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robert tattersall

The Toronto Stock Exchange recently announced that there are now 500 exchange-traded funds available for investment on the exchange. This is double the number five years ago and assets under management in this category are in the region of $130-billion. The dramatic growth in what are primarily passive investments, coupled with a similar trend toward passive index funds on the part of institutional investors, is a positive development. These vehicles typically have low management expense ratios and track closely the performance of the underlying index – two attributes that are frequently lacking in actively managed mutual funds. Investors can now devote more time to deciding the crucial allocation between equities and fixed income and then execute that strategy with low-cost funds which have a clearly defined mandate.

So much for the good news. The flip side of this trend toward passive investments based on an index means that there are no analysts or portfolio managers involved in the decision process. As a result, it doesn't matter if your company is grossly undervalued and you have an active investor relations campaign – if your company is not in an index, no one is listening.

I encounter this on a regular basis when meeting with the management of small-cap companies. They complain that their news releases about quarterly earnings, new products or contracts simply disappear into a black hole. Quarterly conference calls have few attendees and even fewer investor queries, so they question the merit of these events. Some of them even question the value of being a public company. I used to think that if they persevered, investors would in time come to recognize the value of the company, but now I understand that the problem is structural and permanent: If your stock is not in a benchmark index of some kind, a traditional investor relations campaign is doomed no matter how attractive your stock.

If you are an academic, the consequence of this state of affairs is obvious: With minimal research and investor interest in non-index stocks, these stocks will become inefficiently priced and present an opportunity for outsized gains, also known as "positive alpha." Note that inefficient pricing does not mean that all of these non-index stocks are cheap. Some of them, maybe half, will be overpriced because of investor ignorance of the fact that the fundamentals are deteriorating, so the key will be to identify the neglected bargains.

If my analysis is correct and investor neglect of non-index stocks is structural and permanent, there are serious implications, not just for the Canadian equity market but for any developed stock market with a trend toward passive investing.

The first problem is for the stock exchange itself. A management unhappy with the valuation of their stock, coupled with minimal trading activity and investor interest may begin to question the value of being listed on the exchange with all the attendant fees. In fact, a mid-year survey of Canadian initial public offerings by PwC suggested that some emerging companies may now choose to raise funds through private equity rather than a listing on the exchange. It isn't the role of a stock exchange to promote individual stocks, but perhaps they need to host regular conferences to introduce investors to these low-profile companies.

For the individual investor, there are several issues to be addressed. If you have no particular expertise in terms of stock selection, then the bulk of your equity exposure should clearly be in the form of a passive investment, either an index fund or an ETF.

For the active investor in the inefficient sector of the market, the primary concern is whether or not your non-index stock investment will ever be recognized in the market or if it is doomed to be a "value trap." To minimize that risk, I suggest a focus on cash-rich companies. These companies are more likely to exercise the option of going private by using their own cash to buy out the outside shareholders. They are also more attractive takeover candidates for companies looking to bulk up in a slow growth economy.

Finally, for the non-index companies themselves, an investor relations campaign that simply distributes news releases will not generate traction. Since many of these companies are small- and mid-cap in size, there is little value in visiting the big institutional investors who need huge daily trading volumes in order to establish a portfolio position. Instead, they should focus on the discount brokerage clients and retail brokers who actually trade on a daily basis. This is a slower route to success, but the reward is a loyal and more sustainable investor base.

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

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