Innovations in Wealth Management I – The Benefits of Combining Active and Passive Management

glass globe on sheets of investment data

EXECUTIVE SUMMARY

  • In this paper, we tackle the question of whether to employ active or passive investment management1 and conclude that both can be important elements of a well-constructed portfolio.
  • Many sophisticated institutional investors such as sovereign wealth funds, endowments, foundations, and hedge funds have recognized the importance of both active and passive investment strategies in their investment solutions. The question is not “either or”, but rather how to combine the two approaches in order to maximize returns and minimize volatility and cost.
  • The key to determining an appropriate balance of active and passive strategies is to decide in which markets and asset classes it makes sense to simply have broad-based exposure, and in which markets investors with resources and expertise can reasonably pursue excess returns (also known as “alpha”).
  • Pembroke believes in pursuing excess returns in less efficient segments of global markets including small-cap equities, emerging-market equities, corporate bonds, and select areas of large-cap markets. In more efficient market segments, Pembroke believes in minimizing cost by using passive strategies such as exchange-traded funds (ETFs).
  • The GBC Global Balanced Fund (“the Fund”) combines Pembroke’s experience and capabilities in active investment management, portfolio construction, and risk management with low-cost, passively managed funds to create a single, diversified vehicle to pursue long-term capital appreciation in global capital markets.
  • The GBC Global Balanced Fund provides clients with several important benefits. The first is simplicity – a single vehicle that delivers low-cost exposure to global large-cap equity markets, the pursuit of excess returns in small-cap and emerging-market equities, and income from Canadian corporate and government bonds. The Fund’s second major benefit is asset allocation – its automatic rebalancing protocol means that the Fund maintains its strategic asset allocation, which is generally 70% equities and 30% bonds, by responding to market movements. The third consideration is cost, with the 80% active / 20% passive split reducing fees for clients.

Innovations in Wealth Management: Active plus passive investing

Innovation is the competitor’s response to competition; it drives technological disruption in all industries. The best solutions win. At Pembroke, we identify companies with new solutions to meet customer needs, large underlying market opportunities, and long-term earnings power. While we’re at it, we must shine the same light on ourselves and ask the question: what innovations are changing the wealth management industry? How can we respond to the changing landscape to improve our product offering and better meet client needs? Answering these questions, and underwriting our conclusions with our own capital, is one of the most challenging things we do. To remain relevant, we must adapt and innovate while holding our principles and values constant.

One of the most significant trends in the investment industry is the rise of passive investing. Asset flows into passively managed exchange-traded funds (“ETFs”) have increased and gained market share over actively managed funds. For years, active investors have decried the risks of passively managed funds. Passively managed funds are constructed to track a benchmark, index, sector, or factor. Actively managed funds are typically managed with objectives that include beating benchmarks, indices, and sectors. Yet passively managed funds have been beating many actively managed funds at a lower cost. Active managers are on the defensive and must demonstrate the ability to add value in order to survive. In the investment world, this skill is captured in “alpha”, which measures a portfolio manager’s ability to generate returns above an index or benchmark that are large enough to justify higher management fees.

For many years, there was a schism in our industry; an investment firm either specialized in active management or in passive management. Those days are now over. The curtain fell when the most sophisticated investors in the world, including sovereign wealth funds, endowments, foundations and large pension funds recognized the value of having both active and passive investments in a portfolio. Today, the top holders of the world’s largest passively managed ETFs include Asian sovereign wealth funds, European central banks, state pension plans, and other sophisticated institutional investors. The key to determining an appropriate balance of active and passive strategies is to decide in which markets and asset classes it makes sense to simply have broad-based exposure, and in which markets investors with resources and expertise can reasonably pursue excess returns.

Staying active…

For over fifty years, Pembroke has been pursuing alpha in small-cap equity markets in North America. Our investment team, resources, and institutional investment culture are focused in this niche because it still offers underfollowed and misunderstood investment opportunities. Our case for continuing to pursue alpha in small-cap equity markets is based on a few characteristics that have not changed much over the years:

  1. There are more small companies than large companies;
  2. There are fewer analysts covering small companies than large companies;
  3. There is often less information available about small companies than about large companies.

