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Jul 10, 2016

From active to passive management: IROs beware

How IR teams can limit loss of control due to the increase of passive funds on their register

As an industry, asset management is in turmoil, caught in the middle of fundamental change driven by a few key factors: the advent of new technology, the rise of millennials, concerns over fees and performance, and the related shift from active to passive management. While the latter may seem one step removed from the work of IROs, in practice this is a seismic shift that has major consequences, particularly at the lower end of the market. A greater role for passive investment entails a loss of control for IROs, complicates fundraising and may delay IPOs.

Passive investment management, born in the 1970s with the launch of the first index tracker funds, has gained momentum in the wake of the financial crisis. Since 2007, Morningstar records that global assets in passive equity funds have risen 230 percent to $6 tn, while the equivalent growth in active assets is 54 percent, to $24 tn. This trend shows no sign of slowing. Indeed, the world is taking its cue from the US, where already 40 percent of assets are in passive funds and, in 2015, exchange-traded funds attracted nearly $200 bn globally while active vehicles lost $124 bn.

In future, this may be compounded by competition from the likes of Apple or Google, whose appeal to younger generations is far greater than that of the investment management industry. This has already begun in China, with Alibaba-sponsored Tianhong Asset Management attracting more than $80 bn in nine months after launching an online money market fund.

Index trackers are both a blessing and a curse for the IR department. On securing inclusion in an index, a company attracts numerous new investors obliged to track its components. The immediate impact is a boost to the share price and increased liquidity as the number of funds trading the shares soars. But these benefits evaporate if the company is later dropped from the index, dragging down the share price and increasing volatility.

This all-or-nothing game equates to a loss of influence for IROs. In the event of financial underperformance, with an active manager it remains possible to organize meetings with management and reiterate the longer-term investment case. Qualitative factors and pre-existing relationships come into play and may convince a portfolio manager to remain invested. Inclusion in an index, on the other hand, is decided in a black box where IROs have no sway.

Large companies are less vulnerable than the lower echelons of the stock market; by virtue of their size, the impact on liquidity is less significant. Nor does falling from an index such as the FTSE 100 signal the end of passive shareholding as the company is likely a member of many other sector indices and would join the FTSE 250. If a company has survived at the top long enough, it will be known to active managers and attract analyst coverage based on reputation, which is more bankable than its position in the index.

The shift toward passive also complicates fundraising. Active managers are the first port of call if a company issues new equity, so a fall in their proportion thins the constituency IROs can target. Taking stock of this and of the double-sided nature of indices, growing private companies are likely to delay IPOs until they have reached a more mature stage where they enjoy more security. The generalized migration toward passive vehicles is therefore not occurring in a bubble divorced from investor relations. Systematic investing tilts decisions toward quantitative metrics and away from the qualitative where IROs wield influence, while also reducing the audience of active managers who may serve as engaged partners for growth.

In response, IROs should redouble their efforts with a dual strategy of considered outreach focused on active managers, combined with close monitoring of the funds on the register to keep abreast of relevant developments. To avoid letting the market dictate investors’ perception, especially in light of post-referendum uncertainty, they must also be on the front foot when it comes to messaging. Making use of all available channels, including sophisticated digital outreach and use of video, will convey their investment case to the market and help insulate them from the tectonic shifts in asset management.

Rachel Carroll is global head of investor access at Edison Group