about passive
penetration, which is on a market cap basis, it's now about 30% to 35% of the US equity markets.

RAOUL PAL: But 90% of the flows.

MIKE GREEN: Yeah, it was. It's actually more than 100% of the flows. The reason why that's happening
is because the penetration of passive amongst baby boomers and older investors is way below than what
it is for millennials. For millennials, it's now over 90% passive. There's no scenario that I can see under
which millennials suddenly decide, you know what, I'm going to go from three basis point Vanguard funds
to 65 basis point active funds, or even go through the process of figuring it out.

We've talked a lot about 401ks in the past. The staggering statistic for me in 401ks now is 90% of the
money that is going into 401ks is the marginal dollar that's going into 401ks is now going to target date
funds. According to Vanguard statistics, Fidelity has similar statistics, well over 50%, it's now closing in on
60% of all 401ks have a single asset in it, the target date fund.

RAOUL PAL: Some people don't know what target date funds are, unique to the US.

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MIKE GREEN: Yeah, so target date funds are somewhat unique to the US, although they're beginning to
proliferate on an international basis. These are vehicles that are attempts to systematically replace the 110
minus your age exposure between equities and bonds, and do so on a continuous and systematic basis.
One of the biggest challenges that smaller investors have is that their portfolios suffer from inattention. They
don't adjust their weightings frequently enough. They tend to put the money in choosing initial allocation
and then forget that they ever did something like that.

Be candid. I've done that with my kid's 529 plans. Target date funds were created in 2003, first target date
funds were created in 2003 and they were designed to answer this problem so that people would have
their allocations to stocks and bonds, international, domestic, adjusted over time automatically. Those
received a huge shot in the arm when we adopted rules associated with 401ks called QDIA, qualified
default investment alternatives. In the United States, roughly 85% of all salaried employees now have some
form of 401k participation.

The historical model is that you had to choose to opt into a 401k, so now, you're automatically opted into
a 401k. You have to opt out of a 401k. Likewise, the default investment alternative is that it would just put
your money into a money market fund and so unless you made a choice, they just wanted to cash. With the
adoption of QDIAs, qualified default investment alternatives, the corporation that was sponsoring the 401k
had to identify a base investment that you would go into. For almost all corporations, that became target
date funds. It's incredible. Most people--

RAOUL PAL: It's also been championed by the industry.

MIKE GREEN: Of course it was.

RAOUL PAL: Because they didn't want cash, they wanted--

MIKE GREEN: You don't get a lot of asset management fees on cash. In order, for that matter on Vanguard
target date funds. That's a separate issue. That industry, as you pointed out, like a lot of people don't even
know what it is. It's now grown larger. It's about $2.7 trillion in assets, from nothing in 2003, it's now $2.7
trillion in assets. It's larger than the private defined benefit space. This is just an extraordinary growth that
people aren't paying attention to.

RAOUL PAL: It's all passive, essentially.

MIKE GREEN: It's functionally all passive. There are few minor exceptions. Capital Group has some that
are that are non, T. Rowe Price has some that are non-passive, but they're very much index benchmark
huggers. It's led to all sorts of crazy-- digging in and studying this space, it's led to all sorts of crazy insights.
It's like who are the largest holders of negative yielding German bonds? US retirees through their Vanguard
401ks.

RAOUL PAL: Because they have a bond index.

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 The Interview: The Perils of Passive Indexation

MIKE GREEN: Because they have a bond index and that bond index says, the higher something goes--

RAOUL PAL: I want to talk to you about the Austrian bond, you said you checked the holders of it and
the Austrian bond is held by the index funds.

MIKE GREEN: That's exactly correct.

RAOUL PAL: Because everyone's like, who's the idiots buying all of this? It's mom and pop in America.

MIKE GREEN: That's exactly right. It is a byproduct. Many people have heard me talk before about the
unintended consequences of index investing and the difference between float weighted and market cap
weighted as it related to this dot-com cycle with this idea that an improper index construction led to a
dramatic impact in the broader market. We're seeing the same thing in bonds today, because these indices
were created. These are the old Lehman bond aggregates, both domestic and international, they were
created as observation vehicles. They were designed to tell you what the yield was across the bond universe.

The construction of these indices are such that the yield was-- the aggregate yield was calculated based on
the market value of the individual bonds because what you really didn't want to do was take a low quality
distressed bond that was trading at 35 cents on the dollar and weight that on the basis of its issuance, i.e.
at par. What was never considered in the construction of these indices, one that they would be used for
actual trading vehicles or investment vehicles. The second was nobody ever considered what would happen
to longer tender or long dated 30 year plus bonds that when yields moved below their coupons. What
happens then is that their prices explode.

RAOUL PAL: The weighting goes up.

MIKE GREEN: Their weighting goes up. Now, think about that. We know this is absurd. There is no signal
that comes from the market that tells you that a bond that is trading at 200 has meaningfully better credit
exposure which is really what you were concerned about the construction of these indices. A bond trading
at 200 doesn't have better credit exposure than a bond trading at 101. In both situations, you're functionally
saying your risk of principal loss is zero, but because of the index construction, that bond is trading at 200
is far more attractive, attractive in quotes, meaning more heavily weighted in the index than the bond that's
trading at 100 or the distressed bond that you might be considering is trading at 85 cents. We've introduced
momentum into bond indices. This is exactly what we're seeing in terms of the behaviors.

RAOUL PAL: As this picks up pace, and the active managers become much more marginal and the key
driver of price is indexation or passive flows. What does it lead to? Because you've talked about this
convexity and I think that is the key concept that you drive here. It's not like, yeah, the market valuation is
going to change. It's changed somewhat. I thought prices goes quite a bit further in all of this.

MIKE GREEN: Yeah. My view is-- when you talk, convexity is obviously the rate of change that occurs
over time. Effectively, a surface becomes more and more exponential. That can happen in both directions.

