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David Einhorn: Passive Investing Breaks Markets, Fundamentally

  • The rise of passive investing
  • The impact on active money managers
  • The vicious circle in the value industry
  • Adjustments made by Greenlight Capital
  • Opportunities for investors in the current market

Introduction

Hedge-fund titan David Einhorn has voiced his concerns about the state of the markets, claiming that they are fundamentally broken due to the growing dominance of passive investing. In an interview with Barry Ritholtz, Einhorn highlighted the challenges faced by active money managers and the detrimental effects on the value industry. This article delves into Einhorn’s insights and analyzes the consequences of passive investing on the market.

The Rise of Passive Investing

Einhorn argues that passive investing has gained significant traction in recent years, driven by the rise of machine and algorithmic money. Passive investors focus solely on price movements, rather than the underlying value of assets. This shift has created a market environment where value is no longer a consideration for most investment money.

The Impact on Active Money Managers

As money flows from active management to passive strategies, value managers face redemptions, leading them to sell their holdings. This selling pressure causes value stocks to decline further, triggering more redemptions and exacerbating the situation. Consequently, the active managers who perform well are those who own overvalued assets receiving flows from index funds.

The Vicious Circle in the Value Industry

Einhorn describes a vicious circle where money is taken out of value stocks and allocated to index funds. This results in active managers buying more overvalued assets, diverging further from value. The structural changes in the market have made it more profitable for stocks to start overvalued rather than revert to value. The value industry has suffered significant losses as a result.

Adjustments Made by Greenlight Capital

Greenlight Capital, Einhorn’s firm, has made significant changes in response to the rise of passive investing. They no longer pay high multiples for stocks based on expected earnings growth, as passive investors do not notice or care about such improvements. Instead, Greenlight Capital focuses on undervalued assets with low leverage, allowing them to benefit from potential stock buybacks and price appreciation.

Opportunities for Investors in the Current Market

Einhorn suggests that investors can now find similar scenarios to the ones Greenlight Capital previously pursued at lower earnings multiples. By investing in companies with strong balance sheets and low valuations, investors can count on potential stock buybacks or price appreciation to drive returns. This shift in market dynamics presents new opportunities for those willing to navigate the broken markets.

Conclusion

The rise of passive investing has fundamentally changed the market landscape, posing challenges for active money managers and the value industry. David Einhorn’s insights shed light on the structural issues faced by investors. However, by adapting their strategies and focusing on undervalued assets, there are still opportunities for investors to thrive in the current market environment. Share your thoughts on passive investing and its impact on the markets in the comments below.

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