Both Sides Now: The Active Vs. Passive Debate Revisited (Podcast Transcript)

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Summary

  • In the midst of the extreme market dislocations of 2020, the active vs. passive debate continues to rage on as powerfully as ever.
  • While nearly 4 of 5 active U.S. large cap funds continue to underperform the S&P 500, the most recent SPIVA data shows key areas where active management has the upper-hand.
  • XOUT Capital CEO David Barse spent nearly 25 years running active value shop Third Avenue Management before embracing a passive, rules-based indexing approach.
  • He joins Let's Talk ETFs to discuss how his surprising metamorphosis took place. We also cover the active vs. passive debate from multiple different angles.
  • This article includes a full transcript of the podcast that was posted last week.

Editors' Note: This is the transcript of the podcast we posted last week. Please note that due to time and audio constraints, transcription may not be perfect. We encourage you to listen to the podcast, embedded below, if you need any clarification. We hope you enjoy.

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Jonathan Liss: Welcome to Let's talk ETFs. I'm your host Jonathan Liss, and I've been closely tracking the ETF space for more than 13 years through a variety of roles here at seekingalpha.com. Each week, a different guest and I will take an in depth look at a particular aspect of the rapidly evolving exchange traded fund space with a focus on how investors can best utilize ETFs to reach their investing goals.

Before we begin a brief disclaimer. This podcast is for entertainment and educational purposes only. Nothing said here should be taken as investment advice. All opinions expressed on this show are those of the individuals expressing them alone. A full set of disclosures will be included at the end of this show. You can subscribe to Let's talk ETFs on Apple podcasts, Google podcasts, Spotify, or whichever podcast platform you prefer.

Brief bit of housekeeping here. There will be no episode next week. Thanksgiving week, hopefully everyone gets to spend Thanksgiving with some friends or loved ones. I know that's not necessarily the easiest thing to do this year. I'll be back the following week with Paul Baiocchi of ALPS discussing their lineup. They have some really unique funds that I think investors will find interesting in this environment in particular. Wishing all of our listeners, a safe and enjoyable Thanksgiving.

For reference purposes, this show is being recorded on the morning of Wednesday, October 28, 2020. My guest today is David Barse. David is the Founder and Chief Executive Officer of XOUT Capital. The indexer behind the GraniteShares XOUT U.S. Large Cap ETF, ticker symbol XOUT. For listeners interested in learning more about XOUT, I have GraniteShares Founder and CEO, Will Rhind on the show in March in an episode titled XOUT Eliminating losers is more important than picking winners.

It's Episode 34 for those of you keeping track at home. In addition to XOUT Capital, David is also the founder of DMV Holdings, a private family office. He was formerly the CEO of Third Avenue Management for 25 years, pioneer and fundamental bottom up deep value investing. It is David's metamorphosis from active stock picker to a van indexer that will form the basis of today's conversation.

David earned his JD at Brooklyn law school and holds a Bachelor's Degree from George Washington University. He serves as a member of the EQM XOUT U.S. Large Cap Index Estimate. Anyway enough of an intro, welcome to the show David, I'm really excited for our conversation.

David Barse: Yeah, thank you, Jonathan. So am I, looking forward to it.

JL: Nice. And I think we do have a lot to discuss here in terms of the indexing versus active debate. As we speak right now markets are getting just absolutely hammered. Probably some jitters heading into the election, as well as just general I think concerns around the virus kind of rearing its ugly head back in Europe, in the U.S. huge spike in number of cases and concerns with what the economic fallout will be there.

And it's around this sort of market environment that you always hear people making claims to be effective. Oh, in a down market, this is where active management really kind of wins the day. And I think the evidence probably is pretty clear that that's actually not the case in these kinds of market environments, but certainly a good time or as good a time as any to have the Active Passive debate, the indexing versus active stock picking debate, of course, you've been on both sides of that argument.

Before we get into the broader debate, what have you been working on recently? What is XOUT? What's the strategy underlying the index? And how did you end up getting into this?

DB: Yeah, so I think, the debate will be an interesting discussion topic for the two of us, but it is quite frankly the guide or inspiration, if you will, for what transformed or as you use the word metamorphosed my career and living in an active world where all that you did was promote your high active share, your ability to select securities that you researched and identified more than what you perceived the rest of the market to do because the market price did not reflect that value.

And watching that strategy struggle against passive benchmarks that we all have to measure ourselves against is what really drove my inspiration. And so, I think as basic as it can be and it is so intuitively simple that listeners might just say really, it's not easy. It's more important what you leave out of your portfolio than what you put in.

We drive that decision towards where flows are going. So I like to use my Wayne Gretzky analogy, you know that Wayne Gretzky always went to where the puck was going to be, as opposed to where the puck is, where are flows going? I like to think about that study that considered all the time, I think large cap U.S. equity was a first choice selection, which is why we licensed the first index to GraniteShares for the large cap ETF.

And then lastly, what’s driving that exclusion decision. And that exclusion decision also based a little bit about what I view to be one of the most significant forward facing risks, and that's technological disruption. And so, more important what you leave out let's go where flows are. Tech disruption is impacting all companies in all industries. That's the three simple insights for what drove our strategy.

