Do you know the difference between active and activist investing?

March 28, 2018

Activist investors and active investors may have a similar ring to their sounds, but the two terms mean completely different things.

Active investors actively select stocks that they believe will outperform the market when compared to a certain benchmark or index. These investors are most likely compared to passive investors, who build portfolio that closely mirror the market or a specific index. Index funds and Exchange-Traded Funds (ETFs) are passive funds, doled out schematically, rather than based on specific company fundamentals and market drivers.

So where do activist investors fit into all of this?

Activist investors take an opposite approach from passive investors, and they’re a little more extreme than active investors: They buy large stakes in companies that seem to be underperforming and push the companies to make the right management changes. The engagement is a rather formal process. One indication that a company may have become a target for activist investors is the filing of SEC Form 13D, which must be filed when an investor purchases 5% or more of a company’s shares.

Passive managers historically don’t engage in shareholder activism. Because of their voting power, stemming from millions of retail investors, most of their fund products own hundreds of companies’ stocks at a time, and it would have been virtually impossible to review all companies’ multiple proposals for change, even if they wanted to. On top of that, passive investors usually support companies’ management teams, as per their algorithms, they are required to be invested in all companies that are included in their benchmark index.

In recent years, passive managers began opting for proposals that urge companies to dramatically change their ways and become “socially responsible.” The move is huge, because passive investors own nearly 40 percent of public companies in America.

Can passive managers do what activist investors do? Renowned activist investor Paul Singer and his company launched 19 activist campaigns in 2017, and that was considered a lot. In comparison, passive investors are choosing to engage with nearly 1,000 companies a year.

If they decide to vote at companies’ annual shareholder meetings, they could easily be the swing votes and determine the outcome without having to convince anyone else of their decisions. The major impact for Main Street investors is this: if anything goes wrong at a company, active investors of a company can sell their shares and remove a company from its portfolio; however, due to the nature of passive investors, retail investors remain stuck in the stock.

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