Problems with Passive, Problems with Active

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Alpha Architect dropped a post about this theory that had me spiraling (in a good way). It took me a couple of read-throughs and a lot of head tilts, but once the dots connected… it clicked.

The central concept is that individuals have a preference for simplicity when making choices under risk. The author develops an axiomatic theory showing how simplicity affects decision-making, and highlights its distinctive predictions compared to standard risk models.

Aside from the theory, the model and the demonstration, it all makes sense:

• Risk premia: As the complexity of a gamble increases, while key statistical moments remain constant, participants demand higher risk premia (i.e., require more compensation to accept the risk).
• Dominance violations: People are more likely to violate stochastic dominance in complex settings.
• Participants’ choices align with the core axioms of the simplicity theory.
• Complexity aversion varies across individuals and is correlated with cognitive ability.

I landed on this paper because asset managers have a great difficulty building products that reduce risk using diversification while keeping the product simple. Take the Golden Butterfly as an example. If I show only the portfolio risk/return profile, many would be happy with it. But the moment I show you what’s inside, the questions start:

• Wait. 20% gold? Are you serious?
• Factors? They do not work anymore…
• Long-duration bonds? Did you SEE 2022?

and let’s not even talk about managed futures or leverage.

All of a sudden, the portfolio that looked so appealing becomes “too complicated.” The diversification that’s supposed to reduce risk adds perceived risk just because it’s harder to explain.

Contrast that with something like SPY. One ticker. One idea. “Own the market.” It’s simple, it’s familiar, and after 20 years of mostly going up, few people even question it anymore.

Structured products enter the chat

And now I’m confused. Because everything I just said? Goes out the window.

We know people don’t like complex stuff. But buffered ETFs in the US? Certificates in Europe? These things are like financial casseroles made with 9 ingredients and a sprinkle of derivatives. And people are eating them up.

Where is the simplicity bias now?

These products are objectively complex. They involve options strategies, path dependency, conditional payoffs. But they’re framed in a way that feels simple:

“If the market doesn’t fall more than 25%, you get 9%”
— people are like “oh that makes sense.”

That’s it. That’s the pitch. And people buy it.

There’s no digging into how the options work. No stress about what’s under the hood. No questions about what the catch might be. Just an easy-to-digest promise that fits neatly into a mental model.

Is it just really good marketing?

The kind that smooths over the actual contents so well that investors don’t want to look under the hood?

Or is this a different kind of investor?

Not the passive-index-only crowd. But the “I found JEPI” people.

“It’s low risk and pays income. I did my research (i.e., watched two YouTube videos and read the fact sheet).”
They feel like they understand it, and that’s what matters.

Maybe what’s happening here is that there are actually two kinds of simplicity:

1. True simplicity: like a low-cost index fund or a one-fund portfolio.
2. Perceived simplicity: a product that’s complex underneath but feels simple on the surface.

And there’s a group of investors who love that second category. Certificate investors hold the same vibe, they know there’s risk. But they feel like they can outsmart it, they believe they can find the right one: the product with the right buffer, the right stocks, the right conditions. There’s a confidence that they can “shop smart.”

“This one has a barrier at -40% and it’s linked to 3 ‘safe’ stocks. I’m chill.”

Again: it’s not actual simplicity. It’s the confidence of perceived control. It is the “This is easy!” crowd:

They’re not passive purists. They don’t want to dig into option pricing models. But they want something that sounds sophisticated and feels smart, without feeling risky.

You could wrap SPY + GLD into a black box, slap some bells and whistles on it, call it “Strategic Income Shield” or something, and probably raise a billion:

But if I told investors exactly what it was, just SPY and gold, a lot of them would lose interest.

The perception of risk matters as much as the risk itself. And as investors, we’re not just making decisions based on spreadsheets, we’re making decisions based on what feels understandable, comfortable, and aligned with our identity.

Sometimes, the best strategy is boring. And most of the time boring is the hardest thing to sell.

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It’s been like two years since I first listened to Mike Green talking about the distortion of the passive flows on stock prices (and wrote about it).