JL: Yeah, nice. And the performance has been really excellent year-to-date. So we're talking about I think I pulled these numbers just a couple of days ago, one year return on the index of 28% versus 15%, for the SPX. So obviously, something's working there. And remind me after we finished the conversation to show you the autographed picture of Wayne Gretzky, I have on my wall on the other side of the office, you can see…

DB: Can see, if I didn't even know that and I picked him. There, this is good karma. This is good karma for the rest of our conversation.

JL: It is yeah, my oldest son is a goalie. He plays hockey pretty seriously. Although unfortunately, because of the virus, they have not been able to do that much but up until March, he was playing a couple of times a week. So Gretzky's always welcome analogy.

So in terms of what you're doing, and I'd love to drill in just a little more to identify tech disruption. And again, as you said, this is across all industries. So we're not only talking about companies that are, let's say classified by Guix as being IT companies or Telecom, we're talking about in the energy space too I assume, or in the financial space.

What exactly are you doing to make that determination? Because it feels like on some level, there would be, it's somewhat subjective to determine what is actually likely to produce tech disruption.

DB: Yeah, I agree with that statement. And there isn't a holy grail for the definition of disruption. As we've seen, there have been thousands of books written about it and every pundit, whether they be a tech expert or non-tech expert likes to talk about disruption with their own sort of viewpoint. So the subject of this clearly at the place, I would tell you that I think at some point in the future, if I had to make a wild prediction, the Financial Accounting Standards Board will have to come up with some additional disclosure items as we evolve as a race and talk about technology as an important component.

However, they end up defining it, but forcing companies to make public disclosures in a more articulate and transparent way about how technology is affected because it is a risk. Why do they report about some things that are sort of risk factors for businesses, but there's no obligation to report about this?

So we're, I made maybe say innovators in the way we're thinking about this kind of disruption, but we use seven factors or seven fundamental screening tools, and we apply a score to each one of those scores. Our secret sauce is exactly how we do that and exactly how we wait each one of those scores. But we amalgamate those seven factor scores, and apply it to the universe of in our case, the largest 500 companies in the U.S. equity market cap market.

And the lowest 250 scores are excluded from the portfolio. Now, why are those particular seven factors instructive on technological disruption? Let me list them out if that's okay with you, and maybe that’s probably contributes to your statement about subjectiveness. But I'd argue they're pretty good proxies until, as I said, the SEC and others mandate these kinds of disclosures.

So growth, clearly if companies are growing revenues versus shrinking revenues, that's an important measurement, how they're doing vis-à-vis capital expenditures or research and development. Not all companies report on research and development. Clearly research and development connotates technological investment of some form or fashion it might be described otherwise, but it's not uniform.

And certainly not all companies report on it. So we, we've come together with a test of using both CapEx and research and development. How are they doing with their labor force? Are they hiring people? Are they letting people go? How are they doing on profitability metric? What are they doing with cash flow in terms of making investments in their own stock buying back stock not borrowing money to buy back stock, but using cash flow to do that?

And then how do we measure a management team? I think, every leader of every public company, every company, quite frankly, but we're only looking at public companies, how do they think about technology and the disruption effects? And what are they doing to prepare, invest, best address and prevent disruption and we've come up with a scoring method for that.

So we take those things together. As I said, we apply score and each quarter we rebalance. So there are some companies that might score below the line, therefore get excluded. That's our focus that in the following quarter, produce new numbers.

And this is all based on fundamental public reporting information as it comes out, we chose the third Thursday of every quarter in October, January, April and July, thinking that's sort of the timeframe where we can fish out as much of the publicly reported information we could get. Obviously, we rebalanced already in October. And now we're just starting to see earnings numbers.

So we're going to get that data and that will be used in our January rebalance. But that's how we do it. And, that's what's created those results. So it was even surprising to us how well this is performed in a live portfolio as opposed to in back tested models.

JL: Yeah, sure that that makes a lot of sense and it also I'll note for listeners is a true rules based index. So for example, I just had a conversation which I think I'll probably be live tomorrow actually with the team at RoboCapital. And they have robotics and automation fund, ROBO, which is actually pretty large ETF. I think it's close to $1.5 billion.

And they're also a rules based index fund, but they have a committee that determines which companies belong in the index. It's not rules based, it's let's take a look every quarter, and see who's really making strides in the robotics and automation space, and hand select them. And then there's rules about modified market cap weighting, and how often you rebalance and things of that nature.

And I do think that the line between active and passive is somewhat blurred when you talk about those kinds of indexes, because you're open to the same kind of human biases as you are with active stock picking. So yeah, you get experts in the space to pick out who's giving you exposure. But at the end of the day, there are subjective calls being made there.

And not to say that it's necessarily better or worse, but just to highlight the fact that it really is a different kind of indexing approach, when you have a committee making subjective decisions, versus just a list of published rules based on publicly available information, and you make all of your decisions based on that. And it doesn't matter if one of the company is being excluded.

Somebody says, oh, but they're a real innovator. Let's put them into the index anyway. I believe, correct me if I'm wrong, there is no kind of work around there. Right. If somebody gets too low of a score, it doesn't matter that somebody thinks they're very innovative. They're still out of the index that quarter.

DB: Yeah, I mean, 100%, and again, back to the conversation, I think we'll have my historical active experience is really the primary driver here for making sure this is 100% rules based that is extremely important to me that we don't have a committee, as esteemed as a committee, maybe we do have a committee.

