(Bloomberg) -- It’s no secret that the index-fund revolution is shaking up Corporate America, as the likes of BlackRock and Vanguard Group become ever-more dominant investors in the world’s biggest companies.
Yet far from being innocent bystanders, corporations have been more proactive throughout this investment shift than many on Wall Street may realize — by selling their shares in droves to meet relentless demand from these trillion-dollar giants.
Recent research from academics at Harvard University and the University of Notre Dame presents evidence that the biggest single seller of equity to index funds over the past 20 years has been listed companies themselves, far ahead of other players in the secondary market like financial institutions or short sellers.
The paper, titled Who Clears the Market When Passive Investors Trade?, challenges various market views. It shows that while the likes of Apple Inc. and Meta Platforms Inc. have made headlines in the passive era for their big buybacks, the average company has been selling shares to meet index demand. Active funds have also been purchasing at the same time as their mechanical counterparts, instead of being on the other side of the trade.
Firms have been meeting this swelling passive appetite with sales of all shapes and sizes, including seasoned stock offerings and convertible bonds or warrants that then got turned into equity. A key channel has been employees with vested options, who then offloaded their stakes.
The findings from authors Marco Sammon and John Shim shed fresh light on how the $10 trillion index boom is impacting the modern stock market as an efficient allocator of capital. They show that, for better or worse, corporations and their favored staff have been able to tap into reliable demand for their shares from these massive price-agnostic buyers, thanks to the privilege of being included in widely followed indexes. Anecdotally, the likes of Twitter Inc., Tesla Inc. and Super Micro Computer Inc. have all raised equity capital right after they were added to the S&P 500.
The rise of passive investing has given companies a “greater degree of flexibility — whether they use the cash to invest more in their growth or it allows them to change their capital structure and get financing in ways that are more optimal,” said Shim, an assistant finance professor at Notre Dame, in an interview. “Index funds through their demand can have a real impact on the real economy.”
The academic presented the working paper at the National Bureau of Economic Research’s conference in July. Meanwhile Sammon, an assistant finance professor at Harvard, is best known within the ETF community for co-authoring a breakthrough paper published this year that suggests passive ownership of the US market might be double the consensus estimate.
At first blush, the duo’s latest study seems to be at odds with a popular narrative that companies are net share buyers during this passive era. But while total share repurchases have been huge, they’re concentrated in a small number of firms like technology megacaps, according to Sammon. The analysis focused on investor behavior through the lens of individual listed companies. On that basis, the vast majority issue new shares and don’t have an active buyback program.
There’s little doubt that index-tracking vehicles have been a boon for everyday investors. Yet Wall Street is on high alert for the unintended consequences wrought by the shift into these funds, which buy and sell on autopilot based on benchmark weightings — with little to no regard to market prices. Thanks to their sheer heft in today’s market, these players, whether they like it or not, are shaping financing decisions in the boardrooms of Corporate America, the new study suggests.
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To Owen Lamont, a portfolio manager at systematic firm Acadian Asset Management, the paper’s conclusions resonated with him. But it doesn’t mean there’s anything uniquely worrying about passive.
“If prices are being distorted by active investors like they were in 1999, the firms will respond,” said Lamont, a former finance professor. “So the fact that some of it is passive and some of it is active seems like a red herring to me.”
One interpretation from the paper, Shim says, is that stock prices would have appreciated more if firms weren’t ready to sell shares when index funds were buying.
On the flip side, the researchers found that when passive funds sell, most groups including corporates are less responsive, leaving the likes of small institutional and retail investors to snap up the equity.
“When index funds sell, there’s kind of no one to buy the shares,” said Shim. “So in order to get someone to buy the shares, prices need to fall a lot.”
The study falls under the so-called inelastic markets hypothesis that takes the impact of capital flows on asset prices seriously, instead of assuming the market is nearly always efficient.
To arrive at the conclusion, the authors sorted market participants into nine groups including active funds, pensions and the like. They then calculated how much their holdings changed every quarter in response to passive demand. Firms came out far ahead in selling shares to indexers. Specifically, for every 1 percentage-point increase in passive ownership, firms issue shares at a rate of 0.95 percentage point.
To isolate the effects of fund flows from the possibility that a fundamental shock, say AI adoption, drove both passive buying and firm issuance, the duo looked at shares that enjoyed inflows simply because other unrelated index members did well. Their conclusion still held: Index fund demand fueled share issuance, and the higher the company’s valuations, the more it sold.
In fact, the researchers found active funds largely bought and sold in sync with their passive counterparts. Sammon theorizes that this may be an example of “shadow indexing,” or because both type of fund managers tend to get similar flows at the same time.
That might ostensibly contradict the widely held view that the rise of passive investing is occurring at the expense of active vehicles. While that’s broadly true for the business of the asset management, the study honed in on how market players actually react to demand from index funds on the individual-company level.
“You didn’t have to reduce your allocation to Apple when VTI bought more of it because those shares came from somewhere else,” said Sammon, referring to the Vanguard Total Stock Market ETF. “As passive has gotten bigger and bigger, firms have become more and more important in clearing the market.”
Meanwhile, the question of exactly how firms are taking advantage of this big demand — and whether the badly managed ones are blowing the opportunity — is beyond the scope of the paper. But as the passive boom shows no sign of slowing down, it remains a pressing matter.
“The natural next question is to ask: How do firms use this source of financing and additional flexibility in compensation?” Shim said. “A more likely possibility is that this is neutral — or positive — for firms on average, but negative for firms with bad management or poor corporate governance.”
--With assistance from Sam Potter.
(Updates with firms’ reaction to index-fund demand in 18th paragraph)
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