Professor Valentin Haddad: How Competitive is the Stock Market? | Rational Reminder 314

This

is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We are hosted by me, Benjamin Felix, and Cameron Passmore, Portfolio Managers at PWL Capital.

Welcome

to Episode 314. And this week, Ben, another

great

guest

and

such an interesting topic.

The

guest was Professor Valentin

Haddad,

who is the Associate Professor of Finance at UCLA

Anderson

School of Management. And boy, really, this one

makes

you think, but he's a great communicator. Loved, loved the conversation.

And

elasticity, information and prices,

noise

in markets. Markets are messy. That might end up being the title. We'll see.

And

then the inelasticity around large stock prices, the impact of index funds. It just really makes you think. And he's got

so

many fascinating counterpoints. It almost sounded like there were accidental

findings

in his research,

which

is so interesting. So I'll let you kind of

tell

more of the backstory again. And we'll talk about his credentials after.

Yeah,

you set it up well. We talked about three

big

chunks. One was index funds and the effect on financial markets, which he's got a paper on.

And

then we also talked about

bubbles

in the value of innovation.

So

like stock market bubbles around the development of new technology. Also

an

incredible paper on that. And then we also talked about

the

response of the investment grade corporate bond

universe

to the COVID-19

crisis,

which was extreme. I mean, he talks about how corporate bonds, investment grade corporate bonds, which is like the safest corporate bonds.

They

dropped around 20% in the U.S.

during

COVID. Why did that happen?

And

what does it mean for the safety of bonds?

And what was the impact

of the Fed? Even

without doing much,

it was really interesting.

Yeah.

And was that a good thing for the Fed to have done? I thought his discussion around that was incredible. Anyway, so three topics that are, I mean, they all

kind

of

bits

and pieces of each one reinforce the other, I think. As we were discussing them, I was noticing that happening in my brain, at least. Yeah. Yeah. So Valentine's

another

University of Chicago Booth School of Business graduate. He's got his PhD and an MBA from Booth. He's at UCLA, like you mentioned. And

I

learned about Valentine from

actually

Mike Green

because

Mike references Valentine's paper on index funds and market elasticity and the relative elasticities of large and small stocks.

Yeah.

We'll

let

you wait for the episode to understand what I'm talking about. But anyway, so Mike

put

me onto that paper. I read it.

It

was incredible.

I

asked Valentine a question about the paper.

and then

I guess I just started poking around his other published research

and

I found all these interesting papers. So I asked him if he would like to come on our

podcast

and he obviously agreed.

It

was great. Okay. So with that, Ben, let's go to our conversation with Professor Valentin Haddad. Valentin Haddad, welcome to the Rational Reminder podcast.

Thank

you for having me.

Super

excited to be talking to you.

All

right. You've got this great paper on how passive investing is affecting financial markets. So I want to start there.

Can

you talk about how substantial the shift toward passive investing has been over the last 20 years?

It's

huge. So there's different ways to look at it. One way is to just focus on mutual funds.

And

then you already get, you know, like

maybe

not 20 years, but let's say 30 years ago, there was virtually no passive mutual funds. And that's, they occupy something like 20, 15, 20% of the market.

And

I think that's just the tip of the iceberg, actually, because there's a lot more in asset management, in like pension funds and so on that have like slowly shifted away from active strategy. So

to

give a number, in our paper, we try to just look at how people trade and look who trades like they're passive. And we get something like 40% of the market is passive these days. There's another paper actually that did something kind of cool that looked at like how

much

people trade on days where we change the indices when we have indexed competition. And they also find a number like 40% actually. So

that

would be my best guess, but, you know,

if

I could do 50 or 30%, you would still say it's a big number.

So yeah. Who

is the other paper by?

By Chinko and Salmon.

Salmon. Yeah. Okay. I thought so. We've got Salmon booked for later this year for, for an

episode.

Oh, great.

Can

you talk about what an investor's demand elasticity is?

Okay,

so that's, that's,

that's

going to be closely related to this notion of being passive.

So

what people call demand elasticity in economics in general is to say, you know,

you

want to buy apples, I give you a coupon, 10% of coupon. How much more apples do you,

how

many more apples do you buy? And then

for

stocks, you can kind of ask the same question. Of course, you never get a coupon to buy stocks at a discount, but it would be something like,

if

you see the price of Apple is lower by, by 1% and you have no idea. Apple now, the stock is lower by 1% and you don't know why it happened. How much, how many more shares do you buy? How much more do you invest?

And

that's an important notion because that's kind of telling us how investors are leaning against prices in a way, are trying to take advantage of good investment opportunities.

How

does the shift towards passive investing affect the demand

elasticity

of the investors who did become passive?

Also, so,

I mean, it depends what those investors were doing before, but it looks in the data like most investors are providing elasticity. So what it means is when this is some stock being cheap, maybe not surprisingly, they tend to buy some. And so if you become passive, you just shut down this mechanism. You just say,

well,

I'm just going to follow in the index. No matter what happens to prices, I'm not going to trade.

And

so that just decreases the elasticity that those investors provide to zero.

Okay.

That's really interesting. So we did an episode with Ralph Coyen a while ago. And when we talked about similar stuff about how demand elasticities may have changed over time. And he said

something related

to what you just said, which is that it matters

what

people were doing before.

And

you're saying that

in

your data, it looks like people

are

becoming less elastic when they shift into index funds. Is that right?

Yeah.

Ah, yeah. Interesting. Okay.

So

what

we

know is for sure at the end, once they switch, they're not providing any elasticities. The question is what were they doing before?

And

so, you know, like the opposite of providing elasticities would be to be more trend chasers in a way to buy more when the price goes up. And we know some investors do that, but the average institutions seem to, the typical institution doesn't seem to be doing that.

Hmm.

Yeah. Okay. Very interesting.

What

are strategic interactions between investors?

Okay.

So that's the part where like these elasticities become a little bit more tricky in a way, which is that

how

you trade

is, it's

not just, it's not like buying apples in the supermarket in a way. So when you buy apples in the supermarket, it's just, well, I get a coupon. Do I really enjoy eating apples? I'm going to eat more apples.

For

stocks, it's really, we're all trying to like, find good investment opportunities. So

it

really matters how other people are trading as well. If you know that other people are already very aggressive, already taking advantage of investment opportunities,

then

there's no point for you to be that aggressive.

And

so this strategy, that's what we mean by strategic interaction in a way. The fact that you choose how you trade based on how other people are trading.

And

so it's not really just, you know, what you like to do, but how you react to others in the market determines how you trade.

Okay.

Interesting. So it's like a, an adaptive system kind of thing.

Yeah. Yeah. Pretty much.

I

think in economics, we would like to say like a

equilibrium

maybe. Yeah. In a way we adapt to each other, we react to each other

in

what we do. Really interesting. And why do strategic interactions matter in financial markets?

Also

because they matter for, for the stability of markets in a way.

So,

so,

so,

um, one way to, to think about that is to say,

you know,

you had a very sophisticated investor, a very active investor,

uh,

that was providing a lot to market. And, and let's say for whatever reason, they wake up one morning, they have an epiphany, they want to become passive.

So,

so not, they are not there in the markets, but, but, um, what you have to ask yourself, well, is maybe somebody else is going to step in. Somebody else is going to replace them. I think, you know, this is, it's like looking for $20 bills on the floor idea. This is, this is the, um, this idea that there's always somebody on the lookout for more

that

would tell us they are very strong strategic interaction in a way. And, and, and often we think about this as a very big reason that's for stability in financial markets.