But our committee is merely there to confirm that the rules we put in place were followed, that the decisions made were makes sense in accordance with the model, but not to override any decisions that would never happen. And our index methodology statement lays that out. So it's fully transparent for everyone to see.

JL: Sure. And I guess one more, maybe caveat, or whatever you want to call it about the thematic space specifically is that Guix and the like, they often lag in terms of getting more niche themes properly identified, and so you sometimes do have to go and figure out how to do those slices and dices on the sector level.

Of course, one could argue that there's no real evidence of themantic indexes outperforming and that you're better off just trying to get the broad market and let whatever sector wants to lead it again in chime lead. But because you're taking a broad approach to large caps here, you can maybe get away with that. Whereas there really is no existing robotics and automation index or there wasn't in 2010 when they launched the fund. So they kind of had to go out and figure out what should actually be in it so some things…

JL: Yeah, I mean, look, another interesting point was where I emphasize we're using the largest U.S.500 market cap companies. The S&P is certainly a proxy for something we're seeking to disrupt and obviously outperform. There were a 91. At least my last count was 91 different names in the constituency, the S&P 591 dividends, then the 500 largest.

Now, I think, what most people buy the S&P I think they buying the largest 500 companies. To your point about an index committee, I think they have some folks there who make very interesting decisions I'll call them active decisions about what ended up going into their constituency versus the 500 largest companies.

So I always found that fascinating. I think they also made a really bizarre move in April, this year of delaying the rebalance date, because of the market pandemic. And what happened to the market in the pandemic, I don't understand that. How do you have a rule that you're going to rebalance on a certain day and then change the rebalance date because the market has a volatile move?

So a lot of decisions get made by these broad indices. And people think they're passive and win entirely real space. But I would tell you that I've discovered that that's not the case.

JL: Yeah, certainly I mean, I think a lot of people were scratching their heads at Tesla being left out of the S&P 500, for example, considering the size of the company. So yeah, people I think would assume they're getting a Tesla when they buy the S&P 500.

DB: Yeah, made the rule too, but their own rule, and that’s excluded.

JL: Yes. So there you go. Okay. So I'd love to take a step back here for a second and get into your specific story here, because you really have been on both sides of this debate, not only in a theoretical way, but in an actual practitioner sort of way. So you spent 25 years as CEO of Third Avenue Management, or were you the CEO the entire time?

DB: No, no, I joined the company. Believe it or not, I'm a lawyer by background. So I think you mentioned that in my bio, but I joined the firm as the General Counsel, and then a few years after being General Counsel rose to the level of President and CEO.

JL: Okay, cool so you must…

DB: Almost 20 -- almost 23.

JL: 23 okay, so you're at the firm for 25 years or longer running it for much of that time. And Third Avenue Management, for those that are not familiar is a famous stock picking value job. So your metamorphosis from an active fundamentals driven approach to a passive rules based indexing, one seems to have mirrored really the broader realignment from active to passive management that's been going on for, I'd say, I guess, two decades or more at this point.

In the 80s and the 90s, active value investors not only Warren Buffett, but the Bill Miller's of the world also famously beat the S&P 500 for 15 years running before absolutely getting destroyed during the global financial crisis, with his over investment in financial sector value plays. So in the 80s, and 90s, they were really the superstars of the investing world.

And at this point, they've been replaced by and large by passive strategies and passive indexing shops, particularly the factor based jobs that came out of academia in the late 90s and early 2000s. So I'd love if you could tell your story in a little bit greater detail of how you ultimately reached the decision process that passive was the way to go and that active stock picking was ultimately a loser's game?

Not or maybe not a loser's game, but not worth the time and energy, you end up spending all your time researching and paying more money to have these huge research departments. And then at the end of the day, low cost index funds end up beating your performance more than you end up outperforming them.

DB: Yeah, I mean, the story might go on a little too long, so cut me off if I get too deep into it, but it's my own story, but it's a cool story. You didn't know but the third day I was founded by a guy named Martin Whitman. Marty was an author, written a book at the time was sort of a cult book called Aggressive Conservative Investor. It's kind of an interesting title.

It was written around the same time that Seth Klarman wrote Margin of Safety. So these kinds of books back then were kind of must have must read books for value investors, besides obviously the Graham and Dodd treatise right. But, really what we were doing was, we were researching and trying to find undervalued or misunderstood investments. And we were agnostic about where to go.

And so, how do you get measured if you're agnostic about where you're going? You measure yourself against the S&P 500 because like you said, Bill Miller touted his performance for years against the S&P 500. And then, everything really did change with the financial crisis, probably leading up to the financial crisis, because I would say our peak year was 2006. And we grew organically from zero to $31 billion.

And the way we were able to do that, not just with one fund, we had multiple funds, a small cap, a real estate, international fund. We had separately managed accounts, we managed money abroad, like all other value investors in our space, we were all able to gather assets and we kept comparing ourselves again to the S&P 500 until we could, right. We couldn't because the financial crisis came, well 2007 came where things just got so crazy, that value investors couldn't justify making investments anymore.

So in our particular case, I remember building up cash positions, we had to go, amend our prospectuses, because our cash positions got the 30%. And you're like, what are you going to do if you can't buy these securities, and we kept buying our own book, right. And so when you buy your own book, your stocks go up, value investors were crowding into the same securities. And so the crisis just really had a double whammy effect, because two things really happened.

