Produced in partnership with ClearBridge Investments
The influx of passive money into the Australian share market may be having unintended consequences, with modest earnings surprises now driving sharp swings in blue-chip stocks.
These “violent” share price plunges have become more common over the past two reporting seasons, with shares such as Westpac, NAB, CSL and Goodman Group recently dropping five to 10 per cent after minimal downward earning revisions, says ClearBridge portfolio manager Matthew Davison.
“What we’ve seen in the last two reporting seasons has been the increased sensitivity of top 50 names to relatively small changes in information, and that trend really extended further in the August reporting season,” he tells Professional Planner.
“That creates opportunity for active managers.”
These shifts in market structure could in fact improve the landscape for fundamental active managers, which have largely underperformed their index benchmarks over the last 15 years as passive flows have pushed share prices away from fundamentals.
The rise and limits of passive management
The trillions of dollars flowing into market cap-weighted products globally have increased co-movement of stocks within major indices, diminished diversification, and eroded price discovery, according to research by Duke University and Research Affiliates.
“We’ve seen the situation where valuations can get quite stretched from the passive flow impact relative to what active investors would view as fair value,” Davison says.
The forward P/E ratio of the S&P ASX/200 Index reached 19 times at the end of June 2025, almost two standard deviations above its long-term average of 14.8 times, according to Clearbridge.
More than 25 per cent of the daily turnover for the most impacted Australian stocks is now driven by index buying, compared with less than 15 per cent five years ago, Davison says. It has created a general upward trend in share prices, which is most evident when markets are quiet and there are fewer investors trading on fundamentals or information flow.
“Within that, there’s two issues for active management – you need to be more cognisant of style influences, how you manage those, and how they can persist in short-to-intermediate performance time horizons. But you also get bigger opportunities when the news changes and bigger opportunities when the actual level of passive flow changes.”
How style factors can be driven by index flows
The market mispricing caused by the rise of passive investing can be exploited by active fundamental managers and its influence can be seen across a variety of factors driving returns, according to Davison.
“It definitely overlaps with things like momentum, size and some of the other factors so if you’re addressing the influence of those elements of style, then you’re in part addressing whatever structural influences passive is having in the market as well,” he says.
Indexing can capture market beta, and smart beta strategies can capture some of those factor returns, but there is still a strong role for active fundamental managers to exploit idiosyncratic alpha.
“When you think about style factors, some have persisted for a long time, but they can also be subject to very violent shifts,” Davison says.
“An example might be something like WiseTech, a fallen darling of the momentum trade that has seen scandal. It really needs a fundamental lens to create a quality check and a sense check for what’s really changing underneath. This is something that a systematic approach alone can’t do.”
Combining fundamental insights with systematic
A strong active approach that aims to neutralise common factors without trying to time them can produce more consistent alpha and reduce the risk of extended underperformance.
What Davison and his colleagues at ClearBridge are doing with the Australian Active Insights strategy is to build from the fundamental work of the group’s research team across a range of key lenses. They then use a systematic process to remove the generic style influence from their signals, resulting in a style-neutral portfolio built from unique insights
“In a YSYF [Your Future Your Super performance test] world where underperformance extremes can’t be tolerated, this is clear differentiation from more traditional fundamental strategies.”
Valuation spreads move to extreme levels
Clearbridge says valuation spreads across the S&P/ASX 200, based on long-term discounted cashflow forecasts and fundamental qualitative assessments, have been at the wide levels last seen during the GFC and Covid-19 pandemic.
“The momentum market has gotten very stretched, and we are now starting to see a swing back to value,” Davison says.
“That tells you that you can get these relatively sharp turnarounds in style, and that’s where I think it’s important to be able to combine systematic with fundamental.”
Davison says a solid fundamental analysis and implementation process is crucial as the market continues to be more volatile and present opportunities for active managers.
“Overall, we would see that swing back to value having further to run,” he says.
“For Active Insights we can benefit from our unique fundamental insights within that value style, whilst also maintaining exposure to our range of lenses. That should result in more reliable alpha across cycles regardless of the impact of passive or which style is in favour.”
