The Battle for Alpha Between Active and Passive Investors
Recently the National Investor Relations Institute (NIRI) and Clermont Partners published a research report entitled, "Proactively Attract Investors in an Increasingly Passive World." Among the report’s findings, active buy-side investors have been more challenged to find “investment alpha” over the past five years, since the growth in lower-cost passive investing has resulted in fee compression, higher correlation among stocks, and upward pressure on larger cap stocks, regardless of fundamentals.
To explore this battleground for investment returns in more depth, Victoria Sivrais of Clermont Partners moderated a panel at the recent NIRI Annual Conference that dealt with the growth and impact of passive investing. The panel featured:
- Richard Glass, an independent portfolio manager focused on value investing with more than 25 years’ experience in the industry at firms such as Deutche Asset and Wealth Management, Lockwell Investments, LLC, and Morgan Stanley Asset Management.
- Irene Aldridge, a quantitative Big Data researcher, author and Adjunct Professor of Big Data and Finance at Cornell University.
- Adam Frederick, Senior Vice President of Intelligence at Q4, responsible for directing the over-all vision and growth of the company’s intelligence division.
Mr. Glass provided data that showed passive investing has more than doubled since 2004, which has been driven by reduced fees, and is now around 45% of the total market for all company sizes. He provided his value-oriented perspective on stock picking, along with advice to companies to help attract investors:
- In a world of rising passive investment, there are many active investors who are really “closet indexers” – those who are categorized as active, but will closely follow the market weight for indices like the Russell or S&P. To stand out with these investors, Mr. Glass believes companies need to focus on making their stock look better than other stocks on a relative basis.
- To compete effectively and attract investor interest, Mr. Glass cautioned, “Don’t overestimate Wall Street.” He said companies need to tell their stories like they’re explaining it to a second grader. If companies don’t dictate the focus, someone else will, whether it’s the buy side or sell side. He also advocates using slides to direct the narrative more effectively during quarterly earnings calls.
- In meeting with investors, he suggested other company leaders – and even board members – get out on the road in addition to the CEO, so they can hear the buy side’s concerns directly.
- Mr. Glass stressed the importance of targeting: “You want to target your investor base and find the right people who are going to drive valuation.”
Ms. Aldridge has a quantitative approach to investing is very different than Mr. Glass’. Her firm helps explain volatile market trading behavior in real time for clients. Her focus and tips to companies are summarized below:
- Ms. Aldridge said much of the market volatility is driven by new technology since today it’s vastly less expensive to develop and deploy automated strategies based on footprints in the data. Mr. Frederick supported this view, and said that technology is much more ubiquitous and available to the quantitative investors and IROs.
- Passive investors prefer to hold larger stocks due to better liquidity. The key for these investors is to be able to get out of a stock quickly if need be. “Only one thing truly differentiates [a company to passive investors] – the ability to sell your stock faster than that of competition,” Ms. Aldridge said.
- Ms. Aldridge also believes companies should make data available to quants on their website. “What you really have to feed them is how your stock is different along with the criteria they care about, such as liquidity,” she advised. Mr. Frederick said passive investors are scouring for data points such as KPIs and industry metrics, and making that data available on IR websites enables companies to tell their story in a more quantitative way.
- Ms. Aldridge also views ETFs as driving more volatility in the market. “The more ETFs[i] hold your stock, the more liquid your stock becomes, so it actually becomes more attractive compared to your competitors. If your stock is included in more ETFs, it will become more volatile because it will be tied to other stocks and financial instruments. While on its face this seems negative, according to a body of finance academic literature, investors pay for the risk with returns. The higher the risk, the higher the volatility, the higher the long-term return should be,” she said.
With this rapidly evolving landscape, Ms. Sivrais of Clermont Partners offered some additional considerations for companies:
- It is clear that companies may not fully understand the extent of index and passive investing represented in their shareholder bases given the increase in “closet indexers.”
- Relying on an institution’s firm-level style alone (e.g., growth, GARP, index) misses hidden passive investors at the fund level. As a result, the remaining active investors in a shareholder base may have a more disproportionate influence than a company originally believed. Fund level analysis for current and potential shareholders is imperative.
- As active investors continue to search for alpha, the competition for capital is intensifying. To stand out, a company must understand the investment drivers of key active managers, and subsequently, ensure its core investor messages are aligned with the information these investors are seeking.
- Finally, management needs to consider how attractive their corporate message is on a relative basis versus the market – not simply against their largest industry competitors.
[i] An ETF, or exchange traded fund, trades like a common stock and tracks an index, a commodity, bonds, or a basket of assets like an index fund.