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Are markets broken?

Earlier this month, famed US hedge fund investor David Einhorn gave one of the more fascinating interviews I’ve heard in recent years. For those that don’t know him, Einhorn has run Greenlight Capital since 1996 and is well-known for having shorted Lehmann Brothers prior to the 2008 bust.

In the interview with Bloomberg, Einhorn declares that passive investing has fundamentally broken markets. And that the changes wrought from passive investing have meant he’s had to change his method of value investing to stay in business.

His claim that passive investing is distorting 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. 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 and 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?

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

… And, all of a sudden, the people who are performing are the people who own the overvalued things, that are getting the flows from the indexes, 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 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 that news publications started to question his ability during this time, if not writing him off altogether.

How Einhorn came through this period is instructive. He analysed his period of underperformance and realised that 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 ETFs, there were few buyers for these stocks.

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. 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 market benchmarks.

Passive a goliath in US, not so much in Australia

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.


Source: Morningstar

That’s after passive US equity funds took in US$244 billion in 2023, while active funds had outflows of US$257 billion, continuing a long-running trend.

The relentless growth in passive funds has resulted in the largest ETF and index providers growing into behemoths. Blackrock now has A$14.5 trillion under management, while Vanguard has A$11 trillion.

The growth in passive funds in the US has been mirrored in Australia. Last year, the ETF industry here grew 33% year-on-year to $177.4 billion in funds under management, according to BetaShares.

Yet unlike in the US, ETFs are relatively small fry still compared to active funds. The latter, which include industry funds, retail funds and other fund managers, have funds under management at close to $4.5 trillion, about 25x the size of the ETF market.

And ETF insiders suggest passive ownership of the ASX 200 is close to 10%, a far cry from the larger share it has in the US.

Yet, 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 an increasing 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 individuals.

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 that 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 that active funds have consistently underperformed passive ones over the past 10 years.

It’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. Also, active funds, to keep up with benchmarks and passive funds, are buying into the same stocks.

According to Einhorn, stocks that are outside of benchmarks are 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 in the current market.

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%.


Source: Goldman Sachs

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% annualized, versus small caps’ 208%, or 9% per annum.

The story of large cap outperformance has also been evident in Australia.

The largest stocks have tended to be ‘growth’ stocks, and growth has destroyed value over the past 15 years.

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 that 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 that 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.

Counterarguments to Einhorn

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

There are several potential counterarguments to Einhorn’s assertions that passive investing is distorting markets and prices:

  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. If stock markets and price discovery are becoming less rational, that should help active investors rather than hinder them. If markets are fully rational and price stocks perfectly, there would be no role for active investors.
  3. Indexing may aid price discovery rather than hinder it. For example, it increases the supply of lendable shares and thus enables short selling.

In short, there may be some truth to Einhorn’s complaints though they are likely exaggerated.

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 that 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 managers.

There 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

You must credit Einhorn for changing his investment style to adapt to the changes that he sees in markets. Here was a guy that was 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.

Investors can learn a lot from Einhorn’s objective assessment of his underperformance, the reasons behind it, and changing his investment process and style to address the issues.

 

James Gruber is an assistant editor at Firstlinks and Morningstar.com.au

 

16 Comments
Steve
February 26, 2024

Not sure how strong the argument is when passive has just managed to match active market share? Until very recently there were more funds under active management than passive but the active managers can't turn a trick? And as pointed out, active managers trade much more frequently, so if active managers handle say 80% of all trades and get to choose the prices they buy/sell, how is the market at the mercy of passive funds? Aren't active managers meant to have certain screening criteria to guide their portfolio choices? If passive funds are loading up on the magnificent 7 its because active traders are setting the trend. Lets face it, most active managers hug their index and try to have just a bit on the side for a boost to justify their fees. Just to make matters worse we now have ETF's that have a degree of screening that active managers used to use, such as quality metrics (debt, ROE etc) or equal weighting or the like. Out of interest do such ETF's get classed at active or passive?

SMSF Trustee
February 23, 2024

If they're "broken" for his idea of trading-as-investing then I don't care. But nothing he says tells me that a well managed company that generates growing earnings over time won't also experience share price growth. Which is all that really matters.

Mark Hayden
February 23, 2024

I agree with SMSF Trustee that earnings growth is THE key, and that share price growth will eventually follow (assuming the investor has a long-term focus).

James Gruber
February 23, 2024

I agree, though Einhorm raises some good issues nonetheless

Steve
February 25, 2024

Earnings growth is one thing but market expectation about that earnings growth can drive prices to unrealistic levels not just over the short term.

SMSF Trustee
February 25, 2024

Yes Steve, that's possible. But that's markets working as they always have, not evidence of markets being broken.
That said, please provide some examples of companies which have not generated earnings growth and yet whose share price has risen over the long term (by which I mean 10 years or more). It just doesn't happen.

Steve
February 26, 2024

SMSF Trustee, I did not say markets were broken. That's the proposition put forward by the author. I agree that is the function of markets - price discovery. I don't disagree with your proposition over a ten year period.
Unfortunately, these days most peoples attention span is not that long and more so when it comes to investing. The focus is increasing on price not value. I find it mildly amusing that people say they invest for the long term but watch markets on a weekly basis. You have to understand what game you are playing. Investing is not a passive game.