Uh,

but

of

course it's just an idea. So, so the,

the

point of our research was, was to go and see, does this process happen? Do we see this stabilization? That is, if you change how you trade Cameron, do, does, does Ben come to replace you or do I come to replace you? Uh, or did we just lose you in a way from markets and markets are different? So that's, that's,

that's

why it matters for kind of stability.

Okay.

Well, I want to keep going on that, on that line of thinking. What is the expected strategic response to arise in passive investing in a market with fierce competition?

So

if you think, if you have this kind of old idea or traditional idea, I would say fierce competition,

then

there would be

a

big strategic reaction, pretty much a one-to-one strategy. That is to say there was an active investors. They were providing, you know, some information, some in a city. They lives. There's somebody else is going to come to replace them. If they were taking advantage of some investment opportunities, somebody comes to replace them. So they should just offset,

uh,

one-to-one. And that's why, you know, historically in, in, in,

in

finance, uh, we don't think very much about who's trading, who is doing what and so on. We have decided that the market as a whole

is

the unit is what's stable.

And,

and, and underlying this idea is really this principle to say, well, if somebody changes, somebody else will replace them one-to-one. Um, so that, that, that's the starting point in a way. That's what, that's what I think the idea a lot of us have in the back of our hand.

Yeah.

Okay. And that's the, I guess the title of your paper,

I

guess the, the premise of the paper is, is really looking at how, how competitive, how fiercely competitive is the market actually?

Yeah,

exactly. We just wanted to know, well, I mean, to be honest, you know, we, we, we all, we come from this long tradition of efficient market, all this stuff. So it's not like we, we, we thought this was a crazy idea, but we, we just wanted to,

to,

to know, well, can we put our hand on this? Like, can we see this in action and how, how big is it?

Hmm.

So if the market is fiercely competitive, how does

the

rise of passive investing affect asset prices?

Well,

the answer is, is, uh,

uh,

deceivingly simple, actually. That is, it doesn't matter.

Hmm.

It doesn't matter at all because

people

become passive. Somebody else is going to become active. Again, it's like, it's like magic market. Like the market is stable, no matter what,

there

will always be the same. So, so that gives us a simple answer, a simple benchmark, actually. That is that just nothing happens.

Hmm. So then the next question is that how,

how

well does that model of fierce competition hold up in your data?

Well,

so not, not, not as well as, at least you,

you

might, you might think. So, so roughly,

if

you start from this idea that, you know, everything should be compensated one, one to one. We find that about 50% to third, you know, between 50% to third

of

these, of changes are compensated.

And

so what that means actually shifts like the change in the rise of passive investing do change the market.

So

it's like about, you know, uh, two investors are living from being passive, from being active. Only one replaces them by becoming more active in a way.

So, so

that, that creates large changes and the market can change over time,

uh,

much more.

Hmm.

And

why would active investors be limited in their strategic response?

Well,

I mean, I, I, I feel, uh, not so smart telling you this, but, uh, it's hard to trade. It's not so easy. And so, you know, if I tell you, well, one of your competitors, uh, has left the market and you want to come in and, and, and, and replace them.

Well, you

have to figure out how to train,

you

have to figure out how to identify these international opportunities. You have to, to, to figure out those things. So that's one, that's one element. There's another element that is, well, maybe you have a mandate, so you can only do

as

an institution what you've been told to do. And, and,

and

you can kind of keep going down the line of like,

there

are many frictions that makes that the world is not as easy. First, you have to even know that your competitor has left.

You

know, when

we

write our theories in finance and, you know, I'm talking from the center of academia. We imagine that everybody knows everything that's going on, but in practice, it's hard to keep track of the, of those things of who is doing what.

And

so all this is kind of like slowing down how people react. You, you can also be concerned about liquidity. If you become too aggressive, then you're going to, you're going to, you're

going

to have too much pricing back. So you don't want to do that either.

And

so there are all those forces are going to tend to like slow you down, um, from reacting to what other people to, to, to, to be very proactive as an investor.

Hmm.

So is that like a, is it kind of like a limit arbitrage idea?

Yeah. Limit arbitrage is another one. For example, it's

also,

it's, it's risky. So sure you can find ways to get more profit. It's risky as well. Um, yeah. And so there are many, many such limits in a way that are there.

Hmm. So what role do demand elasticity play in determining equilibrium asset prices?

Okay.

So, so now, you know, we started from like each of us as the, as our own demand elasticity, each investor has their own demand elasticity.

If

you put all this together, that, that gets you to the market, you know, and so

now

that, that's how you would define a demand elasticity for stock or for the, the overall stock market.

And,

and what that's telling you is telling you how the market overall reacts when there's a change in price. Uh, that's not justified by anything else. So let's say again, one morning I wake up, I want to show, sell all my shares of Tesla.

That's

going to tend to put the price down on the demand elasticity of everybody else in the market. He's going to, he's going to tell us how the market can absorb this. Are people going to come back and I don't want to buy Tesla a lot when they see the price go down or not very much. If the market is very elastic, uh, nothing is going to happen because you know, the moment I'm going to sell, the price is going to drop, you know,

a

tiny, tiny bit. And everybody's going to buy a lot and it's going to buy from me.

And if

the market is very inelastic and investors don't want to trade, don't want to absorb those positions, that makes it much more, uh, it's going to create a much bigger change in price because it's going to take a big discount for investors to,

to

step in. So the, the LSC of the market is, is telling us

how

much the market, again, absorb shocks, absorb selling pressure or buying pressure is completely symmetric. So it's, it's telling us how much noise we can have in the market. Um, and how much volatility we have in the market.

So

if, if the market becomes less elastic because investors are becoming less elastic, it becomes more sensitive to trading activity or changes

in price. Yeah,

exactly. Exactly.

Everybody

becomes, if we all become less elastic, if there's the same kind of noise, like noise trading or, you know, people are moving for whatever reason, maybe, you know, life happens, you have to sell some stocks. Then the prices will move more in response to that.

Hmm.

Can you talk more about how, you did mention this, but how, how individual investor elasticities are related to aggregate market elasticity?

That,

that's just the, the, the addition. So this part, there's no, we can strategically respond to each other, but at the end of the day, we each decide how we trade. And if you add up how we all trade, that's how you get the LSC of the market. So it's simply, um, an addition pretty much of, um, you know, price goes down by, by, by 1%.

You're

going to buy five shares. Cameron is going to buy 10 shares. I'm going to buy two shares. Well, that means together we buy, not a strike, but maybe 17 shares. Yeah. So, so you, you buy, you just add up, uh,

uh, uh,

uh, different investors react. So that's why, uh, you know, I was telling you those numbers of like, which fraction of investors are passive or active, that, that, that, that shows a big time in those calculations. Really interesting.

So

what does the aggregate elasticity of an individual stock mean?

So

that means when the price of a given stock, let's say, you know, we're talking about Apple before.

So

let's say the, the, the, the share of Apple, when, when the, the price of apples draws by 1%,

how

many, how much more, uh, do investors buy of Apple? Um, what,

so

this is the, uh, elasticity.

It

doesn't have to be the same answer as it would be for the market overall. For example, when the S and P 500 drops 1%, how much people buy of the overall market. So,

um,

I think this is something, for example,

um,

uh, right. Cogian and I have talked about like how the market overall response in that study, we focus more on kind of stock by stock.

How

do people respond to one stock moving, another stock price moving? Um, and so that, that's where we focus.

