Actually, rather than say that passive funds have "fundamentally broken the market", maybe the more appropriate word is "fundamentally changed the market"? Since passive funds are here to stay and will only get bigger over time, it will also mean that undervalued smaller cap stocks on aggregate, will be undervalued permanently AND overvalued large cap stocks on aggregate, will be overvalued permanently?
People expecting a "mean reversion" will find that mean does revert, but to a "new mean" - On aggregate, overvalued stocks will not revert to fair valuation but from extreme overvaluation to overvaluation. Undervalued stocks will not revert to fair valuation but from extreme undervaluation to undervaluation.
Greenlight Capital 1Q24 letter
Imagine you have two companies and they are both worth $1 billion on a fair value basis, but one is valued by the market at $500 million and the other one at $2 billion. When a market capitalization-weighted index fund gets $5 to invest in those two companies, it will put $4 in the $2 billion company and only $1 in the $500 million company. The overvalued stock gets 4x the new investment. As a result, it then outperforms while the undervalued company underperforms.
The problem is compounded when the new money invested in the index is the result of a redemption from an active manager trying to invest in undervalued securities. Imagine that the $5 came from a professional manager who correctly understood which stock was undervalued and which was overvalued and had deployed $4 into the undervalued stock and $1 into the overvalued stock.
When that manager is redeemed from, and the funds are reinvested in an index fund, the undervalued stock experiences $3 of net selling (a $4 sale and a $1 buy), while the overvalued stock experiences $3 of net buying (a $1 sale and a $4 buy). Rather than converging to fair value, the result is that the two stocks diverge even further from fair value.
As several trillion dollars have been redeployed in this fashion in recent years, it has fundamentally broken the market. There are significant policy, macroeconomic, capital formation and corporate governance implications of all this and many of them are negative.
David Einhorn does go on and say that he is excited about "cheap equities" as it allows the active buyer to buy cheap equities and get rewarded from share buyback and dividends. We cannot deny this but this must first come from a Mgt willing to perform such shareholder friendly moves.
https://drive.google.com/file/d/1RGPikbh...Hl1Nf/view
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