What Is an Activist Investor?

An activist investor, typically a specialized hedge fund, buys a significant minority stake in a publicly traded company in order to change how it is run.

The activist investor’s goals may be as modest as advising company management or as ambitious as forcing the sale of the company, divestitures or restructuring, or replacing the board of directors.

Unlike private equity firms that buy and restructure companies in order to profit when they are resold, activist investors seldom acquire full or majority stakes. Instead, they use public communications and private discussions to win over other shareholders and company insiders. When such efforts fail, an activist investor may pursue a proxy contest to elect new directors in order to force the company to meet their demands.

Understanding Activist Investors

Activist investors are sometimes called shareholder activists, a term also used to describe those lobbying companies to improve working conditions for the overseas employees of their contractors, or backers of a dissident board slate elected to fight climate change.

However, many activist investor campaigns seek only to maximize shareholder value, and most of those are the work of hedge funds specializing in the unique mix of public pressure, behind-the-scenes lobbying, and business expertise required.

Unlike the public pension funds and mutual funds that also engage in activism at times, activist hedge funds may hold highly concentrated stakes and supplement them with additional leverage from derivatives like stock options to offset the considerable cost of such campaigns. In contrast with institutional investors that sometimes turn to activism after owning a disappointing investment for years, activist hedge funds typically buy a stake in an underperforming company shortly before calling for change, and hope to profit from the resulting turnaround and price appreciation.

In contrast to institutional investors, activist hedge funds are also more willing to use confrontational tactics, from poison-pen letters to management and unflattering public reports to proxy fights seeking to oust incumbent directors.

How Activist Investors Make Their Case

Investor activists often announce their campaigns by filing a Schedule 13D form with the U.S. Securities and Exchange Commission (SEC), which must be filed within 10 calendar days of acquiring 5% or more of a company’s voting class shares.

Qualified institutional investors and passive investors, meaning those not trying to acquire or influence control of the company, may instead file a simplified Schedule 13G with less stringent disclosure requirements and thresholds. Schedule 13D filers must disclose, among other facts, their reasons for acquiring the stake and any plans they may have for the company in terms of mergers and acquisitions, asset disposals, capitalization or dividends, or other policies.

The initial 13D filing gives the activist investor a golden opportunity to publicize their case for change at the targeted company. At the same time, the filing curtails the activist’s ability to alter their stake in, and plans for, the company out of the public eye. Any changes to the facts disclosed on a Schedule 13D must be reported in an amended filing “promptly,” under current SEC rules.

Activist investors may use amended Schedule 13D filings to comment on a company’s response to their proposals. For example, when Netflix, Inc. (NFLX) adopted a poison pill after funds affiliated with Carl Icahn reported a stake of nearly 10% in the video streaming company, the funds filed an amended disclosure calling the poison pill “an example of poor corporate governance.” Activist investors may also write sharply worded letters to incumbent managers, issue press releases arguing their case to other shareholders, or privately lobby institutional investors to side with them.

The Future of Shareholder Activism

There has been a claim that “activism is dying,” lamented Carl Icahn in May 2022, contrasting the legendary investor’s few-holds-barred approach seen in the past. Some have feared the changes proposed to the Schedule 13D disclosure requirements in 2022 constitute a pressing threat, with Elliott Investment Management stating publicly that the proposed rules “will virtually shut down activism.”

In February 2022 the SEC had proposed shortening the initial Schedule 13 filing deadline from 10 calendar days to 5, with amendments due within a day of a material change rather than “promptly” as currently. The proposal, if passed, would effectively force 13D filers to specify holdings of derivatives (such as options) that confer an economic interest in the company without the shareholder rights associated with an outright stock position. Perhaps more controversially, the proposed rules would no longer require investors to agree to act in concert and be designated a single group by the SEC for Schedule 13D reporting purposes. Rules have also been proposed to make it harder for activist shareholders to squash a company’s environmental or other pro-ESG initiatives.

SEC Chair Gary Gensler argued the stepped up requirements proposed would address “an information asymmetry” between activist investors and other shareholders. Critics countered the proposed rules would make activism unprofitable by making it more difficult and costly for activist investors to accumulate significant stakes, while inhibiting communication among shareholders.

