Acquired
03:19:39 · David Rosenthal, Ben Gilbert
[03:19:39] S1: So Market size unconstrained. [03:19:41] S0: It is truly market size unconstrained. You know, think of the largest markets in the world, transportation, housing. This is maybe bigger than any of that. It's a little bit of a crazy thought exercise. So it's not constrained by addressable market. It's it just scales so elegantly other than customer service. It it just doesn't require any additional dollars of cost to serve additional customers and additional revenue. So in theory, a few index funds should continue unabated to scale and own basically everything. [03:20:17] S1: Yep. And we're well on our way to that happening. [03:20:20] S0: Yeah. So here's the stats on it. Thirty five years ago, only 1% of the market was passive. It's now more than 20% of the S and P 500. And a couple of years ago, passive assets in funds overtook active assets in funds for the first time. That that just happened where passive funds eclipsed active funds. So the concern that people have is a few fold based on this. One is there's not enough active traders in the market to accurately discover price. If we're all trusting that the index is gonna buy things at the correct price, you do need active managers to buy and sell to set the price. [03:20:58] S1: Yeah. And the associated criticism of passive, which I think Jack would readily acknowledge is, hey. We're free riders here. Right. We're getting all of that price discovery and price information that the active guys are doing just for free.
03:20:58 · David Rosenthal, Ben Gilbert
[03:20:58] S1: Yeah. And the associated criticism of passive, which I think Jack would readily acknowledge is, hey. We're free riders here. Right. We're getting all of that price discovery and price information that the active guys are doing just for free. [03:21:11] S0: I don't buy this argument. Like, I'm I'm not concerned in any way about this. I think if you had 95% passive, the prices are set by the marginal trader. Right. You don't need very many people in there arguing with their dollars about what something is worth to figure out what it's worth. [03:21:29] S1: Yep. And the profit opportunity from arbitraging Right. Is so great, and that profit opportunity becomes greater as this problem, quote, unquote, gets worse. So, like, the right market balance will figure itself [03:21:44] S0: out here. There is an equilibrium. Long before we get to that problem, you'll have arbitragers that are interested in trading because it's profitable that you're right. It'll hit an equilibrium. At least that's my my perspective on this. The other concern is, well, all these companies now have the same shareholders. Apple, Microsoft, Google, it's all 20% plus. These big [03:22:05] S1: Vanguard, Fidelity, BlackRock, State
03:22:05 · David Rosenthal, Ben Gilbert
[03:22:05] S1: Vanguard, Fidelity, BlackRock, State [03:22:06] S0: Street, etcetera. So why would they compete if, let's say, that 20% goes to 50% or 80%? Shouldn't the owners go tell the CEOs, hey. You guys should just collude and keep prices high. Let's reap in the corporate profits. Let's screw over the American public, the customers, and let's all just make a lot of money together. This also seems a bit far fetched. Right. It it sounds provable in an academic thesis, and then you, like, get actually out in the real world and you talk to some CEOs. Do you think the CEO of any company is is gonna stop competing with their biggest competitor in a fierce battle because an index fund manager [03:22:46] S1: common ownership in index funds? No. [03:22:48] S0: There's just no way. [03:22:49] S1: Yeah. I do think the more legitimate concern version of this is voting and and Yes. Shareholding and, like, sort of being being active shareholders and holding management to account.
03:22:49 · David Rosenthal, Ben Gilbert
[03:22:49] S1: Yeah. I do think the more legitimate concern version of this is voting and and Yes. Shareholding and, like, sort of being being active shareholders and holding management to account. [03:23:02] S0: And right now, it's actually pretty interesting. The way that each of these companies and each of these funds handles how to vote the shares of the index funds is all over the board. Some of them literally let individual index holders vote on individual issues. That's incredibly rare. Usually, what they say is, I wanna pick one of these five options and vote with management, with the majority, with a set of ESG guidelines, and you can kinda that that's the common thing. Most of the times, it's suggestions of how should we vote the shares. But I get where you're going that the fund manager of, let's say, one of these Vanguard or BlackRock grows to be, I don't know, 60% ownership of every company in America. Suddenly, they have voting control over those companies, and it's a big responsibility to decide how they're gonna vote those. [03:23:50] S1: Right. Or or in aggregate, you know, a set of three or four of these large index funds and then their fund holder base, which is the American public. It's like we've turned the board of directors of every company into an election on the order of, like, a, you know, US political election. [03:24:09] S0: That's funny. It turns every corporate governance issue into the court of public opinion. Yeah. Like, how does the American public feel about this?
03:24:09 · Ben Gilbert, David Rosenthal
[03:24:09] S0: That's funny. It turns every corporate governance issue into the court of public opinion. Yeah. Like, how does the American public feel about this? [03:24:17] S1: Which I have no idea if that's a good or a bad thing, but it's certainly not how corporate boards have operated in the past. [03:24:24] S0: I will say this 20% is a little misleadingly low because thanks to direct indexing and people constructing their own portfolios that look like indexes but aren't actually in index funds, the passive ownership in companies could be more like 30 to 40%. [03:24:41] S1: Mhmm. [03:24:42] S0: But the people that are direct indexing or or creating the mirror portfolios, they're not in funds. So you don't really have to worry about how the the funds are voting. But it does impact those people aren't trading. Those people aren't participating in price discovery. That's just passive ownership of everything. [03:24:56] S1: Yep. Yep. So At the end of the day on all of this stuff, I think these are some issues that will get magnified and need to be worked out, but none of them feel like, hey. Real existential threats to me to passive. [03:25:11] S0: Yeah. Totally agree. Alright. Should we do our seven powers analysis? [03:25:16] S1: Let's do it. Seven powers. This will be fun because, you know, Hamilton Helmer's definition of seven powers is what enables a firm to earn sustainably more profits than their closest competitors. And, well, Vanguard, by its very nature, earns no profits.
03:25:16 · David Rosenthal, Ben Gilbert
[03:25:16] S1: Let's do it. Seven powers. This will be fun because, you know, Hamilton Helmer's definition of seven powers is what enables a firm to earn sustainably more profits than their closest competitors. And, well, Vanguard, by its very nature, earns no profits. [03:25:35] S0: Right. We're gonna have to sort of adapt the definition of seven powers to really align with more of its spiritual goal. [03:25:41] S1: Why do 50,000,000 people have $12,000,000,000,000 with this business? [03:25:45] S0: Yeah. Maybe it can be expressed through market share instead of through the sum of profits. [03:25:50] S1: Yeah. Why is Vanguard the market share leader in mutual funds and index funds? [03:25:54] S0: Because you can't really talk about it in terms of theoretical profits, because the only thing that earned them the right to exist is not generating profits. So if they were to recognize their theoretical profits, then they may not exist at all, at least historically. Yep. So you sort of have to do the analysis based on market share rather than on trying to estimate what their theoretical profits would be. [03:26:15] S1: Yep. And maybe one little twist on this that we can keep in mind as we go is a question I was asking through the research of what's to stop another idealistic young person from coming along and saying, I also don't care about profits, and I am also going to start another Vanguard and compete with them.