How Passive Investing Distorts Earnings Season
In a spirited defense of today’s inefficient market, one which is allegedly unimpaired by the relentless metastasis of passive investing, Bloomberg wrote an article using Macro Risk Advisors data, in which it said that “for all the handwringing about how the growth of passive investing strategies is distorting the stock market” it concluded that “there’s virtually no market impact from it. Correlations remain at all-time lows and the amount of shares that are passively managed isn’t affecting single-stock.”
Conventional wisdom has held that as passive investment strategies accumulate larger piles of assets under management — the 14 percent represents an all-time high — it would lead to lockstep moves in stocks, making life harder for traders seeking informational edges by offering fewer opportunities to capitalize on insights into earnings and other signals. Instead, the MRA data show, that any reaction in the market has been muted — if there’s even been one at all.
Bloomberg was referring to these three familiar charts, showing the acute fund flow from passive to active strategies in recent years.
Unfortunately for defenders of the ETF boom, Bloomberg’s assessment is also wrong, because in a separate analysis released concurrently by Bank of America, Savita Subramanian reached just the opposite coinclusion.
BofA looked at the response of stocks which missed EPS estimates, and found two dramatically different outcomes for stocks with high vs low passive ownership. This is how she describes her findings:
Not only can crowding by active managers suggest risk to stocks, but high-passive ownership can matter, particularly during earnings season. Over the past seven quarters (including the 2Q earnings season so far), stocks with high passive ownership that missed on EPS and sales have underperformed those with low passive ownership by 1.5ppt on average during the following day, and the spread has widened significantly during recent quarters. This increased performance spread may be attributable, in part, to lower “true float” in these stocks, which appears to have driven increased volatility.
The increasingly disproportionate adverse reaction of high passive ownership stocks is shown in the chart below: it is most evident in Q2 2017 earnings.
The recent trend of stocks to have a materially more pronounced negative response to earnings misses has been discussed previously, however until now there was no quantifiable explanation.
BofA’s take, which can easily be tested for validation purposes, presents various arbitrage opportunities chief among which is creating a basket of high passive ownership stocks, and betting on sharp declines either through single-name short positions or puts while avoiding low passive ownership names, with expectations of this skewed return profile. One potential hurdle is that this earnings season – which is as of now 66% complete – companies that miss have been relatively few, although if this pattern persists, it should provide significant alpha opportunities during the Q3 earnings season, when the overall quality of earnings is expected to decline substantially as the base effect of last year worst quarter will be in the rearview mirror, while the much anticipated surge in energy earnings will have trouble materializing if oil fails to trade solidly in the mid-$50 range, not to mention the risk of either inflation finally creeping higher or the Fed following through with its balance sheet unwind promise.