Passive Investing has broken the Market?

Three weeks ago David Einhorn was a guest on the Masters in Business Podcast:

“Market structures are broken and value investing is dead. That’s the view from David Einhorn. On this episode, the president of Greenlight Capital sits down for a wide-ranging discussion with Bloomberg Radio host Barry Ritholtz“.

I will go fast. Einhorn became famous, and rich, managing a value-style hedge fund: long undervalued companies and short overvalued ones. After some years, his strategy stopped working. Once I listened to a podcast when a bond investor (I do not recall the name but I recall really well where I was when I heard it. The human brain is a fascinating machine) said: “I like bonds because I do not need the market to prove me right, I just need time”. It is true: if you buy a stock that you think is undervalued, you need someone else to buy it after you, and drive the price higher, in order to realise a gain (at least in the short to medium term). With bonds, barring a default, you know exactly your payoff day: the bond maturity.

During the podcast, Einhorn laments that markets are broken and value is dead because there is no one left willing to buy after he did and drive stocks towards their “fair value” (or sell overpriced stocks). Passive investors are the designated market (and value) assassins. By steering flows towards large caps, they make them even bigger: this generates a cycle where value stocks get even more depressed (at least in relative terms) -> value managers’ performance gets worse -> investors move out of value funds into passive funds -> value stocks go even lower -> rinse and repeat.

After a slump, Einhorn’s performance dramatically improved because he changed his investment style; instead of buying undervalued stocks that needed other investors to increase in value, he buys stocks with great free cash flows to price ratio. This way, the stock itself generates the payback for David through a combination of dividends and buybacks. He now assumes the market does not exist, he has to hold his positions forever and be paid only by the profits generated by his holdings. Assuming he’s buying very low P/FCF because the market does not care anymore, he can repay his investments in less than a decade.

In reality, few names meet that criteria today but there would be more in the future, if his theory is correct. The podcast left me with an okkkkkkkkkk feeling: active managers exploit market inefficiencies and it is normal to see markets adapt, or in this case simply change. Why crying? That’s the rule of the game, innit?

David is fine, he is making profits again. The more interesting part is what it means for all other, and in particular passive, investors the fact that markets are broken (if they are).

Another voice that concurs with David is Michael Green, Portfolio Manager and Chief Strategist at Simplify, who recently joined the Excess Returns podcast to express his view (to be fair, other infamous names in finance like Cliff Asness and Larry Swedroe share the opposite opinion, in case you want to go into this rabbit hole). I’ll report a mix of Michael’s points and my comments.

Spoiler alert: after watching the video, my conclusion didn’t change. But I think Micheal raised very interesting topics.

In academic literature, originally, a passive investor was defined as an entity that never transacts, they hold every security in the market (author: Bill Sharpe). But this is not what happens in reality and what is generally referred to as a passive investor, otherwise Meb Faber’s $GAA would have a trillion in AUM. The closest version to this definition is an investor that holds something like VT (here you can find my opinion on market-cap weighted indexes) but even VT has to transact from time to time when the index changes or rebalances. Passive investors who do not transact simply do not exist.

Index funds are active funds (even if we all know there is active and active) because they receive new investment flows every day and they have to transact to allocate those flows. What I’d call “passive” from now on is rising 3% / year and it currently represents 44% of the market. Flows that must transact on index rebalancing days/week should be around 40% of the total flows.

According to Green, they became so large, and their process so systematic, that markets are indeed broken (he “discovered” it in 2016): he sees market dynamics he never saw before. What are the rules by which they engage the markets? “Passive” do not want to transact in a discretionary manner, therefore the market becomes “gappier” because it is less liquid: I have to look further and further for a counterparty that wants to transact with me. “Passive” is blind and immune to the signals that the market sends them.

Green raises the great point that asset managers use(d) to see cash as an asset they could hold: if they receive an inflow, they at least look(ed) at the market before deploying it. Any cash allocation might represent a potential performance drag but the attitude is (was) different from a blind push on the buy button. And if you buy (pun intended) the theory that active underperforms “passive” because of the higher fees, then that discretionary activity was both beneficial for the market (they provide liquidity when needed) and the fund itself (if the underperformance is less than the fees).

If the majority of active managers would create noise, i.e. non-alpha generating trading, at least that noise might cancel out: some managers are buying while others are selling. “Passive” generates noise always in the same direction.

Problem #1: Lack of Liquidity

The less liquid a market is, the higher the chance a random event would lead to a snowballing catastrophe.

