The growing dominance of index funds, spearheaded by giants like BlackRock and Vanguard, has significantly reshaped Corporate America’s equity market landscape. These funds, which now manage trillions of dollars in assets, have created an enormous demand for shares of the largest publicly traded companies. However, a key and often overlooked element in this transformation is how corporations themselves are capitalizing on this passive investing trend.
Research conducted by academics at Harvard University and the University of Notre Dame reveals that over the past 20 years, listed companies have been the largest sellers of equity to meet index fund demand. This makes them a far more active participant in the market than traditional financial institutions or short sellers.
In their paper, Who Clears the Market When Passive Investors Trade?, authors Marco Sammon and John Shim argue that corporations have strategically sold shares to accommodate the steady inflows into index funds. This has been achieved through various channels, such as seasoned stock offerings, convertible bonds, warrants, and even employees selling shares acquired through vested stock options.
The study sheds new light on how the $10 trillion passive investment boom has shaped modern stock markets. As index funds have grown in prominence, corporations have found an opportunity to sell equity to reliable, price-agnostic buyers. This trend is not just theoretical—companies like Twitter, Tesla, and Super Micro Computer raised capital after being included in the S&P 500, highlighting the tangible benefits of index inclusion.
“The rise of passive investing has provided companies with a unique level of flexibility, allowing them to manage their capital structures more efficiently and tap into consistent demand,” said Shim, an assistant finance professor at Notre Dame. “Index funds, through their demand, are having a real impact on the economy.”
Sammon and Shim’s research challenges a widely held belief that companies have been net buyers of their own shares during the passive investing boom. While it’s true that some firms, especially large technology companies, have engaged in substantial share buybacks, the research indicates that most companies have actually issued new equity to meet index fund demand. This contrast highlights the strategic behavior of companies that see the demand from index funds as an opportunity to raise capital.
Index funds have become a boon for retail investors, offering low-cost exposure to a broad range of stocks. However, as these funds continue to grow in size and influence, concerns arise about their unintended consequences on market dynamics. Since index funds mechanically buy and sell shares based on their weighting in benchmarks, this automatic trading can influence corporate financing decisions. Companies with higher index weightings are increasingly selling shares when demand is high, potentially distorting market prices.
Owen Lamont, a portfolio manager at Acadian Asset Management, noted, “While the paper resonates with me, I don’t believe the rise of passive investing itself is inherently problematic. What we’re seeing is a natural response from corporations adjusting to a new reality in the equity markets.”
Interestingly, the research found that while companies are quick to sell shares when index funds are buying, they are far less responsive when index funds are selling. This results in smaller institutional and retail investors stepping in to buy the shares, often at lower prices.
“When index funds sell, there’s often no one immediately ready to buy, leading to price declines,” said Shim.
The study adds to the growing body of literature on the inelastic markets hypothesis, which suggests that capital flows can have a significant impact on asset prices, challenging the conventional wisdom of market efficiency.
Sammon and Shim’s research identifies companies as the biggest sellers of shares when index funds buy, but they also point out that active funds often mirror the behavior of their passive counterparts. This “shadow indexing” implies that while the narrative of passive funds overtaking active funds is broadly true in asset management, it does not necessarily translate to how these players behave in the stock market.
“As passive investing has grown in size, companies have become more crucial in balancing supply and demand for shares,” Sammon explained.
One of the key unanswered questions the study raises is how companies are utilizing the capital raised through these equity sales. “Are firms wisely reinvesting this capital for growth, or are poorly managed companies squandering the opportunity?” Shim asked, suggesting that future research could explore the effectiveness of this financing strategy.
With passive investing showing no signs of slowing down, the role of corporations in managing equity supply to match the enormous appetite of index funds will continue to be an important topic for both investors and regulators.
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