The popularity of index investing, which is being driven largely by burgeoning investor demand for exchange-traded funds, will ultimately lead to greater opportunities for active managers to outperform as stocks that are bought indiscriminately through index-based strategies become overpriced, said Charles Brandes, chairman of San Diego-based Brandes Investment Partners LP in Toronto on Friday.

“There are times when even the major established companies get ridiculously overvalued and investors need to have some judgment,” said Brandes, who was participating in a debate on the relative merits of active and passive investing. “The price of a company needs to be looked at in relation to what you’re getting in earnings, cash flow and dividend yields.”

Also participating in the debate were Kim Shannon, president and chief investment officer of Sionna Investment Managers Inc. of Toronto and Chris Goolgasian, Boston-based vice president of State Street Global Advisors and head of its U.S. portfolio management solutions group.

Shannon said the popularity of index investing and ETFs has lead to a situation where the correlation between the fundamental factors influencing stock prices and that of overarching market trends is at a high level of 70%, about twice as high as historical averages. Fundamental factors are important to active managers and capture such measurements as a stock’s price relative to its earnings, cash flow, dividends and growth record, as well as the quality of management, corporate governance, and input and output costs. Broad market factors are more important to index investors, and capture the economic environment, interest rates and political winds, and they tend to influence all stocks in a similar fashion at the same time.

“Index investing is becoming high risk/high return, and that creates a phenomenal opportunity for active investors,” Shannon said. “At a 70% correlation level, the market is inefficient. Eventually, there will be a new normal for passive strategies.”

When the market is inefficient, companies are not being priced according to their true worth, which creates opportunities for active managers to buy undervalued stocks and sell those that have become too rich in price. Index strategies, most of which are based on broad stock indices weighted according to each company’s stock market capitalization, make no determination of a company’s true worth but simply duplicate the index.

“I like the fact that as ETFs grow in popularity, the competition is going away on the active side,” Brandes said.

Taken to extremes, the trend to passive investing through ETFs will not serve investors or capital markets well, he and Shannon agreed. If everyone is buying equities based on indices, which tend to be heavily weighted in a handful of large capitalization companies, the bigger the weighting and the more expensive those companies get, the more demand increases, creating a vicious cycle where they get even more expensive without any improvements in their fundamentals. And it becomes increasingly difficult for smaller companies to raise equity capital.

Goolgasian said one of the challenges in the active arena is finding managers who can consistently outperform the market.

“I have seen the creative genius of active managers,” Goolgasian said. “However, the issue is whether you can find them in advance and whether you can hold on to them.”

With ETFs assets in the U.S. recently crossing the US$1 trillion mark as investors make the choice to simply match an index of some kind, he calls ETFs a “category killer” for active managers. He said large institutional clients such as pension funds that are looking to hire active money managers need considerable resources, time and patience to ferret out superior performers, and investment managers are often hampered by inconsistency in their track record. He cited research showing 52% of top managers who were in the top decile of performance during the past 10 years spent at least three years in the bottom quartile. An investment committee looking to hire an active manager has to make it through a lot of red tape, and periods of underperformance can make the choice of a particular active manager difficult to justify.

“There is a lot of selling at the trough,” Goolgasian said. “We believe in active management, but it’s a hard thing to do for investment committees. In the last 10 to 20 years, there’s been a big run on passive.”