What Does The Flight Of Capital From Active To Passive Management Mean For The Future Of Corporate Governance And Market Volatility?

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Includes: DIA, IWM, QQQ, SPY
by: Nader Hashemian

Summary

Investor tastes are starting to shift as capital has flown from active to passively managed vehicles at a record pace last year.

The greater proportion of passively managed funds may contribute to diminished corporate governance quality. However, this may be mitigated by the increasing trend in activist funds.

This phenomenon may have greater implications on overall market risk and volatility, pointing to additional factors to consider in your investment allocation decisions.

As students of the markets and finance, many of us have seen or heard, from time to time, the numerous studies on the overall outperformance of passively managed investment vehicles vs. the traditional actively managed mutual funds (net of fees). But time and time again, people continue to entrust their money with managers whom they hope will perform at above the average. There's nothing wrong with this approach, as many managers do, in fact, consistently surpass the average and beat the returns of passively managed vehicles and ETFs. After all, the "average" is made up of a combination of those above and below the mean. There will always be those who are willing to take on the additional risk in hopes of that potential additional return. However, I'm not going to further discuss the merits of such decisions, as I myself like to select individual stocks as well. But I do want to explore the possibilities of how investors' trends might affect the dynamics of the broader market, as well as the quality of corporate governance.

As discussed in a Wall Street Journal article last week, despite being the year in which the performance of active management surpassed the performance of passive management, 2015 set a record in capital flight to ETFs and passively managed vehicles. Persistent data about passive management's outperformance, net of fees, combined with the growing presence of fintech startups which appeal to the growing base of millennial savers and investors, have finally made the flight of capital towards these vehicles a reality. As investors and market enthusiasts, it's important to consider how this phenomenon might impact the environment we put our money into. The purpose of this article is merely to discuss potential consequences and to stimulate dialogue in order to brainstorm with other fellow enthusiasts about some of the possible results that might come from this.

My first hypothesis is regarding how this phenomenon will influence the quality of corporate governance and management incentives. On first thought, one would assume that as more and more investment capital becomes more "passive" in nature, company managements are under less scrutiny since there aren't as many investors buying or selling shares in response to their actions. This can widen the gap between the interests of shareholders and the interests of corporate executives and lead to destruction of long-term shareholder value. However, although quite difficult to track with accuracy, there seems to be an equally disruptive level of growth in the number of activist investors out there who heavily scrutinize management teams and seek to "unlock shareholder value" through various corporate actions. Therefore, I suppose that capital isn't merely flowing out of actively managed funds and down the route of passive management alone, but becoming divided into more "specialized" forms; away from traditional mutual funds and towards ETFs and passive vehicles on one end and activist funds on the other, effectively balancing each other out. Now how this will affect short-termism and "quarterly capitalism" would likely depend on the particular fund managers involved, which may often times have interests at odds with longer-term shareholders. But that is a separate issue for another article.

"Capital Specialization":

My second hypothesis involves how a greater proportion of stock market capital turning passive might impact market volatility. Now of course there are an infinite number of variables that play into volatility, but for the sake of argument let's just hold all of those constant. Would a greater amount of capital being held by vehicles that don't trade on headlines, quarter-to-quarter results, impulse, or emotional data contribute to more stable markets? Or would the increased dependence on "set-and-forget" style investing create a bigger "mob mentality" issue and promote larger deviations from intrinsic values, and thus more severe bubbles and/or liquidity crises?

Fidelity Investments has shown that assets in passive funds and ETFs have grown from 4% of US equity index funds in 1995 to 27% in 2011 (likely much higher now), resulting in stock correlations that have risen from 24% to 42% over the same period. Simultaneously, average volatility has also risen.

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Passive portfolio turnover is 1/10th that of active managers; surely this impacts market liquidity as well. Furthermore, the advancement of globalization has resulted in enhanced correlations between markets in different regions of the world. While investors may be decreasing their risks to any single company through passive vehicles, they could be, in fact, exposing themselves to greater systematic risk, effectively replacing one type of risk for another. Theoretically then, there could be times in which systematic risk reaches a point where stock picking could actually become a risk reduction strategy. Perhaps this explains the relative outperformance of active management in 2015.

As investors become more passive, they are in effect transforming from "price makers" through their discrimination of stocks and their buying and selling activities, to "price takers" as they purchase passive indices irrespective of the underlying values and prices of the individual stocks in the basket. I would argue that beyond a certain threshold, this phenomenon contributes to enhanced and prolonged systematic risk. Therefore, just like everything else from the unemployment rate to GDP and inflation, there is probably a delicate balance and range in which the proportion of passively managed funds to total assets is optimized. Reach above a certain threshold and systematic risks likely exceed optimal values, resulting in greater (average) mispricings and larger crashes, and therefore making active management more relatively attractive. Below a certain threshold and the fees and performance of active managers are likely no longer justified.

In conclusion, I posit that there is no absolute answer to the active vs. passive management debate in the long run because it is a matter of relativity; and its contribution to volatility is apparent, but not uniform for all market conditions. In some markets, a greater proportion of passive management could contribute to stability, and in others, it may have the opposite effect. Where exactly the optimal range lies will likely be made apparent as the markets mature further and the upper limits of passive management's share of total assets are tested.

What do you all think? Feel free to share your thoughts or constructive criticisms.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.