Passive Investing = Broken Markets. Discuss.

In
an
interview
with

Bloomberg,
Einhorn
declares
passive
investing
has
fundamentally
broken
markets,
and
that
the
changes
it
has
wrought
mean
he’s
had
to
change
his
method
of
value
investing
to
stay
in
business.

Does
Passive
Investing
Distort
Markets?

The
claim
that
passive
investing
distorts
markets
isn’t
new.
Active
managers
have
long
complained
about
the
issue.
Yet
Einhorn
makes
some
important
observations
about
how
he
thinks
indexing
is
changing
the
structure
of
markets:

“There’s
all
the
machine
money
and
algorithmic
money
[…]
which
doesn’t
have
an
opinion
about
value,”
he
says.
“It
has
an
opinion
about
price.”

“Like
what
is
the
price
going
to
be
in
15
minutes?
And
I
want
to
be
ahead
of
that
or
zero-day
options.
What
is
the
price
of
the
S&P
or
whatever
stock
you’re
doing
for
today,
what’s
it
going
to
be
in
the
next
half
hour,
two
hours,
three
hours?

“Those
are
opinions
about
price.
Those
are
not
opinions
about
value.
Passive
investors
have
no
opinion
about
value.
They’re
going
to
assume
everybody
else’s
done
the
work,
right?”

Of
active
management,
Einhorn
says
this:

“And
then
you
have
all
of
what’s
left
of
active
management
and
so
much
of
it,
the
value
industry
has
gotten
completely
annihilated,”
he
continues.

“So,
if
you
have
a
situation
where
money
is
moved
from
active
to
passive,
when
that
happens,
the
value
managers
get
redeemed,
the
value
stocks
go
down
more,
it
causes
more
redemptions
of
the
value
managers,
it
causes
those
stocks
to
go
down
more.

“All
of
a
sudden,
the
people
who
are
performing
are
the
people
who
own
the
overvalued
things,
that
are
getting
the
flows
from
the
indices,
that
are
getting
you
take
the
money
out
of
the
value,
put
it
in
the
index,
they’re
selling
cheap
stuff
and
they’re
buying,
you
know
whatever
the
highest
multiple,
most
overvalued
things
[…]
in
disproportionate
weight.

“So,
then
the
active
managers
who
participate
in
that
area
of
the
market
get
flows
and
they
buy
even
more
of
that
stuff.
So,
what
happens
is
instead
of
stocks
reverting
toward
value,
they
actually
diverge
from
value.
And
that’s
a
change
in
the
market
and
it’s
a
structure
that
means
that
almost
the
best
way
to
get
your
stock
to
go
up
is
to
start
by
being
overvalued.”

How
Passive
Changed
a
Business
Model

How
Einhorn
has
adapted
to
the
changes
in
markets
is
intriguing.
Einhorn
had
a
fantastic
track
record
in
the
almost
20
years
to
2015.
Then
he
had
two
awful
years
and
three
mediocre
ones.
Some
of
you
may
recall
news
publications
started
to
question
his
ability
during
this
time,
if
they
didn’t
write
him
off
altogether.

How
Einhorn
came
through
this
period
is
instructive.
He
analysed
his
period
of
underperformance
and
realised
he
had
continually
bought
cheap
stocks
and
when
these
stocks
handily
beat
earnings
estimates,
they
weren’t
being
re-rated
by
the
market.
Because
they
were
outside
of
indices
and
not
included
in
exchange-traded
funds,
there
were
few
buyers.
This
happened
often
enough
that
it
made
him
change
his
investment
style.

“What
we
have
to
do
now
is
be
even
more
disciplined
on
price,”
he
says.

“So,
we’re
not
buying
things
at
10
times
or
11
times
earnings.
We’re
buying
things
at
four
times
earnings,
five
times
earnings,
and
we’re
buying
them
where
they
have
huge
buybacks,
and
we
can’t
count
on
other
long
only
investors
to
buy
our
things
after
us.

“We’re
going
to
have
to
get
paid
by
the
company.
So
we
need
15-20%
cash
flow
type
of
type
of
numbers.
And
if
that
cash
is
then
being
returned
to
us,
we’re
going
to
do
pretty
well
over
time
[…]
you’re
literally
counting
on
the
companies
to
make
that
happen
for
you.”

