It’s hard to keep a straight face while arguing for active strategies in asset classes like large-cap stocks or government bonds. Those markets are so liquid and so well covered by analysts that it’s almost impossible to find and exploit inefficiencies. But many would argue that active managers at least have a fighting chance in less efficient asset classes like, say, emerging markets or small-cap stocks.
On the heels of my previous posts on Canadian preferred shares, let’s consider whether this is another asset class where active managers can be expected to add value compared with a simple indexed approach using ETFs. I recently explored this idea in a conversation with Nicolas Normandeau of Fiera Capital, who manages the Horizons Active Preferred Share ETF (HPR). I think it’s worth having these debates occasionally, because if you believe in indexing, you should be able to defend the strategy with rational arguments and not ideology.
Here are the main arguments in favour of using an active strategy with preferred shares:
The market is complex and inefficient. The entire preferred share market in Canada is about $60 to $65 billion—about the same as the market cap of Canadian National Railway. Yet within this relatively small market is a dizzying array of issues, each with its own unique set of options, provisions and features.
If you want to buy a bond issued by Fortis, Normandeau explains, you can simply look at the company’s credit rating and then pick the maturity you want. But preferreds are much more complicated: Fortis alone, for example, has seven different issues with various features.
In a market with this level of complexity, it should be easier to find mispriced securities and take advantage of them. “We can find a lot of arbitrage opportunities,” Normandeau says. “With corporate bonds you might be able to get 20 basis points, but with prefs you may be able to find 200.”
There’s a lot of dumb money at the table. Normandeau says retail investors make up a huge proportion of the market for Canadian preferred shares, and a good number of them are making decisions based on little more than yield. He recalls one recent Royal Bank issue that was almost entirely bought by individuals and advisors. “This was a new structure, so all the institutional guys were reading the indentures and asking about the reset mechanism, the formulas they were using, and so on. But retail investors were just buying Royal Bank and the 4% yield. They didn’t really look into the details of what they were buying.”
Of course, naive investors are part of every market. But if they’re buying a few hundred shares of Royal Bank’s common stock it’s not going to have a meaningful impact, because there are more than 1.4 billion shares outstanding. In the preferred market, however, where volumes are much lower and retail participation higher, professionals may be able to take the other side of those trades and exploit the dumb money.
Index ETFs lead to more inefficiencies. Now to the most controversial claim of active managers: some feel the dumb money in the Canadian preferred share market includes index funds. “Like all passive managers, if the security is big enough and the credit rating is high enough, they add it to the index,” Normandeau says. “They don’t do credit analysis or duration analysis like we are doing in HPR.” When a company has multiple preferred share issues, “the indexers are buying whatever is in the benchmark,” he says, “but we are picking the ones that have the best value from each issuer, and then you can do this from one issuer to another.
Moreover, preferred share index ETFs in Canada now make up a significant share of the overall market. The iShares S&P/TSX Canadian Preferred (CPD) has about $1.4 billion in assets, while the BMO S&P/TSX Laddered Preferred Share (ZPR) is also about $1.1 billion. That makes them as the 10th and 16th largest ETFs in the country, respectively, as of the end of February. “So together they make up more than 3.5% of the market, and they’re trading quite often in large quantities,” Normandeau says.
Large flows in a small market create opportunities for active managers to gain an upper hand, he argues. “We’re seeing it every day: we know when these guys are buying or selling. I am never a forced buyer or a forced seller: I can do whatever I want with my cash. With prefs, if you want to buy or sell with big flows, you’re going to pay a high price. What you should do is try to trade on the other side of that.”
Meet you halfway
So, what to make of these claims? Unless you’re an indexing fundamentalist, you have to acknowledge that preferred shares offer comparatively more opportunities for a skilled manager to identify mispriced securities, at least when compared with most other asset classes.
I’m not the only committed indexer who admits that. Norbert Schlenker (of Norbert’s gambit fame) has used the services of James Hymas, generally recognized as Canada’s guru of preferred shares. “I disdain active investing,” Schlenker wrote at the end of a glowing testimonial in 2011. “I realize that the above smells very much like the usual ad for an actively managed fund. I intend no such thing. I am just a happy client, happy to see that my default investing philosophy is wrong in this instance, and happy to recommend Hymas’s services to others.”
But I reject the idea that index funds are part of the dumb money. From the moment index funds were created in the 1970s, fund managers have talked about taking advantage of mindless passive investors, but the proof is in the performance, and the data show that only a tiny minority outperform over meaningful periods. While our practice in Toronto does not use preferred shares in client portfolios, other advisors at PWL Capital use the BMO S&P/TSX Laddered Preferred Share (ZPR), which we recommended in our recent white paper on the subject.
That said, I wouldn’t argue too strenuously with anyone who chose to use a low-cost, prudently managed active fund to get access to preferred shares. (HPR, for example, had an MER of 0.64% in 2014, only slightly more than its indexed counterparts.) Certainly that’s a wiser decision than trying to manage a portfolio of individual preferreds on your own.