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 The Interview: The Perils of Passive Indexation

As these strategies become larger and larger as we move through this path, that convexity accelerates. In
a really extreme scenario, you start asking yourself, how does the market respond if we're 90% passive, or
if we're 100% passive? The response becomes extraordinary, the volatility picks up dramatically. The
concern that I have is that as you move more and more into these vehicles that don't carry their own
endogenous liquidity, they're not holding cash in the fund, when you encounter a scenario in which
redemptions occur, and that's inevitable as they grow in share.

For example, as I said, over 90% of the millennial's money is invested in passive vehicles. At some point,
whether it's because they decided to buy a house, or whether it's because we get all the way to their
retirement, they're going to have to take money out. When they do that, that lack of endogenous liquidity
means they need to tap into the market for liquidity. That's what active managers do.

The goal of active managers, we talked about this dynamic of figure out prices, what I think the price should
be in advance, so that I'm prepared to provide liquidity. If they become so small that their ability to provide
capital is overwhelmed by the systematic and passive strategies, they simply say, hey, I presume that I can
tap the market for liquidity and you can get market behavior that becomes extraordinary.

RAOUL PAL: At what point do we get to the tipping point where passive becomes everything? We talked
about this before where prices could almost be infinite in the right market setup. Talk a bit about that,
because I think, again, that that's not something people understand. Because people think of this as a return
to the main opportunity, and we just have to wait it out and your view's different.

MIKE GREEN: Yeah. No. The way that I think about it, first of all, when I try to model this stuff, typically
what I'll do and certainly what I've done in this situation is I'll effectively program agents. Create individual
agents to simulate a trading environment against themselves. Again, I realized that I'm simplifying with
rules and models but the output from this very closely mirrors what we're seeing in this valuation inflation
component.

When you have what we have today, which is more than 100% of the money that is going into the market
is coming in in the form of passive and all the money that's coming out is coming out of the active space, if
I run a simulation that replicates that, it's once we cross about 50% passive, the market becomes
discontinuous. The way to think about this is it's not how much do I have to pay active managers to set
prices? It's really how much capital do discretionary active managers have to have in order to provide
liquidity to the market.

You can think about it as a model, where if you're seeking a transaction as a player in the market, it's not
what did somebody decided the correct price was, it's that you reach into a bag, and you pull out a marble
and there's black marbles and white marbles. If you pull out a white marble, you get to transact, means
that you've encountered a discretionary trader who in response to your request for a trade is able to facilitate
your liquidity. They can sell to you or they can buy from you. Pull out a black marble, which represents a
non-discretionary passive trader, they don't have the ability to sell to you, don't have the ability to buy from
you unless they receive an instruction from their end investor.

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 The Interview: The Perils of Passive Indexation

RAOUL PAL: And then only in the weight of the index.

MIKE GREEN: And then only on the weight to the index, they have to transact in total. When you run this,
what happens when you cross over the 50% threshold is that your propensity for pulling out a black ball
and not being able to transact begins to rise exponentially. You can just simply think about it on a
compounding basis, if the odds are less than 50%, the compounding basis says eventually you will get a
trade. Once you cross over 50% on the other side, however, it becomes increasingly profitable that you
have a series of discontinuous events.

I think the key insights that actually led to this misunderstanding came out of the behavior of the Chinese
stock market in the summer of 2015 where we saw this crazy behavior where stocks in the Shanghai
Composite-- the Shanghai Composite had this feature where it was market cap weighted, not flow weighted,
we've talked about those dynamics before. We actually were seeing stocks and the peculiar rules where the
index wasn't particularly bound in terms of limits, but any individual stock had a 10% limit in terms of its
daily trading activity.

We were tracking this, we would see stocks that would go 30 days in a row where they were just limit up.
There was no transaction, it was a continuous series of you pulled out a black ball. That's the thing that can
happen where markets could become--

RAOUL PAL: How far are we from that 50%? What's the projection for that?

MIKE GREEN: Yeah. This is part of the challenges figuring out exactly-- nothing is ever as easy as a model
would suggest it.

RAOUL PAL: That's not a science.

MIKE GREEN: It's not a science, there's very much an art to it. Depending on how you want to calculate
it, as a percentage of market cap or somewhere around 35 percent passive right now, as a percentage of
managed assets, we're like right there. We're right at that 50% point. It becomes a question of, are we
modeling the available float correctly?

A friend of mine who's a discretionary active manager, super talented guy. He works at Meritage, which is
the active manager arm of Jim Simons Renaissance Group. He's come to me with a number of companies
that he's struggling with, that he's looking at. He's like, this is completely crazy to me. One is an insurance
company. A specialty insurance company that's trading at four and a half times book, 40 times normalized
earnings, 38 times forward earnings. It's just an insurance company.

An insurance company generates returns off of its book value. It takes the capital that is received in excess
of its loan loss provisions or expected loan loss provisions and invest those to generate the excess return.
It's extraordinarily unusual for an insurance company to be trading at a significant premium to book. A
reason why this is moved-- and I'm not going to name the name of the individual security but the reason

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this has moved in such an extraordinary fashion is because it has a series of cross holdings within the
industry.

You have holders that are not going to sell because they are interested in acquiring this company at some
point in the future. Certainly not at these valuations, but they're not really going to change its strategic
holding. That's not classified as an insider or a non-float holding. As a result, the indexes are trying to buy
this in greater representation right back to the dot-com cycle, than the shares that are actually available.
It's causing the shares to completely explode to the top side.

This guy's absolutely correct. This is absurd. This company can't possibly be worth what it's trading for, but
the mechanism for it correct doesn't really exist.

RAOUL PAL: You talked about that when you get to the very last, what if the market is entirely passive,
then prices go infinite?

MIKE GREEN: It does. Yeah, it depends on the quantity of cash that's held. If it becomes-- Victor Haghani
actually just did an analysis on this where he was talking about perpetual bonds. This is a piece that literally
just came out in the last couple of years.

RAOUL PAL: I'm actually bumped into him last week, actually.

