The Shift in Investment Strategies: A Threat to Value Investing?
The investment landscape has undergone a significant transformation in recent years, with passive investing gaining popularity and value investing facing unprecedented challenges. In a recent interview, David Einhorn, founder of Greenlight Capital, expressed his concerns about the decline of value investing, blaming it on the rise of passive investing.
The Rise of Passive Investing
Einhorn believes that passive investors, who invest in index funds, are not concerned about the value of their investments. They simply follow the market trend, without conducting thorough research or analysis. This approach has led to a surge in growth stocks, while value stocks have been neglected.
The Consequences of Passive Investing
The emphasis on growth has distorted the market, Einhorn argues. Companies that manage expectations well, beating earnings forecasts, are rewarded with high valuations, regardless of their underlying fundamentals. This has created a “gamification” of the market, where companies focus on managing expectations rather than delivering sustainable growth.
The Pain for Value Investors
Value investors like Einhorn have suffered significantly as a result of this shift. Many have seen cash flee their funds, as investors opt for passive investing. Rob Arnott, chairman of Research Affiliates, agrees that value stocks have become cheaper relative to their fundamentals, while growth stocks have commanded higher valuations.
The Logic Behind Passive Investing
It’s hard to blame investors for switching to passive funds. Not only are they less costly, but evidence shows that active managers have underperformed their benchmarks for decades. According to the SPIVA U.S. Scorecard, 87% of large-cap fund managers lagged their benchmarks over a 10-year period.
The Frustration of Value Investors
Einhorn’s frustration is understandable, given that academic research has long supported the idea that value outperforms growth in the long run. However, since the Great Financial Crisis, this trend has been broken. Growth has consistently outperformed value, with the iShares S&P 500 Growth ETF gaining 610% over the past 15 years, compared to 286% for the iShares S&P 500 Value ETF.
The Challenges Facing Active Managers
Arnott attributes the underperformance of active managers to two main issues: higher costs and the lack of competitive advantage. Active managers compete against each other, with little edge over their peers. This leads to lower returns, as they incur higher fees and trading costs.
The Index Fund Conundrum
While index investors may be “free riding” on the price discovery of active managers, Arnott argues that this is not a compelling reason to avoid indexing. From the customer’s perspective, why not index? Indexers can still own value stocks and perform reasonably well, as evidenced by Arnott’s RAFI indexes, which emphasize book value, sales, cash flow, and dividends.
Einhorn’s Surprisingly Bullish Outlook
Despite the challenges facing value investors, Einhorn remains surprisingly bullish. He believes that the current market environment is expensive, but not necessarily bearish. An overvalued stock market does not necessarily mean it will decline soon.
The shift towards passive investing has significant implications for the investment landscape. As value investing continues to face challenges, it remains to be seen how investors will adapt to this new reality. One thing is certain – the investment world is undergoing a significant transformation, and only time will tell what the future holds.
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