The Rise of Passive Investing and Its Impact on Active 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 growing dominance of passive investing, stating that he believes the markets are fundamentally broken. In an interview with Barry Ritholtz on the “Masters in Business” podcast, Einhorn argued that passive investors, who simply track indexes and do not actively evaluate the value of stocks, are causing significant disruptions in the market. This shift towards passive investing has had a detrimental impact on the value industry, leading to a vicious cycle that further exacerbates the challenges faced by active managers.

The Broken Market:

Einhorn highlighted the fact that most investment money today does not consider value as a crucial factor. Algorithmic trading and machine-driven investments focus primarily on price movements rather than the underlying value of assets. This lack of consideration for value has resulted in the annihilation of the value industry, making it increasingly difficult for active managers to generate returns.

The Vicious Cycle:

As money flows from active management to 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 decline further. This triggers more redemptions, creating a self-perpetuating cycle. As a result, the stocks that perform well are the overvalued assets that receive flows from index funds. The active managers participating in this part of the market then buy even more of these overvalued assets, leading to a divergence from value.

The Changing Nature of the Market:

Einhorn emphasized that this structural change in the market means that being overvalued is now one of the best ways to see a stock’s price rise. Greenlight, Einhorn’s hedge fund, has had to adjust to this shift by making significant changes to its investment approach. They can no longer rely on paying 10 times earnings for a stock and expecting earnings to improve by 15% in order to make a profit. With the rise of passive investing, there is a lack of attention and apathy towards such improvements. Instead, Einhorn suggests that investors can now find similar opportunities at four or five times earnings. If the balance sheet is not heavily leveraged, the company should be able to return cash and buy back a significant portion of its stock, leading to potential price appreciation in the future.

Conclusion:

The rise of passive investing has undoubtedly posed challenges for active money managers like David Einhorn. The shift towards passive strategies has disrupted the traditional dynamics of the market, leading to a decline in the value industry and a vicious cycle of redemptions. However, Einhorn believes that there are still opportunities for active managers to profit by adapting their strategies to the changing market landscape. By focusing on undervalued stocks with the potential for significant returns, active managers can navigate the challenges posed by passive investing and continue to generate alpha for their clients.