Since
Einhorn
has
made
these
changes,
he’s
gone
back
to
handily
beating
the
benchmarks.

Passive
a
Goliath
in
US,
Gaining
Ground
in
UK

Einhorn’s
comments
raise
several
important
questions
about
today’s
markets.

There’s
little
doubt
that
passive
investing
is
growing
quickly
and
taking
market
share
from
active
funds.
Last
month,
for
the
first
time,
passively-managed
funds
in
the
US
controlled
more
assets
than
did
their
actively
managed
competitors.
In
the
UK
the
world
of
active
management
still
dominates,
but
is
under
no
less
pressure
to
demonstrate
its
worth.

For
instance,
the
Morningstar
Active
Passive
Barometer
report
showed
last
year
that,
in
an
environment
where
active
managers
really
should
have
proved
their
worth,
their
efforts

amounted
to
nothing
other
than
a
blatant
failure. 

The
relentless
growth
in
passive
funds
has
resulted
in
the
largest
ETF
and
index
providers
growing
into
behemoths.
Blackrock
now
has
the
equivalent
of
£7.4
trillion
under
management,
while
Vanguard
has
the
equivalent
of
£5.6
trillion.

Further
growth
in
passive
funds
seems
likely,
with
investors
attracted
to
the
simple
and
low-cost
access
that
ETFs
provide
to
markets,
as
well
as
their
performance
versus
active
funds.

The
Other
Big
Market
Trend

Along
with
the
rise
of
passive
funds,
there’s
also
been
the
institutionalisation
of
markets.

In
the
US,
professional
money
managers
accounted
for
10%
of
share
ownership
after
the
Second
World
War.
That’s
risen
to
close
to
67%
today.
It
means
that,
in
the
1940s
and
1950s,
active
fund
managers
had
far
fewer
direct
competitors –
their
main
competitors
were
private
citizens.

Professional
fund
managers
are
hired
and
fired
according
to
how
they
perform
compared
to
benchmarks.
As
passive
funds
pile
into
the
stocks
included
in
benchmarks,
it’s
likely
active
managers
are
being
forced
into
buying
into
the
same
stocks
to
keep
up
with
these
benchmarks.
If
they’re
buying
into
the
same
stocks
as
passive
funds,
and
charging
higher
fees
to
clients,
it
isn’t
a
surprise
active
funds
have
consistently
underperformed
passive
ones
over
the
past
decade.

That’s
why
Einhorn
is
complaining
that
passive
funds
are
breaking
markets.
He’s
saying
individual
investors
are
fleeing
into
passive
funds,
and
these
funds
are
buying
stocks
included
in
indices,
which
are
principally
the
larger
companies.
And
they
are
doing
that
automatically,
without
regard
to
price.
To
keep
up
with
benchmarks
and
passive
funds,
active
funds
are
then
buying
into
the
same
stocks.

According
to
Einhorn,
stocks
that
are
outside
of
benchmarks
are
then
being
ignored
by
individual
and
professional
investors.
Even
if
these
stocks
are
undervalued
and
their
fundamentals
are
improving,
there
are
few
(if
any)
buyers
for
these
companies.

Are
Einhorn’s
Concerns
Valid?

There
is
some
anecdotal
and
academic
evidence
to
support
Einhorn’s
claims.

For
instance,
it
does
seem
larger
cap
stocks
are
getting
more
investor
love
than
at
any
time
in
recent
history.
Late
last
year,
Goldman
Sachs
did
a
study
that
found
the
S&P
500
is
more
concentrated
than
it’s
ever
been.
The
average
weight
of
top
10
stocks
in
the
S&P
500
index
has
been
20%
over
the
past
35
years.
During
the
dot-com
bubble,
the
combined
weight
of
top
10
stocks
peaked
at
25%.
Today,
the
figure
stands
at
32%.

That’s
led
to
significant
outperformance
from
large
cap
stocks
versus
small
caps.
Last
year,
US
large
caps
returned
26.2%
compared
to
US
small
caps’
16.8%.
Since
2011,
large
caps
there
have
returned
382%,
or
13%
annualised,
versus
small
caps’
208%,
or
9%
per
annum.