Okay. Interesting. So you're looking less at

aggregate

market elasticity and more at individual stock.

Yeah.

Elasticity. Yes.

Yes.

It's like, do we have a boom or, or burst in the overall market?

Do

we start to see different stocks? Again, we don't quite go to mispricing, but in the back of your mind, that's what we have in mind. It's like one stock becomes mispriced relative to another one. Or like how, how do individual price in your stock move more, more so than the market. That's it.

Okay.

So is, is it relating the individual stock elasticity, like relative to aggregate elasticity? Is that.

That

we're not doing too much actually. So we're just trying to figure out how, how people trade individual stock. Because if you,

if you think

about it, as people switch to passive,

uh,

I mean, there are many changes happening with this, but, but a big change is how you trade individual stocks. Now the, the first order decision when you become passive is say, I'm not going to choose stocks and I'm not going to make decision across stocks. So, so that means for a given stock, whether I was trying to trade this stock actively is not doing it anymore.

For the

market, it's much more ambiguous actually, because

by

becoming passive, now you, maybe you track the market more actively, you

know,

you might choose to come in and come out of the market. That, that we, we leave a little, we leave aside

in,

uh, in the paper. We're more trying to think about how people make decisions for, for individual stocks.

Okay.

Yeah. Interesting.

Um,

so how, how did the, how did the elasticities of individual stocks vary in the cross section?

So first they tend to be not so big. So that, that's the first, first result that, that, uh, we found that, that quite a few people have found as well, actually using a different way. So it turns out, um, if you think about pricing back in a way of like how much the price of a stock moves when you start selling that stock is quite large actually.

I

mean, um, the, the second thing we found

as

we are trying to find those strategic induction is that actually size matters quite a bit.

So,

so somehow large stocks tend to be less elastic,

uh,

which might be actually quite surprising. Uh, uh, because,

you

know, I think we all have in the back of our minds, some idea of like large stocks are more liquid.

Uh,

but, but it, it goes, it goes a bit into, well, what exactly does it estimate? So, so let me try to take you maybe through that a little bit.

Cause

it. Yep. It's something that I find kind of fascinating actually. And it took me some time to wrap my head around this. So

I

think the reason we think

large

stocks are more liquid

is

we think if I sell a hundred dollars of a large stock, I'm going to have much less price impact than I sell a hundred dollars of a small stock.

I

would think that that's kind of a fact. And, and,

and, and

that's a fact, just to be clear, this fact, I'm not going to tell you is not true. Um, but it doesn't really think in those terms. It's thinking more in proportion.

So

it, it thinks more about like, well, what if I sell 1% of the market capitalization of a large stock,

how

much price impact would I have compared to selling 1% of the market capitalization of a small stock?

And

here you start to realize that, well, it could be larger. It could be even much larger because if you think about large stock, not many people like many, many people buy large stocks, but large stocks are large. So, so,

uh,

it's more than what is the composition of investors? And in large stocks, you have a lot of passive funds, like a lot of the, the big passive players, of course, hold something, something like the market. So a lot of large stocks. So, so not many people actually are willing to trade against you.

If

you want to buy large stocks,

if

you want to sell large stocks. So,

and

so that's kind of how you can see that it could be small. And, and we went a little bit in the data and we try to see,

let's

say within your portfolio, so we zoom out on one institution. And we say, well, within its portfolio, how much does the institution trade the small position that it has? That's the large position that it has.

And

we, we see the institution change a lot. They are small position,

not

so much their large position in a way, because

I

mean, that goes back to limits to arbitrage mandates and so on. Is that if you start moving around something that's like 10% of your portfolio, you move it to 20%, you're completely changing the profile of your portfolio.

If

something is 1% of your portfolio, you make it 2%, that that's fine. In a way you're taking advantage of this

investment

opportunity, but you're, you're not really changing your portfolio. So, so there's many things

that

suggest

that

actually people would trade less aggressively in large stocks and, and the markets would be less elastic.

Hmm. Okay. That's interesting. So the, the large stocks are held by,

uh,

less

people

who are less aggressive with their large holdings, I guess, in terms of how much they trade them.

Yeah. So it's large, I mean, at first order, large stocks are held more by passive investors.

Hmm.

So if you, if you think, you know, the, the, the very, very big players like, um, you know, Vanguard, State Farm, BlackRock,

they

are much more highly represented in large stocks than in small stocks.

In

large stocks, pretty much they hold the market share. In small stocks, sometimes they don't hold them as much because, you know, we have a lot of indices that are zooming in on the larger stock

and

so on. So already we have more of those investors and, and those, those players,

they

don't react to prices at all. They're not all explicitly indexing, but mostly they don't react to prices.

So

that means that, again, if we go back to our discussion of elasticity, there's not much elasticity going on in, in, in,

in

those large stocks.

Hmm.

Again, in numbers of investors, many more investors in dollars, many more dollars, but those stocks are so large that if you sold 1% of a large stock,

you

will hit too many passive investors.

Right. So

how have aggregate elasticities changed over time in your sample?

So

in what we find,

uh,

we find a trend that goes with the rise of passive investing. So we find that elasticity that have been going down over time. So again, to go back to how we think about it, some of it is mechanical. We have passive investors, they have zero elasticity. So they're going to make more and more passive investors means a lower and lower elasticity. That's part of what happens in our sample, but there's another part actually that,

uh,

we, we didn't know for sure was going to happen, but, but that we found that is

even

active investors

tend

to become less active, tend to have been trading less and less actively. And that, that trend actually is not, is less kind of steady, steady, uh, in the data. So in what we find,

we

find that actually pretty much up until the crisis, the 2008 crisis, we would see, uh, investors, active investors tend to be, we're, we're shifting towards becoming more active.

But

after that, after that, we've seen a decrease in active investors are trading. So everybody, you know, we have people becoming formally passive in a way. So not training actively at all, but even the, the, the more active investors seem to slowly be turning down. So that, that, that's, that's suggesting that the cities are slowly going down,

uh,

in the market.

Interesting. So it's not necessarily just a story about index funds. It's like active funds are becoming whatever closet index funds or something like that.

Yeah. So I think there's

some closet indexing that there's,

there's

some, um,

you

know, I think there's been more and more discussion of how even active funds get penalized for tracking, having, having poor tracking error. I think every, it looks like there's been a shift in the industry to, to us trading less actively.

The

one limitation to that I'd say, and that, that's something that research is not quite there yet is

if

you went to the very, very extreme of activity, you, you would get hedge funds in a way, or,

you know,

very level, long short investors. And those typically like in our data, we don't see very well. And we, we don't really know. So it, it could be that

those

last most active investors are, are becoming more active. You know, you would have decided that like firms like Citadel, James street, have like more and more sophisticated computers, sophisticated algorithm, uh, whatever, you know, happens

behind

closed doors in, in, in those funds. Um, that's possible, but, but for virtually everybody else, the shift has been to trade less and less actively.

Interesting. What, what, what about the, so you, you talked about how the large stocks are less elastic than the small stocks has the trend. What is the trend in that been like over time?

There's no distinct pattern actually for large stock versus small stock. So everything, everything I described about the market is becoming less, uh, less and less active in a way.

Uh,

is true also in,

in

large stocks, large stocks started less active to start with. So maybe it's a little bit less problems, but, but it's,

it's

kind of a parallel movement, uh, across stock size. So, so,

so,

uh, demand for large stock is more inelastic and, and more so than 20 years ago, but just

pretty

much by as much as it changed.

