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One of the major debates in investing over the last few years has concerned the strengths and weaknesses of “passive” investing. This is the method whereby a type of fund (often called an “index fund”) offered by a fund management company makes no attempt to outperform the broad stock market index. Instead, the fund purchases equities in the same weights as represented in the target index and charges a very low fee.
Championed by Jack Bogle, the legendary founder of low-cost fund company Vanguard, and followed by many other providers, particularly the iShares family offered by BlackRock, passive investment products have grown to such an extent that last year, according to Morningstar, the majority of U.S. investment funds were managed passively. That’s the first time that has happened.
Passively managed U.S. equity funds took in US$244 billion in 2023 alone, compared with an outflow of US$257 billion from actively managed U.S. equity funds.
This trend has continued for many decades. As supporters of passive investing never cease to point out, the vast majority of actively managed equity funds fail to beat the market on a consistent basis after fees, which are much higher than the very low expenses charged on passive funds. Passive fund fees range between 0.01% and 0.05% annually for those tracking broad market indexes such as the S&P 500 and the Nasdaq 100.
Part of this process has been due to the increasing institutionalization of the stock market. U.S. Federal Reserve figures show that the proportion of equities held by individual households has fallen to barely 33% now from more than 90% after World War Two. Thus, as Bloomberg columnist John Authers points out, it was possible for all professional money managers to beat the index 75 years ago, as there weren’t many of them, and they were competing with individual investors who had their own reasons for holding stocks and weren’t concerned with beating the market. It’s way more difficult for active investors to beat the index now.
However, with the growth of passive investing has come the decline of the stock market’s use of what is known as “price discovery.” This essentially involves the analysis of companies in the indexes in an attempt to ascertain whether or not they are fairly reflecting their fundamentals.
A few weeks ago, famous hedge fund manager David Einhorn, best known for his successful short position in Lehman Brothers in 2008, complained that passive managers “had broken the market” as they relied on everyone else to do their homework for them. To take things to their logical extreme, if the market became 100% passively invested, it would cease to function and price discovery would become impossible.
As things stand, and forming the basis of Mr. Einhorn’s complaint, passive index funds trust the valuations placed on companies by the market. This means they send more money towards companies that already have a lofty valuation, contributing to the formation of bubbles.
Some observers feel the present domination of the indexes by the so-called “Magnificent Seven” large-capitalization technology stocks (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia, and Tesla), which now comprise 29% of the value of the S&P 500, is a potential bubble. A similar bubble occurred in 2000 with the domination of the market by large-capitalization internet companies (Cisco, Intel, Nortel, Sun Microsystems). We also saw a similar phenomenon in the Japanese stock market in 1989, and the Nifty Fifty large cap stocks in New York in 1972-73.
Of course, it’s possible to invest passively using other factors, and indexing guru Rob Arnott of Research Affiliates has long been an advocate of “Smart Beta” techniques. These use passive technology to reduce costs, but focus on such factors as revenues and profits instead of market capitalization. He also suggests that price discovery can work even with 90% of the market invested passively, but it will require active managers to make more concentrated bets as they set prices for everyone else. A growing trend in selecting mutual funds (and actively managed ETFs) is looking for a high “active share” measure, which requires funds to have a stock selection process that is widely different from the indexes.
For individuals investing in the markets, beating the index is probably not the major consideration. Investors may be looking for stocks generating reliable and tax efficient income, or perhaps for a less volatile exposure to the equity markets. Of course, there are passive investment vehicles that focus on these factors, but the process of selecting equities that meet these requirements involves a degree of active management by the fund companies.
Also, while it’s true that the majority of actively managed funds fail to consistently beat the index after fees, some investment approaches, such as focusing on less well-covered small- and medium-sized companies or investing in closed-end vehicles selling at discounts to their underlying assets, have proven to deliver good performance over extended periods of time.
One such company is Guardian Capital Group Ltd. (TSX: GCG.A), an asset manager that combines active management with quantitative techniques in its ETFs. The stock sells at a discount to its net asset value.
Guardian Capital is one of the 10 largest independent asset management companies in Canada, with $56.2 billion in assets under management (AUM) as of Sept. 30, 2023. That was ahead 9% from $51.6 billion on Sept. 30, 2022. Founded in 1962, Guardian was one of the first investment counsels to list on the TSX, in 1969.
Under CEO George Mavroudis, appointed in 2011, Guardian has transformed itself from a Canadian institutional asset manager with several retail wealth platforms into a diversified asset manager, through a series of astute acquisitions and controlling stakes in wealth management companies. These include U.S. fixed-income manager Agincourt in 2020, U.S. equities manager Alta Capital in 2023, BNY Mellon’s Canadian Wealth Management Advisory Services business in 2021, and Rae & Lipskie Investment Counsel in Waterloo in 2022. Perhaps the most successful acquisition was the purchase of a London U.K.-based global and emerging markets boutique in 2014, now branded Guardcap Global Equities.
For the nine months ended Sept. 30, 2023, Guardian had revenues of $178.9 million, up 19%, with operating earnings of $46.8 million, ahead 32.5%. Earnings before interest, tax, depreciation, and amortization (EBITDA) attributable to shareholders was reported at $62.7 million up 35%, with operating earnings per share at $1.40.
One of the less appreciated features of Guardian Capital is its very large investment portfolio. Guardian’s portfolio includes 2.2 million Bank of Montreal shares from the sale of its mutual fund subsidiary, Guardian Group of Funds, to BMO in 2001, worth $260 million. In addition, other equity and fixed-income holdings are worth a combined $1.28 billion ($50.49 per share), which is larger than Guardian shareholders’ equity of $1.2 billion ($47.54 per share). The investment portfolio has increased 3.5 times since 2012, notwithstanding the sale of 2.7 million BMO shares over the period.
Selling at 22 times earnings for 2023, Guardian is more highly valued than other Canadian asset managers, but its track record has justified a premium. It has a reasonable yield, which is likely to be increased substantially, and is poised for continued growth in revenues and earnings from the growth of its U.S. and international businesses.
Gavin Graham is a veteran financial analyst, money manager, formerly Chief Investment Officer of BMO Financial, and a specialist in international investing, with over 35 years’ experience in global investment management.
Notes and Disclaimer
Content © 2024 by Gavin Graham. A longer version of this article first appeared in The Income Investor newsletter. Used with permission.
The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
Image: iStock/unomat
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