What happens when most investing is passive?

David Einhorn on new inefficiencies in markets

David Einhorn is a hedge fund manager who rose to prominence by successfully shorting Lehman Brothers before the 2008 crash. He’s also played poker at the highest levels and seems very smart and thoughtful.

In this recent interview he talks about how markets have changed as passive, index-based investing (Vanguard, Wealthfront etc) has captured more and more of the money flowing into the stock market, at the expense of active strategies and specifically “value investing,” the Warren Buffett-esque method of investing in individual companies that are undervalued by the market.

Einhorn came up largely as a value investor, who made money by doing lots of research, finding a company trading at a modest price, and then selling it once the company outperformed and the market caught up to the company’s quality and the stock traded up.

He argues that today, nobody is paying attention to smaller public companies because so much money has shifted to passive investing and the value investing industry has lost a lot of its capital. So, even if a small company does well and grows its earnings, nobody is paying attention enough to bid up the price.

Passive investing strategies favor the most highly valued companies because those companies make up the majorities of an index (for example, Apple may make up ~7% of the S&P 500). So if money is flowing to passive strategies, these valuable companies will continue to get more valuable, and the smallest companies will underperform. The flows to passive investing cause a divergence in outcomes in the market, a “winner take all” dynamic.

Einhorn struggled with this dynamic, underperforming during the mid-2010s. He would find stock ideas that were good, the company would announce strong earnings, but the stock price wouldn’t move substantially: “no one was paying attention” to take the other side of the trade. Now he has changed his approach and the fund is focusing on opportunities where it doesn’t need to rely on other investors bidding up the price of the stock, but instead the companies themselves can make the investments worthwhile — either by issuing dividends or by buying back their own stock.

Thinking about this is funny because it feels like the market should be self-correcting. But Einhorn doesn’t believe that it is; the volume of money flowing to passive is so large that it crowds out the “smart money” doing the work on valuing individual companies.

I don’t know what this means for most of us who are putting money into passive index funds but it feels like something will have to change in markets over the next decade as more and more money moves into passive strategies.