In this interview, he adds many interesting points:

Let’s start with something that seems structurally broken: Treasury bonds and how they get treated inside passive indices. These indices, market-cap weighted in spirit, reward governments for issuing more debt. The more they borrow, the more they dominate the index. It’s like designing a merit system that gives more credit to people for being more in debt. Absurd, but accepted.

The strangest part is that these passive structures still outperform the vast majority of active managers. Despite the structural inefficiency baked into their DNA, the act of trying to outsmart the bond market, by predicting interest rates or credit spreads, remains largely an exercise in futility. Unless, of course, you’re a Reddit oracle posting under a username like NancyPelosiRuinedWhiteMenLives, in which case maybe you have access to some ‘higher-order insight’. But that’s probably a different kind of story…

But this is where things start to bend in interesting ways. The structure, the passive, rule-based, unthinking mechanism of index construction, has consequences that ripple outward. When the Fed began hiking rates, it wasn’t just a macro signal. It became a sorting algorithm. Bonds issued during the ultra-low-rate window between 2015 and 2022, bonds with modest coupons and once-respectable yields, were suddenly marked down. And in the land of bond ETFs, that meant even more crowding into the short end of the curve, where the new, high-yielding paper lives. Simply because a higher price means a higher “market-cap”.

Mike Green points out that this behavior, mechanical and rule-following, has a strange side effect: it blunts the Fed’s (already limited) ability to influence the long end of the curve. Policy tries to lean in one direction, but the flows pull the other way.

Theoretically, the Fed could use this dynamic to its advantage. It could step in, buy those discarded low-coupon bonds at a discount, reissue them at higher rates, and then begin to lower interest rates. A clean reset. A kind of monetary judo move, using the market’s inertia against itself. A manipulation to lower the US debt burden.

But this isn’t just about bonds. The same passive gravity pulling bond prices into strange orbits affects even more speculative assets: Bitcoin, for instance. What drives Bitcoin’s price more than anything else isn’t innovation or adoption in the traditional sense. It’s flow. It’s who’s buying. And increasingly, that buyer is an ETF.

There’s now a direct link between ETF holdings and Bitcoin’s price. The more Bitcoin ETFs accumulate, the more the price rises. But this isn’t really about conviction, it’s about inclusion. Model portfolios go from a 0% Bitcoin allocation to 1%, then 2%, and suddenly an asset that was once fringe becomes institutional. It’s not adoption in the technological sense, it’s adoption in the spreadsheet sense.

And what’s really wild is that this recursive demand loop, the one that pushes Bitcoin higher because it’s being added to portfolios which assume it’s going higher, mirrors the behavior of the same financial system Bitcoin was built to critique. Born out of the ashes of the Great Financial Crisis as an anti-capitalist response, it is now deeply embedded in the same machine. The chart goes up not because there is value, but because value is being assumed.

And this idea of value, how it’s assigned, how it’s defended, how it’s prolonged, leads us into the murky waters of private equity. Historically, the exit strategy in private markets involved returning to public markets. You bought a company, fixed it up, and sold it to public shareholders who believed in the narrative. But that narrative arc is changing.

Now, private vehicle A can sell to private vehicle B, often run by the same asset manager. No need for public validation. No need for price discovery. Just new marks, new valuations, and an internal transaction that allows the game to continue. It’s a closed loop system: a house of mirrors where the image of value bounces around without ever being tested. Add private credit to the mix, also from the same manager extended to the same company owned by the same manager, and you get maturity extensions, debt restructurings, and performance fees built on numbers no one challenges.

The illusion can go on for decades. No one has to prove anything, as long as the cash flows look decent on paper and the IRR models behave. It’s passive in a different way.

Passive isn’t just an index construction method anymore. A way to get cheap beta exposure. It became a philosophy. It actually makes a lot of sense that the passive worries would become greater in these corners of the market. If the issue for public markets was “who’s going to do the homework?”, assign the right price to each asset, who is going to do that for Bitcoin? Who is going to short it when it became too risky to short small stocks that are already, officially, bankrup (Hertz anyone?)?

Maybe one day someone will find a clever way to short private equity fund holdings 🙂

What I am reading now:

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