One, everything went down, right. And guess what? Laggards lag more than the growth companies as we saw what's come out of the crisis, the S&P 500 just crushed everyone. So then most value investors, including ourselves, started changing the benchmarks by which they compare themselves to, it's no longer appropriate to compare as we don't really have an S&P 500 portfolio, we have this eclectic portfolio of undervalued securities.

And so, when I would kind of call a research meeting and have all our portfolio managers research analysts where, guys, you're getting compared to indices, or benchmarks rather that you don't own any securities that are in these men. Yes, that's our advantage, where high active share, 98% active share, but you're getting crushed by these benchmarks. So then you got to think, rethink what you're doing.

Or we have to change the world and convince the marketplace, especially institutional investors that you need to just give us an absolute return proxy. But what ended up happening is, we didn't change that, we didn't change the world. And we continue to get compared to benchmarks. And we continue to get pummeled post the financial crisis and the compounding the double whammy effect that I was mentioning is we were heavily weighted with cash.

And what did the investors who invested with us want to do, they went to the places that were the most liquid right. We were the most liquid so we became an ATM machine. And value investors are very good at buying in rising markets, because they buy their own books and you get an exit two ways. One, your company gets taken out by maybe a private equity firm sees the value that the market doesn't, or the market finally wakes up.

And that happens if neither of those two events have, you have what's commonly referred to as a value trap. And, when you're in value traps, and you're having your funds redeemed on a daily basis, it's a very challenging environment. And so what I like to say, I spent from 2007 until 2015, quite frankly, being tortured. And watching that cycle continuing and then watching the passive indices grow both in asset flows.

But ultimately, the diversification approach just clearly outperformed. And it was very, very hard in there. And you can see, it's a selection world. I mean, we're all smart people in this industry, but the cream rose to the top and those people were able to navigate through that have successfully performed and done well with their firms. But the pack, I would say has really struggled and I don't know, we'll talk about a little bit more, but I don't know what the true outlook is for that broad group of let's call them active stock pickers.

JL: Sure. So it's 2015, let's say and what was it like a specific event that had you throwing the towel in and starting this indexing firm, which I guess really was in direct opposition to what you've been doing for the previous 25 years? Or what was the final part of the metamorphosis there?

DB: Yeah, it is a storied story. But we -- I had sold the firm to a company called AMG. AMG, as you may know, its public company, ticker, AMG. It buys stakes in an asset management companies. So they ultimately had control the business. We had a disagreement over what the strategy for the future, the firm would be. We agreed to part ways. I left the firm.

I'd say since then, the firm has had its continued challenges. It's a fraction of what it used to be. And it's not a great story. But what it got me doing was immediately thinking about, what would be my next gig if I was going to do something, and I had some period of time to reflect on that in connection with a non-compete I had signed by leaving the firm.

And ultimately believed that those insights that I started this podcast with were the drivers, right, you had flows going into passive funds. Let's anticipate that that's going to continue where it will go. Maybe it's more important instead of trying to pick winners to simply exclude losers, and what's this big risk that we all have to deal with is technological disruption, and then drove to educate myself about the cheapest form of way to promote this to the marketplace. And that's the ETF industry.

So I became a student of the ETF industry, attending conferences, reading all this literature, meeting with different people and trying to find an ultimate partner that could help distribute these ideas and GraniteShares became that partner.

JL: Nice. Yeah. And it's been a great partnership so far.

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JL: So, I think it's pretty clear at this point that much of what was classified as alpha was actually beta over much of that period. So in other words, your peak in 2006 corresponded very nicely to the last great run that value had relative to growth, coming out of the tech meltdown in 2000 to 2002, where value strongly outperformed growth in that period.

In your opinion, is there any room left for alpha seeking in the investing world? Or does everybody --should everybody really just be thinking about things in terms of betas at this point? And I guess alpha is really just kind of a concept that's been relegated to the dustbin of history.

DB: Yeah, no, I can't subscribe to that belief. I don't think it’s all hope is lost, and I do believe that alpha is out there for the taking. It's just really hard. And so you have to have every investor meeting, I went into the pitch, what -- someone around the table would ask, what's your edge? Right? What's your edge? And people had different answers to that question.

But there are some folks out there that have edges. And those edges are clever, intelligent ways to identify mis-pricings or opportunities to take advantage of the market. I would say the bulk of them are smart in multiple ways, they went into the hedge fund world, right. They went into a high compensation vehicle world, which is a better way to refer to it because if they are going to succeed, they might as well get rewarded for it beyond a low base management fee and nothing else.

So there's definitely a future, I think forever for alpha seekers just narrower and a select group. Now, I not to talk my own shop, but I'd say that we've actually created an alpha key generation because our beta for the 250 constituents that we end up owning, and again, I'm only focused on what not to own. But the fact of the matter is we own 250 securities in the ETF is roughly equivalent to the beta of the S&P 500.

So if that's the case, then how did those numbers that you quoted earlier, come to be for alpha? So I'd say there is. And that's why I like to refer to what we're doing a smarter data, as opposed to smart data, which has gotten bunched together. And you noted went back to said done, but it is capable of being done. I don't think what I'm doing is so smart. It's just that I haven't seen anybody else do it this way.

JL: Sure. Although I guess one could kind of look through the seven different factors or metrics that you're looking at, and say, Alright, these three really kind of fall into a growth bucket. And these two are quality type things. And, again, they're I'm not knocking beta at all, I think it allows investors to achieve greater long term returns without taking on outsized risk.

