Passive Investing Claims Another Victim: Stock Buybacks

Rejoice, for we have one more reason to freak out about index funds.
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fink-bill2

This guy is ruining stock buybacks.

Stock buybacks are a point of some contention, so let's get some basic facts straight right here at the outset: Companies buy their own shares because it makes the stock price go up. Executives OK buybacks because they are directly incentivized to make their stock price go up. Investors like it when stock prices go up, so they generally cheer buybacks. Aside from Larry Fink and Elizabeth Warren, everyone's happy.

But what if the stock prices of buyback companies don't increase as much as the raging corporate demand would suggest they should? In that case, we need to find something or someone to blame. And since we're looking for a culprit behind a market anomaly, we are obligated here to finger passive investing.

See, index funds don't care whether a company is buying back stock, and they're not going to pile in after a repurchase announcement; all they care about is maintaining consistent allocations. According to Charles Cara of Absolute Strategy Research, this causes some problems.

Buybacks reduce the numbers of outstanding shares. If those shares rise as a result of the buyback, then an ETF or index-tracking fund — which do not sell to companies buying back their stocks — will find itself overweight compared to its benchmark, and will be forced to sell some of the shares and buy the rest of the stock market to rebalance.

“Buybacks are a prop to the whole stock market, but have a subdued impact on individual stocks because there is a countervailing force from passive investors,” Mr Cara argues.

So when some Goldman Sachs trader executes an order to buy 10 million shares of XYZ Corp on behalf of XYZ, the subsequent price move is blunted by index funds dumping XYZ in order to keep their allocations current. Not every outstanding share of XYZ is held passively (at least not yet), so corporate demand moves the price a little, but not as much as one would expect.

You have to give Cara credit for finding anotherthing to blame on passive investing. But there remain some questions about the theory. First off, does the dynamic hold when pretty much every company buys back stock at a similar rate? If every bank in the bulge bracket spends 10 figures on buybacks in a year – i.e., if it's an average year – then a hypothetical financial index fund isn't going to have to ditch any of them on account of potential buyback-related returns.

But the most pertinent question is whether Cara's theory accounts for dilution. As the argument goes, repurchases fail to balance out the issuance of extravagant stock-based awards for employees. Take this purple passage from Research Affiliates:

Alas, like the cool pool of water shimmering on the desert horizon that turns out to be only the refraction of light from blue sky onto hot sand, the 4.8% dividend-plus-buyback yield in the U.S. equity market is a cruel mirage. The reality is that publicly traded companies in the United States are issuing far more new securities than they are buying back, diluting existing investors’ ownership and reducing growth in earnings and dividends per share well below the growth of their reported profits.

This seems like a stickier wicket. Still, points for dumping on passive.

US share buybacks punch below their weight [FT]

Correction: The original version of this article contained an erroneous description of how index funds work. Thanks to Charles Cara for his patient explanation in the comments. The writer has been flogged, and we regret the error.

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