The Rise of Passive Investing: Hedge Fund Titan David Einhorn Warns of Broken Markets
In a recent interview with Ritholtz Wealth Management co-founder Barry Ritholtz, hedge-fund titan David Einhorn expressed his concerns about the current state of the markets. According to Einhorn, the rise of passive investing has fundamentally broken the markets, making it increasingly difficult for active money managers to thrive.
Einhorn argues that passive investors, who make up a significant portion of the market, have no opinion about value. Instead, they focus solely on price and aim to be ahead of the market movements in the short term. This lack of consideration for value has had a detrimental impact on the value industry, which has been “completely annihilated” as a result.
The shift towards passive investing has created a vicious circle for value managers. As money flows out of active management and into passive funds, value managers are forced to deal with redemptions. In order to meet these redemptions, they sell their holdings, causing the prices of value stocks to fall even further. This triggers more redemptions and perpetuates the cycle.
Furthermore, as money flows into passive funds, the assets that receive the most attention and inflows are often overvalued. Active managers participating in this part of the market then buy more of these overvalued assets, leading to a divergence from value rather than a reversion towards it. This structural change in the market means that being overvalued is now almost a prerequisite for a stock to go up in value.
Greenlight Capital, Einhorn’s hedge fund, has had to adjust to this shift in the market. They are no longer willing to pay 10 times earnings for a stock with the expectation of a 15% improvement in earnings. The rise of passive investing means that there is now “complete apathy” in the market, with fewer investors paying attention to earnings. As a result, Greenlight Capital is now able to find similar investment opportunities at four or five times earnings, allowing them to profit from the same situation.
Einhorn emphasizes that investors can now rely on the companies themselves to drive the increase in stock prices, rather than depending on other investors. If an investor pays four to five times earnings for a company with a healthy balance sheet, the company should be able to return cash and buy back 10% to 20% of its stock. This, in turn, will lead to a decrease in available stock or an increase in price over time.
The rise of passive investing has been significant, with passive exchange-traded funds and mutual funds surpassing active funds in terms of assets. According to Morningstar, this milestone was reached in 2023. However, despite the dominance of passive investing, value stocks have still managed to perform relatively well. The iShares S&P 500 Value ETF, which tracks the S&P 500 Value Index, has seen a 0.8% increase so far in 2024, while the S&P 500 has rallied by 4.8%.
In conclusion, David Einhorn’s warning about the broken markets due to the rise of passive investing raises important questions about the future of active money management. As more investors flock to passive funds, the value industry has suffered greatly. However, Einhorn suggests that there are still opportunities for savvy investors who are willing to adapt to the changing market dynamics. By focusing on undervalued stocks and companies with strong balance sheets, investors can still find profitable investments in this new era of passive investing.