The Passive Investing Paradox: Opportunities vs. Systemic Risks
The Passive Investing Paradox: Opportunities vs. Systemic Risks
On closer scrutiny, it turns out that many of today's problems are a result of yesterday's solutions. - Thomas Sowell
by Pierre Daillie, Managing Editor, AdvisorAnalyst.com
The 2008 financial crisis is a prime example of how solutions implemented in the past can lead to significant problems in the future. This crisis was rooted in a series of financial innovations and regulatory changes that were initially designed to expand homeownership and stimulate economic growth. These solutions, however, over time, created vulnerabilities that contributed to the financial meltdown.
The rise of passive investing since has dramatically reshaped financial markets, leading to a range of perspectives from prominent investors and analysts. David Einhorn and Michael Green are two such figures who have voiced concerns about the implications of passive investing, particularly regarding market efficiency, pricing distortions, and systemic risks. While they share some common ground, their perspectives also contrast in significant ways. This piece explores their views, drawing on direct quotes and references from their conversations, here, and here, with Barry Ritholtz on the Masters in Business Podcast, their papers, other interviews and letters, and lightly, further examines how these perspectives connect and contrast with other industry voices like Vincent Deluard, Larry Swedroe, and Patrick Cairns.
For those of you who aren’t familiar with the back story on the extraordinary fundamental analyst, long-short portfolio manager and founder of Greenlight Capital, David Einhorn, here is some background. He is renown for the following:
Allied Capital Short Bet
Einhorn is well-known for his short bet against Allied Capital, a mid-cap financial company1. This story began in May 2002 when Einhorn gave a speech at the Sohn Investment Research Conference, where he recommended shorting Allied Capital.
He accused the company of accounting fraud, alleging that it was inflating the value of its assets and defrauding the Small Business Administration. Einhorn's public disclosure of his short position had an immediate impact on Allied's stock, which fell significantly the day after his speech.
This initiated a prolonged and contentious battle between Einhorn and Allied Capital, which lasted several years. Allied Capital accused Einhorn of market manipulation and even illegally accessing his phone records using pretexting.
The U.S. Securities and Exchange Commission (SEC) conducted an investigation into the matter. In June 2007, the SEC found that Allied Capital had indeed violated securities laws concerning the accounting and valuation of illiquid securities it held.
Despite these findings, Allied Capital continued to face legal challenges and investigations, including civil lawsuits and inquiries by the U.S. Department of Justice and the Small Business Administration Office of Inspector General. Einhorn prevailed.
Einhorn documented his experiences and the details of his investigation into Allied Capital in his book, Fooling Some of the People All of the Time. This terrific book provides a detailed account of the alleged fraud by Allied's management and the challenges Einhorn faced in exposing these practices. It highlights the broader issues of corporate misconduct and the difficulties faced by those attempting to bring such issues to light.
Lehman Brothers Short Bet
Einhorn's short position on Lehman Brothers is one of his most famous and successful investments2. In 2007, he publicly criticized the bank for its accounting practices. His analysis proved correct when Lehman Brothers filed for bankruptcy in 2008, resulting in substantial profits for Greenlight Capital[2][6].
Apple Investment
Einhorn made a successful long investment in Apple Inc. in 2010, recognizing its potential, and the need for some shareholder activism, when the stock was undervalued.
For those who may have forgotten3, Einhorn emerged as Apple's most vocal investor in criticizing the company's capital structure after it unveiled a three-year $45 billion plan to return cash to investors by way of dividends and share buybacks. …
Thankfully for Apple shareholders, a year later the company decided to more than double its capital return, upping the three-year capital return plan to $100 billion after a public spat with Einhorn and Greenlight Capital. Einhorn labeled his plan an "iPref" and advised the company to finance its stock buyback and dividend activity.
This investment paid off as Apple's stock price increased significantly in the following years, contributing to Greenlight Capital's strong performance.
Einhorn's fund boosted its bet by more than seven times4, amassing as many as 67 million shares by 2013. The holding was worth around $1 billion then, making it the largest position in Greenlight's roughly $7 billion US stock portfolio. The same stake would be worth about $11 billion today.
These investment wins have cemented Einhorn's ability to conduct thorough research and take contrarian positions, which have been key to his success in the hedge fund industry. His approach involves deep financial and fundamental analysis and an unflinching willingness to challenge prevailing market sentiments.
David Einhorn: Opportunities in a "Broken" Market
Fast forward to today, and you’ll find David Einhorn has been vocal about the impact of passive investing on market dynamics, as well as discussing how his approach has evolved based on this premise. In his fascinating February 2024 conversation with Barry Ritholtz, Einhorn described the current market as "fundamentally broken," highlighting that "value is just not a consideration for most investment money that’s out there." This perspective stems from the dominance of passive strategies, which allocate capital based on market capitalization, leading to mispricing and divergence from fair value. This echoes with Michael Green’s thesis, that passive funds tend to overweight overvalued stocks and underweight undervalued ones, exacerbating price distortions.