There’s
also
academic
evidence
that
backs
some
of
Einhorn’s
assertions.

In
a
2022
paper

How
Competitive
is
the
Stock
Market?, UCLA’s
Valentin
Haddad
and
colleagues
found
the
rise
of
passive
investing
was
distorting
price
signals
and
pushing
up
the
volatility
of
the
US
market.

The
paper
examined
institutional
investors
and
concluded
the
rise
of
passive
investors’
share
of
the
US
market
over
the
past
two
decades
“has
led
to
substantially
more
inelastic
aggregate
demand
curves
for
individual
stocks,
by
15%.”
Passive
investors
have
a
demand
elasticity
of
zero,
because
they
automatically
buy
stocks
without
regard
to
whether
it’s
cheap
or
not.
If
a
stock
is
cheap,
demand
from
passive
investors
won’t
increase.

In
theory,
that
should
mean
other
investors
step
in
to
make
up
the
demand
shortfall
in
stocks,
but
the
paper
suggested
that
hadn’t
happened.

What
Are
The
Counterarguments
to
Einhorn?

The
anecdotal
evidence
mentioned
above
is
just
that,
however:
anecdotal.
The
academic
evidence
is
also
relatively
new
and
untested.

There
are
several
potential
counterarguments
to
Einhorn’s
assertions.
They
include:

1.
The
influence
of
passive
funds
on
market
prices
may
be
less
than
claimed.

Passive
funds
typically
have
low
turnover,
of
10-20%
each
year.
That
compares
to
active
funds
of
+50%.
Trading
sets
prices,
and
therefore
the
influence
of
passive
investing
on
pricing
may
be
overstated.

2.
Irrational
stock
markets
should,
in
theory,
help
active
investors.

If
markets
are
fully
rational
and
price
stocks
perfectly,
active
investing
would
be
redundant.

3.
Indexing
may
aid
price
discovery
rather
than
hinder
it.

For
example,
it
increases
the
supply
of
lendable
shares
and
thus
enables
short
selling.

The
Danger
of
Passive
Investing
for
Markets

Nonetheless,
Einhorn
is
right
to
point
out
the
changes
that
passive
investing
is
bringing
to
markets.
If
passive
investors
are
crowding
into
the
large
cap
stocks
that
dominate
indices,
and
active
investors
are
mimicking
them
to
keep
up
with
performance
benchmarks,
it’s
logical
the
reverse
can
happen
too.
That
is,
in
a
market
downturn,
there
may
be
a
rush
for
the
exits
as
both
passive
and
active
investors
get
out
of
large
cap
stocks.
This
may
become
even
more
of
an
issue
as
passive
funds
continue
to
take
market
share
from
active
peers.

There
also
hasn’t
been
a
real
test
of
this
sort
for
passive
investing.
That
said,
markets
did
remain
relatively
orderly
in
2022
when
they
were
hit
hard.
A
larger
market
downturn
would
be
a
real
test
for
passive
investing
and
the
changes
it’s
made
to
markets.
Whether
it
leads
to
a
shakeout
in
passive
funds
is
also
an
open
question.

Investors
Can
Learn
From
Einhorn

Whatever
your
view,
you
can
credit
Einhorn
for
changing
his
investment
style
to
adapt
to
the
changes
that
he
sees
in
markets.
Here
was
a
guy
known
as
one
of
the
best
hedge
fund
investors
in
the
world
going
through
an
extended
rough
patch.
He
could
have
easily
doubled
down
on
the
strategy
that
had
brought
him
results
and
fame
over
the
previous
years.
Instead,
he
questioned
that
strategy
and
decided
to
change
tack.

It
would
have
been
a
big
risk
to
change
investment
style
at
that
time.
He
was
under
a
lot
of
pressure
from
his
clients
and
the
media.
If
it
went
wrong,
he
would
have
looked
foolish,
and
it
might
have
been
game
over
for
his
fund.
Instead,
it
helped
him
turn
things
around.

This
article
was
originally
published
on
our
Australia
site
and
has
been
edited
for
UK
readers

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