The value of the fundamental analyst’s traditional tools, such as management interviews, headquarters visits, and financial statement analysis, may be more effective when there are three analysts covering a stock than twenty-five. Because of the relative scarcity of information about small companies, small-cap equity markets are less informationally efficient. In equity markets where information flows less efficiently, there may be more opportunities to buy stocks at attractive prices than in extensively researched markets. For similar reasons, when it comes to hiring external active investment managers, we have also focused on firms investing in markets that are informationally less efficient such as international stocks and Canadian corporate bonds.

The changes in the Canadian investment management industry in recent years are ground-shaking and affect our clients’ choices as much as our own. The proliferation of passive strategies and ETFs has given Canadian investors more choice. Our clients are increasingly interested in diversifying outside of Canada. They want exposure to global markets, and they want to know when they should be adding exposure to some markets and reducing exposure to other markets. They are aware of robo-advisors but do not want to talk about their investments with robots; they want to talk with people they trust. These changes create opportunities for our clients and for Pembroke.

…while acting more like a sovereign wealth fund

One of the recent innovations at Pembroke has been to identify the complementary roles that passive products can play in our clients’ accounts. For example, many of our clients want exposure to Canadian large-cap stocks, including large banks, transportation companies, and consumer businesses. Because information about these large-cap companies is relatively abundant and flows efficiently through the market, the opportunity for active investors to have a differentiated view is limited. Therefore, Pembroke believes the key consideration for investors in these markets is fees, and the lowest cost option is a passive ETF. The same approach may be effective in large-cap equity markets in the US, Europe, and Asia. In many cases, a group of well-known, leading companies dominates international large-cap indices; these companies are comprehensively researched and followed by the world’s financial press. Our clients want exposure to these companies and the most cost-effective solution to achieve this objective is to own ETFs.

Putting it all together – The GBC Global Balanced Fund

When we assessed our own areas of expertise, we identified three key areas:

  1. Active management of North American small-cap equities,
  2. Identification of superior active international equity managers, and
  3. Multi-asset class portfolio construction and risk management.

With that conclusion in mind, Pembroke launched The GBC Global Balanced Fund on April 8, 2019. The Fund is designed as a single vehicle to pursue long-term capital growth while diversifying portfolios across assets, geographies, investment managers, and market capitalization. The Fund’s asset allocation is targeted to be 70% global equities and 30% Canadian fixed income with 80% active and 20% passive exposure. By creating rebalancing corridors for each asset class, we maintain the Fund’s strategic asset allocation, increasing exposure to underperforming asset classes while reducing exposure to outperforming asset classes. With the strategic asset allocation determined at the outset, our clients can spend valuable time with their Pembroke representatives planning contributions and learning about what they own instead of trying to time global equity and fixed income markets.

Conclusion

Innovation typically puts pressure on incumbent firms and creates benefits for clients, including greater choice and lower costs. In the investment management industry, passive investments and robo-advisors are two innovations which have confronted traditional investment managers, as their businesses have long been based on managing active investment funds and providing bespoke advice. Our reaction to passively managed funds bas been to ask: “how can our clients benefit”? Our reaction to asset allocation advice from robo-advisors is to ask: “can we do better”? Our answer to both questions is The GBC Global Balanced Fund. Please contact your Pembroke Private Wealth Management Ltd. representative to learn more.

Insight at Pembroke Click to Learn More

Disclaimer

This report is for the purpose of providing some insight into Pembroke and the GBC funds. Past performance is not indicative of future returns. Any securities listed herein, are for informational purposes only and are not intended and should not be construed as investment advice nor is it a recommendation to buy or sell any particular security. Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Pembroke seeks to ensure that the content of this document is correct and up to date but does not guarantee that the content is accurate and complete and does not assume any responsibility for this. Pembroke is not responsible for decisions or actions taken or made on the basis of information contained in this document.

Publish Date: October 3, 2019


1Managers of active investment strategies, such as Pembroke’s internally managed investment funds, seek to add excess return above an index or benchmark. Managers of passive investment strategies, such as exchange-traded funds (“ETFs”), seek to replicate the return of an index or benchmark.