Deciphering active and passive market dynamics

One overarching theme has dominated the asset management industry since the global financial crisis: the flow of assets from active management to passive vehicles. The flow of funds into passive has rocked the once-lucrative asset management industry and forced fees down from stratospheric heights to more investor-friendly levels. This structural shift in investing behavior has resulted in unique arbitrage opportunities for savvy portfolio managers, but has also yielded significant challenges for both buy-side institutions and corporate issuers.

Many active asset managers have struggled to adapt to the new investing landscape. The reduction in fees has created budget pressure on active managers and left many of them desperate to retain existing assets under management. As a result, it has become a common strategy for active asset managers to heavily market the technical sophistication of their investment strategies while simultaneously reducing innovation budgets, thereby making it nearly impossible for them to engage in widespread adoption of modern artificial intelligence (AI) enabled investment technology.

Meanwhile, corporate issuers are left to engage in a brave new world where passive investors hold substantial percentages of their outstanding stock. Simultaneously, publicly traded companies are forced to decipher hype about systematic investing and AI-driven strategies coming from many active managers. This makes the IRO’s job harder than it has ever been.

Active management struggles, passive thrives

In the 12 years since the global financial crisis, research by Portformer and Passiv AI indicates that active ownership in large-cap stocks has stagnated while passive ownership has increased significantly. This same research indicates that active ownership in small and mid-cap stocks has ‘dramatically declined’ over the same period. The rotation out of small and mid-cap stocks signals the rapid decline in deep research by active managers and the flight to the safety of mega-caps that have been offering share buybacks and large dividends. This dynamic poses substantial challenges for mid and small-cap IROs seeking to attract and retain active investors, many of whom are no longer even looking at smaller companies.

The rotation from active to passive (and from small-to-mid to large caps) began to take shape in the depths of the global financial crisis. According to research by Portformer and Passiv AI, between 2008 and 2010 median passive ownership in small to mid-cap stocks exploded from 6.5 percent to 14.2 percent, while passive ownership of large-cap stocks expanded from 7.9 percent to 14.3 percent. It appears this was the beginning of a trend where, on the heels of every dip in the stock market, passive ownership explodes while active ownership barely recovers. The market corrections in mid-2011, Q1 2016 and Q4 2018 all triggered similar expansion in passive ownership, and all presently available data indicates that the recovery from the Covid-19-induced correction will result in a similar increase in passive holdings.

The flow of funds from active into passive in recent years should come as no surprise. While active managers tout their ability to mitigate downside risk as their core value proposition, only 30 percent of active managers outperformed their benchmark during the global financial crisis. Since that time, 85 percent of all actively managed funds have failed to justify their fees on a risk-adjusted basis. Moreover, all available data from the recent Covid-19 crisis suggests that active managers have fared worse during this crisis than in prior periods of market volatility. This underperformance, coupled with substantially higher fees than passive vehicles charge, makes it clear why investors have abandoned active managers and flocked to passive vehicles.

Where active goes from here

Most active managers have spent the last decade focused on minimizing management costs while preserving large-cap assets under management. For many firms, this has come at the expense of much-needed research and technology modernization that would allow for the efficient generation of alpha in the small to mid-cap universe. Specifically, the failure to modernize consigns many large active institutions to focus more deeply on the crowded and ‘efficient’ large-cap market while touting their ‘new AI initiative’ just enough to retain assets under management.

The aggressive marketing of AI or data-science initiatives by active managers has made quant investing appear ubiquitous, but the actual adoption of these tools has been greatly overstated. This phenomenon whereby large asset managers spend more money advertising their innovation than they do on actual innovation has been dubbed ‘innovation theatre’. The next couple of years will likely make clear which active managers have merely been acting innovative and which have been investing in innovation.

Investors that succeed at mitigating cognitive bias, incorporating alternative data and expanding their universe of investable assets are truly innovating and their performance will indicate that. But 44 percent of companies have already indicated that Covid-19 will cause them to reduce spending on emerging technologies, according to a study by ETR Research. So active asset managers must combat the impulse to cut spending on emerging technology and instead invest heavily in modernization.

What do these market dynamics mean for IR?

The most important behavioral shift in financial markets over the past decade – the rotation of assets from active to passive investment products – will likely persist for the foreseeable future, so IROs need to be increasingly efficient and effective at attracting a shrinking pool of active investors. This means corporate investor relations departments need to modernize their technology stack, just like their buy-side counterparts. IROs need to adopt technology tools that help them better understand and communicate with investors. The remainder of this series will highlight how such tools can improve the IR workflow.

This article is the first in a series intended to explain the shifting landscape of active and passive asset management by highlighting the tools and technology used by both active and passive investors.

The next article in the series will focus on deciphering the specific tools and technology used by active managers. The third article will highlight how technology is used by passive managers and why that results in structural differences in asset allocation.

The final article in the series will explain how IROs can keep pace with changes in the asset management industry by adopting new technologies to better understand investor behavior.

Evan Schnidman is founder of EAS Innovation Consulting