Author: Special to Financial Post

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Well, I won’t back down
No I won’t back down
You could stand me up at the gates of hell
But I won’t back down

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No I’ll stand my ground
Won’t be turned around
And I’ll keep this world from draggin’ me down
Gonna stand my ground
And I won’t back down ~ Tom Petty

There has been a major shift from actively managed funds into passive, index-tracking investments since 2008, with more than US$1 trillion flowing from actively managed U.S. equity funds into their passive counterparts, which have increased their share of the investment pie to more than 40 per cent from less than 20 per cent.

The theory underlying passive investing is the efficient-market hypothesis (EMH), which posits that markets are efficient, thereby causing asset prices to always be correctly priced. The theory contends that it is impossible to beat the market without assuming additional risk. Applied to the decision to hire an active manager rather than invest in a passive index fund, the EMH can be neatly summarized as “why bother?”

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It might seem that as an active manager, I am shooting myself in the foot by pointing out the success of passive investing at the expense of its active counterpart, but bear with me.

Not backing down: Bogle’s Folly

The first index funds were launched in the early 1970s and were only available to large pension plans. A few years later, the Vanguard First Index Investment Fund (now the Vanguard S&P 500 Index Fund) was launched as the first index fund available to individual investors. The fund was the brainchild of Vanguard Group Inc. founder Jack Bogle, who believed it would be difficult for actively managed mutual funds to outperform an index fund.

In its initial public offering, the fund brought in only US$11.3 million. Vanguard’s competitors referred to the fund as “Bogle’s Folly.” To the benefit of the investing public, he did not back down. Vanguard currently manages more than US$9 trillion in assets, the bulk of which is in index funds and exchange-traded funds.

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Approximately half of all assets managed by investment companies in the United States are now invested in Bogle’s Folly and its descendants.

At Berkshire Hathaway Inc.’s 2017 annual meeting, Warren Buffett estimated that by making low-cost index funds so popular for investors, Bogle “put tens and tens and tens of billions of dollars into their pockets.”

According to Buffett, “Jack did more for American investors as a whole than any individual I’ve known.”

The numbers don’t lie

In most cases, the long-term evidence makes it hard to strongly disagree with the EMH and, by extension, to advocate for active management over passive management.

According to S&P Global Inc., 78.7 per cent of U.S. active large-cap managers have underperformed the S&P 500 index over the five years ending Dec. 31, 2023.

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A US$10-million investment in the index made at the end of 2018 would have been worth US$20,724,263 five years later, compared to an average value for active managers of US$18,481,489, representing a shortfall of US$2,242,774 versus the index.

The Canadian experience has been similarly damning: 93 per cent of Canadian equity managers have underperformed the S&P/TSX composite index over the five years ending Dec. 31, 2023, according to S&P Global.

A $10-million investment in the index made at the end of 2018 would have been worth $17,079,526 five years later, compared to an average value of $15,217,594 for active managers, representing a shortfall of $1,861,932 versus the index.

Given these dire statistics, it is no wonder that there has been a massive migration from active to passive investing. Investors have been getting the message that the proclaimed advantages of active management are more hype than reality.

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Acceptable and unacceptable failure

“I can accept failure, everyone fails at something,” legendary basketball superstar Michael Jordan once said. “But I can’t accept not trying.”

Relatedly, within the sphere of active management, it is imperative to discern between what I refer to as sincere and disingenuous underperformers.

Sincere underperformers try their level best to outperform (an A-for-effort scenario). These active efforts entail expenses that passive funds do not face, such as paying investment professionals to analyze companies with the goal of identifying stocks that will outperform. These extra costs must be passed on to investors, resulting in higher fees than those for passive vehicles.

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In contrast, disingenuous underperformers are not truly trying to outperform. Their portfolios more or less replicate benchmark indexes. Such funds, which are pejoratively referred to as “closet indexers,” are charging active management fees for doing something that investors could do for a fraction of the cost by investing in an index fund or ETF — good work if you can find it.

An academic study — The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance — determined the pervasiveness of closet indexers across a sample of developed countries.