MIKE GREEN: He points out that in a world of negative interest rates, how do you value a perpetual
bond? It potentially becomes infinite in price. You have a similar dynamic in a passive framework where if
money comes in, let's imagine the market is completely passive and I decided to try to put $1 in, what's the
impact that that has, because nobody else has the ability to sell to me? How do we set prices?

There's you're shaking your head. That's the right answer. We actually don't really know. If we can
mathematically solve for it, the actual answer is, is that it becomes a function of how much cash is being
held in the market, but it becomes nearly infinite in its behavior.

RAOUL PAL: That leads me into two things, which are the next part of the things I want to talk to you
about, leads me into what does that mean for volatility? Then we can talk a bit about the volatility structure
the markets today. The other thing that I think before we go into that, because I think it sets us up into all of
this. The other part that you and I've talked about on camera and off camera a lot is the retirees and where
we are. These are the active holders. The whole passive--

MIKE GREEN: Primarily active managers.

RAOUL PAL: Yeah, and these guys are all hitting services or--

MIKE GREEN: They're all hitting the point at which they need to take distributions in one form or another.
It creates perverse dynamic, because purely on the basis of demographics, all the incremental saving and
investing is occurring from the millennials and to a lesser extent, the Gen X-ers we can always forget them.

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All the distributions and all the money that is being taken out is being taken out by the boomers and the
older generations who are disproportionately invested into the active manager space. You have this natural
portfolio shift that regardless of performance or anything else is pushing the market more and more passive
like this is-- and its accelerated by the dynamics of the boomer retirements, the active outflows.

The offsetting feature to that is that the lion's share of the assets reside with older generations. About 70%
of the assets in wealth are held by those over the age of 65, and they're selling. As you just move slightly
forward in time and you move from those over 65 today or 80% active 20% passive, if we move a little bit
forward in time, suddenly, they're going to be 50/50. Anywhere close to that point, it becomes inevitable
that we start seeing significant sales coming from the passive space. That's particularly exacerbated if you
actually do have this inflationary dynamic, which I'm highly confident in.

What that actually means is that the incremental dollars that are coming in from the millennials, those who
are working, and now saving represents less and less of the actual market itself. Those who hold the assets
benefit from the inflation. While this seems like it's a hugely beneficial thing for millennials, like oh, this is
great, the market is going to go up as they're saving, the reality is that their incremental dollar contribution
becomes less and less valuable. The workers get hurt in this process.

RAOUL PAL: Also, the dynamic of all the capital, which is active, selling to these millennials, who don't
have as much, leaves a massive overhang of non-index stocks, which is why everybody in the value space
has been nuked, and it's not going to change.

MIKE GREEN: It's not going to change.

RAOUL PAL: There's literally no reason for that to change.

MIKE GREEN: Yeah. There is a seasonal component to it. There are periods of portfolio rebalancing.
Everybody knows because of the work of Eugene Fama and Ken French, that value outperforms, although
some recent research calls that into question. The underlying base effect is when it sounds more intelligent
to say I'm a value investor. Secondly, we do have data that suggests that over a long period of time, buying
cheap stocks outperforms expensive stocks.

There are programs that automatically rebalance and actually, if you look at on a seasonal basis, they're
very distinct patterns associated with the rebalancing periods for pensions, which are disproportionately
allocated to these types of strategies, trying to capture just a little bit of excess return. The underlying feature
is that almost the only time we now see value stocks outperform is not because value stocks are going up,
but because the market is going down. Those periods, in my analysis, represent periods of outflows.
Basically, they're precursors, they're indications of what the world looks like when we see money come out
of these markets.

RAOUL PAL: That leads me to the next point. We talked about the sheer amount of passive investing.
There is an element of discretion based on let's say, me, as a millennial, gets nervous about the market,
because I've read there's going to be a recession and I want to sell. There is a potential outflows that come,

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not just inflows, and it tends to happen in that human behavioral all at once whilst at the same time, we
have ongoing negative outflows

MIKE GREEN: From the older generation.

RAOUL PAL: From the older generation. Stock buybacks is the clearing thing in the middle, which is very
cyclical.

MIKE GREEN: Procyclical, yes.

RAOUL PAL: Procyclical and we're at the end of the cycle right now. We have this setup where if
something turns at the margin, liquidity is just not going to exist.

MIKE GREEN: Yeah. One of the points that I would highlight is whether we're actually at the end of the
economic cycle or not, that same dynamic where the incremental dollar of buybacks just like the incremental
contribution of the millennials, it becomes smaller and smaller as a share of the market. Buybacks in 2019
were roughly equivalent to the buybacks in 2018 but it represents a smaller fraction of the market because
the market is up. Market is up sharply over the past year.

As a percentage of shares outstanding, we're actually seeing less impact on say the S&P multiplier, the
index divisor. The percentage that is getting bought back, that yield is falling. That is another dynamic that
has played out. Just the world that we've entered into, yields are so low, both in the form of interest coupons
and in the form of dividend yields. That increasingly there is no plausible scenario in which people can live
off their interest and their coupons, they're dependent on their ability to sell these products.

All right, and so we've created a dynamic of roach motel. You can get in, and it feels great. You check your
return profile and it says you're doing fantastically, and then you try to sell and the fragility of the market,
that inability to provide the liquidity means that when you try to sell, you get far less than you had ultimately
expected.

RAOUL PAL: There's a couple of things that that well, we're going to talk about, and I've looked at as
well is, is obviously, we talked about the buybacks being procyclical because copper cash flow is cyclical.
Therefore, when we're at the low point in the cycle, buybacks, slow down and stop. That takes out at one
point, almost a large part of the market. The other side, the flip side of that is I only realized this, there was
an interview I think Tyler did on Real Vision with the corporate bond guy.

