For the better part of the past decade, Michael Green has been on a mission.
From talking to money managers to making the rounds of hedge fund idea dinners to attending conferences geared to everyone from financial analysts to family offices, even wrangling meetings at the International Monetary Fund and the Securities and Exchange Commission, Green has had one message: The craze to invest passively — earn the returns of an entire market rather than those of individual stocks — isn’t the low-cost, risk-free future of investing that everyone thinks it is. Instead, he argues, the growing dominance of passive investing distorts capital formation, creates market instability, and carries the potential for a crash.
Green calls it a passive bubble. “We know what happens when everybody does the same thing in markets,” he told a rapt crowd at a CFA Society Virginia event in April. The pitch is low-key and the delivery droll, but it hits its mark: “Active managers can’t have enough scale to even stand in front of it, right? It’s like leaning against the steamroller and trying to stop it.” Green calls his presentation, which he also gave in October at the annual conference run by Jim Grant and his Grant’s Interest Rate Observer, “The Greatest Story Ever Sold,” a not-so-subtle hint that he thinks it’s all marketing — and an intellectual fraud.
A former hedge fund manager with some serious Street cred — he worked for Canyon Capital and tech billionaire Peter Thiel, and founded a fund seeded by George Soros — Green isn’t the first person to opine on the impact of increased passive investing. Academics have been writing about it for years, and a recent Goldman Sachs report noted that during the past decade, passive stock mutual funds and exchange-traded funds have seen $2.8 trillion of inflows compared with $3 trillion of outflows from actively managed funds. As a result, the share of passive owners for the typical S&P 500 company has risen from 18 percent 20 years ago to 26 percent today, according to Goldman.
Others acknowledge passive’s growing role in finance, but few have the fervor of Green, who has followed the analysis to his ominous conclusions. “The contribution that I made is the importance of flows,” Green says in something of an understatement, putting forth his views in a series of interviews with Institutional Investor in which he detailed how he became known as the Cassandra of passive investment — the skeptic whose warnings go unheeded.
Green is concerned about the enormous amount of capital that continues to flood passive strategies and could leave the market prone to violent swings and potential crashes if the rug is pulled. For starters, he says, the percentage of the market controlled by passive investors is much higher than many realize — about 45 percent, including index funds, futures, total return swaps, and option hedging based on indices.
As they increase in importance, passive investors have become the latest group with the potential to cause market disruptions, as others have done in the past. Highly leveraged hedge funds invested in the same stocks have sparked contagion events, as have meme stock investors betting on heavily shorted names.
Consider the fact that a lot of passive money is held by individual investors in target-date funds through their 401(k) retirement plans. What happens if these investors lose their jobs in a recession or they retire and begin spending their savings, leaving few active managers left to buy stocks that might seem cheap as a result? With buyers scarce on the other side, the markets could melt down, Green suggests.
With warnings like these — and a couple of stunning trades under his belt — Green has gotten close to many hedge fund notables, including Scott Bessent, a former Soros Fund Management CIO and President-elect Donald Trump’s appointee for Treasury secretary. Bessent calls Green an “if, not when” kind of thinker. “He’s very uncorrelated and very original,” he says.
Green says he has also become a “consigliere” to many short-sellers, including Muddy Waters Capital CEO Carson Block, who notes that Green “says things I don’t hear elsewhere. And when he explains them to me, I tend to think this guy could be right.”
Meanwhile, Greenlight Capital’s David Einhorn credits Green with helping him understand why the value investing playbook he ran didn’t work for many years as investors yanked money from active managers and put it into index funds. “We had just a rough go until we figured this out,” he said in a recent interview with Ritholtz Wealth Management founder and CIO Barry Ritholtz. That’s because passive investors don’t analyze companies the way value investors do, but merely own stocks that have made it into the indices. “Passive investors have no opinion about value. They’re going to assume everybody else has done the work,” he explained.
Now 54, Green’s latest job in asset management is as chief strategist and portfolio manager at $6 billion Simplify Asset Management, co-founded in 2000 by former PIMCO and Principal Global Investors ETF manager Paul Kim after an SEC rule change facilitated the inclusion of derivative strategies in active exchange-traded funds. That led to an explosion in ETFs as they became “far more attractive than hedge funds,” according to Green, because now ETFs can engage in similar strategies while charging much lower fees.
When he began his research years ago, Green says he discovered that so-called passive investment strategies aren’t passive in the textbook sense, which assumes that the index-based approaches are those of long-term investors who hold on to securities — essentially free riders on active management but harmless market participants. In reality, these investors are trading all the time — and almost always in one direction: up. The realization is core to his argument: “What I recognized was that what was actually going on is just money was flowing into the S&P 500 companies at a pace that was far greater than anything else,” he says.
