David Einhorn on the Broken Market: Value Investing’s Slow Descent and the Rise of Passive Investing
Veteran hedge fund manager David Einhorn, in a recent CNBC interview at the Delivering Alpha event, reiterated his long-held concerns about the state of the market, particularly the struggles faced by value investors amidst the dominance of passive investing. He highlighted the “secular destruction of the professional asset management community,” blaming the rise of passive index funds and their inherent disregard for **fundamental valuation** as a key driver of this trend. This article delves into Einhorn’s critique, exploring the underlying dynamics of the market shift and the implications for both active and passive investors.
Key Takeaways:
- Value investing struggles: David Einhorn highlights the ongoing decline of value investing, attributing it to the rise of passive investing strategies.
- Passive investing’s dominance: The increasing dominance of passive index funds is cited as a major factor distorting market valuations, favoring growth stocks over value stocks.
- Market distortions: The focus on earnings growth is creating a market where companies manage expectations, leading to overvalued stocks trading at exorbitant multiples.
- Active management underperformance: Active managers, including those focused on value, have struggled to outperform benchmarks for years, partly due to higher costs and intense competition.
- The “Free Rider” Argument: While passive investors benefit from the price discovery efforts of active managers, the question remains whether this is a valid criticism given the clear advantages of low-cost passive investing.
- Record High Valuations: Despite the high valuations, Einhorn isn’t necessarily bearish, suggesting that an overvalued market doesn’t automatically translate to an imminent market downturn.
The Secular Decline of Value Investing
Einhorn’s central argument revolves around the perceived “broken” nature of the market, a theme he’s consistently highlighted this year. He believes this brokenness stems largely from the overwhelming influence of **passive index funds**, such as those tracking the S&P 500. Einhorn contends that because the S&P 500 has exhibited a strong growth tilt in recent years, due largely to the dominance of technology stocks, index investors inadvertently prop up growth stocks at the expense of undervalued companies. He explains, **”The passive people, they don’t care what the value is.”** This, he argues, leads to market distortions where growth stocks command excessive valuations based on expectations rather than true underlying value.
The Gamification of Market Expectations
Einhorn further criticizes the excessive focus on **earnings growth**, describing a system where companies repeatedly “beat and raise” expectations, maintaining high valuations even when growth rates are modest. He observes, **”They beat and they raise, and they beat and they raise, and they’re pretty good companies, and the next thing you know, they’re trading at, you know, 55 times earnings, even though they’re growing [at] GDP plus two [percentage points] and something like that.”** This, he believes, is a “gamification” of the market, driven by the mechanics of the current market structure, causing significant pain for value investors.
The Logic of Passive Investing and the Underperformance of Active Management
While Einhorn’s concerns resonate with many value investors, it’s crucial to acknowledge the broader context. The recent switch towards passive investing isn’t entirely irrational. **Passive funds offer lower costs**, and decades of data show that active managers, far more often than not, fail to outperform their benchmarks. The S&P SPIVA U.S. Scorecard, a significant benchmark study, revealed that 87% of large-cap fund managers lagged their benchmarks over a 10-year period.
This underperformance isn’t simply a value-investing specific crisis. Rob Arnott, chairman of Research Affiliates, notes: **”Value stocks have been getting cheaper and cheaper relative to their underlying fundamentals, while growth stocks have been commanding richer and richer valuation multiples.”** Arnott suggests high costs and intense competition among active managers contribute greatly to this underperformance. He emphasizes the importance of costs, explaining that **”If indexers own the market… then active managers must have lower returns because their fees and trading costs are higher.”** He uses a particularly blunt metaphor: **”A winning active manager has to have a losing active manager on the other side of their trades. It’s like looking for the sucker at a poker game.”**
The “Free Rider” Argument Reexamined
Einhorn, and others, often argue that passive investors are “free riders,” benefiting from the price discovery efforts of active managers without paying the costs of fundamental research. However, Arnott correctly points out that this observation, while technically true, isn’t particularly insightful. He stated**,”So what? It’s a cop-out to blame index funds and their customers, because – from the customer’s perspective – why should an investor NOT index?”** The logic is irrefutable: lower costs and consistently superior returns for passive investors make it a rationally appealing strategy.
The Most Expensive Market Ever, But Not Necessarily A Bear Market
Despite characterizing the current market as **”the most expensive market of all time,”** Einhorn notably refrains from declaring himself outright bearish. He acknowledges the high valuations but suggests this doesn’t automatically predict an imminent downturn. He states, **”An overvalued stock market is not necessarily a bear market and it doesn’t necessarily mean it has to go down anytime soon. I’m not particularly bearish; I can’t really see what’s going to break the market at this time.”** This nuanced perspective highlights the complexity of predicting market movements, particularly in an environment characterized by historically high valuations and rapidly evolving investment strategies. The fact that value stocks have drastically underperformed growth stocks over the past 15 years, with the iShares S&P 500 Growth ETF (IVW) outperforming the iShares S&P 500 Value ETF (IVE) significantly during that time, further underscores the challenges faced by value investors and the need for alternative strategies to achieve long-term outperformance.