What he was saying was what was fascinating is that the pension funds in bankrupt states like Illinois are
taking tax receipts and put them straight into the pension system, which are going straight into bonds,
corporate bonds. That's the other side of the buyback because the company is issuing this stuff. All of that
tax receipts are basically the business cycle as well. Almost all the liquidity to the financial system is now
driven by players are not making decisions based really on anything.

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We've got the baby boomers, who are forced to release, even at 70 and a half years old, they're forced to
release equity. They will do anyway. We've got a whole bunch of passive that not taking a choice in
anything. Then we've got a bunch of people who are just either buying bonds or buying shares based on
the business cycle and will stop as soon as they don't.

MIKE GREEN: Well, there is a little bit of a push back. Because the business cycle also affects the issuance
of bonds. Yes. Corporations will not issue--

RAOUL PAL: It's the baby boomers selling I'm worried about. They have all the bonds. It's all in the
pension system and as they hit 70 and a half or whatever, they're choosing to redeem some of their assets.
If that happens to be in a business cycle, you've got a big mess, because you've got no buyer.

MIKE GREEN: I'm less concerned about-- just be to be careful, I want to disaggregate bonds and credit.
When you say corporate bonds, you're referring to the credit market as [indiscernible] to the sovereign
bond market. I'm concerned about the credit cycle for two reasons. One is deteriorating profit margins on
the corporate side, make servicing the debt even at today's low interest rates or future low interest rates
more difficult and credit has the dynamic of when interest rates fall in a recessionary environment, credit
spreads rise and so, corporations don't really benefit from a significant reduction in the interest rate.

The other component, though, is we have a pattern of not just pension plans buying bonds. The tax receipt
is going to buy them, but also the employment dynamics. If you think about the behavior of an investor once
they cross 55, virtually all of their incremental dollars and savings begin to go into bonds. Yes, I think that
there is a risk that there will be selling coming from the baby boomers, I'm more concerned actually on the
ability to service the debt on the corporate side, a deterioration in the credit cycle, than I am actually about
the impact of the selling.

If they do try to sell, which can happen in a recessionary environment in part because of fears of the credit
cycle, you'd become uncertain as to what the value you hold in the corporate credit market is, when you
enter into that type of environment, then it's basically everybody in a crowded theater trying to make their
way out through the door. A lot of guys have talked about this dynamic in the context of ETFs, and it's true
for mutual funds as well. It's true not just in bonds, it's also true and other assets.

We're sitting here in London, and today, it was announced that MMG is gaining their mutual funds tied to
real estate primarily because of the liquidity. They received a surge in redemptions. If they try to meet all of
those, the only way they can do it is by selling the liquid assets that they hold and the quality of the portfolio
deteriorates, it becomes increasingly illiquid, which then invites even more of a run on the bank effectively,
because it's the exact same dynamic.

ETFs have a very similar dynamic where it takes multiple days for bond trades to settle, bonds that are lower
in quality less supported by the bank trading operations. This is broadly true in the aftermath of Dodd Frank
and the Volcker rule, that banks carry far less inventory. These are all less liquid.

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 The Interview: The Perils of Passive Indexation

Those ETFs have a mismatch in terms of their liquidity. They are providing daily or hourly or tick by tick
liquidity on non-liquid assets. Those sorts of concerns, I think, are super valid. I'm much more concerned in
the equity space because of how over allocated people are, particularly the older ages. Fidelity just came
out with a report in the past couple of weeks, about three weeks ago now, where they were highlighting
that when they look at their 401k allocations for their investors that they're seeing the baby boomers
fantastically over allocated. Many of the allocations--

RAOUL PAL: Because they thought there's a shortage of returns compound over time that these guys don't
have enough to retire and because as you said, the coupons are zero now, nobody can retire off the assets
that they thought they could. Everyone's got it wrong.

MIKE GREEN: They can't retire and hold the assets, they actually have to sell the assets. They have to sell
the assets in order to get that. We've talked about the dynamics of 401ks. Once you pass 70.5, you have
to take roughly 4% out of your portfolio every year. Well, the dividend yield on the S&P is 1.6% or 1.7%,
the coupon that you're going to receive on a decent investment grade bond which would be suitable for
somebody at that age to own, 2.5, 3, so like under no scenario can you meet that 4% withdrawal without
selling something. That's fairly unprecedented in history.

RAOUL PAL: Yeah. That's meant that people have then applied leverage strategies. This is where we get
into the vault sellings. There's stuff that people start doing now to just take more risks. At a pension fund
level, at individual level, there's too much equity. Because that equity is their hope because maybe the price
will go up enough that I don't need the yield. Okay, that's not really going to help and they're taking way
too much risk because if you hit a bear market--

MIKE GREEN: Then volatility go in both directions.

RAOUL PAL: Yeah. When you hit a bear market, you're going to obliterate half your savings because
you're about to retire. We got this whole dynamic going on right now. Then so the pension funds are trying
to get around that by doing crazy stuff, whether it's these CLOs or selling vol.

MIKE GREEN: Yeah. It's not just the pension plans. We've talked about the variety of vol sellers that exists
and you can take them off. It's pension plans that are outright selling vol, particularly some of our northern
neighbors are very aggressive in that. You have huge vol selling that's occurring through the corporate
share repurchase market. Much of that takes the form of synthetic put selling. Things like accelerated share
repurchase programs or systematic 10-B51 plans. These are all ways of selling volatility.

The biggest chunk of it is taking the form of what are called the yield enhancement strategies. This is where
I think central banks have actually played a significant role. Unlike most macro investors, I tend to under
emphasize the direct role of central banks except if you're in a credit cycle where they can dramatically
impact the value of assets. When they lower interest rates to support assets, and they do so as aggressively
has occurred over the past 15 to 20 years, it changes people's ability to save for retirement and live off of
those assets.

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 The Interview: The Perils of Passive Indexation

The extreme version of this can actually be found in places in Asia. Korea has seen within the past 20 years,
they've seen their bond yields go from 10% to today, they're about 1%. Korean and Taiwanese and
Singapore and all sorts of countries across Asia are suddenly faced with a collapse in yields. Japan is a
slower version of this. That has functionally prevented them from generating the returns that they thought
they were going to be able to generate off of the assets that they were investing in.