In late 2016, Green started taking his thesis around the world. “I was literally asking the smartest investors that I knew, ‘Show me how I’m wrong on the implications of passive investing and what’s actually going on.’” He says none of them could.
“It’s not like I was born from the brow of Zeus preaching about passive. I had no reason to really suspect this,” Green insists. But he saw other sophisticated investors, like Stanley Druckenmiller, noting that “the markets started acting weird. They just weren’t conforming to the behavioral set that I had experienced post-1999, which was largely around people doing fundamental analysis and really digging in and trying to understand companies. All that behavior started to change pretty significantly between 2012 and 2016. Things were just very, very different,” Green says. What happened was that value investing — selling stocks that are overvalued by traditional metrics and buying those that are cheap — was losing money.
Green’s interest was further piqued by a comment Bessent made to him in 2015 — that the S&P 500 might be “unshortable.”
Some joke that Green’s speeches should come with a warning label. When John Ellison, CIO of Richmond Quantitative Advisors, introduced the market strategist at the CFA Society Virginia’s meeting, he likened Green’s message on passive investing to “taking the red pill in The Matrix. Once you’ve listened to his thesis, there is no going back,” he said. “The world’s going to look a little different to you.”
Tongue in cheek, Green concurred: “If you want to leave and keep your world sane, go for it. Door’s right there. You’ve still got a few seconds left.”
His contrarian streak notwithstanding, Green is an unassuming finance geek whose favorite pastime is making dinner for members of his son’s swim team at the U.S. Naval Academy in Annapolis, Maryland. “Lately, I’m on a Vietnamese food kick,” Green says. After leaving Marin County, California, and traveling around the country in an RV, he and his wife settled in Annapolis last year to be near their three adult children. Another son works for Nasdaq in Washington, D.C., and their daughter is graduating from the Wharton School at the University of Pennsylvania — Green’s alma mater — and plans to work for Blackstone in New York later this year.
“Mike is a physically towering figure but a gentle giant, and he has a towering intellect that is polymathic,” says venture capitalist and Lux Capital co-founder Josh Wolfe of the 6-foot-4 Green, who met Wolfe 15 years ago and considers him a close friend.
The polymath loves a good debate — as can be witnessed on his X account, @profplum99 — and feels more at home on the East Coast despite his childhood in California. “My kids like to say, ‘Dad, you’re a little too intense for the West Coast,’” Green admits.
Yet the West Coast is clearly where the seeds of iconoclasm were planted. Green was conceived in San Francisco in 1969 when it was the city of hippies and free love. “You can imagine how that happened,” he quips. In the spirit of the times, the family moved outside the city and ran what Green calls a “gentleman’s farm.” They raised chickens, horses, and goats while his mom baked bread and his father continued to practice as a personal injury lawyer. The elder Green’s clients included the Hell’s Angels, one of whom offered to give his Harley to three-year-old Mike if he could figure out how to turn it on.
Eventually, the family moved back to San Francisco, where Green enrolled in special science programs. He did a summer physics class at UC Santa Barbara and worked briefly for UC Berkeley physics professor Luis Alvarez before he says he realized “I was not going to come anywhere close to winning a Nobel Prize [as Alvarez had], and so I redirected my interest in math and quantitative analysis to the stock market.”
Green says the 1987 crash also influenced that decision. “If [that] had not happened in my senior year in high school, there’s a very good chance I never would’ve gone to Wharton,” he says.
After Wharton, Green went to work as a management consultant at Bain and Co. and then became a value investor focused on small and midcap companies at two different firms. His career took a consequential turn when he joined Canyon Partners in 2006 to start its New York office. While there, he put on a short against the ABX Index, the mortgage-backed securities derivative that hedge funds were using to bet on a housing crash — the legendary “big short.” Green was simply hedging a bet the firm had on a Florida home builder that activist investor Carl Icahn was backing. When the company, WCI Communities, went bankrupt, the hedge paid off — but Green admits he’d underestimated how bad things could get. “We built a position that would offset $250 million worth of exposure in the event that the ABX traded down five points,” he recalls. But it went down 37 points. “We lacked the imagination to see how far it could actually go.”
Green says his success around the big short, as well as other derivatives plays, gave him “the opportunity to transition from a more traditional investor to a derivatives- and macro-based investor.” His next move came when Bessent, then the Soros CIO, offered to stake a hedge fund of Green’s own, which Green named Ice Farm. (“He’s a hedge fund manager’s hedge fund manager,” Bessent says.) Though Ice Farm’s performance was strong, the fund didn’t last long; after Bessent left Soros in 2015, the firm pulled its capital from several hedge funds Bessent had seeded, including Green’s. “It was literally known as the Soros bloodbath,” Green recalls.