From Greenlight Capital’s Q1 2024 Letter5, David Einhorn writes:
We first shared our thinking on this topic in our year-end 2020 letter and our contention remains that the market structure has changed such that most investment capital either:
Does not care about valuation (passive index funds);
Cannot figure out valuation (most retail investors who have no formal valuation training); or
Chooses not to care about valuation (various technical strategies, quant strategies, and any trading strategy with short-term holding periods, which by definition expresses an opinion about price, but not value).
He describes the problem and opportunity set that passive indexing is causing, eloquently:
Imagine you have two companies and they are both worth $1 billion on a fair value basis, but 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 gets 4x the new investment. As a result, it then outperforms while the undervalued company underperforms.
Despite these challenges, Einhorn sees significant investment opportunities in this environment. He believes that the mispricing caused by passive investing allows for the acquisition of undervalued stocks at attractive prices.
But, from our perspective, the result of this historic shifting of capital is a beautiful opportunity set in which we can invest. We are not complaining. In fact, we are excited!
He explained, "We can find that same type of situation right now at four times earnings and at five times earnings." This approach highlights the potential for substantial returns through dividends and buybacks, independent of broader market recognition. Einhorn focuses on companies with no debt and significant buyback programs, allowing investors to benefit directly from the company's financial performance rather than relying on market sentiment.6
A little bit about Michael Green
And now for the back story on Michael Green, whom we have had the distinct pleasure of getting to know at AdvisorAnalyst.com, over the course of numerous thought-provoking podcast episodes and conversations.
Initially, Green had planned to pursue a career in science, having studied physics. However, he realized he wasn't as talented in physics as he had hoped, prompting a transition to finance, which was a common path for many in his generation who had strong skills in mathematics or physics.
Green's entrepreneurial journey began with the founding of a valuation software (Value Add) company in the late 1980s and early 1990s. This company focused on developing valuation tools, particularly discounted cash flow and residual income models, for corporate strategic planning departments. This venture eventually led to the sale of the business to Credit Suisse in the late 1990s, marking his entry into the asset management space.
He later joined Canyon Capital Partners (a relationship that was sparked by Canyon Capital’s interest in his software), where he established their New York office and managed a significant portfolio of $5-billion. When Soros came knocking on his door, he was offered the chance to start his own hedge fund, Ice Farm Capital (named after a holiday property he owns in New Jersey), a hedge fund seeded by Soros Fund Management, and later managed macro strategies at Thiel Macro, handling the personal capital of Peter Thiel, with great success, as described later in this piece – a successful large trade which he developed from his research, went on to become the basis of his present research on passive investing today.
He subsequently joined Logica Capital and has since gone on to be the Chief Investment Strategist at ETF firm Simplify Asset Management, as of 2021, where he plays a pivotal role in overseeing and designing in institutional-grade alternative strategy ETFs with over $5-billion in AUM.
Throughout his career, Green has been known for his insights into market dynamics, particularly his research on passive investing and its impact on market structure, the background, details and research of which have been pubicly shared across the industry at large and to major institutions like the Federal Reserve, IMF, and BIS, over nearly a decade. Here is a taste of Michael Green’s research thesis.
Michael Green: Systemic Risks and Market Inelasticity
Understanding Market Fragility
Market fragility, as described by Michael Green, refers to a market's increased susceptibility to large swings in price due to shifts in buying and selling pressures. This fragility stems from the way passive investing operates.7 Unlike active investing, where fund managers make decisions based on the fundamental value of stocks, passive investing involves buying and holding a basket of stocks that make up an index, regardless of their individual valuations.
Green argues that this approach contributes to market inelasticity, meaning that stock prices become less responsive to changes in supply and demand. This is because passive funds buy stocks based on their presence in an index rather than their valuation, leading to price insensitivity. As more money flows into passive funds, these funds continue to buy stocks in proportion to their market capitalization, which can inflate stock prices beyond their intrinsic value.
Risks of Passive Investing
Price Insensitivity: Green points out that passive funds do not adjust their holdings based on price changes or company fundamentals. He states, "The key risk ultimately lies in that very simple language, right? Did you give me cash? If so, then buy. Did you ask for cash? If so, then sell" 8. This can lead to a situation where overvalued stocks continue to rise simply because they are part of an index, while undervalued stocks are ignored.
Momentum Driven Markets: Green highlights that passive investing creates a momentum bid, where rising stocks receive more investment, potentially leading to a self-reinforcing cycle of overvaluation. He notes, "As more and more investors transition to this systematic algorithmic investment...that starts to change the market behavior in a measurable and meaningful fashion." This can result in a market that is driven more by flows of money into and out of funds rather than the underlying economic realities of the companies within the index.
Potential for Sharp Declines: Green warns that the dominance of passive investing could result in market fragility9. If inflows into passive funds were to reverse, the market could experience sharp declines. This is because the same mechanisms that drive prices up in a bull market—continuous buying regardless of price—can exacerbate declines in a bear market when funds are forced to sell.
Reduced Price Discovery: The traditional role of active investors is to buy undervalued stocks and sell overvalued ones, thereby helping to set prices that reflect the true value of companies. With the rise of passive investing, this mechanism is weakened, leading to less efficient markets.