A yield enhancement strategy is just a way of creating an overlay that takes more risk by selling insurance
on other risky assets. When we talk about selling insurance, we're really just saying they're selling puts.
That obviously creates significant risk of catastrophic debt drawdowns in extreme scenarios, i.e. global
recessions like we saw in 2008, but it feels like very safe because the data series that we have says that--
the data series being the history that we have says that we haven't had that many catastrophic events.

This is one of the biggest risks that we generally run. The way that we think about financial markets is that
we look at the available history of data and we presume that that's what the range of possible outcomes
looks like. Then we construct trading strategies around that. The minute you can start a trading strategy, the
minute you start executing against a benchmark or a realized history in which that didn't occur, you totally
changed the distribution of outcomes. The most extreme and the most clear example of this is what happened
in February of 2018 with the blow up of the XIV, the inverse ex-ETF product.

RAOUL PAL: Yeah, you are actively involved in that one.

MIKE GREEN: Yeah, I was. We were involved in it. Yeah, not positive blow up but yes. That was a very
clear one where the growth of the retail participation in the market had changed the underlying demand
on extreme moves in volatility. It was very clear that the liquidity that was being provided to the market from

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 The Interview: The Perils of Passive Indexation

retail investors selling volatility in the form of the XIV, for example, had become the basis of the pricing in
the market. Their desire to sell this product had facilitated other people's desire to buy it.

The problem was, because of the structure of this product, when the moves became large enough, any
attempts to sell that product basically, if you were an investor who had bought XIV, if you tried to exit
because of an extreme move, you were suddenly joining the crowd rushing out of the theater. You were
trying to buy vol at exactly by covering your shorts at exactly the same time that everybody else was
demanding the insurance.

Very publicly, I got into an argument in May of 2017 with the founder of Velocity Shares, which was the
sponsor of XIV. His assertion was that the product had been designed to survive the 1987 crash, in which
the market fell give or take 25% in a single day. My calculation was that it was going to go to zero on a
4% decline in the S&P, it ended up doing it on a 3.9% decline. I was pretty happy with the way that played
out, but it's literally an order of magnitude difference. 25% almost an order of magnitude difference. 25%
versus 4%. They had no idea because they had not thought about the dynamics of what their own product
was creating in terms of the impact on the market liquidity.

RAOUL PAL: It feels that was a structural change. I want to get your thoughts on that because we saw
what happened this time last year. Last November, December. Talk me through what you perceive that to
be because that was a really interesting scenario that caught everybody by surprise, again, much like the
February had earlier in the year.

MIKE GREEN: There are two things that were super interesting that happened in the context of those two
events last year. For me, one of the most important things that happened was that-- and this goes to what I
believe are the dynamics of the rise of passive penetration and the importance of index vehicles being
traded in for the first time in history, on February 5th, 2018, every single stock in the S&P went in the same
direction. That's a pretty extraordinary statement as [indiscernible]-- there you go. I'm not going to say it
was your fault, but a milestone.

On Lehman Brothers, the S&P fell 10% in a single day, and not all 500 stocks went in the same direction.
Gold stocks, lumen in particular went up. Similar dynamics occurred in 1987 when the market fell 20 plus
percent. On that 4% decline, 3.9% decline, every single stock in the S&P went in the same direction. It was
because all of the trading activity was in functionally S&P futures. Those S&P futures were actually tapped
to make up for the lack of liquidity that existed in the VIX futures.

In December, with that selloff on the penultimate waterfall events on the 24 th and then the rebound on the
26th, we saw it happened twice. Once the downside of the 24th and once to the top side on the 26th.
Something that never happened before in history happened three times last year.

When we look at what happened in the fourth quarter of last year, like there's no question that in the
discretionary space, whether it was CTAs or vol targeting entities, or just overly aggressive investors had
positioned themselves very aggressively coming into the end of September. I think there were a variety of
things that happened that caused a lot of transactions and caused some fairly significant volatility that then

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 The Interview: The Perils of Passive Indexation

began to morph on a more discretionary basis into the September-October framework. I think it's
underappreciated the impact of the rebalancing of the S&P-- not the S&P but the sector ETFs.

Google transitioned to a communications company and Apple transitioned to a consumer discretionary

company. What this meant was people who had placed bets on the XLK, technology ETF, suddenly had to
change their allocations if they wanted to maintain exposure to Apple, for example. There's a lot of
transactions that occurred around that. There's also adverse news around the economy and the China trade
dynamics and the behavior of the Fed, etc.

Something very different happened in the period after Thanksgiving, from basically, thanksgiving through
December 24th. That's that we saw a fantastic outflow from mutual funds and ETFs. Actually, I'm sorry to be
very precise, we saw a fantastic outflow from mutual funds, active and passive. We actually saw inflows
into ETFs. I think there's a clue there.

When you take a required minimum distribution from your 401k, people save in their 401ks in mutual
funds. The reason why is the average American collects somewhere in the neighborhood of $1,000 a week
in terms of a paycheck. You get paid bi-weekly, it's about $2,000. Your typical 401k allocation is going to
be anywhere from five to six minute-- five to 8%, depending on your underlying exposures. The amount
that you're actually saving if you're doing it at 5%, it's only $100 that is going into your 401k.

A SPY share, the most commonly traded ETF is 280 bucks, and it's 315 today, you can't buy a fractional
ETF share. You can buy fractional index shares and mutual fund shares. The money that get saved in these
401ks tends to go in the form of mutual funds, both active and passive. The money, when it comes out when
a required minimum distribution period happens--

RAOUL PAL: That's when somebody reaches 70 and a half.

MIKE GREEN: That's when somebody reaches 70 and a half.

RAOUL PAL: Then every year thereafter.