Of the 20 countries included in the study, Canada ranked highest in terms of its percentage of purportedly active mutual fund assets that are actually invested in closet index portfolios. Every year, such funds are unjustifiably charging investors billions of dollars in fees.

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Although the historical data clearly indicate that the vast majority of managers have underperformed their benchmarks, this is not universally the case. Although few and far between, there are managers who have managed to outperform, either in simple terms, in risk-adjusted terms or both, as our machine-learning based, algorithmically driven approach has done.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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By David Barr

The British pop band Dead or Alive had a massive hit in the mid-1980s with You Spin Me Round (Like a Record) on their Youthquake album. It’s a catchy little number.

On the other side of the pond in the investment world, something else is catching on: renewed investor interest in small-cap stocks. They, too, have been spinning “round, right round” in a long-awaited comeback in sentiment and capital inflows — albeit with a bit of a wobble in August.

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After being flat year to date, the Russell 2000 index was up more than 12 per cent by the end of July. The Russell 2000 tracks approximately 2,000 of the smallest public companies in the U.S. market. In Canada, we have the S&P/TSX smallcap index, which includes 246 companies.

Like all indexes, including the S&P 500, these contain a grab bag of constituents of varying quality and profitability (or lack thereof). Studies show only a small percentage of companies generate the majority of returns over the long run. For example, just 21 companies generated more than 64 per cent of the net wealth in Canada from January 1990 to December 2022.

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Because of the wide dispersion in the quality and profitability of smaller public companies, this sector presents a less efficient opportunity set than the large-cap sector. Hence, investors who passively follow the momo — the current positive momentum — must understand they are also buying a significant portion of companies with no earnings, which potentially increases volatility and capital risk.

Apparent tailwinds abound for experienced stock pickers, too. Now, with rate cuts in Canada and the spectre of a September cut in the U.S., smaller companies — often viewed as cyclical and riskier — are starting to come out of their multi-year slumber.

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In comparison to large and megacap stocks, smaller stocks squarely remain in bargain territory, with the S&P/TSX smallcap index trading at approximately 10 times its forward price-to-earnings compared to nearly 14 times for the S&P/TSX 60. A mean reversion would give them a nice pop.

Furthermore, the change in the interest rate regime will bring welcome relief to the balance sheets of smaller companies, which rely more on floating-rate or shorter-term loans and have been disproportionately oppressed by the fast-rising interest rates and reduced capital inflows of the past several years.

For example, 30 per cent of the debt in Russell 2000 companies is floating rate, compared to only six per cent for companies in the S&P 500.

The attractive valuations of these companies are just too good to pass up. They are pulling the focus of private equity and venture capital firms, which have a record-setting US$2.62 trillion of cash reserves that could be deployed on a giant spending spree.

At just past the halfway mark of the year, there have already been several high-profile acquisitions, including Copperleaf Technologies Inc., Nuvei Corp., Héroux Devtek Inc. and Sleep Country Canada Holdings Inc., among others.

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Current prices have a built-in margin of safety that should appeal to value investors. At the most recent Berkshire Hathaway Inc. annual meeting, Warren Buffett (whose right-hand man and likely successor, Greg Abel, just happens to be Canadian) told attendees:

“We do not feel uncomfortable in any way, shape or form putting our money into Canada. We don’t have any mental blocks about that country. And, of course, there’s a lot of countries we don’t understand at all.”

We agree with Buffett. We have no mental blocks either when it comes to Canadian companies because we continue to see an attractive set-up for them. Even with the recent positive moves, valuations are still very attractive on a relative and absolute basis.

Rather than thinking of small caps as a shorter-term tactical investment, smaller, high-quality companies make excellent long-term additions to a portfolio, providing investors can accept short-term volatility. Given how fast small-cap markets can move, it’s important to have an allocation to the asset class to fully experience the long-term returns of small caps.

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One silver lining of the past couple of tough years is that it has allowed investors to position their portfolios into higher-quality businesses trading at reasonable prices. While Berkshire, due to liquidity constraints, must restrict its shopping in Canada to very large enterprises, domestic investors can take a nimbler approach, which means taking meaningful positions in a hand-picked selection of high-quality smaller companies.

David Barr, CFA, is CEO of PenderFund Capital Management.

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