In a recent interview with Bloomberg, Greenlight Capital founder David Einhorn explains how passive investing broke the stock market.

Investing Legend David Einhorn: Passive Investing Broke the Stock Market

David Einhorn, founder and portfolio manager of Greenlight Capital, is well-known for speaking out on major issues affecting the financial markets. He called out Lehman Brothers questionable accounting practices in 2008 and wrote a book on the shenanigans at Allied Capital.

In a recent interview with Bloomberg, Einhorn detailed how the mass adoption of passive investing has destroyed price discovery in the U.S. stock market.

 

 

David Einhorn: Passive Investing Broke the Stock Market

Einhorn says, “When I say that the market is broken, what I’m saying is, there is not enough money that is being dedicated to investing, trying to identify undervalued companies, and reward companies with new capital that have good opportunities for growth, and to punish companies that don’t have such good situations, because the professional industry of figuring this stuff out has largely been eradicated. And so, the main problem that comes from that is that you just wind up with index funds or other strategies, they are just going to buy whatever is the most overvalued thing because that gets the biggest weight in the index. So new money comes in and overvalued [stocks] become more overvalued and undervalued [stocks] become more undervalued and values actually diverge from fair value rather than come to fair value.”

Consequences for Corporate Governance

“But, there’s other ramifications of that. Once you have the largest shareholder in every major important company be a passive fund, shareholder activism becomes nearly impossible to improve corporate governance, because if you go to one of these index funds and you say, “I have an idea for how this company can improve that will make the stock price go up.” They just kind of look at you and say, “Well, we want all of the stock prices to go up.” And they don’t have anybody in those proxy departments who even know how to value a company, let alone vote index shares in that kind of way.”

Dearth of IPOs

“Another thing that’s come is obviously the IPO market. The S&P is making highs, right? We are in a favorable economic environment, yet where is the IPO market? Why aren’t companies able to become public? And the reason is, companies used to do these things called roadshows, and they would come to these managers, these long-only managers. And they would say, “Hi, I’m the midcap manager of the such-and-such fund, would you like to buy my new stock?” And if that person isn’t there or they don’t have any money, there is no one to buy that stock. So you have a closed IPO market.”

With more and more investors indexing, fewer portfolio managers are setting prices. This causes the market to be less efficient, as prices only reflect blind inflows from passive funds into float-adjusted marketcap-weighted indices.

Essentially, indexing is a big Ponzi scheme that will end in chaos.

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