Despite these proposed rule changes, shareholder activism does not seem to be slowing down (at least, not yet). For example, activist investor Nelson Peltz reportedly made a profit of more than $150 million by acquiring shares of Disney (DIS) in November 2022, in a move that prompted a proxy fight against the returning CEO, Bob Iger; however, this brief fight was called off after Iger announced a restructuring plan that is expected to save the media giant $5.5 billion in costs and cut 7,000 employees. Peltz has expressed satisfaction with the company’s direction and decision to make changes, praising Iger and his management team. In early 2023, ValueAct Capital Management, a San Francisco-based activist hedge fund, took a stake in streaming media company Spotify Technology SA (SPOT), with the goal of cutting costs and streamlining management. ValueAct has also disclosed a major position and board seat in SalesForce (CRM), which now has no less than five large activist investor shareholders on board with long positions, resulting in early 2023 cost cutting measures that include layoffs of 10% of the company’s employees. In all three of the these examples, markets have reacted positively to the inclusion of activist shareholders, seeing their share prices afterwards outperform.

What Is Attribution Analysis?

Attribution analysis is a sophisticated method for evaluating the performance of a portfolio or fund manager. Also known as “return attribution” or “performance attribution,” it attempts to quantitatively analyze aspects of an active fund manager’s investment selections and decisions—and to identify sources of excess returns, especially as compared to an index or other benchmark.

For portfolio managers and investment firms, attribution analysis can be an effective tool to assess strategies. For investors, attribution analysis works as a way to assess the performance of fund or money managers.

How Attribution Analysis Works

Attribution analysis focuses on three factors: the manager’s investment picks and asset allocation, their investment style, and the market timing of their decisions and trades.

The method begins by identifying the asset class in which a fund manager chooses to invest. An asset class generally describes the type of investments that a manager chooses; within that, it can also get more specific, describing a geographical marketplace in which they originate and/or an industry sector. European fixed income debt or U.S. technology equities could both be examples.

Then, there is the allocation of the different assets—that is, what percentage of the portfolio is weighted to specific segments, sectors, or industries. 

Specifying the type of assets will help identify a general benchmark for the comparison of performance. Often, this benchmark will take the form of a market index, a basket of comparable assets.

Analyzing Investment Style

The next step in attribution analysis is to determine the manager’s investment style. Like the class identification discussed above, a style will provide a benchmark against which to gauge the manager’s performance.

The first method of style analysis concentrates on the nature of the manager’s holdings. If they are equities, for example, are they the stocks of large-cap or small-cap companies? Value- or growth-oriented?

American economist Bill Sharpe introduced the second type of style analysis in 1988. Returns-based style analysis (RBSA) charts a fund’s returns and seeks an index with comparable performance history. Sharpe refined this method with a technique that he called quadratic optimization, which allowed him to assign a blend of indices that correlated most closely to a manager’s returns.

Explaining Alpha

Once an attribution analyst identifies that blend, they can formulate a customized benchmark of returns against which they can evaluate the manager’s performance. Such an analysis should shine a light on the excess returns, or alpha, that the manager enjoys over those benchmarks.

The next step in attribution analysis attempts to explain that alpha. Is it due to the manager’s stock picks, selection of sectors, or market timing? To determine the alpha generated by their stock picks, an analyst must identify and subtract the portion of the alpha attributable to sector and timing. Again, this can be done by developing customize benchmarks based on the manager’s selected blend of sectors and the timing of their trades. If the alpha of the fund is 13%, it is possible to assign a certain slice of that 13% to sector selection and timing of entry and exit from those sectors. The remainder will be stock selection alpha.

Market Timing and Attribution Analysis

Though some managers employ a buy-and-hold strategy, most are constantly trading, making buy and sell decisions throughout a given period. Segmenting returns by activity can be useful, telling you if a manager’s decisions to add or subtract positions from the portfolio helped or hurt the final return—vis-à-vis a more passive buy-and-hold approach.

Enter market timing, the third big factor that goes into attribution analysis. A fair amount of debate exists on its importance, though.

Certainly, this is the most difficult part of attribute analysis to put into quantitative terms. To the extent that market timing can be measured, scholars point out the importance of gauging a manager’s returns against benchmarks reflective of upturns and downturns. Ideally, the fund will go up in bullish times and will decline less than the market in bearish periods.

Even so, some scholars note that a significant portion of a manager’s performance with respect to timing is random, or luck. As a result, in general, most analysts attribute less significance to market timing than asset selection and investment style.