But it still, I think, maybe does point to the fact that humans even the most intelligent ones have no proven ability to over time continually outperform rules based historically tested strategies that have delivered better returns.

DB: Now and you hit on an important topic to me. And over my career, what I think is one of the most meaningful takeaways is that that's human bias. The so called the broadly defined behavioral finance impact of decision making by portfolio managers, be it single manager or team managers, has always been a challenge.

And, as I've advised, if you're making a decision to allocate to an active manager, don't just look at his or her historical track record. Examine that individual, learn about their belief system; understand what's driving, what ultimately their decisions can be, because at some point in time, that bias is going to impact their decision. And that's where I think the rules based system just trumps them every time and sorry to use that word. But it's, I think, academic at this point.

JL: So in terms of getting back into something that we touched on a bit earlier, there's this notion out there that active management is totally different animal than passive indexing. And yet indexing in many forms, at least has become increasingly complex.

And there are indexes and index funds at this point I've actually spoken to a few of them that are literally trading in and out of their portfolio with a turnover of between 50% and 100%, every single week. And again, these are rules based indexing strategies, and yet, they look and smell a lot like active management in terms of following what they perceive to be some market anomaly and then trying on a weekly basis to flip the script on the market.

And additionally, as we touched on earlier, there are many indexes small and large, sometimes in niche sector kinds of spaces where maybe Guix haven't properly classified a sector but more in terms of the S&P 500 and the Dow Jones Industrial averages and the NASDAQ 100s of the world where they literally have committees making subjective decisions. And yet, everybody considers this totally removed from active management.

And that, I guess, there's a committee and they only get to make their decisions once a year or whatever, but there is still a level of human capital there. And then there, of course, are indexes like yours, where they literally are just rules based. There is no human capital being invested in what goes in and out of the index. There are simple rules, you spit the numbers into a machine, the machine spits the numbers out and you rebalance that set periods of time.

Do you draw a distinction between these different kinds of passive indexes? And ultimately, do you think these definitions matter to investors into their bottom line?

DB: Yeah, I mean, 100%, I think this goes to the proliferation of product that's come out into the marketplace, there's a lot of differences between all of them. And, folks need to spend the time to understand when they invest in something, don't just take a word or a moniker or a classification.

And think that that's what they're getting, because I agree wholeheartedly with what you said, if a rules based strategy is having the effect of having a portfolio turned over at that kind of rate, then one best understand what they're getting themselves into, before they do that. Or we made strides to spend an enormous amount of time, quite frankly, a few years building the methodology for what went into our rule.

And that's the active component of what we did. Right. But once we put it in place, so the index was launched on July 1, 2019 and went live, we're not changing it. And, I'm not convinced, as I said to you earlier, that I've come up with the perfect Holy Grail definition for technological disruption. I'm going to my hope is to continue to roll out additional index strategies that improve over time. We may choose a different underlying benchmark to disrupt whether it's small caps and mid-caps or subtler international benchmarks, but our goal is to do this and to do it better each and every time we do it.

But I agree with you, there is a very big difference between those who do it by rules. And I think even as we've talked earlier, the S&P 500 has murky rules to say the best, I like to say the most active passive large index in the marketplace.

JL: Absolutely. Yeah. And I do think that is lost on most investors. I think if you talk to the typical retail investor on the street, who owns their SPY or their IVV or VOO index fund, or maybe one of the low cost mutual fund versions of it, and you say to them, what is the S&P 500? They will tell you, it's the 500 largest companies traded in the U.S. And that is obviously far from the truth.

So, yeah you want just large companies based on size probably need to go with Russell not S&P for as your indexer. So I'd love to move over to an argument that I'm hearing a rear its head every so often, and maybe I feel like increasingly, over the last year or so. So going back two decades at this point, we've seen roughly 1% to 2% of equity assets move from active to passive strategies.

I believe, we've finally crossed a threshold now where I think more than 50% of at least U.S. based fund investment is in passive and non-active. This is on the equity side of the equation. Of course, this doesn't talk about actual traded shares on a daily basis. So I'm fairly certain 80% or 90% of actual trading is still done by active strategies.

The fixed income side I believe it's up to 25% or 30% in passive now, so it's still much more of an active landscape. But again, we see the shifts happening and that the sea change of more and more investors, both institutional and retail moving assets from active to passive indexing strategies. And the argument that I hear made is that, at some point, if too many assets move into passive index funds, the market will lose its ability to achieve true price discovery.

And as a result will become less efficient, at which point, it will actually be beneficial to be an active investor at that point, assuming you have some skill at actually identifying those inefficiencies. Is this a real concern from your perspective?

DB: No, I don't think it's a real concern. I think actually, it's one of the insights that I didn't mention that I thought about as I built this index, which is there are some flaws with passive index investing. And, as I said that the flow is they buy everything, and index buys everything. And so, if more and more flows continue to go into the same index, then that will lift all boats as the tide comes in.

And so, as the tide goes out you get exposed. But what the pandemic exposed for me is that there were obvious sectors and obvious companies that have really been impacted. And those companies have performed so significantly worse than others. So if it's true, that we've distorted price discovery, how can that be the case? We've seen a very compressed, maybe the most compressed market volatility in the history of our time, with the down and back, but not everything came back. Right.

