The traditional worry about the rise of passive investment is that it will result in less informed asset pricing in the market overall.
A new paper digs into how this rise of passive or quantitative investing impacts the efficiency with which firms are run.
Less active management means fewer investors are seeking out mispriced securities and better aligning them with reality. This can cause negative real-world effects, the most simple 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 and one of the paper’s co-authors.
As passive and active trends influence the market, it’s important to examine how the impacts of the strategies interact which each other, says Michael Gallmeyer, a professor of commerce at the University of Virginia and another co-author. “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 [quantitative] shops in the past say 10 years now are adding more capacity towards more activist-based investors.”
Quantitative investors 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 exercise 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 stock selections, ultimately investing in the same companies as active investors, but without attempting any additional engagement.
Gallmeyer argues these quant investors play a negative role. For example, the paper assumes that quantitative investors will replace activist investors.
Baker notes this would be 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. 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.”
The paper was presented at the Northern Finance Association’s 2020 conference. The Canadian Investment Review is a proud partner of the NFA conference. David A. Chapman, a professor of commerce from the University of Virginia also co-authored the paper.