Analysis probes potential of shareholder activism in pursuing market outperformance
In a September interview with Bloomberg, famed fund manager Michael Burry grabbed headlines by calling a bubble in index investing. He also presented a possible way forward for active managers hoping to beat their passive rivals: focusing on small, value-type securities and improving them through shareholder activism.
Intuitively, it makes sense. Stock-pickers’ in-depth knowledge of company and industry fundamentals might not help them do better than index funds, quants, and AI at forecasting asset prices. But as Factor Research Managing Director Nicolas Rabener highlighted in a recent commentary, that knowledge might be better applied by campaigning to change companies.
“As assets have flooded into passive, the structure of ETFs and index funds have made it more difficult for institutional investors to challenge company management,” Rabener said in a piece published by the CFA Institute. “That’s where activist investors ought to come in: They are useful tools for policing stock markets.”
However, the AUM of activist hedge funds has slightly declined compared to where they were in 2014, he said, citing financial data firm Hedge Funds Research (HFR). Data from Activist Insight also shows that the number of public companies targeted by activist investors worldwide has stayed flat over the last four years, with a low of 784 in 2015 and a peak of 943 last year.
To understand what drives the performance of activist hedge funds, FactorResearch focused on two indices from HFR: the HFRI Activist Index and the HFRX Activist Index. After conducting a factor exposure analysis on the two benchmarks, they found that most of the performance can be explained by stock market exposure, with some meaningful exposure to value, size, quality, and growth factors.
“That activist investors focus on cheap, small, and poor-quality stocks is intuitive,” Rabener said, noting their focus on companies that are ripe for transformation. The focus on growth, however, was more of a surprise as they indicate a focus on firms with strong sales and earnings growth; in such cases, activist investors would discuss matters of strategy rather than restructuring.
Because they might use alternative strategies or be exposed to non-traditional assets, hedge funds generally shouldn’t be benchmarked against stock market indices. But the factor exposure analysis of activist hedge funds suggested that most of their returns are derived from the stock market. And even more concerning, activist hedge funds have underperformed the market since 2009, even on a risk-adjusted basis.
“Investors can live with hedge funds that generate lower returns than the stock market if risk is reduced as measured by volatility and drawdowns,” Rabener said. “But that was not the case for activist hedge funds.”
The takeaway, he said, seems to be that even if they turn their attention to shareholder activism, it seems that active managers aren’t necessarily rewarded with market-beating performance.
“Mutual fund managers who don’t want to be run over by the ETF industry might think about applying their company and industry expertise as activist investors,” Rabener said. “But it won’t be an easy path and may just mean exchanging one set of oncoming headlights for another.”