Who's Selling When Index Funds Are Buying?

It's no secret that the index fund revolution is shaking up corporate America, as firms like BlackRock and Vanguard Group become increasingly dominant investors in the world's largest companies.

Far from being innocent bystanders, however, corporations are more active in this investment shift than many on Wall Street realize, selling their shares en masse to meet the relentless demand from these trillion-dollar behemoths.

Recent research by researchers at Harvard University and the University of Notre Dame suggests that the largest sellers of shares to index funds over the past 20 years have been the listed companies themselves, significantly outpacing other secondary market players such as financial institutions or short sellers.

Article entitled Who clears the market when passive investors trade? Challenges different views of the market. It shows that while companies like Apple Inc. and Meta Platforms Inc. made headlines during the passive era with their big buybacks, the average company was selling shares to meet index demand. Active funds were also buying at the same time as their mechanical counterparts, rather than being on the other side of the trade.

Firms fed this growing passive appetite with sales of all shapes and sizes, including seasoned stock offerings and convertible bonds or warrants that were then converted into equity. A key channel was employees with vested options who then sold their shares.

The findings of the authors, Marco Sammon and John Shim, shed new light on how the $10 trillion index boom affects the modern stock market as an efficient allocator of capital. They show that, for better or worse, corporations and their cronies have been able to secure reliable demand for their shares from these large, price-neutral buyers thanks to the privilege of being included in widely followed indexes. Companies like Twitter Inc., Tesla Inc., and Super Micro Computer Inc. are said to have attracted equity capital immediately after being added to the S&P 500.

The rise of passive investing has given companies “a greater degree of flexibility — whether they use cash to invest more in their growth, or it allows them to change their capital structure and get funding in more optimal ways,” Shim, an associate professor of finance at Notre Dame, said in an interview. “Index funds, because of their demand, can have a real impact on the real economy.”

The researchers presented a working paper at a National Bureau of Economic Research conference in July. Meanwhile, Sammon, an associate professor of finance at Harvard, is best known in the ETF community as the co-author of a groundbreaking paper published this year that suggested passive holdings of the U.S. market could be twice the consensus estimate.

At first glance, the duo’s latest research seems to contradict the popular view that companies are net buyers of shares in this passive era. But while the overall amount of share buybacks has been huge, it is concentrated in a small number of firms, such as tech megacaps, according to Sammon. The analysis focused on investor behavior through the lens of individual listed companies. Based on this, the vast majority are issuing new shares and do not have an active buyback program.

There’s little doubt that index-tracking vehicles have been a boon for ordinary investors. Yet Wall Street is bracing for the unintended consequences of the shift to these funds, which buy and sell on autopilot based on weightings — with little regard for market prices. With their outsized heft in today’s market, these players are shaping financial decisions in corporate America’s boardrooms, whether they like it or not, a new study suggests.

Bloomberg LP, the parent company of Bloomberg News, competes with index companies in the financial services industry.

Owen Lamont, a portfolio manager at systems firm Acadian Asset Management, found the paper's findings resonant. But that doesn't mean there's anything uniquely worrisome about passive investing.

“If prices are distorted by active investors, as they were in 1999, companies will react,” said Lamont, a former finance professor. “So the fact that some of it is passive and some of it is active seems to me like a red herring.”

One interpretation of the paper, Shim said, is that stock prices would have risen more if companies had not been willing to sell shares when index funds were buying them.

On the other hand, the researchers found that when passive funds sell, most groups, including corporations, are less responsive, resulting in smaller institutional and retail investors buying up the shares.

“When index funds are selling, there's no one to buy the stock,” Shim said. “So for someone to buy the stock, the price has to go down a lot.”

The study falls under the so-called inelastic markets hypothesis, which takes seriously the impact of capital flows on asset prices, rather than assuming that the market is almost always efficient.

To reach this conclusion, the authors divided market participants into nine groups, including active funds, pension funds, and the like. They then calculated how much their holdings changed each quarter in response to passive demand. Firms were far ahead in selling shares to indexers. Specifically, for every 1 percentage point increase in passive ownership, firms issued shares at a rate of 0.95 percentage points.

This article examines how different groups of market participants react to each incremental change in the ownership of an equity index fund. (Source: Marco Sammon and John Shim)

To separate the effects of fund flows from the possibility that a fundamental shock, say, the adoption of AI, triggered both passive buying and hard issuance, the duo looked at stocks that received inflows simply because other unrelated index members performed well. Their conclusion still held: Demand for index funds fueled stock issuance, and the higher a company’s valuation, the more it sold.

In fact, the researchers found that active funds were largely bought and sold in sync with their passive counterparts. Sammon suggests that this could be an example of “shadow indexing,” or because both types of fund managers tend to receive similar flows at the same time.

This may seem to contradict the widely held belief that the growth of passive investing is coming at the expense of active vehicles. While this is generally true for the asset management business, the study focused on how market participants actually respond to demand from index funds at the individual company level.

“You didn’t have to reduce your Apple stake when VTI bought more because those shares came from somewhere else,” Sammon said, referring to the Vanguard Total Stock Market ETF. “As the liability got bigger and bigger, the firms became more and more important in cleaning up the market.”

Meanwhile, how exactly firms are tapping into this massive demand—and whether they are squandering poorly managed opportunities—is beyond the scope of this article. But with the passive boom showing no signs of slowing, it remains a pressing question.

“The natural next question is: How do firms use this source of funding and the additional flexibility in compensation?” Shim said. “It's more likely that it's neutral — or positive — for firms on average, but negative for firms with poor management or poor corporate governance.”

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