MIKE GREEN: Then every year thereafter, they have to start taking distributions and the deadline for that
to be done, and if you don't do it, you incur a 50% tax penalty. The deadline is December 31st. At the end
of the year, basically anyone who's forgotten to or who has ignored their advisor emails, or who simply
doesn't want to because they want to stay invested in the market for most of the year, about 50% of the
requirement of distributions occur over that time period.

We saw exactly in this pattern that money coming out of mutual funds and in some fraction does get
reinvested. People always point this out that people will put it back into the market in a different form, that
once you pull it out of a tax deferred account, you want to put it into something that is tax advantaged in a
taxable account, and ETFs are tax advantaged. You're taking out a large enough sum because 4% of your
total portfolio and you're reinvesting some fraction, that suddenly the $280 price on the SPY or $270 price
at that time is not an impediment. You saw huge inflows into ETFs over that same time period, that you saw

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 The Interview: The Perils of Passive Indexation

these massive outflows coming out of the mutual funds. To me, that's a very clear indicator that what we
actually saw was the initial impacts of these RMDs.

RAOUL PAL: I think people don't really understand yet is there is an enormous demographic wave of
which they've started to hit on mass 70 and a half. Each year, you're adding to the selling because it's all
cumulative.

MIKE GREEN: Not only are you adding to the number of people, again, because 401ks and IRAs, which
are both subject to this RMD dynamic, because they're creatures of the 1970s, and really creatures of the
1980s and 1990s. They're heavily disproportionately owned by baby boomers. Those who came before
them did not really accumulate their assets and these types of products. We're seeing both a dramatic
increase in the size of the portfolios when they hit 70.5 and in the number of people and so these numbers
are beginning to explode.

RAOUL PAL: It feels that if that theory is right, we should probably see some volatility again this month.

MIKE GREEN: That's my expectation.

RAOUL PAL: I actually feel that as well. It feels it looks that way.

MIKE GREEN: It feels very vulnerable, like.

RAOUL PAL: There's something-- that's not the dynamic that's interesting, I don't know if you've been
following this, but the whole money market story of the Treasury issuing all the bills, and then the Fed
basically having to mop up some of that issuance because the money markets couldn't take it because of
regulatory capital requirements. Within the middle of that and if you saw what JP Morgan had done, they've
shifted 190 billion out of cash and put it into the long end. They were playing the yield curve steepener.

MIKE GREEN: I didn't see that actually.

RAOUL PAL: Yeah. Part of this whole issue that's gone on, in the middle of all of this, the Treasury issuing
basically 400 billion of bills that the Fed having to buy it because there wasn't enough liquidity in the
market, because regulatory capital issues and then in the middle of that, JP Morgan said, we're out of cash,
we're going to the long end, meaning the curve steepeners aren't, we're going to recession. They've pulled
the largest amount of cash out before the CCC markets widening, the liquidity in the equity market feels
funny. Everything starts to feel a little bit screwy because you're withdrawing even more marginal liquidity
out of the market. They also cut their lending book by 4%.

MIKE GREEN: We're seeing this in the senior loan survey, senior loan officer survey, etc. Like, it's
unquestionable in my mind that we're beginning to see the first, at minimum, the first warning signs on a
credit cycle. The credit provision is tightening. Bankruptcies and defaults are beginning to rise, particularly
amongst the lower quality credits. If we see a deterioration in the energy markets, which certainly appears

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 The Interview: The Perils of Passive Indexation

to be threatened in one way, shape or form, they continue to be a number of very exposed energy credits
and in particular to that sector, you're seeing increased hesitation to lend.

RAOUL PAL: The oil price. It keeps trying to break down, bounces back up, breaks down, and if it does
break down, there's an issue I think.

MIKE GREEN: Yeah, I think that's right. Even if it breaks up many of the entities in the United States that
are heavy borrowers are actually not gas producers, and other players. It's not at all clear that it's going to
be a homogenous expansion. I'm very aware of the dynamics in terms of the widening credit spreads,
particularly for the lower quality credits.

Again, if you think about the dynamics of what happens in the bond market, as they fall in price, they
become lower fraction of the index. As a result, they attract less capital, which makes it more difficult for
them to refinance. It puts the more and more of the control of these products into the hand of distressed
credit managers. The cycle feels like it's very much underway.

RAOUL PAL: Yeah. I think December's going to be a really interesting period for that.

MIKE GREEN: Yeah.

RAOUL PAL: How should people think about this because a lot of this is conceptual and someone's going
to work here. What does it mean for me?

MIKE GREEN: Yeah, hopefully nothing. That would be great. I don't think it actually is the case. We are
unquestionably seeing a slowdown both in terms of job creation. We just saw the ADP numbers came out
yesterday. We've now seen consistent deceleration in terms of the number of jobs that are being created.
That has a perverse impact as well on the dynamics we're talking about, because it means that there's less
people contributing, less incremental people contributing to the to the market.

It also starts to create issues in terms of how do you allocate resources. Do you have to pay more to people
to retain them as you get to very, very low levels of unemployment under the risk that they may switch. One
of the things you would expect to see at this stage of the cycle is people increasingly switching jobs to
increase their compensation.

What's surprising is we're not seeing that. We're actually seeing people express the type of hesitancy about
changing jobs that's far more common leading into a recession. Now, I realized that it feels like the all clear
has been signaled because the yield curve is no longer inverted, etc. but as some very smart people, Charlie
McElligott at Nomura talks very eloquently about this. What you really need to fear is the steepener.

RAOUL PAL: Yeah, it always precedes the trouble, the inversion is the orange lights, the red light is the
steepener afterwards and if JP Morgan's from their entire balance sheet on the steepener, it's screaming
something at you.