Not only “passive” does not trade in a discretionary manner but, Green says, market makers have fewer incentives to provide liquidity to large caps because bid/ask spreads are lower and trading volumes do not compensate for that.

I have mixed feelings about this last point for two reasons:

1. if market makers do not engage in certain stocks, it means they are liquid enough by themselves, at least in normal times. This is good. And it is not a given that a market maker would still be there, for any stock, in a time of crisis. There is actually good evidence about the contrary: if volatility grows, market makers step away.
2. we heard the same concern when banks were prevented by regulation to warehouse bonds while acting as dealers. Even at the peak of the Covid-crisis, bonds and bond ETFs traded fine. “Yes but the FED had to step in” the more attentive might argue: true but that’s what you would expect in that situation…no?

The fact that markets are becoming more susceptible to fast melt-downs (or melt-ups) is something also Cem Karsan mentions often, albeit for different reasons (0DTE options). At this point I’m telling myself: does it matter anymore why it will happen? The “why” is above my pay grade, the relevant part is to be ready for it. Especially if, as we will see later, there is not much we can do about it.

Were active managers stepping in front of a selling wave doing the best thing for their investors? Are we simply longing for useful idiots that are no more?

Problem #2: The Creation of a Bubble

Markets are reflective: “passive” behaviour changes the behaviour of the market. “When you start assuming that the asset class itself has an embedded return that is distinct and separate from the fundamentals, you are naturally changing the behaviour of the market itself” (Michael Green).

“If everyone is pushing one way, you better take that trade. It doesn’t have anything to do with fundamentals, is supply and demand” (Cem Karsan).

Both Green and Karsan agree that the rise of “passive” increases the probabilities of bubbles, both short and long-term. It makes the market more irrational.

According to Green, markets are getting inelastic, meaning that changes in demand drive big changes in prices. If before $1 of demand ($1 added to the market) was creating $5 of market cap, now $1 of active creates $2 of market cap but $1 of passive creates $17 of market cap (these are Green numbers): it is extremely inflationary. This is because of the imbalance between offer and demand.

What about the wisdom of the crowds? Aren’t “markets” supposed to be the best system to find the right estimate / equilibrium point? The issue with the Grossman-Stiglitz paradox is that it assumes all the participants have the same means, the same amount of money. The wisdom of crowds requires everybody to have the same vote (and hold diverse opinions). When passive is 40%, you break the wisdom of crowds (here is where Green disagrees with Swedroe). The market is not efficient anymore and prices are wrong.

The increase in market cap for most stocks is not related to fundamentals. According to Green, examples like Google, where the price rose X.000% but also earnings increased X.000%, are just cherry-picking. The bigger the stock, the more inelastic its price to demand is. As a professional, you cannot avoid being allocated to Apple if you want to mimic the SPY returns (but you can avoid Delta Airlines, for example). Money managers are not allocating to achieve great performances, they allocate first to avoid getting fired. As Chuck Prince, the infamous CitiGroup CEO, said “When the music plays, you gotta dance”.

And the only way to beat this market, Green and Karsan contour, is levered beta. When we risk a bubble, this is like pouring gas on fire. No one wants to short this market, the mechanism by which some bubbles were averted in the past, because…$GME anyone?

“Each person being “passive” is rational but all of them doing the same becomes the issue”

It is like pollution (or as Green put it, defecating in the street), good for me but bad for society. This is why I think this issue is really interesting. Our individual inability to stomach tracking error makes the issue even worse. There are (rational) alternatives but who has the gut to take them and stick with them?

Money managers might be aware of running towards a cliff but, as with any bubble, it is really hard to say when the music is gonna stop: they cannot sit out too early or they risk losing their job.

According to Green, passive is a free ride that is not sustainable. He uses the metaphor of Web2.0, if you are not putting in the work and you are not paying, you are the product. But I think it refers to it as you cannot expect to extract high returns from passive indexes without the associated massive volatility and crashes. That’s the cost of passive: systemic risks.

The active comeback

Einhorn agrees that at a certain point, this becomes good for fundamental investors. “Passive” being dismissive of fundamentals creates great opportunities -> active managers overperform -> active grow vs passive -> sucker managers launch their active funds -> passive outperform active -> rinse and repeat.

Also, the fable of that being 100% allocated to stocks is fine will be burned in public (and digital) squares. The appeal for different asset classes will surge, nature will heal.

What I am reading now:

Follow me on Twitter @nprotasoni