What Is a 12b-1 Fund?

A 12b-1 fund is a mutual fund that charges its holders a 12b-1 fee. A 12b-1 fee pays for a mutual fund’s distribution and marketing costs. It is often used as a commission to brokers for selling the fund.

12b-1 funds take a portion of investment assets held and use them to pay expensive fees and distribution costs. These costs are included in the fund’s expense ratio and are described in the prospectus. 12b-1 fees are sometimes called a “level load.”

Understanding 12b-1 Funds

The name 12b-1 comes from the Investment Company Act of 1940’s Rule 12b-1, which allows fund companies to act as distributors of their own shares. Rule 12b-1 further states that a mutual fund’s own assets can be used to pay distribution charges.

Distribution fees include fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. The SEC does not limit the size of 12b-1 fees that funds may pay, but under FINRA rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75% of a fund’s average net assets per year.

12b-1 Fees

Some 12b-1 plans also authorize and include “shareholder service fees,” which are fees paid to persons to respond to investor inquiries and provide investors with information about their investments. A fund may pay shareholder service fees without adopting a 12b-1 plan. If shareholder service fees are part of a fund’s 12b-1 plan, these fees will be included in this category of the fee table.

If shareholder service fees are paid outside a 12b-1 plan, then they will be included in the “Other expenses” category, discussed below. FINRA imposes an annual 0.25% cap on shareholder service fees (regardless of whether these fees are authorized as part of a 12b-1 plan).

Originally, the rule was intended to pay advertising and marketing expenses; today, however, a very small percentage of the fee tends to go toward these costs.

Special Considerations

12b-1 funds have fallen out of favor in recent years. The growth in exchange-traded fund (ETF) options and the subsequent growth of low-fee mutual fund options has given consumers a wide range of option. Notably, 12b-1 fees are considered a dead weight, and experts believe consumers who shop around can find comparable funds to ones charging 12b-1 fees.

What Is an Annualized Rate of Return?

An annualized rate of return is calculated as the equivalent annual return an investor receives over a given period. The Global Investment Performance Standards dictate that returns of portfolios or composites for periods of less than one year may not be annualized. This prevents “projected” performance in the remainder of the year from occurring.

Understanding Annualized Rate

Annualized returns are returns over a period scaled down to a 12-month period. This scaling process allows investors to objectively compare the returns of any assets over any period.

Calculation Using Annual Data

Calculating the annualized performance of an investment or index using yearly data uses the following data points:

P = principal, or initial investment

G = gains or losses

n = number of years

AP = annualized performance rate

The generalized formula, which is exponential to take into account compound interest over time, is:

AP = ((P + G) / P) ^ (1 / n) – 1

Annualized Rate of Return Examples

For example, assume an investor invested $50,000 into a mutual fund and, four years later, the investment is worth $75,000. This is a $25,000 gain in four years. Thus, the annualized performance is:

AP = (($50,000 + $25,000) / $50,000) ^ (1/4) – 1

In this example, the annualized performance is 10.67 percent.

A $25,000 gain on a $50,000 investment over four years is a 50 percent return. It is inaccurate to say the annualized return is 12.5 percent, or 50 percent divided by four because this does not take into effect compound interest. If reversing the 10.67 percent result to compound over four years, the result is exactly what is expected:

$75,000 = $50,000 x (1 + 10.67%) ^ 4

It is important not to confuse annualized performance with annual performance. The annualized performance is the rate at which an investment grows each year over the period to arrive at the final valuation. In this example, a 10.67 percent return each year for four years grows $50,000 to $75,000. But this says nothing about the actual annual returns over the four-year period. Returns of 4.5 percent, 13.1 percent, 18.95 percent and 6.7 percent grow $50,000 into approximately $75,000. Also, returns of 15 percent, -7.5 percent, 28 percent, and 10.2 percent provide the same result.

Using Days in the Calculation

Industry standards for most investments dictate the most precise form of annualized return calculation, which uses days instead of years. The formula is the same, except for the exponent:

AP = ((P + G) / P) ^ (365 / n) – 1

Assume from the previous example that the fund returned $25,000 over a 1,275-day period. The annualized return is then:

AP = (($50,000 + $25,000) / $50,000) ^ (365/1275) – 1

The annualized performance in this example is 12.31 percent.