Firms With High Passive Ownership Are More Likely to Make Suspect Repurchases

Companies with a lot of passive fund ownership are more likely to repurchase shares in order to boost their short-term stock price, subsequently harming performance over the long haul.

Researchers studied share repurchase activity for a range of U.S. companies from 2005 to 2017. They found that those with higher passive investor ownership spent more on stock repurchases but experienced worse financial results. In addition, the researchers found that companies with higher levels of passive ownership are more likely to strategically repurchase shares to report earnings that meet or exceed benchmarks, which is also known as “suspect” repurchases.

Following the financial crisis, passive investments consistently outperformed most actively managed funds, thus increasing the popularity of passive strategies. Passively managed funds generally seek to mirror the market index rather than beat it and do not modify holdings based on company performance or management decisions. Passive investors are viewed by firms as not closely monitoring the actions of corporate management, giving managers an incentive to raise earnings through share repurchases. The study’s authors wrote, “The growing influence of passive investment may lead firms to make repurchase decisions that are inconsistent with the interests of investors.”

Typically, share repurchases are an effective and efficient way in which companies can distribute excess cash among investors, as an alternative to cash dividends. Share buybacks also have a positive impact on earnings and return on equity and assets. However, companies with high passive ownership are monitored less closely and therefore are more likely to engage in “opportunistic repurchase activity” to help report higher levels of earnings. The study’s authors continue, “Passive investment may thus disproportionately lead to management engagement in repurchases that improve short-term performance, potentially at the expense of long-term value.”

Higher passive ownership was shown to negatively impact the relationship between buybacks and future capital expenditures, employment, cash flow and return on assets and equity. They conclude, “repurchases by firms with higher levels of passive ownership are likely lead to investment reductions and ultimately reductions of firm performance and value.”

Source: “Passive Investment and Stock Repurchase Activity,” by Brian Bratten, Meng Huang and Jeff L. Payne; Centre for Economic Policy Research, April 2020.