The Rise of Passive Investing and Its Impact on Active Money Managers
Hedge-fund titan David Einhorn warns of a broken market as passive investing gains momentum
The dominance of passive investing has become a cause for concern among active money managers, who argue that the rise of algorithmic trading and index funds has fundamentally altered the market landscape. David Einhorn, a prominent hedge-fund manager, recently voiced his concerns about the impact of passive investing on the value industry. In an interview with Barry Ritholtz, Einhorn highlighted the challenges faced by active managers and the potential consequences of the relentless growth of passive investment strategies.
The Broken Market: A Shift from Value to Price
Einhorn argues that the markets are fundamentally broken due to the overwhelming influence of passive investing. He suggests that passive investors, who do not consider value but rather focus on price, assume that other investors have already done the work of valuing securities. This lack of consideration for value has led to a significant decline in the value industry, as more money flows into passive funds. This vicious circle is perpetuated by value managers being forced to sell their holdings, causing value stocks to decline further and triggering more redemptions.
Divergence from Value: The Effect of Passive Investing
As money continues to flow from active management to passive strategies, the divergence from value becomes more pronounced. Einhorn explains that the best-performing assets are often the overvalued ones that receive flows from index funds. Active managers participating in this part of the market then buy more of these overvalued assets, exacerbating the divergence from value. This structural change in the market means that being overvalued can actually be beneficial for a stock, as it attracts flows from passive investors.
Adapting to the Shift: Greenlight’s Approach
Einhorn acknowledges that Greenlight, his own hedge fund, took some time to adjust to the shift towards passive investing. However, the fund has made significant changes to its investment strategy. Instead of paying 10 times earnings for a stock with the expectation of a 15% improvement in earnings, Greenlight now looks for similar opportunities at four or five times earnings. This shift reflects the market’s apathy towards earnings improvements, as passive investors do not pay attention to such details. By investing at a lower multiple, Greenlight aims to benefit from the potential returns generated by companies with strong balance sheets that can buy back their stock.
The Changing Landscape: Passive Investing Surpasses Active
Passive investing has reached a significant milestone, with passive exchange-traded funds and mutual funds surpassing active funds in terms of assets under management. This shift highlights the growing popularity of passive strategies among investors. However, Einhorn’s cautionary words serve as a reminder that active management still has a role to play in identifying undervalued opportunities and generating alpha.
Conclusion:
The rise of passive investing has disrupted the traditional market dynamics and posed challenges for active money managers. David Einhorn’s concerns about the broken market and the impact on the value industry shed light on the potential consequences of the relentless growth of passive investment strategies. While passive investing continues to gain popularity, Einhorn’s adaptation to the shift and his emphasis on finding undervalued opportunities demonstrate that active management can still thrive in this changing landscape. As investors navigate the complexities of the market, a balanced approach that incorporates both active and passive strategies may be the key to long-term success.