The bad companies are still struggling, and may continue to struggle, as we see what's happening even today, as you've noted in the outset of this podcast, the markets getting hammered. And we're seeing it impact everything in the market. But at some point in time, maybe some companies that are being hammered have deserved right to be hammered because they're struggling with what to do.

So I don't agree with it. And it is getting a lot of question. We talked earlier, you've got a lot of pundits out there, continue to talk both sides of this argument. So I'm calling for passive index funds or strategies to be equivalent to what happened in the derivative space during the financial crisis. And others, talking about how this argument have been going on for decades, and it still hasn't happened. So I don't know what you're talking about.

So I just don't think it's a legitimate argument, but because I see what we have real time evidence that price discovery is occurring. Notwithstanding away, flows have gone. So what more can we do for them, to convince them that we, all the folks who were the original pioneers in the space, and then the regulator's who've created the rules on how they get formed, and how things are trade, we've done a really good job at setting up the market place landscape to give investors the protections, the transparency.

And it's just up to those making the fiduciary decisions to do their work. Do your work, figure out what you mean. And look, I'm a product of a firm that grew very large. But I know what I had to go through to get large, you had to develop a track record, you had to have meaningful AUM, so people could feel like they could allocate to you. I'm dealing with that right now.

We have performance in a one year, very small track record but short track record, but we have a good track record. Still, I can't get people to pay attention to me. Because it's one year, and we have roughly a little less than $100 million in assets under management. At some point in time, I'll get to that critical level.

And then I'm hopeful people will flow into us, but it's they're doing their work. They're doing their job. They're being careful on their studying. So I hope that that is what will help people overcome these kinds of scare tactics. I don't know what else to call it, but a scare tactic.

JL: Yeah, absolutely. I guess one of the beautiful democratizing things about exchange traded funds is that if you're not one of the let's say, three or four firms, the oligopoly is they're referred to sometimes where they just have these massive wholesaling teams and people that get out there and pound the pavement, frequently takes accumulating a $100 million a $150 million in AUM before you can get institutions to really look at your fund.

You won't necessarily be listed on all of the brokerage platforms out of the gate either. And so, what generally ends up happening is that the funds that succeed that are not from those top, I don't know five maybe there's 10 issuers that really fall into that category. It really is retail investors that get them off the ground, they put money into them, they believe in the strategy it performs for them.

And then, eventually they build the fund up to large enough that the institutions can ignore it no more, and they're forced to take a look at it, and it enters their coverage universe, and then the flows can really take off very quickly at that point.

DB: Yes, you've accurately reflected a guy can share one story just because it's frustrating, but it's the real world. When I launched this index, and then the ETF came to market, I naturally called up a number of my friends to say, Hey, this is what I'm doing, would you be supportive?

So one particular friend, has an account with Merrill Lynch went to go buy, told us his registered representative to buy the ticker. I'm sorry, I can't buy that for you. Why not? It's not approved. But it's not as solicited. This is an unsolicited order, I just want to put some money into this thing. I'm sorry, you can't do it. And then, he -- I kept telling him push, push, push.

So finally, he gets a one page waiver that says, you're letting go. But now, let's look under, like I said, do your research. It's 250 of the largest 500 listed U.S. market cap equities. What's the underlying real risk to the investor? And so this is what a Merrill Lynch puts you through to get you to let them buy it. But yes, that is the world that we live in.

And so that problem probably won't go away until I get to a much more significant number than even where I am today. And yet that that client keeps telling his registered representative, See, look, what happened to this fund, look what I've done, you had me an S&P 500. Look what I've done. So, I don't know, it'll be a wake-up call. And I'm probably cursing myself by talking about past performance, because we know it's not indicative of future returns.

JL: Yeah, sure. Although, again, you have a broad enough strategy that hopefully should be adaptive to ongoing market conditions. But yeah, certainly not indicative of future returns and yeah, Merrill Edge is notoriously bad when it comes to this kind of stuff. I can report from firsthand experience also. So when I bought gold for the first time in January, it's an asset I've never touched historically.

But just seemed like the time was right to have some exposure to it and so I was able to buy BAR, which is GraniteShares, Gold ETF lowest cost fund in the space. Again, why would you pay 40 basis points for something that doesn't really produce any interest or anything of that sort? Your cost to hold, it really should be as low as possible.

If you're going to buy an asset like that, again, because you're buying it to smooth out your return path, you're not buying it because you think it's undervalued because there is no way to value something like gold. And I then went into my parents non-tax deferred Merrill Edge account, which I keep an eye on for them to try to buy BAR there also and the thing is just not available, even those $0.5 billion in AUM at the time, I think it's probably well over a billion at this point.

And so, you get locked into buying a higher cost ETF. And I guess, maybe that's in Merrill's benefit, because maybe they take a little bit of that also, or I'm not sure what the…

DB: Yeah, I can give you insights. I mean, there's two reasons for one is, obviously it's pay to play.

JL: Yeah. Okay.

DB: GLD is paid to put that on their platform BAR has yet to do that and…

JL: Yeah you can buy GLD. You can do cheaper than that without going as low as BAR but yes, for sure.

DB: And the second reason is this new compliance regulation called the REGBI, right, best information. And so if they offer BAR to you and Merrill, they have to disclose to all their GLD clients, I'll just pick on GLD, that there's a cheaper alternative. And they have a fiduciary obligation to do that under REGBI. If they don't offer BAR, they don't have that obligation.

