For years, skeptics have warned that the popularity of passive funds could destabilize the markets, making the latter more volatile than they would otherwise be during times of economic stress. 

However, during the 2020 stock market plunge that came with the COVID-19 pandemic, the opposite was true. What destabilized the market then? Professionals who pick stocks at big institutional investors, as new research shows.

Over the most frenzied selling period of 24 February through 20 March 2020, which saw the S&P 500 index drop 29 percent, it was not the investors in passive funds that were the problem. Instead, the active fund managers created a more volatile market, according to a recently released paper by scholars at the University of Virginia and the University of Zurich. 

Exchange-traded funds and mutual funds that follow indexes are commonly known as passive investments. It was those that employ managers to decide which stocks to trade — actively managed funds — that dumped stocks during the crash in February and March, the research shows.

Wall Street Whipped Up a Tempest

“Overall, the results suggest that when a tail risk realizes, institutional investors amplify price crashes by fire-selling and seeking shelter in ‘hard’ measures of firm resilience,” states the paper “Where Do Institutional Investors Seek Shelter When Disaster Strikes? Evidence From COVID-19.” It was written by Pedro Matos and Simon Glossner of the University of Virginia Darden School of Business, as well as Stefano Ramelli and Alexander F. Wagner, from the University of Zurich. 

Put another way, these active institutional investors fled risky stocks in favor of those with strong balance sheets and, as a consequence, caused the market to crash more than it would have otherwise done.

That conclusion was based on an analysis of the institutional ownership of stocks at the end of the fourth quarter of 2019, along with the performance of stocks during the frenzy period. They found that stocks with higher institutional ownership were hit harder than those with lower institutional ownership.

However, while the sales were frenzied, the active managers knew precisely the stocks they wanted to ditch and the ones they wanted to accumulate. It was those stocks that were financially weaker, based on the strength of their balance sheets, that were hit hardest.

“The biggest driver of a stock being up or down was how much cash or little leverage it had on its balance sheet,” says Pedro Matos, professor of finance at the University of Virginia’s Darden School and academic director of Darden’s Richard A. Mayo Center for Asset Management. “They were not selling indiscriminately, but instead rebalanced their portfolios in a flight to quality.”

What surprised Matos and his co-authors was that the active fund managers behaved in this way, as it goes against received wisdom: that portfolio managers take risks by going against the trend. “Active managers get paid to be contrarians,” says Matos. Instead of being contrarian, the active managers became part of the herd in the second quarter.

Matos and his colleagues wondered whether the institutional investors would return to the market in the second quarter of 2020 when the market seemed to have stabilized. But what they found was the active managers stayed away. “We thought that maybe they reversed the trade, and we found that they didn’t,” Matos says.

Robinhood Comes to the Rescue

Whenever there is a sale in the stock market, there is also a purchase. Of course — without both, there would be no trade. Who bought stocks during this period while active investors were selling? It turns out that small investors piled into riskier stocks, the authors deduce from looking at data from discount brokerage Robinhood Financial. They used that data, which showed active buying of riskier stocks by Robinhood customers, as a proxy for all individual investors. By purchasing risky stocks, the Robinhood investors provided much-needed liquidity to the market during the most frenzied period.

Another unexpected finding the authors made was that active institutional investors had little care for non-financial metrics, despite much publicity to the contrary. In particular, the authors found that positive environmental, social and governance (ESG) measures made no difference to the active-fund managers’ decisions on whether to ditch holdings of stocks. 

“It was more about leverage and cash and not about the soft criteria such as ESG and sustainability,” says Simon Glossner, a post-doc research associate at the Mayo Center and Darden.

This bucks the received wisdom that large institutions embrace ESG metrics as a vital part of a thorough investing process.

While the pandemic-led bear market of February and March 2020 could have been an opportunity for institutional investors to behave responsibly, this time they blew it, says Matos. “When the rubber meets the road, how did you behave?” he says. “In this case, investing in sustainable businesses was not a priority.”

Darden’s Mayo Center for Asset Management at the Darden School of Business, at which Pedro Matos is academic director and Simon Glossner is a post-doctoral researcher, provided financial support for the research.

Pedro Matos and Simon Glossner co-authored “Where Do Institutional Investors Seek Shelter When Disaster Strikes? Evidence From COVID-19” with Stefano Ramelli and Alexander F. Wagner of the University of Zurich.

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About the Expert

Pedro Matos

Academic Director of the Richard A. Mayo Center for Asset Management; John G. Macfarlane Family Chair and James A. and Stacy Cooper Bicentennial Professor of Business Administration

Matos is an expert in the fields of asset management, investments, corporate governance and international finance. His research focuses on international corporate governance and the growing importance of institutional investors in financial markets worldwide.

Before Darden, Matos served as an economist for the Portuguese Ministry of Finance and as a consultant for the World Bank in Washington, D.C., and taught at the University of Southern California. He is a research associate at the European Corporate Governance Institute.

Matos is one of the authors of “Are US CEOs Paid More? New International Evidence,” published in February of 2013 in The Review of Financial Studies.

B.A., Universidade Nova de Lisboa; M.S., IST Universidade Tecnica de Lisboa and INSEAD; Ph.D., INSEAD