Goldman: Here's One Way Passive Investing Actually Looks A Little Marxist
From each according to his ability, to each according to his flows?
Goldman Sachs Group Inc. has hit on one way in which the rise of passive investing might resemble Marxism, arguing that the popularity of funds seeking to replicate market indexes has the effect of rewarding corporate directors more equally than the fundamental performance of their respective businesses might warrant.
A team led by Global Head of Investment Steven Strongin notes -- echoing an observation from analysts at Sanford C. Bernstein & Co. -- that the increase in funds dedicated to passive products has been associated with a rise in intra-stock correlation, or a tendency for an increasing share of equities to move in tandem based on flows into or out of exchange-traded funds and other passively-managed vehicles.
“The decline of active investing means that, in many cases, stock prices have become more correlated and more closely linked to a company’s ‘characteristics,’ such as its index membership, ETF inclusion or quantitative-factor attributes,” the analysts write.
That means the specter haunting corporate management might well turn out to be the proliferation of passive strategies, which make it more difficult to distinguish and appropriately compensate ‘good’ corporate directors. Throw in the fact that many board members are paid based on stock returns and dividend payouts, and the problem becomes more acute, Goldman argues.
“Given the significantly lower turnover of passively-managed investments and the extent to which equity prices now also move for other reasons, boards need to be able to separate ‘characteristic-driven’ or ‘flow-driven’ movements from fundamental ones in order to better evaluate underlying corporate performance,” says the team.
Strongin's recommendation? A shift away from total shareholder return as a method of ascertaining directors’ performance.
“To gain a clearer picture of a firm’s performance – particularly on a relative basis – boards may want to put greater emphasis on broader assessments, leveraging financial metrics that are both standardized and comparable across companies,” he writes. “In our view, this may include focusing more on metrics such as cash returns on cash invested for non-financial firms, or return on tangible common equity for financial companies.”
To be sure, this problem is most acutely a made-in-the-U.S.A. and Britain one; Goldman strategist Peter Oppenheimer previously noted that for executives leading more than 60 percent of firms in the S&P 500 and FTSE 100, compensation is linked to total shareholder returns, compared to less than 40 percent for companies in the Euro Stoxx 50, for example.
Goldman’s proposals represent a sort of middle ground to solve this “director’s dilemma,” as Strongin dubs it, but the danger would be the pendulum swinging too far in the other direction -- towards more esoteric or qualitative metrics as a means of gauging management’s performance at a time when companies' shift away from standardized Generally Accepted Accounting Principles (GAAP) is already under scrutiny.
Pinterest Inc.’s emphasis on resurrected users, Twitter Inc.’s use of monthly active users, and Valeant Pharmaceuticals International Inc.’s proclivity for earnings adjustments are three examples of custom metrics used to communicate corporate performance to shareholders and other investors.
Of course, these worries could soon be rendered moot in the age of Donald Trump and the market moves that the president-elect has sparked. The decline in intra-stock correlation in recent months would, if sustained, mark fertile ground for stock-picking and effectively remedy some of the concerns raised by Strongin in this note.