JL: Yeah, yeah, that does make sense. Although, again, I guess it's the end investor that ends up paying more for the same exact product.

DB: Yeah, yeah. That's just not the intent to the rule, but it's the unfortunate unintended consequence.

JL: Yeah. Well, the good news is there is choice though, because you can always just open your open an Ameritrade account or a swap account and get your whatever you want, because they don't have to pay to play rules. They're more democratized. And in that regard, the irony is of course, that if you want to buy a triple leveraged or inverse ETF on Merrill Edge they've got no problem with that whatsoever.

Even though one could argue that retail investors have no business touching those products whatsoever. There needs to be some level of training involved. But yeah, so, certainly the conversation for another day but this is the kind of research that if ETF investors are going to take their craft seriously, they really should be looking into what different issuers offer, how soon they're likely to be able to offer new funds that come out whether they're going to ever let certain ones onto the platform, because you end up paying a real cost, just based on which platform you choose.

DB: Yes, I totally agree with you on that. And that's to my larger point, people just do your work. Spend the time understanding what's underlying that particular ETF and its index and what's driving decisions and that information is available. It's transparent, it's out there. So if you do your work, you should be able to get comfortable with the investment selection.

JL: Yeah, definitely. So I'd love to start winding things down by moving the active passive debate beyond U.S. large cap equities, where speed the data and others who have tracked us have just shown no ability for active stock pickers to outperform.

And I'd love to focus on some areas where active management does actually seem to offer outperformance. And again, you could argue looking back five years is obviously not long enough. This is the data that I have open here but I highlighted there are three different slices of the market, where active stock pickers have actually or funds have actually outperformed greatly in some cases, passive equivalence.

And I'm referring specifically to mid-cap growth, small cap growth, real estate and investment grade, intermediate corporate bonds. In some of these cases, for example, mid-cap growth, I think really stands out. Active managers have only underperformed the benchmark S&P mid-cap 400 growth index 35% of the time going back five years. And if you look at this calendar year, only seven -- sorry, if you look at the last 12 months, only 17% of active mid-cap growth stock pickers have underperformed.

So it does seem to be a case of you have the one year the three year the five year and four out of five active pickers are outperforming over the recent period, six or seven out of 10 are outperforming going back five years. And I do wonder what your feeling is about the dynamics here. And the fact that there does seem to be at least some slices of the market.

I don't know if they're less efficient or more open to good research and price discovery, where active managers really do seem to continue to have a leg up on passive equivalence.

DB: Yeah, I think it goes to the efficiency component primarily as the driver for that. It takes me back to the story I shared with you as I started my career, we were just looking for places where inefficient markets existed where folks weren't traveling.

I mean, I didn't tell you what kind of lawyer I was. I was a bankruptcy lawyer. I used to invest in distressed securities. Why because that was the most cowboy market you can have. You had hugely inefficient markets desks on started date myself, but desks on Wall Street did not exist to trade distressed securities at that time. So you had the most inefficient markets.

I think what you've identified here is something that your listeners should be focused on. These markets are less efficient in an environment where things are theoretically becoming more efficient. I'd argue that disruption events going back to my insight, disruption events are going to continue to occur, whether it's a global pandemic or something else, that's going to sort of shake the market up a little bit, because there are some companies prepared and others not.

But if there are segments within the market that are significantly less efficient, where managers can do their work and obviously, they're able to do this by concentration and limiting their investment in a smaller number of securities that if you're -- if you have I'd say most important thing, a good sell discipline, so you know when to get out of something, when you've when you've gotten your performance out of it.

That's a good place for people to go. So, you're onto something that I think, folks should really be paying attention to because I'm going to pay attention to and see if I can figure out a way to make a an X out version of the mid cap growth index.

JL: I think also, particularly because this data is published as of June 30, which means it includes in the case of the S&P 500 a 37% peak to trough sell off from February 19 to March 23 in the case of mid and some small caps, the selloff was obviously even more violent than that.

And I think particularly when you're talking about an index that only rebalances once a year, for example, versus the ability of an active manager in, let's say, the small cap space to say, Okay, I don't like where the global economy is headed. Right now, I'm eliminating any company for my portfolio that has any kind of credit risk, any risk of going belly up. That would have been a hugely outperforming strategy.

Quality obviously killed it, I think it goes a long way towards explaining why the NASDAQ 100 has outperformed the S&P 500 or the Dow Jones Industrial Average as much as it has. Everybody's focused on the growth components of it. Everyone wants to pay for growth in a low growth world or a low yield world.

But I think a lot of it was just a flight to safety to some extent where you look at the balance sheets of some of these companies, the Apples, the Microsofts, the Googles, the Amazons, the Facebooks, and so on. And in a market where the entire world seems to be collapsing and the global economy seems to be going under, investors at some point start thinking about a return of capital and not a return on capital.

And so, there's just a total flight to safety. And again, maybe particularly with small cap and mid-cap growth companies, and I suppose real estate is the other area where it looks like only 20% of active real estate, investors or funds underperformed the broader indexes over that 12 month period, ending in June. Again, the ability to on the fly, just look at what's actually happening does give you somewhat of a leg up over, set it and forget it types of indexes.

Of course, strategy likes like XOUT, because of your focus on growth and the excess capital that's required, for example, to buy your own shares back would have protected you to some extent from a lot of that which I think explains the outperformance there also. But it is a good case in point for places where maybe more intelligent indexes can really do the trick here, or where it does make sense if you want to have that exposure to riskier assets, like small cap stocks.