Okay. Interesting. So

what, what do you think the implications are of your findings for how

passive

investing is affecting asset prices?

There, there, there's quite a few.

So

there, there,

there,

there's some we, we, we cannot understand. There are some that are harder to, to measure or, or,

or

to,

to

completely, uh, get a grasp on.

Uh,

the, the simple one we understand is that,

I

mean, it's pretty much the definition of elasticity. That noise will have a bigger effect,

uh,

on markets. So, so that would tell us that this far, the shift of passive investing is going to push in, in your sub prices to be more volatile.

Uh,

that we see some evidence in the data. So we try to look at, you know, if I compare stocks that are more or less elastic, um,

uh,

the, the more, the less elastic, sorry, the stocks for which the demand is less elastic tend to be more volatile. So, so, so that, I think we're, we have a good sense that it's going to tend to push volatility of individual stocks, uh, up.

The

parts that are a little bit more ambiguous, I would think is what about information, for example? So, so, uh, something people discuss a lot is, you

know,

our price is more or less informative.

Did

we, and, and, you

know,

the way I started telling the stories of LSCT that often people have been thinking about information in a way that is,

um,

uh, active investors provide information, make, make prices more informative. So are we losing information? That's really hard to do. So in our paper, we try to look at some measures of information, uh, that a

lot

of people have come up with, uh, and we don't find much, but it's really hard to tell if it's that nothing is happening, that the measures we use are not that precise.

I

mean, if I, if I asked you guys, you know, like,

how

would you tell if this price is informative or not? It's really hard to tell. So, so there's resources.

I

actually found some pretty clever ways to try to get at that, but, but it's very noisy. So, so, uh, I'm not quite sure, but I think in terms of concern, that would be the main concern. Uh, the flip side of that though, I think is if, if you're an investor and a more active investor, he's telling us there might be more investment opportunities out there. And, and actually, you know,

um,

that is the whole idea in finance called the Grossman-Siglis paradox that, that is, you know, this idea that like, if nobody's acquiring information, then markets are very inefficient

and

then you, you should step in in a way. So, so if everybody's becoming passive, some, there's more gains for being not passive. Yep. And, and, and I think what, what, what, I guess our results suggest that this is kind of happening in a way that is like, well, maybe there are gains to be more, more passive and more active somewhere. And there were, of course, again, that goes back to our previous conversation. Like, well, why don't everybody become active and it's hard, it's

difficult,

it's challenging. But, but I, I think this, this is the flip side in a way that, well, maybe markets are a little bit less efficient, but there are more investment opportunities.

Yeah.

That's really interesting. So that's,

you

drew a distinction there between informational efficiency, which is

hard

to measure and elasticity. Is there a relationship between those two things though? Like if the market becomes much less elastic,

even

if we can measure that it's still informationally efficient,

it

doesn't the inelasticity introduce something like noise or I don't know what you'd call it.

Okay.

So, sorry. It gets tricky. Let me try to, to, to, to take us through that. And let's try to think through this together. So if

the

LST just measures how you react to the price. Uh, it doesn't really tell us, um, why you react to the price.

Right.

And so

typically

we think that if you're more informed,

you

can understand why prices are moving.

And

so when you see the price move for no informational reason, you're going to step in aggressively because you know, that's what it is. If I'm, if I'm completely uninformed, I see the price drop. I don't know if it's because, uh, there was bad news about the stock or because it's a good deal. So I will tend to not affect very much. So that creates this connection, this very natural connection between LST and information that like the active invest. That's why we think that, uh, informed investors are more active is that they get signal, they trade based on their signal. When they see the price move for a wrong reason, they come in aggressively and so on.

But it doesn't have to be, I can just be aggressive because maybe I don't know much, but I, I, I know I'm just aggressive, you know, I'm an aggressive investor. I'm not very afraid of risk. And so this distinction makes that it's not so easy to know.

Now, the

other thing you ask in a way is like, well,

could

the consequences beyond,

you

know, price informativeness,

um,

matter? I think the answer is yes, but, but, but,

um,

I think it kind of depends on what we mean by price informativeness. So, so there's two parts in a way, again, is that one part is, is the information into prices? And the other part is, do you have, is, is only the information into prices? So what I mean by that is, is there noise as well? So you could have,

you know, the

price moves one to one when we have a good news,

bad

news, like these markets are really smart. There's a ton of noise around this. People

make

mistakes. And so it might be that the information is still there, but that we have more noise. And, and the noise is bad, of course, because that the noise is really risk for investors that come in and out of the market and so on. So, so those two aspects might be somewhat independent.

Hmm. Yeah. It makes sense that you, you,

you

explain that, you explain that well, connected, connected the dots for the dots for me.

This

is a really interesting conversation. Um, do your findings support the concept of a bubble in large stocks due to flows into index funds?

Hmm. So

there's been a lot of discussion of that. Yeah. And I,

I

have mixed feelings towards this. And, and, and I'm going to give you the researcher answer that is, we don't really know, uh, which is not very satisfying. No. So let me try to say more, maybe, maybe it's a little bit more satisfying. So, so the, um, what our, our findings say is they say two things. They say, well, we have more large stocks are not that, not that demand for large stock is not that elastic

and,

and even less so than it used to be.

So,

so that's telling us that the potential of flows in like irrational flows into large stock to have a big price impact.

Uh,

that's true.

I

think another piece of the puzzle that, that suggests this could happen is that,

as

we said, passive, the passive investors are tilted towards large stock.

So

they will tend to come in more into large stock. That's not about LST. That's just to tell you about dollars coming into those stocks. That there's more, more investors coming into large stocks. It has been a shift away from, from smaller stocks.

If

you put those two together, it starts to tell you, well, that's going to push the price of those large stocks,

uh,

up, uh, and potentially too much.

The,

the reason I am a little bit unsure is we don't know if that's the case.

We

also, um,

we

don't know if the prices were right before, like that's, that's the other, other thing going on. Um, and, and we, we don't have a good sense of the magnitude of those flows. So,

so,

you know,

there's

a bunch of ingredients that tells you it's possible. And so, uh, I think, I think a few years ago, people would have dismissed these kind of like stories. And I think by now we, we have a grasp that this is possible, but have we seen clear evidence of that is difficult to tell. You know, it's like, if we think about the large stocks

these

days,

they

are, they are, the, um, it's plausible

that there's

a bubble,

I

think like, like, no, at least they're very, very highly valued. And there are companies that are very highly valued relative to, to, to the output right now, their profits today.

So

anyway, is it a bubble quite yet? I guess it's too early for me to, to, to call it, I think. Right. So I will not go there. But I, there are some ingredients that says it could be possible. It's just, you know,

I've

tried a little bit to think through this algebra, like, well, how many more dollars are coming if I must pay the rest city, but it's not completely clear to me that it's a very large number.

Does

this start to tie into your other research on bubbles and, uh, and innovation?

Do

you think?

Yeah.

A

little bit. Yeah. Yeah.

So

in that other research, in a way we're, we're,

we're

more thinking about what, what, what starts the bubble in a way. So in that other work, we're, we're thinking more about, uh, people speculating, uh, people have different views on stocks. I think that the,

the

story today for why passive investing,

I

create a bubble on large stock is more

where

flows of money is in flow of money into large stocks. Most just because passive investing invest more into large.

Yeah.

I'm just thinking about like, uh, sorry,

I

interrupted you.

I

was thinking about alternative explanations for

the, the

value, the valuations of those large stocks being so,

so

high

right

now. Cause it could, could be index funds, but it could be innovation.

