A Hidden Danger in Explosion of Index Funds
All That Dumb Index Money May Be Creating Worse-Run Companies
(Bloomberg) -- New research has directly connected the explosive growth of passive investing to deteriorating corporate performance over the long haul.
In a paper posted this month, a trio of academics tracked share-buyback activity for a range of companies and found those with higher passive ownership spent more on stock repurchases but saw worse financial outcomes.
Having disengaged owners “lowered the association” between buybacks and future performance, according to authors Brian Bratten and Jeff Payne of the University of Kentucky and Meng Huang of the University of Toledo. It was also positively associated with “suspect” repurchases -- those that resulted in companies meeting or beating near-term earnings expectations.
“Our study provides evidence that passive investment may allow opportunistic management behavior that negatively affects future firm performance,” they wrote. “The growing influence of passive investment may lead firms to make repurchase decisions that are inconsistent with the interests of investors.”
The findings are the latest twist in the raging debate about the rise of passive investing. A growing body of literature has raised issues such as the erosion of rivalry between companies, but research over the role of index-tracking funds in corporate governance has delivered mixed conclusions. One notable study in 2016 strongly connected passive investing to improved management.
The researchers take a different view. They contend that companies with high passive ownership are less monitored, and therefore more likely to engage in strategic repurchase activity to help report forecast-beating earnings. The work took in more than a decade of U.S. company behavior.
“Passive investment may imply less monitoring, but it does not remove manager’s incentives to report higher levels of earnings per share to support current period stock prices,” they wrote. “Passive investment may thus disproportionately lead to management engagement in repurchases that improve short-term performance, potentially at the expense of long term value.”
Passive Attack
The rise of passive investing has been relentless in recent years, with U.S.-listed exchange-traded funds now holding more than $4.5 trillion. Lured by simplicity, low fees and reduced risk of lagging the market, investors have poured cash into mutual and ETFs that track indexes instead of actively managed counterparts.
While passive ownership is still in the minority, last year assets in index-based U.S. equity funds surpassed those in stock-picking funds for the first time.
The new research is focused on only one area of corporate decision making -- share buybacks -- and therefore makes no allowance for where passive ownership may lead to positive governance outcomes. But the study of performance subsequent to repurchases covers multiple areas.
Increased passive ownership was shown to negatively affect the link between buybacks and future capital expenditure, employment, cash flow, return on assets and return on equity.
Repurchases by firms with higher levels of passive ownership are likely to lead to “investment reductions and ultimately reductions of firm performance and value,” the paper said.
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