E428: Michael Green on Peter Thiel, SpaceX, and Inefficient Markets

David Weisburd (0:00)

So Michael, you're a Portfolio Manager at Thiel Macro, which is Peter Thiel's hedge fund. What did you learn working with Peter Thiel?

Michael Green (0:07)

What I would define as Peter's core characteristic is the willing to challenge conventional thinking, right?

When you interview with Peter, the question he is famous for asking is, what is the one thing you believe to be true that nobody else believes or the vast majority of other people believe to be false? Or the reverse, what is the one thing you believe to be that everybody else believes to be true? And this really meant to effectively stimulate and isolate a deviation from the crowd, which is necessary for extraordinary or breakout performance. That thought process, combined with the second Peter Thiel insight, which is you should never straw man your opponent's arguments. You should steel man them. You should prepare yourself against the best argument that they can make, even if they can't make it themselves. That approach is very rigorous, and I think Peter has exploited that to an extraordinary extent within his portfolios and his investments. And it's very much aligned with the way I approach the world from the standpoint of you should always use the scientific method, adopt the null hypothesis, try to disprove your conjecture as compared to try to prove your conjecture.

David Weisburd (1:14)

What do you believe that most smart people in the industry do not?

Michael Green (1:18)

This was actually the topic of the discussion that I had with Peter, and my argument at the time was that passive investing was not passive in any incarnation, that it was creating distortions by virtue of the fact that they transact. And so the definition of passive investing in the academic literature is an entity or an individual who always holds every security in proportion to the market capitalization or its exposure within the market. Perversely that means that there's no mechanism for them to get into that position or to get out of that position. And since we know that can't exist, it would require magic. And literally in Bill Sharpe's 1991 paper, he describes it as, they are able to trade in the liminal hours in which the markets are not open.

Obviously, that's absurd, but as a thought exercise, it was useful for his purposes, which was basically demonstrating why index investing was better. He was an index consultant. He was pitching his own book. 2016, Lasse Peterson in AQR successfully challenged that with another paper called Sharpening the Arithmetic of Active Management, in which he looked at the behavior of passive managers. He said, well, what about index reconstitution? That's a change in the portfolio that requires them to transact. Therefore, they become active managers during that time period, and the thought experiment of sharps where they own the same aggregate securities and therefore, passive and active are identical except for the fees associated with the product was untrue. That actually has grown into the single largest hedge fund strategy in equity space by allocation. It sits at the core of most multi-manager platforms or pod shop type books.

David Weisburd (2:54)

Which is betting against the passive investor.

Michael Green (2:58)

Actually, what you're doing in that strategy is you're betting with the passive investor. So you're trying to anticipate, you're front running them. You're trying to anticipate the trades that they will have to make when a new stock is included in the index by buying those, or when a stock is ejected from the index and selling those. So that long short portfolio is trying to capture the impact of the eventual passive trade into the individual securities themselves.

Where it becomes a facilitation exercise as compared to betting against them, is perversely the rules of passive. You are raising the probability of entering an index if you drive the price higher.

Are you raising the probability of exiting the index if you drive the price lower? And so it's actually a self-reinforcing trade. It's a characteristic I refer to as investment judo. Using the heft of the passive investing complex against itself in large flow characteristics where a new stock enters the index or one exits, that creates a large rebalancing flow that most of your listeners will be aware of. That's what index arbitrage is doing.

David Weisburd (4:04)

And this is why you think many stocks are driven not by business fundamentals but by net inflows.

Michael Green (4:11)

They're always driven by net inflows. Fundamentals themselves are simply a signal of information that causes somebody to transact.

An active discretionary manager seeing a favorable earnings report from a company says, gosh, the prospects are better than I thought. I should probably buy this stock that I was evaluating. Or if the earnings report is poor and they have an existing position, it failed to confirm my hypothesis around the fundamental behaviors. Therefore, I should sell. It's the actual act of transacting that causes prices to change. Markets are not truly weighing mechanisms in the sense that you put them on a scale and you compare it against the DCF.