Yeah.

So, so yeah. So innovation is a little bit of a double edge for, I think, for, for stock prices. Or more,

it

does two things that go in the same direction, but, but, uh, with different long-term consequences, uh, so innovation. And that was the symbol of this other paper we have on bubbles and value of innovation. So, so the, um, the, um, innovation is good. I think that the, the, the, the, the, the

first,

the starting point always is that innovation is good, it's valuable. And so when we have lots of innovation, we see these firms getting very highly valued. And

then,

you know, in recent years, we've seen like this line electric cars these days, I guess we talk a lot about Nvidia and GPU for AI. Um, it's the,

the,

the, um, the other set of innovation. And that, that's what got us thinking in that other paper. What was,

well,

that speculate speculation often comes with innovation.

That

is, we want to know who is the winner.

You

know, you know, it's like every day we, we see articles about is, um, is, you know, is like, um, open AI going to be the thing we all use, or is it going to be, uh, the Google solution, the Lama from Facebook? Um, and,

and

so

there's

this kind of like messiness of, of, of, of innovation that naturally creates speculation. It's like, well, we, we're all trying to guess or to be informed about, about, uh, who's going to win.

And

we found views on this. We, we don't know too much about,

you

know, no,

no. Two

years ago, none of us knew anything about AI pretty much. But somehow we, today I bet we all have opinions about, uh, which company is going to be the leader in AI and so on. And,

and out of these

disagreements, kind

of

speculation and, and can come, bubbles can come out of the, of this phenomenon as well. That would be the other side of innovation. We're partly

high

stock prices because of speculation and partly high stock prices just because the innovation is good.

And

we're going to come back to that in a sec. Cause your research on that is super, super interesting. We're going to

dig

into it more, but

before

we go there, uh, on, on the index fund,

uh,

the growth of index funds, what regulatory interventions do you think

makes,

if any,

do

you think makes sense to address what's going on with

index

funds?

The

first thing I'll say is, is that's one dimension we haven't talked at all about. And maybe it's my fault, but

the

first other fact about index funds is where a bunch of people are investing in like, kind of like random stocks and, and, and taking lots of individual risk. Like forget about how the market works and we just for their own personal consequences, taking a lot of risk.

And

they're not doing that.

You

know, as finance, I'm a finance professor. Like what every finance professor has thought for the past 50 years maybe is we should all invest in index funds.

And,

and,

and

so at first order, this is a massive gain of welfare of like a massive positive passive funds.

So

I think, you know, even if work like my research points that there can be other consequences and some of those consequences might be negative. Uh, I think we should not forget kind of the elephant in the room. That is for many individuals life. This, this has been progress, you know, whether that's the shift has been progress.

So

I think

my

sense is, is these questions of regulations and so on. They're not quite yet for today. I think they are on the horizon, you know, it's like if passive funds become more like, you

know,

you went, you know, from like five, 10% to 40%. If we go to 60, 70, 80%,

this

might become a problem. We might see, you know, bigger spikes in volatility.

You

know, we were at GameStop a few years ago or actually, sorry, a few years ago.

I

know in the past months as well, those things might multiply, might happen more frequently and might become a concern.

But,

but I,

again,

I, I try, I've been thinking about doing research on this to try to, to know when it's going to become too much, but I think it's hard to forget the part of the tradeoff that is just like vast amount of people are just much better off, out of, out of more passive investing. And, and,

and

the market might be a little bit different. And that's, you know, we should pay attention to that, but that, that's not necessarily

the

dominant effect. It's quite it. It's like, I don't think,

you

know, this example of maybe a bubble on large stocks,

you

know, of course, if it had a massive crash could have big consequences. If we saw,

you

know, if we had a stock market crash that we could really

pin,

pin on a passive phone,

maybe,

but I think it's way too early

to,

to, to,

to

think. I mean, this is not impossible, but it's not a very, very possible at this stage, at this in my mind. And I

hope

I'm not going wrong too fast. But

yeah. Yeah.

You mentioned that we hadn't talked about the benefits of index funds yet. I would say that's a,

a

key message of our last, this, this is episode 314 of our podcast. I think that

the

reason we didn't ask what that specifically is because we, we've talked about it so much already. Yeah. So we, we definitely agree with that message. Yeah.

And again, you know, that doesn't mean we, we shouldn't worry about it.

And,

you know, it's very,

very

important for the, like, it's extremely important for the economy that markets work well. You know, again, we, we'll talk maybe more about my research on bubble and stuff like that, but it's like, you know, market crashes that, that are not, that not always look rational, that are a big problem. Even homes and busts, mispricing, all these things that can have big consequences. They, they can make firms invest in wrong directions

and

so on. And I,

I

think these concerns with passive investing are, are very, very, are meaningful. Uh, but I,

I

don't, I don't think it's quite at the time for,

for

very strong regulatory call. I mean, clearly regular regulators should keep track of this evolution. You know, there,

there

was, I think a few years ago, there was a proposal to, to get rid of 13F filings or to, or to like, of the publication of 13F filings. Uh, so, so that, you

know,

we, we, we can't tell anymore what, what large investors are doing or what most investors are doing. I think this type of information is important, is, is quite relevant, uh, to keep track of. But, but in terms of

co

-active action of, of preventing, uh, people from investing passively, I, I, I don't think that time has come yet.

So

just to finish up on this section, what do you think individual investors should do with this information?

Depends on how,

uh,

informed they think they are,

I

would say.

That's such a good answer.

No, no,

but, but I,

I

mean, again, that, that comes back to this kind of like two sided aspect that is like,

you

know,

first

you can become passive. And if anything that that's telling you, because markets have become more fragile,

you

know, for individual stocks. If you don't know too much, you should become more,

more,

you have even more incentive to become passive than before anyway. And then that

goes

back to this gross fancy list paradox is a, at least from the point of view of an unsophisticated investor. Like the more other people are passive, the, the, the,

the

more markets are, are messy and hard to understand.

The

more value, the, the, the, the more as somebody who's not informed you, you should go and be passive. And not informed doesn't mean, you know, that you know, nothing like just like, that sounds like diminutive. It's

the

people who are very informed markets are extremely sophisticated. So it's more relatively uninformed.

And so,

you know, that's saying, you know, the,

the

flip side again is there are more, there are more opportunities that they might be hard to find, but there are more opportunities. And actually, you know, I think we, for a long time, we think trading into your stocks is not a great idea. The more

I look at

this research,

the,

the, the, the, the, the,

the

more I think, well, maybe it's, it's not that bad an idea that you, you have to, you focus on something, you try to learn about a stock and so on. Of course, it's not an idea for everybody and you need to have a way

to

get information and so on. I, I don't mean to say, you

know,

we, we should live in a world where everybody's trying to pick stocks, but, but, but, but there's something to, to this in a way to try to identify situations that large groups have investors that miss. Because again,

there

are just less investors around trying to identify these situations than before.

So

that's going

to

be some spots in the market, uh, that are profitable. Now,

you know,

I, I'm not going to tell you how to find them. I don't know how to find them, but maybe somebody can, can know how to find them. Right.

Uh, yeah, somebody,

somebody

is going to find them. Maybe

it's

interesting though. Maybe not the active funds. So maybe if,

if index

funds are growing, active funds are becoming less active. Maybe there are more opportunities for

informed

individual investors.

Yeah.

