Hedge-fund titan David Einhorn recently expressed his concerns about the current state of the markets, stating that he believes they are fundamentally broken. In an interview with Barry Ritholtz for his "Masters in Business" podcast, Einhorn discussed the challenges that active money managers face due to the unstoppable rise of passive investing.

According to Einhorn, passive investors do not consider value when making their investment decisions. Instead, they rely on algorithms and machine-driven strategies that focus solely on price movements. This lack of consideration for value has led to the marginalization of the value industry within the investment landscape.

The consequences of this shift are far-reaching. As more money flows into passive investments, active managers who specialize in identifying undervalued stocks are forced to deal with increasing redemption requests. To meet these demands, they are compelled to sell their holdings, causing the value stocks to decline further. This downward spiral perpetuates itself as the continuous selling triggers more redemptions.

Ironically, those who benefit from this pattern are the investors who own overvalued assets receiving inflows from index funds. As money is withdrawn from value investments and allocated to passive index funds, active managers purchase more of these overvalued assets, exacerbating their overvaluation.

Consequently, stock prices stray further away from their underlying value. Rather than reverting towards fair value, stocks diverge from it, creating a market structure where being overvalued is often rewarded with share price appreciation.

Einhorn's view paints a bleak picture for active money managers and underscores the challenges they currently face in a market dominated by passive investing strategies. The implications of this trend are significant and raise questions about the long-term viability of traditional active management approaches.

It remains to be seen how the industry will adapt and respond to these shifting dynamics. However, one thing is clear - the rise of passive investing continues to reshape the investment landscape, challenging the traditional notions of value and active management practices.

Embracing Change: Einhorn's Shift in Investment Strategy

The shifting landscape of the investment world has prompted Greenlight, a prominent firm, to make significant changes, according to its founder, David Einhorn.

In the past, Greenlight readily paid 10 times earnings for stocks that demonstrated a potential 15% improvement in earnings. This strategy allowed the firm to capitalize on a 13-times-earnings multiple, enabling them to generate a substantial 50% return over an 18-month period. However, with the advent of passive investing, this approach has become less effective.

Einhorn explains that in today's market, there is a prevailing "complete apathy" towards noticing improvements in earnings. As a result, few investors will pay attention, leading to limited buying and minimal interest. Consequently, Greenlight no longer needs to pay such high multiples. A similar situation can now be found at four or five times earnings. By investing at this lower valuation and ensuring a balanced balance sheet, companies can return cash and repurchase 10% to 20% of their stock. This approach provides two potential outcomes: either the company will exhaust its stock or the price will rise in the years to come.

This revised investment strategy places greater emphasis on the active role companies play in boosting their own stock value. Rather than relying on external investors, Einhorn believes success hinges on the companies themselves taking necessary steps.

In a groundbreaking development, passive exchange-traded funds and mutual funds surpassed active funds in terms of assets in 2023, as reported by Morningstar.

Currently, the iShares S&P 500 Value ETF (IVE) - which closely follows the S&P 500 Value Index - has gained 0.8% since the beginning of 2024. In comparison, the S&P 500 index has experienced a more substantial rally with a 4.8% increase and achieving its eighth record close this year. In 2023, the value ETF outperformed the S&P 500 by rising 19.9% versus a 24.2% rise for the broader index.

As the investment landscape continues to evolve, Einhorn's adaptive approach serves as a testament to the need for change in order to thrive.

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