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Wall Street's Newest Puzzle: What Passive Buying and Selling Means for Individual Stocks; Even active investors have resigned themselves to the influence of indexing--and are looking to profit from itWall Street's Newest Puzzle: What Passive Buying and Selling Means for Individual Stocks; Even active investors have resigned themselves to the influence of indexing--and are looking to profit from itDieterich, Chris; Driebusch, Corrie. Wall Street Journal (Online); New York, N.Y. Stock pickers, who for so long decried the rise of passive investing , are now trying to profit from it. In what's emerging as a nascent line of market research across Wall Street, investors are attempting to puzzle out how passive investing creates opportunities--or pitfalls--for individual stock trading. They are looking at factors such as the percentage of a stock owned by index funds and money flows into and out of such funds as they size up whether to buy or sell shares of a company. This new type of analysis shows how the rise of passive investing --tracking a basket of securities rather than picking individual ones--is changing the makeup of markets . Even active investors are now resigning themselves to the influence of indexing and are contriving ways to take advantage of its impact. The research, by investors and academics alike, is largely in its infancy, many say. And fundamental factors, such as valuations, generally remain most important to stock pickers. But with passive investing this year representing about 29% of assets in domestic stock funds alone, according to Moody's Investors Service--a figure the firm sees topping 50% as soon as 2021--investors who pick single stocks are paying attention. "When I think about what makes a stock tick, it comes back to earnings, the quality of management and the ability of a company to execute, but being in an ETF is a factor to be aware of," said Christopher Marinac, director of research at Atlanta-based FIG Partners, of exchange-traded funds, a popular form of index investing. "Passive ownership is not first or second on the list, but now it is definitely on that list," he said. So far, researchers say, the influence of passive investing is most pronounced for midsize- and small-company stocks, which generally trade less frequently than the largest ones. Pankaj Patel, head of quantitative research at Cirrus Research, in Tarrytown, N.Y., earlier this year published a series of reports on ETF ownership of U.S. stocks, prompted by client demand. He found dozens of small and midsize companies with more than 20% of their shares outstanding owned by ETFs. Mr. Patel said one-way money flows into or out of index funds potentially create opportunities for active managers who, for example, might opt to hold a stock longer than they might otherwise when flows are cresting, or pare back a holding sooner if money is moving out. "Portfolio managers should be aware of heavy ETF ownership," Mr. Patel said. "It can be an advantage when flows are positive, but you want to be careful when they turn around." Analysts say November's presidential election provided a case study for the effects of passive investing on small-cap stocks. Roughly $9 billion poured into more than two dozen financial-stock ETFs in the month following the election, according to Keefe, Bruyette & Woods. Melissa Roberts and Pell Bermingham, quantitative analysts at the firm, found that ETF flows had a meaningful impact both on the daily trading volumes and performance of certain financial-sector stocks. Shares of companies included in financial ETFs rose by a median 19.4% over the period, compared with 14.2% for financial stocks not in these ETFs, they found. The passive effect was compounded, they said, because many financial-sector stocks are included in the Russell 2000 index of small-company shares. Some $5 billion flowed into the largest ETF tied to this index, the iShares Russell 2000 ETF, in the month after the election. KBW estimates that ETF flows into all financial ETFs, plus the small-cap stock ETF, resulted in 24% of share turnover in Southwest Bancorp Inc. in the month after the election and 23% in First Connecticut Bancorp Inc. These small banks' stock prices rose 28% and 27%, respectively, over that period. "ETFs aren't really driving performance, but flows can exacerbate performance," Ms. Bermingham said. Research from Savita Subramanian, equity and quantitative strategist at Bank of America Merrill Lynch, suggests that companies with a larger proportion of tradable shares in passive funds tend to see heightened choppiness since fewer shares are available for active traders. That is because the "true float" of available shares is diminished, she said. "Stocks with more float held by passive funds exhibit, on the margin, higher volatility," Ms. Subramanian said. Still, being owned by indexes can be a good thing. Nearly 40% of the tradable shares of Meredith Corp., a media company with a market capitalization of $2.4 billion, are owned by passive mutual and exchange-traded funds--more than any stock in the U.S. market, according to Steven DeSanctis, a small- and midcap analyst at Jefferies. Passive ownership in Meredith received a major boost in January, when the stock was tapped for inclusion in an index that powers the $16 billion SPDR S&P 500 Dividend ETF, which includes only companies that have raised dividends for 20 years in a row. In a matter of days, the ETF bought nearly three million Meredith shares and became one of the stock's biggest single owners. Trading volume during the session when Meredith was added to the index was the heaviest in more than a year, according to FactSet. "We have seen inclusion in indexes add to demand for Meredith stock," said Mike Lovell, Meredith's director of investor relations. He said the company doesn't manage its business with an aim toward index inclusion, but added that its fundamentals, including a long record of paying dividends, tick many boxes for indexes that screen for such traits. Since 2004, professional small-cap stock pickers have fared worse when passive inflows accelerate and better when money is moving out of index-tracking small-cap funds, according to Mr. DeSanctis. His analysis shows that active managers who favor larger small-caps fall behind as index-tracking money bids up the smallest ones. The trend reverses when money moves out of index-tracking small-cap funds, as the smallest stocks fall hardest. "Flows are the incremental buyer of the smaller small-caps," he said. "They can really push performance of these less-liquid names." |
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