Connections and Contrasts
Connection
Both Einhorn and Green agree that passive investing has significant implications for market dynamics. They highlight concerns about reduced price discovery and the potential risks of inflated valuations. Einhorn acknowledges Green's influence in shaping his understanding of these dynamics, stating, "I sat down... in early 2019 with Michael Green and he explained what was going on to me better with the index funds. And then I was able to take what he was seeing along with a couple of other insights that I had relating to how the market structure was. And I developed this understanding of what was going on." Since 2019, Einhorn has successfully restructured his approach to ‘value’ investing.
Contrast
While Einhorn sees opportunities in the mispricing created by passive strategies, Green emphasizes the systemic risks and market fragility. Einhorn focuses on exploiting undervalued stocks, whereas Green is more concerned with the broader market implications and the potential for a massive market event akin to the "volmageddon" of 2018. Green, by the way, is credited not only for identifying the dislocation between the VIX (CBOE Volatility Index) and XIV10 (VelocityShares Daily Inverse VIX Short-Term ETN - no longer exists), which culminated in ‘volmageddon,’ according to Barry Ritholtz, he also reportedly scored a 9-figure payday (>100-million gain) for Thiel Macro, from that market dislocation, where he managed macro strategies for billionaire Peter Thiel.
Other Industry Perspectives
Vincent Deluard: Inflated Valuations and Market Bubbles
Vincent Deluard, a global macro strategist, shares concerns about passive investing inflating stock market valuations11. He argues that the shift from active to passive investing has led to structurally higher stock valuations disconnected from fundamentals. Deluard believes that a sustained bear market can only occur if the passive sector shrinks, as passive funds provide a steady inflow that supports high valuations.
Larry Swedroe: Market Efficiency and Active Management
Larry Swedroe, head of financial and economic research at Buckingham Wealth Partners, focuses on the impact of passive investing on market efficiency12. He argues that increased passive ownership decreases market liquidity and reduces the informativeness of stock prices. His view concurs with David Einhorn’s that it can lead to market mispricing and create opportunities for active managers to add value.
Patrick Cairns: Pricing Distortions and Market Dynamics
Patrick Cairns, a financial journalist, examines the evidence on passive investing and market distortions13. He notes that passive funds can contribute to pricing inefficiencies by buying entire indexes without regard to individual stock valuations. However, Cairns also argues that the impact of passive investing on market prices may not be as significant as some critics suggest, as active investors continue to trade around mispricings.
While Einhorn and Green share concerns about the effects of passive investing, their perspectives reflect their unique backgrounds and focus areas. Einhorn sees opportunities in the mispricing created by passive strategies, while Green warns of systemic risks and market fragility. Other industry voices like Deluard, Swedroe, and Cairns add further dimensions to the debate, highlighting the complexity of passive investing's impact on market dynamics.
Einhorn's perspective is rooted in his experience as a value investor, allowing him to identify opportunities in undervalued stocks that passive strategies overlook. His approach highlights the potential for active managers to exploit inefficiencies and achieve substantial returns through careful stock selection. On the other hand, Green's focus on market structure and systemic risks underscores the potential dangers of a market driven by passive inflows, which could lead to significant volatility and instability. In the meantime, he does agree that everyday investors should continue to consider investing in inexpensive index ETFs and funds for their core portfolio holdings, while advocating that investors seek satellite and ‘defense’ exposures that mitigate the risks of those commonly held stock and fixed income exposures in the event of future market dislocations.
Where investment is concerned for Green, we speculate (we haven’t yet had the chance to ask him about this specifically, and we will) he is most likely using his deft insight to inform his strategies in the here and now, as well as ultimately building up to a ‘big event’ trade to capitalize on his market inelasticity research, should flows reverse meaningfully for any reason, in a way similar to the success he experienced in the ‘Volmageddon’ trade. Einhorn, on the other hand is looking to exploit the inefficiencies caused by the leviathan ‘passive’ indexing trend, now, to identify literally a concentrated handful of stocks that will benefit he and his investors.
As passive investing continues to grow, understanding these diverse perspectives will be crucial for navigating the evolving financial landscape. Investors and policymakers alike must consider the implications of passive strategies on market dynamics, efficiency, and stability, balancing the benefits of broad market exposure with the potential risks of reduced price discovery and increased market fragility. The insights of Einhorn, Green, and their contemporaries provide valuable guidance for those seeking to understand and respond to the challenges and opportunities presented by the rise of passive investing.
Following the recent spike in volatility and rapid-fire drawdown we experienced at the beginning of August due to what Howard Marks states was a triple whammy of Japan carry trade unwind, poorer-than-expected economic results, and Warren Buffett’s reveal that he had sold off over half his Apple position. It was confirmation, once again, that it doesn’t take very long for perception to swing from ‘flawless’ to ‘hopeless.’ In the immediate whipsaw recovery that followed, we’ve been given both a glimpse of what’s possible on the horizon, and yet another chance to reconsider risk exposure in our portfolios.
Thank you for reading and take care until next time.
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