Examining how passive investors influence markets

Nov 18, 2020
The growing complexity of thematic and rules-based investment vehicles presents a fantastic opportunity for companies to present themselves in ways that will gain them entry into novel indexes, writes Evan Schnidman

Since the dawn of the 21st century the rise of passive investing has been the dominant story across asset management. In those 20 years, passive ownership in US equities has more than quadrupled, according to statistics compiled by Portformer.

The Portformer research indicates that this rise in passive holdings has not been driven by linear growth but punctuated by rapid increases in passive holdings on the heels of each market correction, especially the global financial crisis. This rise in passive holdings would be more than enough to warrant the attention of every investor relations officer, but what makes passive investing so important today is that it is not only rapidly growing, but also becoming increasingly complex.

A brief history of passive

The popularization of passive investing is generally attributed to Vanguard founder Jack Bogle, who first commercialized index investing in the late 1970s. Bogle was heavily influenced by the academic work of Nobel Prize-winning economist Paul Samuelson, but famed value investor and Warren Buffett mentor Benjamin Graham also endorsed this style of investing. In fact, Graham noted that a diversified basket of holdings (an index) is suitable for most investors as they lack the time and resources to do the difficult work necessary to adequately perform due diligence on a more concentrated portfolio.

The bedrock theory on which passive indexing rests is that a well-diversified portfolio of quality equities will rise in value faster than inflation. While this generally proved true in the 1980s and 1990s, passive investing did not really take off until the 2000s. This is largely due to the rapid increase in compute power and available data to create increasingly nuanced index vehicles, typically ETFs. While ETFs emerged as the preferred mechanism for index investing during and after the global financial crisis, in recent years the proliferation of these investment vehicles has led to competition for new index styles and growing complexity in passive investment strategies. This combination of the proliferation of passive investing and the rising complexity of passive vehicles make it vital that IROs understand how passive investors impact their stock price performance.

Anecdotal evidence

In the last few years countless stories have circulated about individual companies that have had a record quarter (or a very strong one) only to watch their stock sell off after reporting stellar quarterly earnings and revenue figures. In some cases, these companies have reported superb figures, but still underwhelmed consensus estimates, causing investors’ concern about their future performance prospects. In many cases, however, these companies have beaten estimates only to watch their stock sell off. Understandably, this phenomenon has left many IROs asking what caused the sell-off: was it bots misinterpreting their language? Was it traders covering other positions? Were long investors taking profits? Or were passive investors to blame?

Detangling the mess of trading on the day of an earnings call is a tall order for any IRO, but it helps to have a framework on which to evaluate the market moves. In particular, it helps to know which KPIs fundamental and quantamental investors are tracking in your specific company. If fundamental investors are tracking KPIs that underperformed that quarter, even ones that are only one factor in a multi-factor model, such individual datapoints may be a driver of the sell-off – even if solid earnings or revenue numbers are reported.

Similarly, it helps to know how natural language processing (NLP) systems are interpreting the language of your corporate officers so that an IRO can understand the movements of strategies that rely on such tools. These same investors may also be taking positions to hedge on other investments, cover shorts or simply diversify their holdings. Unfortunately, none of these explanations cover the movement of passive investors in and out of certain positions.

As passive investors typically rely on index strategies (often via ETFs), a large move elsewhere in the market can cause passive investors to sell positions even when another company in the portfolio is performing well and/or reporting good news. Moreover, these passive investment vehicles often rely on large allocations from funds seeking diversification.

If one of these funds moves money from one index to another, it can cause significant price dislocations in the underlying holdings. This phenomenon is particularly acute for small and mid-cap companies where many investors hold a basket encompassing the entire Russell 2000 making movements in and out of individual companies largely irrelevant to the timing of investment moves. In fact, tax implications and liquidity constraints are typically the driver of such market moves, not the underlying fundamentals of each of the holdings.

Technology tools and complex indexes

In the last few years, the path to explaining market moves driven by passive investors has become increasingly complex due to both the proliferation of a huge number of new ETFs and the rising complexity of those investment vehicles. It is helpful to break these new vehicles down into three broad categories.

  1. Basic index strategies: These basic strategies rely on broad-scale diversification, such as investing in the entire Russell 2000. These strategies are the simplest to understand and make it easiest to identify why moves in one stock may be counterintuitive relative to their underlying metrics.
  2. Thematic indexes: Thematic strategies became increasingly popular after the financial crisis as they allowed investors to target a specific investment thesis while diversifying across a number of companies. Strategies allowing investors to purchase a basket of companies in a specific vertical like cloud computing, cyber-security or clean energy have become so common that thematic ETFs now exist for virtually every investment thesis. IROs should be aware if their company sits in any of these thematic vehicles.
  3. Rules-based indexes: Rules-based strategies are intended to mimic the work of fundamental investors by holding a basket of stocks that meet certain criteria. These criteria are often tied to company KPIs and traditional factor models, though many ETFs are increasingly using alternative data to determine optimal holdings. Like their buy-side counterparts, IROs can leverage factor models and alternative data to see how their company fits into the landscape of rules-based investment vehicles. Tools to build these models and dissect what the data is saying about individual companies used to be available only inside large buy-side institutions, but several high-quality platforms have been commercialized in recent years, making them readily available to the IR community.

Notably absent from this list is the presence of artificial intelligence (AI), machine learning and NLP. These modern technology tools have only recently begun to be used in creating passive investment vehicles. That’s not to say IROs should ignore how bots might be interpreting their company’s value – quite the contrary. IROs now need to pay closer attention to modern technology-driven investment strategies because they are growing in popularity as additional factors in fundamental investments, quant trading and index strategies. Perhaps most noteworthy, with the return of market volatility in 2020, the next wave of ETFs may very well include index strategies that are predicated on exposure to volatility as an asset unto itself.

Understanding passive

In the 40-plus years since Vanguard first introduced index investing, these passive vehicles have become increasingly complex. Modern ETFs are predicated on a diverse set of strategies that often make little sense for one individual component of the index, but function effectively as a diversification vehicle. This likely provides little solace to a small or mid-cap IRO seeking to explain seemingly nonsensical market moves while also fighting for analysts to simply cover the stock so that active investors can be made aware of price dislocations driven by passive vehicles.

But the growing complexity of these investment vehicles presents a fantastic opportunity for companies to present themselves in ways that will gain them entry into novel indexes. These thematic and rules-based strategies are often transparent about the criteria for a company to be included, offering IROs the opportunity to target specific indexes where they would like their company included. It is vital that IROs take advantage of this information transparency now, so their company can maximize the benefits of having passive investors while also preparing for even more complex ETFs predicated on AI to drive the next generation of passive investing.

 

This article is the third in a series intended to explain the shifting landscape of active and passive asset management by highlighting the tools and technology used by active investors. Click here to view the first article, which explores active and passive dynamics. Click here for the second article, which explains the technology and data tools used by active managers.

The final article in the series will explain how IROs can keep pace with changes in the asset management industry by adopting new technologies to better understand investor behavior. The article will delve into the specific technology and data tools IROs could use to enhance communication with active and passive managers alike.

Evan Schnidman is founder of EAS Innovation Consulting

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