Soon he convinced Thiel to give him a job, which led to a trade that made Green famous in geeky finance circles. It had its origins in an inverse volatility exchange-traded note called XIV — a passive instrument — as well as capital requirements for banks under the Volcker rule that made it highly profitable to short volatility by buying the XIV rather than equities for clients who wanted market exposure.
Under normal conditions, the two were perfectly correlated, Green explains. But as the stock market took off that year, there was so much bank demand for the XIV relative to buying stocks that the leverage embedded in it implied that a 1 percent change in the S&P 500 would cause a 22 percent change in the inverse index. That created a huge opportunity to buy puts on the XIV, which Green did.
The banks’ strategy ran out of steam when volatility spiked on February 5, 2018, in an event that became known as Volmageddon. The S&P 500 fell 4 percent and the XIV cratered, losing 95 percent of its value. Thiel’s macro fund made $244 million on the trade, and Green became something of an overnight sensation on Wall Street — a man worth listening to.
By that time, Green had started talking up his passive thesis. “It was probably the most provocative argumentation set he’s made that I’m aware of,” says Dan McMurtrie, founder of hedge fund Tyro Partners, which was seeded by Einhorn’s fund of funds. “Mike is claiming that the intellectual bedrock of the main way of investing capital now is false, which is a huge statement.”
Jack Bogle, who famously created the Vanguard 500 Fund tracking the S&P 500, is a pioneer of passive investing. Although others predated him, Bogle was “a marketing genius” who took index investing to the masses, Green says. Bogle “created an industry, but more importantly, he created the story: Don’t invest with these schmuck active managers. They just overcharge you. Invest in low-cost funds that simply buy the indices and hold them,” Green says, summarizing the Bogle pitch that has become an investing mantra.
“Now that’s great advice in a lot of ways, but the more people that take that advice, the more that becomes a dominant investment style and corrupts the underlying behavior,” Green notes.
He cites a paper by AQR Capital Management’s Lasse Pedersen, “Sharpening the Arithmetic of Active Management,” as a spur to his own research. Pedersen’s title refers to Nobel-winning economist William Sharpe’s 1991 paper “The Arithmetic of Active Management,” which concludes that the only true difference between active and passive management is the fees, which explains why passive overperforms over time.
Pedersen points out that in a footnote to Sharpe’s paper, the economist defines a passive investor as somebody who never transacts. “But during periods of index reconstitution, passive investors must transact. And so for a period of time, they have to become active managers,” Green explains. “And that footnote refers to when they transact, theoretically, they were transacting in the liminal hours when the market’s not even open, so they could have no impact whatsoever. Well, that’s obviously garbage. These are actually active investors operating under a different rule set.”
Using statistics compiled from various market and academic sources, Green estimates that passive direct trading now accounts for about 20 percent of all trading, passive index derivatives make up 8 percent, and passive market making contributes a further 36 percent. By contrast, trading by active managers totals only 10 percent, down from 80 percent in 1995.
Vanguard disputes Green’s analysis of the outsize role of passive in today’s markets, saying its trading is a “drop in the bucket.” In a statement to II, Vanguard says: “Our base case estimates that index funds account for approximately 1 percent of overall trading volume on U.S. exchanges, well below the more widely quoted 5 percent to 7 percent. Even after accounting for indexed portfolio management outside of registered funds and removing trading volume due to [high-frequency trading] and shares of ETFs, we estimate that indexing represents less than 5 percent of overall U.S. trading volume.”
Green argues that the basic finance lessons he learned at Wharton are no longer pertinent. “Historically, we’ve thought about the market as discounting information, and it no longer does that,” he says. Investors who analyze a company regarding its prospects “have been replaced by machines that are simply saying, ‘Did you give me cash? If so, then buy. Did you ask for cash? If so, then sell.’ That’s it. That’s the secret of passive.”
He sums it up this way: “Passive is really just the world’s simplest algorithm.”
And because passive strategies buy in proportion to the market capitalization of the companies in the indices, they “buy more of stuff that went up since I bought last. And so that reinforces the momentum characteristics of the market,” Green explains. As passive becomes a bigger proportion of the stock market, it leads to increased concentration and correlation.
Active managers are trading “in an increasingly thin and inelastic market,” Green asserts. “This is why we’re seeing these crazy price swings. It’s not that people are really that blown away by Nvidia. It’s just that half the market doesn’t actually care and won’t sell you shares.”
