The hottest investment strategy on the planet makes hitting earnings more crucial than ever

Falling short during earnings season is never good news for a company. But the miss can be even more painful if the firm has passive investors battening down the hatches.

Over the past seven quarters, stocks with high passive ownership that missed on both earnings and revenue have lagged those with low passive exposure by 1.5 percentage points the following day, according to data compiled by Bank of America Merrill Lynch. And that gap has only widened over time.

With a smaller proportion of shares managed by actual humans, the active trades that do occur are having an outsized influence, contributing to this increase in volatility, says a group of BAML strategists led by Savita Subramanian.

And while bigger price swings don’t necessarily hurt a trader’s bottom line, these mounting fluctuations still highlight the risk associated with passive strategies, which are exploding in popularity.

Stocks with high passive ownership are seeing outsized punishments for missing earnings and sales forecasts.Bank of America Merrill Lynch

By trading large swaths of the equity market, rather than individual stocks, participating investors are diluting the effects of specific company fundamentals during non-earnings periods. Then, once earnings season rolls around, stock prices are spring-loaded to react more sharply to any new information.

The dynamic is playing out again this quarter. Reporting companies are seeing their shares move four times the normal daily average, the most in the past 18 years, Goldman Sachs data show.

But it doesn’t end there. The punishment for missing earnings is also the harshest in almost two years. In the first quarter of this year, companies that fell short dropped more than 2.5% in a single day, on average, according to Wells Fargo data.

Rather than wring their hands about the changing landscape, it’s probably more advisable for investors to simply adapt. After all, all signs point to the continued dominance of exchange-traded funds and other such vehicles.

Passive funds have attracted net inflows in each of the last nine years, dwarfing the appeal of their active counterparts, which have absorbed money on a net basis in just two of those years, BAML finds.

Earlier this year, passive investments like ETFs and index funds accounted for just under 30% of assets under management in the US. That share will rise to more than 50% by 2024 at the latest, according to a Moody’s forecast.

Passive has dominated active for the entirety of the stock bull market.Bank of America Merrill Lynch

This development is certainly not lost on some of the market’s most influential investors. Dmitry Balyasny, the managing partner at $2.6 billion hedge fund Balyasny Asset Management, recognizes the increased importance of getting earnings season right.

“Day-to-day action is very ETF-driven,” he said in a letter to investors obtained by Business Insider. “While this action won’t change the ultimate valuation of individual companies, it will increase short-term correlations … This makes catalysts, earnings, and other events extremely important to play — and play correctly — because that is when dispersion is most likely to occur.”