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 The Interview: The Perils of Passive Indexation

MIKE GREEN: Well, it's an interesting one too, because my view on the steepener is a little more mixed.
I think ultimately the trade will work but I think many that are involved in that trade, and it's a very popular
and crowded trade. Many that are involved in that trade haven't fully understood the dynamics of passive
penetration in the bond space. Again, if we go back to that underlying characteristic where bonds become
more attractive when they get higher in price, if you think about what happens when the Fed cuts interest
rates, it has a greater yield impact on a 2-year bond or a 1-year bond, but has a much greater price impact
to the top side on a 10 or a 30. As a result, those actually become larger components of the benchmark,
and therefore get more buying.

Something really interesting has happened in these three Fed cuts. On every single Fed cut, for the past
three, we've actually seen the yield curve flatten. Never happened before in history. There's a lot of very
public bets for the yield curve to steepen, my fear is that unless the Fed behaves very, very aggressively and
others who have talked about this repo dynamic, the demand for cash dynamic have also hit on this issue
that the Fed needs to be a very aggressively. I think you actually could see the yield curve stay flatter or
flatten.

RAOUL PAL: I think that's right. For me, I think rates have to go to zero. There is no way around all the
situation that we've got going on and whether the yield curve remains flat all the way through that, it's a
possibility.

MIKE GREEN: It's a scary thought but yeah, it's a risk that I thought of.

RAOUL PAL: I think what that means the banking sector, so JP Morgan, they're doing it not because they
want to pump their balance sheets, because that's what you do going to recession, you take it out of the
cash market, you try and get the extra yield, and you take less risk. Now, if they don't get compensated for
that in any way, the yield curve stays flat then they got a couple lending. That was really problematic.

MIKE GREEN: That's exactly correct. Yes. The transformation process becomes very difficult. The only way
that you can get paid is by taking additional credit.

RAOUL PAL: That's the European banking situation. It's not necessarily the negative rates. It's the fact you
can steepen the curve, just can't do anything.

MIKE GREEN: Yeah, I think it's a mixture of the two. I do think that negative rates are actually
contractionary to a banking system. I think the Europeans have underplayed their hand, the European banks
have underplayed their hand relative to their regulators, by trying to not pass through the negative rates to
depositors.

I have no strong opinions on what happens when you start putting negative rates on depositors. It can be
both very bad and potentially very inflationary. It's difficult to know. The fact that they didn't do that for so
long basically shielded the ECB for what I think was a subset and Japan was much-- the Japanese banks
were much more aggressive about passing this through. The European banks, I think, shielded the ECB from
the exposure to, I think it was a terrible mistake.

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 The Interview: The Perils of Passive Indexation

RAOUL PAL: To pin you down a bit more, people look at this and say, well, sure, just buy VIX. It sounds
like volatility should be structurally higher, but it can't because of the general suppressions. You have to
wait for the vol explosion. It's actually quite skills thing.

MIKE GREEN: Yeah, shorting the VIX is-- or I'm sorry, going long the VIX is very hard to do well. Part of
the attraction to shorting volatility is the steepness of the volatility surface. If I want to institutionalize the idea
of buy higher, sell low or sell high and buy back low if I'm shorting, that's made very easy when you have
a steep forward curve. If I go out three months in US S&P equity volatility, the VIX, and look at the third UX
future, it's going to be somewhere in the 18 th.

If I look at the spot it's going to be-- I don't know exactly where it is today, but I would guess somewhere
14.5, 15. Well, that's give or take a 20% return over the course of three months. That is super attractive
and doing the reverse, trying to go long means I'm buying at 18 and it's rolling down to 15 if nothing
happens. Very, very hard to express that. I am not a fan of retail investors trying to retail or even most
institutional investors on trying to express a position strictly in the VIX.

RAOUL PAL: Even in the straightforward S&P options market, skews are so high. Again, it's not an easy-
- because I don't think it's so great. I'll just buy some puts. Yeah, you actually pay quite a lot if you're not
careful.

MIKE GREEN: Yeah, you pay in two ways. One is if you go forward and you try to buy a three-month
put so that you're not getting killed by decay or a 12-month put so you're not getting killed by decay. You
face two to risks. One is, if I start the year off by saying I'm going to buy puts at today's strike or 5% below
today's strike, and the market happens to appreciate 10% to 15% over the course of three quarters of the
year going into a December type event, if my seasonal forecasts are remotely correct, suddenly, I have no
protection for 20% move because my options have almost fully depreciated on the down 5% as they've
decayed over the course of the year, they have very little underlying exposure and the market has moved
away. I have a pin risk, a strike risk associated with this.

RAOUL PAL: There's also another risk that's interesting. It's when a whole bunch of options that far below
in the market does, if it does fall.

MIKE GREEN: It tends to stop there.

RAOUL PAL: Either stop sale or the negative gamma from all the dealers having to go from basically
unhedged options to hedged options. You tend to get huge amount of potential selling.

MIKE GREEN: Yes. It's very challenging to effectively hedge on that. Now, the other side of that equation
though is there's been an explosion in volatility selling as we were talking about. If you can figure out where
that is actually happening, I think there's an extraordinary opportunity to take advantage of that. Corporate
share buybacks tend to occur about 3% below spot levels. That provision of synthetic volatility means that
options that are shorter dated one month and in 2% to 3% out of the money are dramatically cheaper than

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 The Interview: The Perils of Passive Indexation

trying to take the exact same position in a longer dated option further out of the money. That's where the
skew factor that you're referring to comes in.

It's also really important, if you think about this dynamic that I referred to very early on about the passive
inflation, to understand that volatility is incurring in both directions. I encourage people to understand that
you need [indiscernible] on both sides.

RAOUL PAL: This time last year was the exact example of that with the extraordinary volatility that
happened in both directions.

MIKE GREEN: Correct. That's exactly right. Again, it goes back to this underlying dynamic of the change
in market structure. Because it's influenced across a variety of ways. It doesn't just matter that you have
passive. It actually also matters how many passive players you have, what's the horizontal consolidation or
concentration? When I invest at Vanguard, and you invest at Vanguard, if I am selling and you're buying,
Vanguard doesn't actually put that into the market necessarily. They cross us.

