Passive investors have 'fundamentally broken' the market, David Einhorn says

• "The value industry has gotten completely annihilated," David Einhorn said on the Masters in Business podcast.
• He said fewer traders are paying attention to a firm's fundamental merits as passive investment has taken over.

The takeover of passive and algorithmic trading has made value investing significantly harder, with overvalued stocks now more likely to win out, Greenlight Capital founder David Einhorn said.

"I view the market as fundamentally broken," he said on a recent episode of the Masters in Business podcast. He later added that "the value industry has gotten completely annihilated."

Recent years have seen traders shift away from actively managed investment, preferring to park their money in passive vehicles such as index funds. It's led to fewer investors trading on the merits of individual stocks, making it harder for firms like Greenlight to find undervalued companies that will eventually close the gap between them and the rest of the market.

"Our thinking before used to be: if we buy this at this times earnings, and they're going to do 20% better than everybody thinks, and the multiple re-rates as a result of that, we're going to do terrifically," Einhorn said.

But now, Greenlight has become more disciplined on price, no longer buying stocks at 10 or 11 times earnings, he noted. He also said long-only investors can no longer be expected to purchase shares after the hedge fund does first, putting pressure on the stock to pay out.

Algorithmic machine trading only compounds the issue, as quant traders heavily focus on short-term price moves, instead of a company's broader value, he said. As both passive and algorithmic traders chase after price, overvalued portions of the market are disproportionately bought.

"What happens is, instead of stocks reverting toward value, they actually diverge from value," he said. "It's a structure that means that almost the best way to get your stock to go up is to start by being overvalued."

Last year, Greenlight was up 22.1%. But further upside was limited by four especially notable losses on the fund's short positions, Einhorn explained in a letter to clients.