Are Passive ETFs Distorting Prices in Small-Cap Stocks?
We see elevated valuations in some stocks with low float and high passive ownership
By: Verdad Research
Since 2008, passive investment vehicles have become increasingly popular. Given the long-term outperformance of passive funds relative to active funds, we have tended to think of this shift as generally positive for most investors.
Yet we have also been paying attention to those who have warned that the shift to passive could have unintended negative consequences, and we have been working to assess their claims empirically. While many of the arguments against passive are non-falsifiable (it’s a bubble, claims Michael Burry), we figured that if passive was in some way distorting the market we should be able to see it impacting low-volume small-cap stocks, our market niche. Today, Furey Research reports that passive vehicles own 14–20% of the average small-cap stock.
We came up with a simple — though imperfect — way to test this empirically by looking at small-cap stocks with limited float, where a substantial number of shares are not available for trading and liquidity is limited. We looked at stocks where passive ownership was significantly higher as a percentage of the float than as a percentage of the total number of outstanding shares, where we would be most likely to observe a price impact.
To simplify the analysis, we looked at BlackRock’s ownership specifically, because it manages two of the largest pure-play small-cap passive vehicles. BlackRock’s flagship small-cap ETFs—the iShares Russell 2000 ETF (ARCA:IWM) and iShares Core S&P Small Cap ETF (ARCA:IJR)—account for approximately $80B in small-cap assets, up from under $20B ten years ago according to Capital IQ. We looked at the ratio of BlackRock’s ownership of every small-cap stock’s free float relative to BlackRock’s ownership of the company’s common shares outstanding (CSO) to attempt to identify companies for whom BlackRock’s passive ownership could distort price discovery.
The below table shows the enterprise value to sales ratios for small-cap stocks with low and high BlackRock ownership (the x-axis) and by the percentage of shares floated on the y-axis.
Figure 1: BlackRock Ownership Impact on Low-Float Stocks
Source: Capital IQ, Verdad Analysis
This table supports the hypothesis of potential market distortion. Low-float companies with high levels of BlackRock ownership trade at significantly higher multiples than equivalently liquid stocks with low BlackRock ownership or high float stocks.
We do not, of course, know if this is causal. But we also looked at how the valuation ratios of this subset of stocks had traded over time relative to the assets under management in these two BlackRock ETFs. Figure 2 shows the EV/sales multiples of ~90 companies where BlackRock’s ownership (defined again as the ratio of their ownership of float to ownership of the shares outstanding) is highest. The data shows a 94% correlation between BlackRock’s ownership of small-cap assets and the EV/sales of companies within this universe.
Figure 2: BlackRock AUM vs. Valuations of Companies with Low Float and High BlackRock Ownership
Source: Capital IQ, Verdad Analysis
We wanted to ensure this relationship was not due to these stocks being materially different on other variables that matter to valuation, so we regressed the enterprise value to sales ratio against a set of variables we know to predict valuation multiples (net income margin, dividend/sales, two-year growth estimates, ROA, and industry classification). We found that even controlling for these variables, BlackRock ownership was a statistically significant predictor of enterprise value to sales ratio (with a 2.2 t-statistic).
Previously, we have sought to explain why some companies trade at such high multiples. More recently, we highlighted a perplexing dynamic: the outperformance of high growth stocks with poor accounting fundamentals. We called this universe of companies the Bubble 500 and attributed their lofty valuations to the difference in growth expectations relative to the FANMAGs. Of the Bubble 500, 342 claim membership in the BlackRock small-cap indices IJR and IWM. Our analysis here offers reason to expand our explanation for pricey stocks beyond exuberant expectations for growth: it seems that outsized passive ownership is contributing to a more general price inflation in low-float stocks.
Now, this is a very narrow observation about a very small segment of small stocks. But if this is indeed evidence of market distortions caused by passive, then it would lend credence to the arguments of those concerned about the interrelationship between US equity valuations and passive share ownership.