That's a positive feature in a lot of ways. It reduces my transaction costs, it reduces your transaction costs,
it reduces the impact that it has on the market. If BlackRock or Vanguard is very, very large, and they enter
into a net imbalance and so much of this has been on the buy side because money has flowed into the
strategies, it becomes very large single player that hits the market. On the other side of the equation, if it
turns into a net sale, again, it doesn't hit the market, it doesn't hit the market. Then it's an explosive amount
that all the other players can't absorb. Again, it ends up in the exact same dynamic.

RAOUL PAL: To, I think, finish up on this, I want to get your thoughts on because there's another really
interesting dynamic. The dynamic for me is now repeated that I saw in the Eurodollar market 18 months
ago, where it was the record all-time short position in the history of Eurodollars, whichever way you want
to adjust it with multiple standard deviations away from trend. The VIX futures short position is now that. I
actually mapped them, they look almost identical. It feels like we've got kindling in place of a magnitude
that you saw with the XIV which is a different structure, but the same thing. It's manifested itself in something
that is now way too big again. What's your thoughts on that?

MIKE GREEN: First of all, I think your observation is correct. Most market participants will point out that
a large portion of the short positioning in UX futures, the VIX futures, is a function of actually these retail
ETFs being long, the idea is it theoretically registered investment advisors or retail investors are now hedging
their portfolio through VXX or UVXY, which are direct analogs in attempts to be long the VIX, as compared
to XIV which was an attempt to be short the VIX through an inverse product.

Most of those analyses fail to consider that the lion's share of the demand for UVXY and VXX is actually
now occurring for shorting them. People are synthetically creating XIV exposures. It's not as clear as people
would make out to say, this is just a function of the other side of lots of shares being in issued in VXX and
UVXY.

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The second is that if you look at the positions that are outstanding, the open interest in options on these
products and so these are similar to some of the positions that we had had, people will point out that there
are more calls than puts on these products, but because these products like VXX or UVXY fall on such a
continuous basis, the high cost of being long volatility, which is why everyone wants to be short them exactly
as they did in the XIV, those calls that are outstanding tend to be way out of the money and the puts are
close to the money.

The delta exposure that you end up having, when you adjust for that dynamic between the calls and the
post suggest again it's just another really big short position, short vol position. I agree with you that we are
facing the potential risks of something like a February 5th event where there's a dramatic spike in volatility.
Because we don't have the same, the exact same types of products in the form of the XIV or a fully levered
SPXY, which has now de-levered itself, I'm more concerned about the delta, the behavior of the S&P and
the presence of this than I am about a super spike in volatility, although that I could be 100% wrong on this.

RAOUL PAL: Interesting. That plays into all the other factors that we talked about all the thing. Mike,
fascinating as ever. There's a hell of a lot going on right now. What's interesting is it's all beneath the
surface. I think it's seeing how that develops over time.

MIKE GREEN: It's extraordinarily hard because what we're describing on all of these are emergent
phenomenon. We've never had this stuff happened before. You can't subject it to a back test. We can't say
this is exactly what's going to happen. Those of us who've been in the market for a long time, we know
there's something wrong. Things are not working the way they have.

RAOUL PAL: Though your point has been that this could be secular, that there may not be any change in
behavior over time. We have a selloff, we have a bear market, we have a recession, whatever happens,
but in the end, it just still continues to be passive. The whole active versus passive thing falls apart, the whole
structure of the markets changed forever. A lot of what we will live in our careers didn't stand for anything
any longer.

MIKE GREEN: Yeah. It's a little bit of a terrifying prospect but I do think the single biggest risk that people
have is articulating this idea that well, this will eventually pass, that it's going to go back to the way that we
knew it. When you consider the dynamics, again, of this 90% passive penetration amongst the younger
generation, I'm not sure how it reverses without just an extraordinary event. That really places pressure on
our industry, I would say it actually places a tremendous responsibility on many of us who are involved to
start to make people aware of these problems.

RAOUL PAL: Yeah. You've done a lot of that. You've gone to D.C., talk to people, you've explained to
everybody the structure of the market and what is happening, they don't really want to listen now, do they?

MIKE GREEN: It's challenging because the-- we're all familiar with regulatory capture that occurred with
the mortgage space in 2006-2007. It's very similar. The marginal capital that is available, the marginal
money to spend on lobbying, the marginal smart money to spend on regulatory behavior belongs to
BlackRock and Vanguard. If you're a mid-level bureaucrat at the IMF financial stability group or at the

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 The Interview: The Perils of Passive Indexation

Federal Reserve, and you try to raise the alarm, your boss is going to call Vanguard or BlackRock for
comment and they're going to say, that guy's an idiot, and he should be fired, or that girl is an idiot and
she should be fired, not to pick on anyone.

That makes it very, very difficult for regulators. I sympathize with the position that they're in. They're going
up against Bahamas. To give some idea, actually, of how powerful that lobby is, there's currently an act
that's working its way through Congress called the Secure Act. This was initially proposed by a Republican
congressman in the aftermath of the Donald Trump tax cuts. The idea was there needed to be an offset. We
somehow needed to fund this significant tax cut.

The proposal was initially floated to eliminate the tax deductibility of 401ks for those with incomes beyond
a certain level. By the time that made its way through the regulatory process, and BlackRock and Vanguard
lobbyists had gotten their hands on it, it actually turned into a product that expanded 401ks and expanded
the tax deductibility. The systems are not in place to adjust for this yet. It has the same dynamic we saw with
the housing cycle. If it blows, that may change but this is a very challenging situation.

RAOUL PAL: Well, thank you for sharing it with us as well. I think it really is important people understand
this dynamic because something has to change because it's just increasing people's risk and it's risk they
don't understand, esoteric risk is a very hard thing to deal with. Mike, well, great to get you back on Real
Vision. Good to see you again.

MIKE GREEN: It's fantastic to be here, Raoul. Thank you very much.

RAOUL PAL: Thanks a lot.

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