- By John Engle
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:
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.