GM101: When Passive Breaks the Market ft. Hari Krishnan & Cem Karsan

**Hari Krishnan** (0:01)
I feel worried about all this, though, because I don't like an economy putting my free market cap on. I don't like an economy that is reliant on a small number of people to act as the watchdogs for a system that is bloated and fragile. They're very well qualified to deal with this.
But still, it's dependence on a small number of people to support a global financial system that impinges upon everything in society.

**SPEAKER_2** (0:32)
Welcome to Top Traders Unplugged. In markets, success doesn't come from predicting what happens next. It comes from being prepared for what you can't predict.
In each episode, we go deep with some of the world's most thoughtful minds in investing, economics and beyond to understand how they think, how they prepare and how they decide and the experiences that shaped how they see the world. No noise, no short cuts, just real conversations to help you think better and invest with confidence.

**Niels Kaastrup-Larsen** (1:06)
Hari, welcome back to the show. Cem and I have been looking forward to this conversation. It's been a few months since you were last on the show. How have you been?

**Hari Krishnan** (1:14)
I've been well and it's a pleasure to be back. I hope to be. I hope this will be the first of many occasions in the future.

**Niels Kaastrup-Larsen** (1:21)
Yeah, so do we. Now, the reason why we're here today is to talk about a new paper that you wrote with Mike Green, Stefan Sturm, called A Model for Passive That Breaks the Market. And I actually think our conversation today is perfectly timed. As we've just witnessed, equity markets around the world have an exceptionally strong performance the last month with double-digit gains in the S&P 500 and the Nasdaq. Whilst at the same time, we have two wars going on, no clarity on where inflation is heading and what the next move from the Fed will be, as well as global alliances breaking down, which suggests that something other than fundamentals and logic is controlling the markets. Now, you can correct me if I'm wrong, but your paper is not really about passive investing. It's about what happens when markets lose enough active participants to maintain price discovery. And that is a important distinction, I think.
The three of you are essentially arguing that modern equity markets may be transforming from a value-driven system, or valuation-driven system, I should say, to a flow-driven system. And once flows dominate fundamentals, markets can become reflexive and unstable.
But before we get into whether that's a fair description, perhaps you can start and take us back to talking about the kind of the origins of the idea, how you got involved in the topic, and why you thought it was worth researching along with Mike and Stefan.

**Hari Krishnan** (2:59)
Well, I have to give Mike a tip of the hat. He was kind of the driving force behind this. I think in 2018, he was one of several people, but a notable person who mapped out the Volmageddon, where the VIX ETNs caused damage to the VIX futures markets very suddenly based on overcrowding effects. Now, after that, he sort of turned his attention to where the next big overcrowding or structural risk might be, and so he decided to tackle the big one, which is the rise of passive investing.
And what we do know is that even though dollar flows in and out of passive vehicles have fluctuated over time as the S&P has gone up and down, the share of dollars in the US equity market in passive have gone up pretty steadily, almost deterministically. So passive share has increased in an almost surprisingly predictable way.
Now, he felt and we felt that as passive share increases, the linkage between fundamental value, whatever that means, for the S&P and price would be broken. And the reason it would be broken can be described in the singular limit, to use a fancy phrase, where if there were no active investors left and everyone was passive, and whenever a dollar went into a retirement fund, it would go straight into the S&P or some fraction of it would, then the S&P could go up indefinitely with no constraints. And by the same token, if there were outflows, the S&P could collapse and there would be no active bid to defend against that. So we felt that the process which describes stock market dynamics could easily move from one with significant mean reversion and control and stabilization into one which is almost a purely diffusive process where volatility feeds back into itself and can engender really steep increases in risk. So that was the idea. Now this was about two years ago that Mike came to us or came to me. And as may not be surprising, I did nothing because I didn't have a solution to the problem. But one day, Stefan and I were chatting about something else, and we figured out that we could come up with a very simplified, almost toy model of the impact of passive investing on the dollar value of the US equity market.