I

mean,

I

mean,

I mean,

look, maybe I should, it's a,

too

big of a kind of worms to go, to go in there. But like, if you think about what happened with GameStop,

you

know, yeah. I mean, I, it's, to me, it's an obvious that there was a bubble on GameStop and so on, but it's like the, the short squeeze that happened.

And

this idea that like, while a bunch of investors can go and target

this

short and break this short, like you could imagine a few years ago, a couple

of

active investors do it. And, and this was something that was led by individual investors. And,

and

again, we can have debates on whether short squeeze should happen, whether they should be forbidden or like, this is not my point. My point is, this was possible that this happened. And, and I think if you had asked most people before it happened, whether this is possible, I think we said, no way.

For

two reasons. Exactly. We would have said first, individual investors cannot matter for anything, but we also have said, if there's a good deal to be made there, active investors will take advantage of it. And it didn't seem like that happened.

Yeah. Yeah.

Yeah. Really interesting.

All

right. I want to move on to that, the bubbles and innovation research. I love this topic. And this paper is very cool. How do you define bubbles in your research?

Indirectly. So, so we, we, we, we don't try, we don't try to be the, the, the true sayer to say we know it's going to be a bubble in advance.

Uh,

we, we, we,

we

use the method that some other research actually came up with and say, well,

if

it looks like a bubble, if it sounds like a bubble, if it smells like a bubble,

then

there's a good chance it's a bubble. So, so, so, so,

so,

uh, of course we try to be not forward looking. So it's, it's all based on backward looking measures so that, so that we don't cheat in a way and just define a bubble by the fact that it has crashed experts.

So

we, we, we take, we look at episodes, uh, industries, what has been a big, big price ramp up, uh, over the past few years. And, and, and, uh, at the same time, there's been big increasing trading volume, uh, all together. And so what other people have shown is that, you know, this is not a perfect way to detect a bubble. There will be lots of false positive, but on average, this is much more likely to be a bubble than a typical episode. So, so it's a way to say, well, episode where all of us would, you know, look at market and say, it's a bubble or it's likely to be a bubble. That, that's what we call bubbles in the data. In, in, um, in our theory for us,

a

bubble is an episode where people speculate,

uh,

disagree, make prices being, uh, too high.

So

you're taking industry portfolios and then defining a bubble as a, an industry that's had a big price run up and a big increase in trading volume. in recent. Yeah. Okay.

In the past. Um, I should have looked at

it

recently, but,

uh,

you know, I think in the past two years. Okay.

Yeah. Yeah. It makes sense. Both

a big run up. Uh, I think it's, it needs to be both a big run up for the industry and relative to the index. So it cannot be

just that the whole

index is climbing up.

Got it.

How

do you measure the value of an innovation?

So

here as well, we,

we,

we,

we,

we

leverage

some research, but that a lot of people have done, but that that's kind of a cool idea. So, uh, it's, I mean, firstly, we should think it's hard to, to measure the value of innovation. You know, we have like something like chat GPT comes out.

You

know, we,

we

all understand that it's extremely valuable, but how valuable is it? Yeah. Um, one simple way to define that is to think, well, what are the consequences of this innovation? So, you know, you're going to see, keep track of all the profits that open AI is going to make. That's the way you could call the private value of innovation. So to the innovator, the social value also that like other people will make more profits.

So

you can think about this in your head now, measuring the profits of open AI is okay. The other people profits from this innovation is already gets tricky, but you can start thinking through that.

The

idea that we're leveraging up and that is something that we're

going

to criticize is to say, well, you can try to use the, the, the stock market.

So

you could say, well,

take

the day where open AI released a chat GPT. It's not a great example because they were not that public, but like, no, take the day where,

uh,

so formally what we do is take a day where the US PTO approves a patent by a firm

and

looks at how much the stock price of that firm goes up when this patent is approved.

If

the, and so this, this increase in dollars, none of one share, but of the total market capitalization is telling us how much value was created by this patent being approved and released. And there's also evidence that people will pay a lot of attention to those releases. So

that's

the way to measure the value of the innovation.

That's

the market value of innovation, right? We

try to separate those two values in the ideal world. Those two numbers are the same in a way. The actual realized value and, or

not

necessarily realized, but expected realized value and the market value. And, but we, we, we, in the paper,

we

try to measure the two together to see, well, do they always line up?

Hmm.

Starting point was this concern. I would say, well, but when, when there's lots of innovation, so that's when we really need those measures, there's also lots of speculation and we start to worry that market prices might be off.

So how does the market value of innovation, of innovation change during bubble periods?

It

goes up.

So

maybe, I mean, it's not as obvious as it seems because, you know, we all know during bubbles, like the, the market values go up, but that's not what we measure. So we measure how much the price change,

how

big are the prices after the release of innovation, but it tells that those are bigger as well. And where the market does, like price, everything bigger. And so we see these big reactions to innovation. And of course, you know, the, the, the,

part

of it should not be unexpected in that when we're big waves of innovation,

the

innovations are better. So we should see the markets value those innovations better,

but,

but I think what we, what we've kind of find out both who kind of theory and trying to look at different measures is that it looks like it's too much, you know? So it looks like this price increase are larger than what's justified by the subsequent performance of those innovation.

That

is super interesting. So the, the market tends to respond positively to patents, but during bubbles, the response is more extreme.

Yeah.

If you look at, for example, how do the profits of a firm respond to a patent,

it

also responds positively

subsequently,

but not more so after bubble, during bubble.

Hmm.

Wow. So we see kind of disconnect in a way between the markets have to value things a lot, even though they don't have better consequences.

So

that's, that's kind of the next question I think is, is, is what effect does innovation have on real outcomes?

Yeah.

Yes.

It

has positive effects.

So

that, the,

the, the, I

mean, the large, large effects. Again, the point of that, is to point out, you know, some issues, but

innovation

is valuable and is valuable to firms. And so on. But what,

what

we find is that in order to the market, kind of overvalues, uh, those innovation relative to the gain they provide in

terms

of actual real outcomes, profits, sales, and so

on.

So it's like

they

produce good real outcomes, but

when

you look back, the stock prices react more positively than they should have?

Yes,

exactly.

And

how are competitors of the innovative firm affected by the innovation?

So

that to us was kind of the flair that really made us think that it has to be above all. So when I do an innovation and you're my competitors, this is kind of bad news for you typically. You could say, well, you can build on my innovation, but at first order, I step ahead of you. And so competitors tend to suffer. So if you look outside of the bubble, you see this phenomenon. So you see the stock price of competitors drop when an innovation pattern is approved. And you also see subsequently the sales of those competitors or the profits of those competitors go down. If you look during bubbles, you still see in the real outcomes, you still see that the sales will suffer.

You still see that those other outcomes will suffer.

But

now you don't see a stock price reaction.

So

in a way, the market is giving

too

much credit to the firm that innovated,

but

it's not punishing the firms that are suffering, that are the kind of losers of this innovation process.

Wow.

And that's because they're in the same bubble industry?

So

the

way

we

sort of it is actually by trying to dissect a little bit what does it mean to be in a bubble?

Like,

how do bubble pricing work? So it might be a little bit strange, but bubbles are not just a big mess where people overvalue everything in a way. So the overvaluation is an outcome, but we thought maybe there's a kind of method to this madness a little bit of the bubble. So the kind of mechanism we had in mind was something based on disagreement, that different investors have different views on who are going to be the winners.

So,

you know, if we go back, we're talking a little bit about AI, you know, it's like, you know, I might believe that open AI, they're the ones that are going to be the big successful innovators. That's just Cameron might believe, you might believe that meta is going to get all the profits.

