Earlier today, we brought you a short excerpt from a new Goldman note in which the bank observes that “the share of stock that might trade on fundamental views has dropped to 77% for S&P500 average stock from 95%” in the short space of a decade.
When they say “the share of stock that might trade on fundamental views” they’re referring to what they’ve dubbed the “passive-adjusted float” or, simply, shares outstanding minus insider holdings and passive holdings.
When that figure declines, it suggests that stocks are driven increasingly by indiscriminate flows and decreasingly by fundamentals. This is an extension of the notion that the rampant proliferation of passive vehicles is destroying price discovery.
Of course this is great on the way up. The question, as noted in our original post, is what happens on the way down. To wit:
So that’s all fine and good on the way up. But what happens on the way down?
Something about babies and bathwater…
“The fact that most Passive managers have low turnover means their positions rarely change,” Goldman goes on to write in the same note we cited earlier. They add: “Therefore, we find stocks across all sectors in the S&P500 where Passive ETFs and Mutual Funds have concentrated positions and will likely need to buy if inflows continue or sell if Passive sees outflows.”
In other words, if the passive position in a stock is outsized and flows into passive vehicles reverse course, those stocks may be the babies that get tossed out with the bathwater. Well with that in mind, consider this from Goldman:
Because Passive turnover is just 3% a year, current holdings can give us insight into what stocks Passives will need to buy and sell to meet inflows/outflows. We focus on Concentrated Passive Positions for where the impact of a sudden change in flows could be the greatest. ETFs and Passive Mutual Funds own 10% to more than 35% of the shares outstanding of S&P500 stocks. In the Consumer Discretionary sector, at one extreme sits Leggett & Platt (LEG) where Passives own 27% of the market cap. At the other extreme, Passive investors own just 10% of Carnival Cruise (CCL). Indeed, LEG is a member of several dividend ETFs, and when these ETFs see inflows, the managers have to buy more LEG shares relative to CCL.
If inflows into passive strategies continue, the impact from Passives having to buy these stocks to deploy capital could be greater. However, if Passive Funds see outflows, the impact from selling concentrated holdings to meet redemptions could be greater. Continuing on the example above, more than 120 US Equity ETFs own LEG shares and 80% of ETF holders are Smart Beta funds. While the two largest ETF holders are Smart Beta Dividend ETFs, the SPDR S&P Dividend ETF ($16bn AUM) and the iShares Select Dividend ETF ($17bn DVY), LEG is held by more than 15 different dividend ETFs. If investors sentiment on dividends changes, not to mention if LEG’s dividend policy changes, flows in the broader ETF or a rebalance could impact LEG more than others in the sector. LEG is also held by 22 Index ETFs and 19 Sector ETFs, and broader flows in these ETFs could lead Passive investors to buy or sell LEG shares for reasons outside of fundamentals in LEG’s business.
So you know, feel free to throw some shade towards that assessment if that’s how you’re feelin’, but don’t be surprised if some of the names on that list plunge more than they should during a broad-based selloff.