Field of play
Has the world really changed?
Most every investor knows about the rise of index/passive investing in the last fifty years. We also know about the rise of trading that has no relationship to value, the rise of algorithm trading done by computers and retail crazes like memes or stuff that is hot or just cool. The question I look at in this post is whether the investment landscape has changed so much that active investing is no longer a viable approach to investing.
It’s a big question. But there is a relatively straightforward answer. The answer is no. Let me explain.
Some thoughts that raise the question
Consider this quote about the way things were in days gone by: “Used to be that most money was invested by these long only investors, these big mutual funds and stuff like that. And they had money coming in every day and they were getting nice fees on all of that money. And they had large research teams and they would sit around following all of the companies with teams of analysts.” Back then, the process was analytical and conviction-driven: “They would say this company, we think, is undervalued by 30%… And if I buy it and I hold it, I’ll make the S&P plus 30.”
And today?
“Now, as we’ve moved to passive, they’ve lost their customers and the remaining customers are paying them lower fees and they have reduced their research staffs and they don’t have new money coming in to make new investments in any case.”
“The market is now dominated by 1) passive, you know, index funds which buy what everyone else has already decided things that are worth, or 2) algorithms which are basically trying to figure out what is everybody else doing and how do I front-run that, or 3) retail, which is buying things because they think it’s cool or they think it’s going up.” ( 1), 2), 3) Added for Clarity)
“Most of the investing these days is no longer done by people who are buying something because they think it’s worth more. They have opinions about price, like what is the price going to be tomorrow? And so the result is, most trading that is going on right now has nothing to do with value.” (Emphasis Added)
These observations come from Greenlight Capital’s David Einhorn. He talks about how the value investing industry has changed. He spoke in an interview for “Bloomberg Wealth with David Rubenstein” on April 10. https://youtu.be/dg-4c-YCRTA
David M. Einhorn is an American investor, hedge fund manager, and amateur poker player. He is the founder and president of Greenlight Capital, a “long-short value-oriented hedge fund”. Born in New Jersey, Einhorn graduated from Cornell University, before starting Greenlight Capital in 1996. Wikipedia
A nod to The Acquirer’s Multiple for this.
- Passive
I come at the distinction between active and passive investing slightly differently. Any style of investing that is Price Accepting I think of as passive. Any style of investing that sees a distinction between price and value, is active investing. As Warren Buffett put it in the 2008 Berkshire Hathaway annual report: “Price is what you pay. Value is what you get.”
A chart in The Economist magazine a couple of years ago illustrates the active vs passive trend. See article.
The numbers are probably higher than shown on this chart. A paper published by the Harvard Business School, titled The Passive-Ownership Share Is Double What You Think It Is, offers the view:
“While index funds held 16% of the US stock market in 2021, we put the true passive-ownership share at 33.3%. Our headline number is twice as large because it reflects index funds as well as other kinds of passive investors, such as direct indexers and active managers who are closet indexing.” (emphasis added)
So, investors who follow passive strategies include: indexing; use rules-based investing; systematic investment strategies; themed strategies; dynamic asset allocation; smart beta; quantitative investment strategies; as well as active managers who are closet indexing. They are all Price Accepting investors.
If we include active managers who are closet indexers, we have to go back fifty years and say that passive investing and indexing was actually quite common fifty years ago, i.e. there were never as many active investors as thought years ago.
Rise of passive and stock market inefficiency
In my view the rise of passive investing is likely good for active investors. I have examined this in my post: The rise of passive investing and opportunities for active investors
The conclusion I came to in that post is that passive investing and systematic investing may lead to greater stock market inefficiency. By this I mean no more than a divergence between price and fair value.
This is because it will lead to more and more investors being price acceptors. The rise in ETF investing is leading to more and more theme and sector investing by price accepting investors. I don’ buy the argument that the average skill level of the shrinking cohort of active money managers is increasing nor that it is making the stock market more efficient.
Active investing will always be very difficult. For example, a stock may be seen as underpriced and even a bargain but it may remain so for a very long time. Similarly, an overpriced stock or an overpriced market may remain overpriced for ages. Active investors will still be faced with their own human foibles and other investment psychology issues.
- 2) Algorithms
Einhorn talks about algorithms which are “basically trying to figure out what is everybody else doing and how do I front-run that.” Computer based trading and computer based systematic investing are hairy beasts but not necessarily scary. On the pure trading end, it is simply crunching a bunch of price data to produce trading signals. On the systematic investing end, it is simply crunching a bunch of fundamental data taken from company financial statements and elsewhere or other data like economic data to give buy and sell signals. Quants would be included in this group.
Plus ca change
This is a great French expression that means: The more things change, the more they stay the same. Consider this from Maynard Keynes:
“It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of and investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.” (Keynes, The General Theory of Employment, Interest and Money. 1936,2007) p154 (Emphasis Added) This sounds a lot like what a lot of algorithms are used for today.
A Pershing Square August 2024 Interim Report from Bill Ackman talks about the impact of short-term, highly leveraged professional investors on the stock market. He says: “These shorter-term investors – which include so-called market-neutral and quantitative funds – use large amounts of margin, derivative, and total return swap leverage in their strategies. As highly leveraged market participants, these investors’ tolerance for mark-to-market losses is small, which contributes to stock price volatility as they can become effectively forced sellers when companies disappoint, even in the short term.”
His conclusion for active investors:
“Greater stock market volatility is the long-term friend of the active investor with permanent capital who seeks to identify high-quality companies which are not dependent on the capital markets to implement their business strategies. While an earnings’ miss or other business metric disappointment in a quarter could reflect the beginning of deterioration in fundamentals, in many cases the impact of the disappointment has only a marginal effect on long-term intrinsic value.” (Emphasis Added)
Pershing Square 2024 Interim Report
- 3) Retail
Einhorn refers to the rise of individual investors who are “buying things because they think it’s cool or they think it’s going up.” Human nature has not changed in the last fifty years or even the last thousand years. Retail investors who engage in pure buy and hold passive investing would tend to stabilize the market. The ETF industry has created hosts of sector, themed and a juicy array of other trade-worthy products for retail investors that can only add to market volatility and inefficiency.
Conclusion
Since my approach to investing is to look for superb companies that can be bought at very attractive prices, I am naturally very interested in any long-term changes in the stock market that might affect this approach.
The bottom line for me is that I don’t see any tendency caused by passive investing or algorithmic trading or retail investor trends to lead to greater stock market efficiency. Stock market efficiency is the enemy of value investors. Stock market inefficiency is their friend and continues unabated.
Ironically, in many ways, the stock market is essentially inefficient because investors believe it is efficient; i.e. they tend to think the price is right, which is why they get things wrong. They buy without thinking about value vs price.
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