Greenlight Capital’s David Einhorn was interviewed by our Leslie Picker at CNBC’s Delivering Alpha event Wednesday.
Einhorn spoke about the election results, inflation and some of his current stock picks (including CNH Industrial and Peloton Interactive), but soon returned to a familiar theme: the long, slow descent of value investing.
“It’s continuing to get worse,” the hedge fund manager told Picker. “We are in a secular destruction of the professional asset management community.”
As he has done several times before, Einhorn pointed a finger at passive, index investors: “The passive people, they don’t care what the value is.”
Markets are ‘broken’
In Einhorn’s estimation, markets are “broken,” repeating a claim he has repeatedly made this year.
“I view the markets as fundamentally broken,” Einhorn said back in February on Barry Ritholtz’s “Masters in Business”podcast. “Passive investors have no opinion about value. They’re going to assume everybody else has done the work.”
Einhorn puts much of the blame on passive investing in index funds like the S&P 500, noting that because the S&P has had a pronounced growth tilt in the past decade as technology has dominated, investors buying index funds are by default propping up growth stocks at the expense of value stocks.
What’s more, the emphasis on earnings growth is distorting markets, the Cornell grad said.
“You have these companies, and all they do is they manage these expectations, right?,” Einhorn told Picker. “And they beat and they raise, and they beat and they raise, and they beat and they raise, and they’re pretty good companies, and the next thing you know, they’re trading at, you know, 55 times earnings, even though they’re growing [at] GDP plus two [percentage points] and something like that. And that’s kind of the gamification of the way that the market structure has changed, right?”
Einhorn noted that “growth can be undervalued” as well, but lamented that value players had become marginalized: “We are such marginal players in terms of the amount of trading that’s going on, so the price discovery from professional people who have a valuation framework, not as the dominant part of their process, but as any part of their process, is much, much smaller than it used to be. And so effectively instead of the valuation becoming the signal, the valuation people were just noise and everybody else is sort of the signal. And this is why I think we have a structurally dysfunctional market, a bit of a broken market, and essentially a perpetual erosion of value as a strategy, as you would.”
This is causing great pain to value investors like Einhorn, many of whom have seen cash flee their funds.
Other market observers agree: “Value stocks have been getting cheaper and cheaper relative to their underlying fundamentals, while growth stocks have been commanding richer and richer valuation multiples,” Rob Arnott, chairman of Research Affiliates, told me in an email. Arnott is well known in the investment and academic community for his work in asset management and quantitative investing.
Logical switch to passive investing
You can’t blame investors for switching to index funds.
Not only are passive funds less costly than paying an active manager, the evidence shows that active managers have been underperforming their benchmarks for decades. The most recent report from the SPIVA U.S. Scorecard, the benchmark study on active management by S&P Global, said 87% of large-cap fund managers lag their benchmarks over a 10-year period.
In other words, passive investors in index funds are making a perfectly logical decision by switching from active portfolio management.
Still, Einhorn’s frustration is understandable. Academic research has long supported the belief that, in the long run, value outperforms growth.
Yet, since the great financial crisis, that long-term trend has been broken. In the last 15 years, for example, the iShares S&P 500 Value ETF (IVE) has gained 286%, while the iShares S&P 500 Growth ETF (IVW) is up 610% — twice as much. Growth has beaten value almost every year since.
Value and active continue to lag
Investors, for better or worse, have come to value profitability (growth) as a primary investment metric, more important than traditional measurements like price to earnings (P/E) or value measurements like price to book.
As for why active managers in general — of all stripes, not just value managers — have underperformed, Arnott told me it boils down to two main issues: higher costs and the fact that active managers compete against each other with little competitive advantage.
“Costs matter,” Arnott told me. “If indexers own the market … then removing them from the market leaves that self-same portfolio for active managers to collectively own. As their fees and trading costs are higher, their returns must be lower.”
Another reason for long-term underperformance by active managers: They are competing against other active managers who have very little competitive edge against each other.
“Active investors win if there’s a loser on the other side of their trades,” Arnott told me. Since passive investors tend to stay invested, “A winning active manager has to have a losing active manager on the other side of their trades. It’s like looking for the sucker at a poker game: any active manager who doesn’t know who that loser might be, IS that loser.”
‘Free riding’ passive
In this context, the assertion that index investors are “free riding” on the price discovery of active managers falls into the category of statements that are true — but not very interesting.
Arnott readily agreed they are free riders, but then said, “So what? It’s a cop-out to blame index funds and their customers, because – from the customer’s perspective – why should an investor NOT index?”
And indexers may be able to still own value and do reasonably well. Arnott also runs the RAFI indexes, which emphasize book value, sales, cash flow and dividends, unlike other indexes that are based solely on market capitalization. He says this emphasis, particularly on profitability, has led to outperformance over time.
Most expensive market ever
With valuations at these levels, you’d think Einhorn would be bearish. But you’d be wrong.
“This is the most expensive market of all time,” the 55-year-old told Picker. “This is a really, really pricey environment, but it doesn’t necessarily make me bearish. … An overvalued stock market is not necessarily a bear market and it doesn’t necessarily mean it has to go down anytime soon. I’m not particularly bearish; I can’t really see what’s going to break the market at this time.”
