For David Einhorn (Trades, Portfolio), 2020 was another tough year. His hedge fund, Greenlight Capital, underperformed once again with a full-year return of just 5.2% even as the S&P 500 index rose 18.4%.
This was mainly due to the short positions, however, as fellow GuruFocus author Rupert Hargreaves discussed on Jan. 22. Greenlight ended the year strong, delivering a 25% return in the fourth quarter off the back of stellar turnarounds in key common stock holdings such as Green Brick Partners (GRBK).
Despite his latest attempt at beating the market having ended in failure, Einhorn has shown no sign of wavering from his long held investing principles. Among the commentary in his latest letter to investors, his criticism of passive investing particularly intrigued me, as it raised serious questions about the rising power of index funds over stock prices.
A chilling hypothesis
Index funds have exploded in popularity, going from niche to ubiquitous in the span of a decade. In 2019, total assets allocated to index funds surpassed those allocated to actively managed funds for the first time. According to Einhorn, the unprecedented flood of capital into index funds has fundamentally transformed the nature of the asset class:
"Passive investing has become so prevalent that passive index investors are no long price-takers, buying at the prevailing price set by active investors engaging in a vigorous effort to determine the correct value, but rather price-makers. Their demand sets the price. From our perspective, price-making rather than price-taking calls into question the entire premise of passive investing."
Put simply, Einhorn's contention is that index funds have gotten so big that their buying can have a tangible effect on prices. To mirror its chosen market index, a fund must regularly buy and sell securities. However, when there are many trillions of dollars seeking to do the same thing, their demand alters the flow of the capital market.
Much as a planet's gravitational field can pull objects into its orbit, the money flows generated by index funds' aggregated buying and selling may exert a pull on the prices of individual securities. If that proves to be the case in reality, it might indeed compromise one of the key premises of passive strategies.
The science agrees
Einhorn is not alone in his assertion that passive investing is no longer truly passive. The subject has intrigued a number of academics and industry professionals, many of whom have contributed to a host of research projects and empirical analyses on the power of index funds to influence asset prices.
There is now a growing body of data supporting Einhorn's view. In 2018, for example, researchers from financial services firm StoneX Group Inc. (SNEX), published a fascinating study of stock price behavior across multiple indices. The study determined that, while the average U.S. stock was included in 115 indices, those that were included in more than 200 indices were 2.5 times more expensive on average than were stocks that were included in fewer than 75 indexes.
A more recent study, published by the National Bureau of Economic Research (NBER) in December, has added further color to the issue. The study found that, as the amount of capital allocated to index funds has grown, the impact of those funds' supposedly passive money flows on individual stock prices has also been magnified. The study also determined that this price impact is greatest among the index components with the largest market capitalizations:
"Flows into funds tracking the S&P 500 index raise disproportionately the prices of large-capitalization stocks in the index relative to the prices of the index's small stocks."
An opportunity for investors
The studies I have discussed in this article can offer investors actionable insights. The authors of last month's NBER paper, for example, observed that big companies' flow-driven outperformance appears to have made indices' smaller components relatively cheap:
"The flows predict a high future return of the small-minus-large index portfolio."
With more money than ever flowing through index funds and sending mega-cap stocks soaring ever higher, the relative underperformance of more under-the-radar names has also widened. Investors who are willing to dig deeper into the smaller components of the S&P 500 and other indices may discover that there are still some bargains to be found.
Disclosure: No positions.
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