Passive’s Influence on U.S. Small-Cap

July 21, 2017

This week’s chart examines the percentage of active and passive ownership within the large, mid, and small-cap segments of U.S. equities. The longstanding trend of increased investor usage of passive strategies over time has been well documented. Since January 2000, the percentage of passive investments has grown from 15% to represent nearly 47% of total U.S. equity mutual fund and ETF assets through June 2017. While true that the bulk of passive assets are directed towards informationally efficient areas of the market such as U.S. large-cap, the overall percentage of passive ownership within each market cap segment varies.

As seen in the above chart, passive investments comprise a greater percentage of the small-cap segment than those for mid or large-cap. Critics of passive investing argue that these investments have the potential to distort the price discovery mechanism of the market should passive assets become too large a percent of total invested assets. The reason for this being that strong passive flows provide support or pressure to index constituents depending on the direction of asset flow regardless of a company’s fundamentals. Given the higher overall percentage of passive ownership in small-cap, the impact of passive investing is arguably greater in this market cap segment.

The situation is further compounded for active managers in small-cap since approximately one-third of stocks in the Russell 2000 index do not generate earnings. Active managers generally have a quality bias thus tend to underweight companies that exhibit no earnings, have low trading volume, or short operating histories. Strong passive flows provide support to this segment of small-cap that is underrepresented by most active small-cap managers. Active small-cap managers in aggregate have been able to generate greater consistency of value-add over their index than active managers within the mid and large-cap market segments despite the higher percentage of passive assets. The reason for this discrepancy is likely because of informational inefficiencies which remain among small-cap companies. If the strong inflow trend continues in passive products, small-cap managers may experience greater difficulties outperforming their index in the future.

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