(Bloomberg) — David Einhorn put it bluntly: The damn valuation boom in passive investing has ‘fundamentally broken’ markets as it continues to crush Wall Street’s centuries-old hunt for cheap stocks – year after year.
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According to the famous hedge fund manager, the explosion of index tracking flows is putting so many active investors out of business that the quiet era of Warren Buffett and Benjamin Graham defending undervalued companies is no more. And it compromises everything from price discovery to corporate governance. “Passive investors have no opinion on value,” Einhorn said on Barry Ritholtz’s Masters in Business podcast in February.
The Greenlight Capital founder’s views come at a time when cheap stocks are lagging behind high-growth tech companies like never before, just as passive assets are outpacing their active counterparts. After two banner years for his fund, Einhorn’s views constitute a criticism rather than a lament, given his optimistic talk that there’s still a way to make high-value investing work.
Yet it reignites the broader debate over the market disruption caused by the Big Passive, a frenzy once described as “worse than Marxism.” But has the reaction gone too far? Maybe. Here’s why many professionals say the indexing boom — far from breaking things — is still having a modest impact on the stock-picking environment, citing largely business-as-usual data on valuations and stock returns.
Disappearing value
First of all, the 55-year-old value manager’s central assertion – that it’s a tough time for adherents of the old-school style of investing – rings true. Back then, investors could score big gains by getting good deals across the board. However, for more than a decade, this strategy has repeatedly failed for the majority of managers.
An index of value stocks, those ranked low in metrics such as price-to-earnings or book value, has lagged the benchmark Russell 1000 for almost two years since 2012. Compared with faster-growing stocks, the value fell earlier this year to a record low, thanks to a profit boom sparked by artificial intelligence fervor.
For people like Einhorn, the hidden hand of passive money is largely to blame for all of this. Since new money goes to index vehicles, cash automatically goes after winning stocks. Latecomers, who are therefore often cheap, are rejected. According to the view, this creates a vicious cycle in which value managers fail to deliver on their promises, cash is withdrawn and stocks fall even further.
Indeed, the population of actively managed funds dedicated to value investing is shrinking. The number of mutual funds and ETFs focused on this style peaked at 1,082 in 2015 and has since fallen 15%, according to data compiled by Bloomberg Intelligence mutual fund analyst David Cohne.
Even stock-picking professionals with a broader mandate have bought into the idea that bargain hunting today is largely a…