At the same time, the original purpose of the market, which is to allocate capital where it is most productive, has been distorted. For example, Green says, without a big stable of active investors to buy smaller stocks, young companies find it harder to go public. Venture capitalists like Wolfe note that companies stay private longer, hoping to become large enough to attract buyers like Fidelity or T. Rowe Price. “It’s much harder for them to buy unseasoned small companies. It just doesn’t really move the needle,” Wolfe says.
More draconian is Green’s argument that the markets are headed off a demographic cliff because younger people are bigger passive investors than their elders. Only 25 percent of investors over 70 are in passive strategies, whereas 95 percent of those under 40 are invested in passive vehicles, including target-date funds, which have become the default for many workers, he says.
“Every single day people are employed, they’re making their contributions to their 401(k)s,” Green explains. But, he cautions, “if people lose their jobs and stop contributing to their 401(k)s, the passive flows would decrease.”
Adds McMurtrie, “It’s not at all clear who would buy the shares because you purged all the people that would normally step in and buy.” That potential problem is exacerbated by the fact that, unlike traditional active managers who typically have at least 5 percent of their assets in cash to buy stocks if markets tumble, passive buyers are required to invest all their assets and don’t have spare cash in case of an emergency.
But Green’s arguments are still a hard sell. “Whether you’re talking about RIAs, family offices, normal financial advisers, passive is the dominant product now. It’s kind of considered increasingly silly to do anything else,” McMurtrie notes. “And so everybody’s like, ‘Yeah, at some point this could be a problem, but it’s just really not worth worrying about right now.’” His analogy is the Yellowstone supervolcano. “People who are aware that there’s a massive volcano under Yellowstone are like, ‘Yeah, at some point it could blow up, but what is the point of thinking about it?’”
Although plenty of momentum investors aren’t complaining about passive’s impact, Green’s argument has held sway among short-sellers and value investors who’ve been hurt by these market dynamics. Block says he was aware that passive investors would create a bid under stocks in the index, which was something he had to look out for. “I kind of assumed that would be a linear impact on stock prices.” But when Green explained his theory, the short-seller says he realized it “makes complete sense” that as passive flows replace active ones, there are fewer shares for sale, creating a parabolic impact on prices.
The rise of passive is also cited as a reason that value investors have been sidelined, creating what Einhorn and others call a broken market. As Einhorn said at a recent conference, “We are such marginal players in terms of the amount of trading that’s going on, so the price discovery from professional people who have a valuation framework, not as the dominant part of their process but as any part of their process, is much, much smaller than it used to be. And so effectively, instead of the valuation becoming the signal, the valuation people were just noise and everybody else is sort of the signal. And this is why I think we have a structurally dysfunctional market, a bit of a broken market.”
Are the complaints merely sour grapes? “When most active managers talk about passive, whether they’re right or they’re wrong, they’re providing excuses for not performing well, and people don’t want to hear that,” McMurtrie says. “And so if somebody has heard an excuse ten times, if they hear it an 11th time, but as an intellectual argument, they just chalk it up as another excuse. No one wants to hear another excuse from an active manager. What they want to hear is a solution.”
That said, the analysis has proved useful. Value managers like McMurtrie say they’ve used Green’s analysis to help manage their portfolios. “A big focus for me the last few years is how do I use this to augment my fundamental investing process?” McMurtrie says, noting that an individual stock’s valuation meaningfully rises simply from index inclusion — not because a fundamental investor believes the company should be worth more. “I essentially now want to find a business that is cheap, that is well run, that will grow — all the normal Buffett stuff,” he adds. “But I want something where if it plays out, it will get included into these passive flows. Because if it never will, I don’t understand mechanically how it actually reprices.”
Companies are also learning how to play the game. For example, Thiel-backed Palantir went public through a 2020 direct listing, which gave it fast-track status to be included in the S&P 500 Index in September. Now 22 percent of its stock is owned by the big three indexers: BlackRock, Vanguard, and State Street. The software maker recently moved its listing to the Nasdaq from the New York Stock Exchange, which included it in an index popular with momentum investors: the Nasdaq 100.
Meanwhile, financiers like Wolfe are on board with Green’s analysis of what Wolfe refers to as a potential “Minsky moment” in reference to a sudden collapse in an overheated market: “There is a risk that you see a breakdown. When you have a sandpile that’s building and building and building, sometimes one or two grains can end up in a nonlinear complex way leading to an avalanche.”
For the time being, however, Green acknowledges that the passive juggernaut is likely to keep the market afloat. “Until this stops, you can’t beat the indices,” he says. “And until things change, markets will continue to go up.”
