The Market Structure That Now Controls Asset Prices w/ Michael Green

Quick Overview

Michael Green asserts that the structure of market trading has fundamentally shifted from being dominated by active management (80% in 1995) to being driven by passive index trading and systematic algorithms (only 7% active management in 2022), which forces market makers to hedge passively, leading to massive inflows into index funds and potentially distorting asset prices, as seen with Tesla's pre-inclusion surge in the S&P 500.

Key Points: Trading composition drastically shifted: Active Management dropped from 80% of total trading in 1995 to just 7% in 2022. Passive index trading and systematic trading now account for the majority of market activity in 2022, with Systematic Trading at 17% and Passive Index Trading at 17%. The growth of passive investing forces market makers to hedge their derivative positions by transacting in the underlying stock, leading to forced buying/selling that impacts prices. Michael Green cites the example of Tesla soaring prior to its S&P 500 inclusion, noting that index rebalancing forced vehicles to transact, resulting in massive, algorithmically driven flows. The massive inflow of capital into index funds (estimated at $850 million per day into the S&P 500) means that index-driven flows are now the largest source of trading. The premise of passive investing—that you don't pay for execution—is false, as market makers are paid through Payment for Order Flow (PFOF) to facilitate these trades, often leaving retail traders exposed.

Context: Michael Green of Simplify Asset Management discusses the profound structural changes in market trading composition since 1995, referencing an academic paper by a partner at AQR, Lasse Heje Petersen, which analyzed the shift away from discretionary active management toward systematic and passive trading strategies. This shift has major implications for how asset prices are determined and how liquidity functions in the market, particularly regarding forced hedging by market makers.

Detailed Analysis