And

so now what this does is that well, I'm going to be the investor in open AI naturally and Cameron is going to invest in meta. So we start to get this specialization of investor in a way, it's kind of like fan clubs for value stocks and of course the fan clubs of each stock is investing in that stock.

So

now if you start thinking what happens when you when you get the good when you get a good news about open AI,

the

people who are valuing it are people like me who love open AI.

So

then the stock price of open AI is going to climb up like crazy because they're like, well, I already knew open AI was amazing. I get this good news. It's so amazing. That's just Cameron from his point of view. He's the one that matters for meta. You're the one that matters for meta, sorry. And you hear about open AI but you're like,

well,

open AI sucks.

You

know, this is, who cares? Like I know meta is going to be the best so they can innovate. It doesn't matter to me. So why would I worry? It's a little bit like, you know, we're going to run a race and we think we're the best in the race in a way. So if you tell me if you think you're going to win if Cameron thinks he's going to win and I break my leg, he still thinks he's going to win. If I get better shoes and I run faster, he still thinks he's going to win. So that's how you get that the competitors don't respond in a way is that everybody has strong belief into their own firm and competitors don't worry and the firm that innovates gets all the gains.

That's

really interesting. It's like the the cult of Tesla kind of concept.

Yeah, exactly. Yes.

But

you see, you know, you see both the cult of Tesla

and

the competitors don't suffer that much.

You

know,

the cult

of Tesla tells you why Tesla

is

going up so much. Again, it's not that we show for Tesla specifically, but

if

you apply this, the cult of Tesla is so good, but people like Ford so much. People who invest in Ford like Ford so much, they think electric cars don't matter. So Ford doesn't suffer too much.

I

think we, like these two sides of the same coin, I think is what to us was kind of a big, a kind of flare gun to say, well, this is what's

going

on.

So

what are the implications of this research for, I guess, innovation policy?

So it

depends how much innovation you think we should have. A common view and maybe the most common view is

innovation

is always good in the end. And so

what

underlies that view is this idea that there's always going to be good spillovers to innovation. So, you know, when open it, let me not talk about AI actually because I think there's also a debate around this, but you

know,

it's like, we get better computers that's going to be good not only for whoever came up with better computers, but like, over time, all of us will get more computing power and everything will get better. And of course, but if you're the person creating the computer, you don't get gains from those spillovers. So there's a common view that there's just not enough innovation

and

so then in that view, bubbles are kind of good news because they amplify the incentives for innovation and they

they

create more incentive for innovation because you can ride the bubble and get extra gain in terms of market capitalization.

So

that's the positive view. So to say, well, you know, as innovation policy, you should be aware there's a bubble so you shouldn't overestimate how much innovation is going on but at

the

same time it's good news that innovation is stimulated. The flip side is that

the

bubble can create kind of overinvestment. so if you're not necessarily so convinced that we always need more innovation, we always need more investment,

you

know, like if we go back to Tesla, for example, you could say, well, it's great, like this huge Tesla bubble kind of completely accelerated the development of electric cars. The issue though is there's a bubble. So people will lose their job, you know, Tesla will suffer subsequently compared to the peak and we see, you know, we see sales go down, we see jobs being lost and these are real consequences that are some fragility and I think we should also be concerned. So I think, you know, the first

other

message for policy makers was more,

you

know, watch out in a way that you can gain from bubbles but like the, at the end, the end of the bubble comes and, you know, the long-term gains and the innovation are still there but many people who partake in the bubble are going to suffer a lot so

you

would have to balance those aspects.

So

you touched on this but what are the implications for

investors

hoping to earn high returns by investing in innovative firms?

Be careful.

Be

careful. I think, like, this is an extremely common pattern so, you know, we went back through

a

lot of history actually like it's like, not only our data but we try to read a lot about this because, you know, people, when we talk about bubbles, the historical example, people talk about like the tulip bubbles, things that are like bubbles on goods that don't matter, you know, like gold bubbles, like, but it turns out a lot of bubbles look more like tech bubbles.

Like,

there is, there's something new and exciting, it's clearly good, it's clearly valuable and people rush to try to develop the technology. and

so,

you know, sometimes you win because the technology comes to fruition but often there's overvaluation along the way and prices drop subsequently.

I

think the other thing to me that's important to realize is

it's

really difficult to pick winners. That's why like OpenAI, like the AI, when, as AI has been developing, that's something that keeps coming to my mind

and

it's like, OpenAI showed up, now it's a huge firm and I have nothing negative to say about them, I don't know that much to be honest, but it's,

if

I ask you what, in four years is OpenAI going to be the leader of AI? Who knows, you

know,

if you go back to the beginning, I was thinking like, go back to the beginning of like online commerce.

We

said

like eBay was going to be the big online commerce, I think eBay was the clear leader. One of those is Amazon who won. And so, even if you're doing the right bet, if you're betting on the right technology,

I

think we have a bias of like betting on thinking we can identify who's going to win

and

that's something to avoid. I think it's like, you know, I would say if you want to bet on AI today,

first

it's risky because they're likely above all, I would say, but also, don't try to be a winner. I think you will have lots of failures along the

way. Yeah,

totally. There tends to be crazy skewness in technology bubbles where even if you're right about, let's like what you said, if you're right about the industry,

it's

going to be one firm that drives most of the value creation and you can't know which one it's going to be.

Yes,

exactly.

Like,

you know, it's like these days I think we would think like, so people have different biases or different priors in how they evaluate that. I think many people would say OpenAI is the first one so they're going to be ahead of everybody else. I think historically there's no evidence that this is true but many people think like that, I would say.

Yes, yes, for sure. Many other

people would think, well, you know, for example, Meta, they have a long, or Google, they have a long track record of success and technology so they will be able to take them over. That's also plausible but,

again,

not clear that that happens. Often we see new firms come out. So that part, I think, is the part that

triggers,

amplifies the bubble in a way and is quite dangerous for investors and I think that investors often don't realize.

All

right, I want to move on to one more paper of yours that's in the Review of Financial Studies

on

Fixed Income During COVID-19. another just

fascinating

paper.

Can

you talk about what happened in the U.S.

investment

-grade corporate bond market in March of 2020?

It

blew up. It completely blew up and that's, you know, so COVID was a terrible period for humanity, I think. Actually, not I think, I know.

But

something was kind of interesting happening in finance and I'm a finance professor so it serves. Looking for a cure

for

COVID, I look for that.

But

something that happened is that you

said

in late February, March 2020, as the pandemic was expanding, markets started to crash. And this is a really unprecedented crash due to its speed. So the one I think many people paid attention to at that time just because we're used to follow the stock market was the stock market. so the stock market dropped a little bit more than 30% and maybe even quite a bit more than 30% over a few weeks.

If

you go back to 2008, for example, it was a massive stock market drawdown but it took six months, nine months, you know, the bottom of the market was in March 2009, six months later. This was just over a few weeks.

So

that's already a pretty

strong

event but what we found out is that

if

you look at corporate bond and so in particular we looked at investment grade corporate bond so the safest of corporate bond

their

price dropped nearly 20% and that's unprecedented because, you know, stock prices are extremely volatile but bonds, we expect them to be safe and safe bonds will be safe so that almost never happened before such extreme extreme movements.

