The traditional worry about the rise of passive investments is that the trend makes for less informed pricing of assets in the market overall.
Less active management means fewer investors are seeking out mispriced securities and bringing them better in line with reality. This can cause negative real-world effects, the most simplistic of which is that capital will flow to firms that won’t use it productively, says Steven Baker, assistant professor of finance at the University of Virginia.
“Our paper is looking at another concern which is that many active investors do engage with the companies with which they invest, they engage with management,” he says, referring to a work he co-wrote with Michael Gallmeyer, Consumer Bankers Association professor of commerce and David Chapman, professor of commerce, both at at the McIntire School of Commerce at the University of Virginia “[Active managers] may, through monitoring, lead those firms to become more efficient. This can be an explicit objective of the fund, if it’s an activist fund . . . but what we mean more broadly are active managers that have some kind of engagement with the firms in which they invest that is positive.”
As passive and active trends influence the market, it’s important to examine how the impacts of the strategies interact which each other, says Gallmeyer.
“You do see more activism-type roles in the managed money business now. And you even see it in non-traditional places – even in hedge funds that have long been pure quant shops in the past, say, 10 years, now are adding more capacity towards more activist-based investors.”
There’s another relevant set of players the paper refers to as quants that falls somewhere in the middle of the active/passive spectrum. These investors actively seek a better set of investments, along a proprietary set of parameters, but they don’t exercising their “voice” or attempt to influence the operational performance of the firms in which they invest, he says. They might sort through and optimize their selections of stocks, ultimately investing in the same companies as active investors, but without attempting any kind of additional engagement.
Gallmeyer argues these quant investors play a negative role. “At the end of the day, they displace the more productive activists.”
Baker notes this impact is problematic for investors overall. “Generally if you have changes in the way the market works that lead there to be relatively more quants and fewer activists, this is usually bad . . . for the investment community generally, with the exception of the quants themselves, maybe.”
“It does depend on how this happens. . . . Let’s suppose the technology of quants improves so that it’s cheaper for someone to set up a quant fund and implement a strategy that allows them to find efficient firms to invest in. So they become better at searching for opportunities,” he says “That is going to drive, not only activists out of the marketplace, but eventually if quants become efficient enough, they will even drive quants themselves out of the marketplace because there will be so few targets for them, so few firms for them to invest in that will provide value to investors, that they’re going to eliminate their own demand.”