Activist and passive investors make unlikely bed-fellows but there is reason to think they work well together.
Both activist and passive investment are on the rise, the latter now accounting for upwards of a third of all US mutual fund assets and the former launching about 400 campaigns a year in the US. Yet the two styles could not be more different.
Passive investors usually make no distinction between what they see as good or bad corporate strategy, or even business models, buying shares in a company solely based on its proportion in a given index. Activists, in contrast, exist to exert pressure on management, hoping, via suasion, proxy fights or even gaining seats on corporate boards to change policy and, hopefully, improve the share price.
Though passive shareholders appear to get a free ride from the efforts of activists, a new study finds the two have a symbiotic relationship.
“Overall, our findings suggest that the increasingly large ownership stakes of passive institutional investors mitigate free-rider problems associated with certain forms of intervention and ultimately increase the likelihood of success by activists,” Ian Appel of Boston College and Todd Gormley and Donald Keim of The Wharton School write in the study.
The study found that increasing ownership in companies by passive investors between 2008-2014 didn’t make activist campaigns more likely, but did affect strategy, leading to more campaigns to get seats on boards. Companies with higher passive ownership were also more likely to make settlements on proxy fights. Activist investors in firms with higher passive ownership were also more likely to get takeover defence provisions removed, as well as being more likely to facilitate a sale to a third party.
This higher rate of intervention and success may be, in part, a function of organization. As passive investment is a scale business, it tends to have very few very large players, meaning that an activist can be more efficient in seeking support for her efforts. Think of the last 15 years as being a period in which small individual shareholders and active mutual funds have lost market share to more monolithic passive funds. These large passive funds may also be more sophisticated and better able to support activist campaigns which they don’t themselves start.
“Passive investors appear to be willing supporters of activists that seek board representation, and the increasing share of stock held by large passive institutions seems to facilitate activists’ ability to successfully enact change.”
An improving world
The study aligns well with an argument made this week by the blog Philosophical Economics which asserts that, far from being simply dumb money, passive investment is making financial markets and the economy more, not less, efficient.
Again, one critique of passive investment has been that, by buying indiscriminately, it will lead to more misplacing in markets. That, according to this argument, would be good for active fund managers, who will find themselves in a target-rich environment, but perhaps bad for companies and the economy.
It may be that the reverse is true, as “dumb” small or unsuccessful active investors are pushed out and replaced by passive giants.
“The trend towards passive management is not only sustainable, but that it actually increases the accuracy of market prices. It does so by preferentially removing lower-skilled investors from the market fray, thus increasing the average skill level of those investors that remain,” according to the post.
The net result is a more efficient market and economy, with less labour and treasure wasted on price discovery. That money which otherwise would have gone to line the pockets of active fund managers can then be deployed to more useful ends, upping productivity and output.
Philosophical Economics makes the argument that markets aren’t a “marketplace of ideas” where good chases out bad, but simply a place where my stupid opinion has exactly the force of the dollars I put behind it and so does Warren Buffett’s clever trade.
“All of the decisions impact the price, at all times. If the average skill that underlies the decisions goes down, then so too will the quality of the ultimate product – the price,” according to the post.
Quality prices are not, of course, by necessity higher prices. They do, however, ultimately lead to quality allocations of assets, which must ultimately increase wealth.
So, we may owe thanks to passive investors, not for acting in their own best interests, but for contributing to ours.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
