The rise of passive investing

Early in 2018, Warren Buffett will learn whether his famous $1 mn bet that index investing will outdo active management pays off. With only months to go on the decade-long wager, Buffett’s designated index fund is far ahead of Protégé Partners, which invested in positions in a range of different hedge funds.

‘It looks like Buffett will win and passive investing over a period of time will outperform active hedge fund managers,’ says Rachel Carroll, global head of investor relations at Edison Group in London. ‘It’s very hard for active fund mangers to justify their fees when they’re underperforming.’ And so passive investing continues its meteoric climb.

A February 2017 report put out by Moody’s Investors Service finds that by 2024, the money in index and exchange-traded funds (ETFs) will outstrip active investments in the US. According to Moody’s, passive investments currently account for 28.5 percent of US assets under management.

Tim Quast, president of ModernIR, a Denver, Colorado-based data analytics company, tracks the rise of passive investment. He notes that today there is roughly $9 tn in active funds, versus $6 tn in passive. Given that active funds are shrinking by roughly $200 bn a year and passive growing by roughly $400 bn-$500bn a year, ‘you can see that passive is going to displace active very soon,’ he says.

Understanding the new dynamics

For IR professionals, the inexorable rise of passive investing could be a game-changer. ‘The IR job has always been about telling the story to the buy side and the sell side,’ says Quast. ‘The problem is that the money flooding into the market doesn’t pay any attention to ‘the story’. It doesn’t tune into earnings calls – and it doesn’t use sell-side research.’

Carroll points out that companies benefiting from inclusion in indexes and ETFs should understand how passive investments work because they can have what she calls ‘a multiplier effect’. ‘For public companies, being included in an index is great on the upside,’ she explains. ‘You get a spike in your trading volumes and in your share price –but it’s all more pronounced on the way down.’

When a company cuts a dividend or sees its capitalization dip, that company might be dumped from multiple indexes, and the IRO has no recourse to presenting its fundamental story to investors with which it has long-standing relationships. ‘This multiplier effect has sometimes been called the vortex of doom,’ says Carroll.

Patrick Gallagher, senior adviser at Dix & Eaton in Cleveland, Ohio, notes that the toll can be particularly dire for small caps. With fewer IPOs, index funds have trouble finding enough small-cap stocks to hold, while the assets of small-cap index funds have almost quadrupled since 2007. ‘A lot of these small-cap index ETFs want to own small companies and they may be squeezing out other small-cap investors because they’re increasing the volatility and making it more expensive to buy these stocks,’ he says.

Although the penetration of passive investing is most pronounced in the US, the trend is a global one. Moody’s estimates that between 5 percent and 15 percent of assets outside the US are passive, and predicts that passive investing will grow internationally as markets mature and overseas investors become more aware of non-active investment products.

What the future holds

Gallagher suggests that the Trump administration could potentially upset the applecart when it comes to the growth trajectory of passive investments. That’s because with low interest rates and a stable economy, the dispersion among US stocks has been fairly low – an ideal environment for index funds.

‘The dramatic changes the Trump administration is promising and starting to implement make for more winners and losers – and that makes for more dispersion among different stocks,’ Gallagher points out. Such an environment might just allow active managers to shine again.

That said, others believe the steady climb of passive funds is unlikely to be reversed because it is a function of market structure. Quast says the regulatory rule that investors must trade between the best bid and offer prices has led to stocks trading at the average price roughly 80 percent of the time – and so, he says, ‘you end up with a marketplace that is riven with average prices.’ Because indexes and ETFs track the averages while stock pickers look for outliers, market structure is dictating that ‘stocks mean-revert’ and passive investors usually outperform active ones.

As long as current market rules are in place, Quast argues that IROs ‘can’t remain storytellers’ but must instead become data analysts, informing management of what particular data means and devising a strategy accordingly. But how can an IRO add value in a passive-investing world? ‘You track trends and use those trends to your advantage,’ says Quast.

‘If asset allocation is rising and your shares are rising, too, start calling on growth money. Surf the wave.’ For Quast, IROs will be no less important in a world of high-frequency trading, ETFs and indexes, but they will need to carve out a new niche for themselves. ‘Stop trying to do the same old thing you used to do until you disappear,’ he concludes. ‘You have to adapt to the world and the market that we have.’

Five steps to take in an indexed world

‘As an IRO, you’re operating with one hand behind your back’ when it comes to coping with an ever-growing population of index and exchange-traded fund (ETF) investors, says Rachel Carroll, global head of IR at Edison Group. On the other hand, there are plenty of strategies IR professionals can employ in this environment.

1.  Understand ETFs and indices. ‘Companies are trying to figure out how to get onto the indices, how the S&P and the FTSE work,’ says Stephen Tu, vice president and senior analyst at Moody’s. Understanding the screening methodology for a given index is critical as it lets IR professionals know when changes in their company’s performance might make a company eligible for inclusion, or vulnerable to being dropped.

2. Provide management and the board with clarity on stock volatility and price spikes. Even though index fund and ETF managers cannot buy or sell based on a company’s fundamentals, reaching out to them makes sense. Doing so lets IROs communicate more effectively with their CEO, CFO and directors about what’s moving their company’s share price and contributing to volatility.

3. Communicate with passive funds on governance. Tu argues that as passive investors don’t have the ability to sell, some might take an even keener interest in governance. ‘Passive investors are stuck with the stock, even if they don’t like the way the company is managed,’ he says. ‘In that sense, there’s a lot more need for [passive funds] to have a dialogue with management and IR.’

4. Provide detailed explanations in annual reports, proxies and other key investor documents. Gone are the days when IROs can assume all investors know a company’s story. With more indexes and ETFs on the shareholder roster, it makes sense to provide more comprehensive information to shareholders.

5. Check all third-party data about your company. Carroll says IROs should carefully monitor information presented on key financial platforms to ensure consensus numbers and other metrics are accurate. ‘You want your numbers to be right so they can be adequately screened for,’ she says.

A glossary of passive investing terms

1. Smart beta investing: investment strategies that use alternative index-construction rules to come up with a customized index. Smart-beta strategies resemble traditional index strategies in that the rules are set and transparent.

2. Multifactor funds: a type of smart beta investing in which several different factors are combined in assembling a customized portfolio of stocks.

3. SPDR exchange-traded funds (ETFs), also known as ‘spiders’: a type of ETF originated by State Street Global Advisors in 1993. Spider ETFs are made up of a basket of S&P 500 stocks.

4. Robo-advisers: advisers that work for lower fees by providing digital financial advice or portfolio management with a minimum of human intervention.

This article appeared in the Summer 2017 issue of IR Magazine.