Passive investing stirs up earnings season volatility: Martin Currie

New commentary from active equity specialist, Martin Currie, has attributed the atypical levels of volatility seen during the recent reporting season to investors returning to passive “index-hugging” strategies, driving inflated share prices despite stable earnings.

Reece Birtles, Chief Investment Officer at Martin Currie Australia, said “passive investing-induced volatility” cemented itself as an influential theme during reporting season.

“A concept we introduced at the last reporting season was the impact of high index flow, an increasing dominance of index -aware strategies and the falling daily stock turnover of some of Australia’s largest index stocks,” he said.

“The willingness of investors to trade to match an index, regardless of price, is creating a persistent upward bias to price discovery for many stocks and greater volatility in these names.

“We have looked more closely at Wesfarmers during this period and are seeing the same issues as what we reported for CBA last season. The number of Wesfarmers shares traded over time is falling; the stock has a high index weight; and for each dollar flowing into the index, we are seeing a higher percentage of daily traded turnover being driven by that high index flow.”

“For so many of these index flow stocks, the common consequence we are observing, is a disconnect between any concept of fundamental cash flow valuation and share prices, creating very divergent market conditions.

“In the case of Wesfarmers, we can see that price has had a massive re-rating, but relatively subdued earnings using all valuation measures. Interestingly, we noticed that the company returned capital to shareholders rather than undertaking an on-market buyback or declaring a special dividend. By eschewing the opportunity to buy their own shares, this gives a clear signal of their own view of how overvalued they are at this point.”

According to Birtles, investors have reanimated the “great ‘no information’ index re-allocation trade”, driving exaggerated price reactions.

“The index flow distortion is most evident when markets are quiet and there are fewer information traders. However, when the market sees new information on a stock, such as during results season, the overall volume of shares traded typically increases and the impact of pure index buying diminishes as it is overpowered by the trading based on the new information.

“This typically results in small levels of information or ‘news’ causing large price reactions. This is what we have seen for several companies in the top 50 where their earnings were revised less than +/-2% (what we would consider ‘in-line’) but had big share price reactions. Compared to prior periods, this is becoming more pronounced.

“We also saw that big index weight and high index flow pressure companies like CSL, CBA and James Hardie have relatively large negative price reactions to small news. One would normally expect that given their weight, this would impact the overall return of the market and drag it down, but that wasn’t the case this season as it went up 3.1% in aggregate.

“In addition to the gap between price and fundamentals, this is another sub issue in the high passive flows thematic. The market is now no longer acting in a traditional ‘sum of the parts’ manner, as when these stocks go down, investors just move their positions to other big index weight stocks like Westpac Banking Corporation (WBC), National Australia Bank, ANZ Group Holdings, Wesfarmers, and Coles, causing them to go up on little information instead.

“As long-term fundamental investors, the divergence between fundamentals and share prices that this sort of indiscriminate index flow-driven market is creating is very concerning to us. The 0.5x price reaction/EPS revision relationship that we typically see for the S&P/ASX 200 stocks mentioned earlier jumps to a 2x relationship for the highest 25 index flow names. For very small changes in fundamentals, this is a very large price reaction.”

Birtles said this phenomenon only strengthens the case for a “dedicated” portfolio construction strategy that leverages the power of active stockpicking.

“For investors who are trying to find alpha in this sort of market, we believe that there still is a benefit to focus on active fundamental insights. However, with many active managers who are underweight large caps and banks in particular underperforming their benchmarks, asset owners often pose the question of is there any benefit to be active, particularly in high index flow stocks in the top-20,” he said.

“We believe that a more nuanced risk factor-controlled approach can be used to avoid being swamped by the price reactions of the high index flow / top 20 stock under and overweights.”