Active investing is here to stay

Passive investing follows markets and is considered a safe hedge against near-term volatility.

But dramatic increases in passive investing introduced mispricing to the markets that let active value-oriented investors to find hidden long-term gems.

We may be at a pivotal point. Passive strategies have worked for the last few years as a safe harbour from economic upheaval, but are ready to give way to active value investing. So say debaters at the Annual Brandes Institute Sessions in Toronto this month.

One of the biggest challenges faced by active managers is the growing popularity of ETFs, the new face of index investing, which provides a cheaper, more flexible alternative to actively managed mutual funds.

However, one panellist, San Diego-based Charles Brandes, chairman of Brandes Investment Partners, turned the perception on its head. Contrary to popular belief, he said ETFs may be a blessing in disguise for active managers.

Read: Combining ETFs with active management

“ETFs are going to be helpful for active managers over a long period because they will cause stocks that aren’t in the index to get undervalued,” he said.

It’s argued the weighted nature of indices leads passive investors to keep their money in the largest, but not necessarily the best-performing markets. Small companies that aren’t part of a major index get ignored or become undervalued. Skilled active managers can exploit this excessive undervaluation and identify companies likely to produce better returns.

Another aspect to consider is the trade off between risk and reward, said panellist Kim Shannon, president and chief investment officer, Sionna Investment Managers.

“If you look at the risk-reward trade off picture [of the Index], it is high-risk, high-rewards by itself [but is] slightly lower-risk lower-reward for mutual funds and fund managers in aggregate,” she said. “A lot of the value people are lower risk in some cases doing better than the average funds.”

Shannon points to the tech bubble of 2000, when the index was high-risk, high-reward, but the subsequent crash of the benchmark indexes brought the risk-reward balance back down to normal levels, helping active investors to come out on top.

“As soon as [a company] is on the benchmark, their valuations pop and as soon as they come out of the benchmark their valuations sink significantly,” she said.

The phenomenon makes it harder for new companies, excepting the likes of Facebook, because fewer active managers are willing to buy IPOs these days.

Capital markets are supposed to be a source of funding for new business, but increasing IPO-aversion on the part of investors and money managers is starving new businesses out of the market.

Read: Active versus passive

The two investing strategies are also said to be at odds on the tax efficiency front. Proponents of passive investing say it avoids frequent trading and, therefore, attracts lower fees and fewer capital gains distributions impact a client’s tax return.

Brandes, an active manager, says it is rather the matter of turnover. “The average mutual fund has a 100% turnover, that doesn’t make sense to me,” he said. “That’s just playing the market; that’s speculating. That’s nothing to do with owning a company over a long period of time for the value you get from the owner of that company. You can be an active manager and still be tax efficient if you keep your turnover low.”

He admits, though, that all things considered, while active value-based investing has the proven potential to produce long-term positive returns, a balanced portfolio could wisely combine both elements.