Chase R
February 26, 2024

Steve,

The author didn't say markets are broken, David Einhorn did.

SMSF Trustee
February 26, 2024

Steve that's my point. Who cares if people wanting to punt short term market direction find it harder to do that? I'm in stocks in my fund for at least 10 years.
So I've got no idea why you jumped on my comment with your remark about prices getting out of whack with earnings. They don't over time.
And I watch the markets very regularly because when things do get out of whack I'll buy more or take some profits. Lo g term investing doesn't mean you go to sleep at the wheel.

Cornish
February 23, 2024

Markets aren't really broken. Beating them has always been a game that inspires new strategies. As long as they aren't fraudulent, they're essentially legitimate.

A more fundamental problem is that we've lost sight of the way they were set up and how they've always worked: https://www.youtube.com/watch?v=tYWI2cAjQdA&t=833s

Considering Book Value and dividend returns has always made sense. And active trading has always been a game of musical chairs.

Mark Hayden
February 23, 2024

An important quote from Ben Graham - in the long run it is a weighing machine. I also note that hedge funds don't consider the long run, but that article was useful. Einhorn says he is now getting the returns directly from the company. I describe that part as the return from the economy; which, in the long term, forms the majority of the return.

James Gruber
February 23, 2024

Hi Mark,

Thanks for the comments. I'd add that Ben Graham wasn't a buy-and-hold forever type, as he bought undervalued stocks and liked to sell them 3-5yrs later, exactly like Einhorn used to do. Einhorn is saying that strategy doesn't work anymore and that the stock market isn't a weighing machine. It's a flow machine, thanks to passive investing.

The performance of small and mid caps over the past 15yrs supports his view. Though perhaps the weighing machine will reassert itself at some stage. Time will tell.

Steve
February 26, 2024

SMSF Trustee, I did not say markets were broken. That's the proposition put forward by the author. I agree that is the function of markets - price discovery. I don't disagree with your proposition over a ten year period. Unfortunately, these days most peoples attention span is not that long and more so when it comes to investing. The focus is increasing on price not value. That will change in time. I find it mildly amusing that people say they invest for the long term but watch markets on a weekly basis. You have to understand what game you are playing. Investing is not a passive game.

Guy
February 22, 2024

It strikes me that the only real way for active managers to compete with passive ETF's is to list a version of their active funds on the stock exchange. This at least would give self directed investors the opportunity to purchase their funds without the large sums associated with wholesale offerings and without the ridiculous paper work associated with unlisted funds.
It would then be a relatively simple task for investors to do their research and purchase the funds which best suit their needs.

Stuart Morrow
February 22, 2024

I know that another well known investor, Rob Arnott, suggests that even if passive investors become 90% of the market, that there will still be the change for active managers to outperform. Yet, as Ben Inker in another article in this edition points out, if passive crowds into a handful of stocks, it's almost impossible for active managers to outperform when that happens.

As Inker hints at, a shakeout in passive will come once market cap indices start to outperform equal weighted ones, and active managers again have their day in the sun.

Let's hope the shakeout doesn't get disorderly.

ruth from brisbane
February 25, 2024

Stuart Morrow and others
I think they will want an orderly shakeout.
I recall 1987 with 'portfolio insurance'; how decent people put their funds into super while they worked and lost it all as their so-called adviser sold out just before the Fed unleashed one of their games. Funds in Australia were charging 8% for their services.
I also recall 2008.
If passive is too big, would you tell me how active managers cannot outperform in such an environment? Their algos can tell how much is invested and in what to the date in advance. If they are so good, they would outperform in such an environment and keep their secrets. There are a few decent advisers who exist, but they do not advertise.
Increasingly, investment is done via private equity, with funds not handicapped by ESG rubbish convinced that a necessary trace gas CO2 (0.04% of atmosphere) needed for plants to breathe is a poison. A company board must be composed of individuals who know the business. Unfortunately, the powers that be have closed off all opportunity to markets that matter, such as Russia's, going through an early birth of capitalism again and which I believe to be excellent value, Latin America, and oil and gas.
If you actually support yourself or intend to, we must put up with endless iterations of changes to our savings in superannuation. The purpose of superannuation was made clear: to make Australians wealthy and attract capital to the country for business investment so that real jobs could be created, yet all I see is reiterations of 'the purpose' which seems to me to make it compulsory, delay the age at which you can access it, and lock up your own savings for life, as it is a perfect way to fleece you, whether you like it or not.
In addition arguments about the 'ceilings' are frustrating. We were in a disinflationary period for 40 years. We have entered an inflationary period, most likely for the next 40 years, and guess what we are in WWIII. I remember RBLs; disbanded as too complex; this system's new proposals are even more complex.
It seems like $3 million is a lot. I promise you it will not be in 10 years' time. Anyone with a memory of the '70s will tell you, although to me the period is more like the late '30s and we know how that worked out.

 

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