Prominent hedge fund manager David Einhorn of Greenlight Capital exposes how index funds have broken the stock market and impaired price discovery.

David Einhorn Exposes the Major Problems With Passive Index Funds

Greenlight Capital founder and prominent value investor David Einhorn cogently exposes the flaws inherent in index investing in his latest quarterly letter to shareholders. At the heart of the problems with passive investing is the simple algorithm that governs how funds are allocated. If the end investor gives cash to an index fund, that fund must buy all the stocks in its designated index in proportion with its float-adjusted market capitalization. Very simply, this means that the stocks of larger companies, like Amazon and Microsoft, get the bulk of the new money, while smaller companies only get a small fraction.

Einhorn shows how this simple, dumb model can lead to illogical consequences that would make any rational investor investor doing basic security analysis scratch his head in disbelief.

Greenlight Capital Q1 2024 Letter: David Einhorn Exposes the Major Problems With Passive Index Funds

Einhorn explains in his letter:

Imagine you have two companies and they are both worth $1 billion on a fair-value basisbut one is valued by the market at $500 million and the other one at $2 billion. When a market-capitalization-weighted index fund gets $5 to invest in those two companies, it will put $4 in the $2 billion company and only $1 in the $500 million company. The overvalued stock get 4X the the new investment. As a result, it then outperforms while the undervalued company underperforms.

In this way, index investing is a momentum strategy. The stocks that have done well continue to do well, while the stocks that have done poorly continue to do poorly. This flies in the face of decades of market history, where there is typically a reversion to the mean function that ties stock prices back to intrinsic value based on profitability.

Einhorn continues with a terrific example of how intelligent investors are giving up because the undervalued stocks they uncover do not get recognized by the market:

The problem is compounded when the new money invested in the index is the result of a redemption from an active manger trying to invest in undervalued securities. Imagine that the $5 came from a professional manager who correctly understood the stock was undervalued and which was overvalued and had deployed $4 into the undervalued stock and $1 into the overvalued stock.

When that manager is redeemed from, and the funds are reinvested in an index fund, the undervalued stock experiences $3 of net selling (a $4 sale and a $1 buy), while the overvalued stock experiences $3 of net buying (a $1 sale and a $4 buy). Rather than converging to fair value, the result is that the two stock diverge even further from fair value.

As several trillion dollars have bee redeployed in this fashion in recent years, it has fundamentally broken the market, according to Einhorn and also many academic studies.

You can read the Greenlight Capital Q1 2024 letter here:

As index funds continue to gain share at the expense of active management, these issues will only get worse. However, at a time when the job market appears to be deteriorating, white collar employment is a very important metric to watch, because a big portion of inflows into index funds come from 401(k) contributions from workers’ paychecks. If layoffs increase significantly, this will put major pressure on inflows into Vanguard, Blackrock, and State Street and could bring about the passive investing endgame.

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