So it does make sense to maybe have more of an active or less of a traditional just set it and forget it once a year kind of approach.

DB: Yeah, I agree with you. Notwithstanding, it's different than the strategy I'm taking out into the marketplace. But I certainly agree in these less places. And you have to caveat it with real estate might have active outperforming passive, but the outlook for real estate in a post pandemic world is going to be a challenge.

And so, you might get a manager who's going to outperform the benchmark, but the ultimate absolute returns are going to be not so great for a little while, I think. And so, not only -- it shouldn't only be about picking active that outperforms passive, but actually getting -- you want some kind of return on your investment.

JL: Sure, yeah. Again, you could see where somebody who has just a little bit of prescient in terms of their ability to look forward says okay, I'm actively managing the broad benchmark fund, the VNQ or whatever that benchmark is for many people has to buy everything whereas I'm going to heavily underweight mall REITs and overweight ones that are investing in data processing firms.

So, you can kind of I think, figure those things out. But again, you look at the retail space, for example, and indexers have figured that out also so you have all these different indexes that overweight or totally avoid brick and mortar retail and that outperformance has been incredible. And again, there's no human element in the picking there.

They've just set up a rules based index that looks into the future in an intelligent way and is able to capitalize on it without the human bias or error. Anyway, David, this has been -- it's been really awesome. I'm starting to get a bit mindful of your time here. Is there any parting advice you'd like to leave listeners with your before we call it a wrap?

DB: No, I just emphasize my human bias point I think that's critical for folks who are making investment decisions to really dig in deep on that and while you're doing your work which is going to take a long time, because you're going to have to do all kinds of psychological studies. Look at XOUT.

JL: Nice. And you are planning some, I'm sure you can't talk about specifics, but it does sound like you're planning your next moves in terms of additional indexes.

DB: Yes, there is a plan to create a family, if you will, of strategies based on exclusion.

JL: Sure. Another words, allow investors to get their full market exposure and not just be limited to a single slice as they are right now with the strategy.

DB: That's correct.

JL: Nice. One other question, where is the best place for investors to find you online? Should they want to research any of the things we've been talking about today?

DB: Yeah, XOUT has a website, xoutcapital.com. And obviously, GraniteShares also has their own website, and I'm on Twitter, but less so than the President and we also have hyperlinks on our site to our index calculation agent that can give you even more transparency into how we make decisions. So, I suggest people take a look at it and obviously be in touch with me if they have any questions.

JL: Sure. And of course, I would point listeners to Seeking Alpha’s XOUT cool page. Also, we've got six primary ticker articles on it right now, which means articles that focus exclusively on this one fund. So, I think a fair amount of research for a single ETF that doesn't yet have billions of dollars and assets accumulated inside of it.

You want to see the Gretzky picture before I go here?

DB: Yeah, yeah show me.

JL: It’s pretty awesome. Alright, so it's him on the Oilers. And you could see this is a good, I think it's kind of a good metaphor for how he always plays the pockets right ahead of him here. He's, I think about to try to get a shot off on goal.

And he's also about to take a real beating because he's about to get flipped off the guy's back. But you can see that his entire focus is just on the puck and what he's going to be able to do in the next half hour or so, before he gets tossed onto the ice by the guy who's back on. So, yeah, no, I got him to sign it because I didn't get him to sign it. I bought it from other guy.

DB: Okay. That’s great, it's an awesome shot. And it is -- that's funny. I didn't know you had a fan of that. The coolest thing to read about is Malcolm Gladwell when he wrote about him in his book. I think, it's great.

JL: I actually haven't, I've only read one Gladwell book. I read most of his stuff in the New Yorker, although he doesn't really write that much for the New Yorker anymore. But I've read David and Goliath that's the only one I've read. But I blink I hear is really…

DB: It's great. And he does this whole thing about how about Gretzky, and it's -- but it is this thing about how the guy just -- he was different than everybody else. So that's I love using it. And I started -- I've heard other people use it too, but I it just feels right for what I'm trying to do.

JL: Totally. Yeah, it's like, you’re lucky if you get one of those guys in each for you like in your lifetime. Anyway, David, I want to wish you best of luck out there in all your future endeavors, health during the pandemic. Hopefully it'll end soon, but doesn't seem like it's going away all that soon. So, stay safe out there and hope we can do this again sometime.

DB: Jonathan, thank you very much. This was a wonderful experience. I really appreciate it all the time you took with me. Thank you.

Recorded Message: For disclosures, David Barse is Long XOUT. I am long, VOO, QQQ, BAR, and VNQ. If you've been enjoying Let's talk ETFs, you can subscribe on Apple podcasts, Google podcasts, Spotify, or whichever podcast platform you prefer. And if you find this podcast useful, please consider leaving a review on one of those platforms so that other investors can discover it. You can also find this podcast on seekingalpha.com by typing Let's talk ETFs into the search bar at the top of the site.

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Let’s Talk ETFs is Seeking Alpha's podcast dedicated to the exchange traded fund space. Hosted by Seeking Alpha’s ETF expert, Jonathan Liss, the podcast features long-form conversations with industry insiders, ETF issuers, asset managers and investment advisers to explore the ways in which ETFs continue to evolve, helping investors to reach their financial goals.

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