So that kind of got us puzzled like you have to imagine this is the beginning of the lockdown and with my co-host we're locked down at home and we look at the news every day, the financial news every day and we see this happening and we have done a lot of work before like our financial institutions can create crises we have done a lot of work around the 2000 crisis and so on but that looked like nothing we had seen before so we wanted to dig into this some more pretty

much.

And how did the response in the bond market differ from the credit default swap market?

So

that's interesting so the way you can think about

a

simple way to think about bond prices corporate bond prices you say well

the

price is going to be down if the company is likely to default so that would be the natural explanation at least at first glance for this period to say well we're going to have a big recession due to COVID many firms are going to go bankrupt so that's why we see the price go down but there's another place where you can get that information that's the credit default swap market so there are contracts where investors buy and sell insurance against default and so if this insurance is expensive that means that likely the company is likely to default and we didn't see the price of those insurance go up during that period for the sale it went up a little bit I shouldn't say we didn't see it go up but by a small amount to give you a concrete example and that's kind of my favorite example of this period is to look at if you look at Google at Google so Google is an extremely safe company first before even I tell you any price number there was no reason to believe COVID-19 was going to do harm to Google if anything we all spend more time on computers this was good news for Google and if you look at the CDS or the credit default swap for Google the price didn't move so I think it costs a few basis points to ensure the default of Google something like 50 basis points it went up a little bit but if I show you the plot it looks pretty flat the price of a five-year Google bond went down to pretty much 80 cents on the dollars that looks like it's pricing a massive risk of default for Google but again once you look at everything else you don't see this risk of default we like credit default because it's also a price it's also in the market and you didn't see this price move so you just see the price of the bond itself go down and that's something that told us that something wrong was going on in markets more so than like with the way markets worked more so than with Google itself

man

that's interesting so

that you

see the bond prices tank

you

think it's

the

price of risk is increasing but then you look at

another

place where you can see the price of risk and it hasn't actually changed that much

so

what what was causing the crash in bonds then

okay

so that's where the detective part of the paper starts so we

a

natural guess I mean actually the natural way you would describe it is that well

people

don't want to buy bonds or more presented people want to sell bonds but it's not because the bonds themselves are risky in a way it's because people want to offer positions so that's what you would call a fire sale a massive fire sale going on in this market so then we try to ask ourselves well

who

are the investors selling

and

how come this has such

a

big effect

and

here there's a few dimensions you can point to a big one maybe the biggest one and even after our paper people have done more studies and I think that's the one that seems the most important is that bond mutual funds sold a lot of positions so a lot of bond mutual funds experienced very large outflows

and

what a lot of them did not even funds specialize in more safe bonds but a lot of mutual funds would sell their safer bonds first

so

you have to imagine even if you have a mix of investment grade high yield bond

you

get a bigger flow it turns out the funds chose to sell the more liquid bonds first the usually more liquid bonds first so everybody went to all those funds went to like the simple rule of thumb that is by the way a good rule of thumb 99% of the time that is

if

you have to liquidate sell liquid assets but it is so much so that the liquidity deteriorated a ton in those markets so that's one big aspect and that's unprecedented because until that period pretty much until 2008 we didn't have very big bond mutual funds in the US I mean there are some big ones that we know like PIMCO was actually in bond mutual funds all this stuff but most bonds were held through insurance companies through much more stable institutions

after

2008 we saw this big growth of bond mutual funds and that has completely kicked back the economy because there were just massive sales

so why weren't market participants stepping in to buy the bonds as these prices fell

so

you have to ask who can step in and try to look for that so

there's

various people you can look at so one category that historically plays a role when those acute episodes are dealers so the bond dealers so you think

about

large investment banks and so so historically they intermediate a lot of the trading in this market and so they will say we have an acute crisis we're going to buy those bonds keep them on our balance sheet for a few days things will pull down and we put it back

in

this case there were two concerns that prevented this from happening

one

is the reality that dealers cannot intermediate as much as they used to we just have much more regulation in the market preventing that

the

other one

is

that this crisis and the pandemic did last quite a long time so there was a sense that even though it's very acute it can be a long lasting problem so what we would need is investors that can wait it tend to be much more stable in terms of their inflows than bond funds but they start to worry because as the price of the bonds drop if it drops too much the company will go bankrupt and so it seemed like they were worried and not that willing to participate some did participate I think

I

might be quoting the wrong one but I believe like MetLife for example did come into this market a bit during that time

but

just not nearly enough to stabilize the market there was not enough capacity to come in

so

what was needed at this point was to come in on short notice and to be able to come in and hold up throughout the pandemic perfectly

and

that nobody it seemed like not many investors were willing to do it

we

talked to

something

interesting we even talked and

they

asked you to talk about this research and what was interesting is that

the

people managing the phone were saying we knew this we knew there were good deals we could see those good deals but it's just our management was like it's the crisis we're not going to suddenly start to switch to buy tons of bonds out of nowhere we cannot switch our policies so there was also just

that's super interesting sounds like a job for the Fed what effect did the Fed's intervention have

so

the Fed did step in actually well they might step in I should say to be precise so what happened is the Fed did something they never did before they stepped into the corporate bond markets so in 2008 the Fed did QE so that was one of the first time they would say we buy long term treasuries we buy mortgage back securities but even after that I think most people saw this was very limited to treasuries or treasury like securities there was always I think there was always this idea that you shouldn't participate in stock market you shouldn't start to decide which firms are doing better on but in a pretty unexpected way they just stepped in and said we going to create to have solved some of those bonds so they said at first they could buy up to 300 billion dollars of investment rate corporate bond later it got expanded in different dimensions but up to about 800 billion dollars

so that's a big

big step in and the day they announced that the market recovers you know I think about a third

of

the crash recovers just that morning is

that good

for

markets

so

I

can tell you about it so I tell you briefly about some other paper we've done and that is going to amplify the debate I think

so

they said we can step in up to $300 billion and later we can step in up to $800 billion

the

market did recover

and

it turned up the Fed never really stepped in

the

Fed only bought something like $14 billion of assets and everything got by the fall 2020 the Fed is not owning any corporate bond anymore pretty

much so what

happened so then we have another paper where we think about those issues and

what

we think is that well there was a possibility that the file cell could get even worse

and

what the Fed did really was say I'm willing to do whatever it takes to fix it

so

it turns out the pandemic was not as bad as people thought it could get

it

was extremely bad just to be completely clear but it was not as bad as we thought it could get and so really most of the Fed intervention did not happen it could have happened but it did not happen

okay

so why does that make things worse much so then there's not much cost

the

worry some part is well they might be willing to step in again and now they can open ponderance box and create this implicit commitment that's another form of Fed puts that it will always step in when things are risky we tried to look a little bit in that sub secondary research do we see traces on that we see some traces that suggests a bit of this

after

the pandemic cooled down

the

price of investment grade carbide bond if anything seems too high

so

it looks and if you talk to a lot of investment grade bond trader even a year or two ago they would tell you the Fed is in this market somehow like even

though they are not

intervening there the view that the possibility that the Fed steps in is just popping up the market and that can be worrisome that creates more lazar that creates issues of the Fed stepping in too much

at

the same time markets are not perfect

the

crash to start with is not an efficient market phenomenon that we want to let happen it makes sense that we want to fix this the reason they step in to

me

I view it more as the cost benefit trade off I think the view

in

my mind we are past the world to say the Fed should never intervene in markets we should always respect markets when I

look

at this episode everything screams that something wrong is going on in the organization of markets that there are frictions and it makes sense for a policy maker to interview

the

problem is once again and those commitments might be costly and that only time will tell us

it's