The Rise of Passive Investing: A Threat to Active Money Managers?

Hedge-fund titan David Einhorn discusses the challenges faced by active money managers in the era of passive investing.

Hedge-fund manager David Einhorn recently expressed his concerns about the rise of passive investing, arguing that it has fundamentally changed the dynamics of the market. In an interview with Barry Ritholtz on the “Masters in Business” podcast, Einhorn highlighted the impact of passive investing on the value industry and the vicious circle it creates. As more money flows into passive funds, active managers are forced to deal with redemptions, leading to the sale of their holdings and further declines in value stocks. This, in turn, triggers more redemptions and exacerbates the problem. Einhorn’s remarks shed light on the challenges faced by active money managers in an increasingly passive-dominated market.

The Annihilation of the Value Industry

Einhorn argues that the rise of passive investing has resulted in the decimation of the value industry. He attributes this to the fact that passive investors have no opinion on value; instead, they focus solely on price. Algorithmic trading and machine-driven investing dominate the market, prioritizing short-term price movements rather than long-term value. This shift has created a vicious circle where value managers face redemptions, leading to the sale of their holdings and further declines in value stocks. As a result, active managers who participate in this part of the market face inflows and end up buying overvalued assets. This divergence from value undermines the traditional principles of investing and challenges the role of active management.

Adapting to the Changing Landscape

Einhorn acknowledges that his hedge fund, Greenlight, has had to adapt to the changing market dynamics. They can no longer rely on paying 10 times earnings for a stock and expecting a multiple expansion based on improved earnings. With the rise of passive investing, there is a lack of attention and apathy in the market, making it difficult for such strategies to succeed. However, Einhorn suggests that there are still opportunities to profit from undervalued stocks. Investors can now find similar scenarios at four or five times earnings, allowing for potential cash returns and stock buybacks. By counting on the companies themselves to drive the stock price higher, rather than relying on other investors, Einhorn believes there is still room for active managers to generate returns.

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The Growing Dominance of Passive Investing

Passive investing has been steadily gaining popularity, with passive exchange-traded funds and mutual funds surpassing active funds in terms of assets. This milestone reflects the growing preference for low-cost, index-tracking strategies. However, it also raises concerns about the potential impact on market dynamics and the role of active money managers.

Conclusion:

The rise of passive investing has undoubtedly reshaped the investment landscape, posing significant challenges for active money managers like David Einhorn. The dominance of passive strategies has led to the annihilation of the value industry, as algorithmic trading and machine-driven investing prioritize short-term price movements over long-term value. However, Einhorn remains optimistic, suggesting that there are still opportunities for active managers to profit from undervalued stocks. As the market continues to evolve, it is crucial for investors and fund managers to adapt to these changing dynamics and find innovative ways to navigate the new investment landscape.