Active managers beat benchmark: Russell Investments

“This sounds like a repeat of what we said a year ago at this time, but the environment was excellent for active managers in the first quarter of 2013,” says Kathleen Wylie, head, Canadian equity research at Russell Investments. “In fact, taking into account the fourth quarter of 2012, the back-to-back percentage of investment managers outperforming the benchmark was the highest since the middle of 2001.”

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The quarterly report notes good sector breadth during the first quarter was a key factor with eight out of 10 sectors outperforming the Index. However, the underperformance of the materials sector, specifically gold stocks, benefited large cap managers.

Gold stocks fell 16% in the first quarter of 2013, following a decline of 13% in the fourth quarter of 2012. The declines in the first quarter were broad-based with 27 of the 31 gold miners included in the S&P/TSX Composite Index falling in price.

“The performance of gold stocks has a notable impact on the quarter-to-quarter relative performance of investment managers in Canada because it is such a large weight in the benchmark,” says Wylie. “At the start of the first quarter, gold companies accounted for 10% of the S&P/TSX Composite Index, and large cap managers on average were 4% underweight. With the decline in gold stocks during the first quarter, the Index weight of gold companies is now below 7%.”

Gold producers still have a large weight in the Index, although it has come down significantly from a peak of 14% in the third quarter of 2011.

Some of the most challenging quarters for active managers to beat the benchmark since the start of the financial crisis in 2008 were when gold stocks spiked, adds Wylie.

The largest negatively contributing stock to the S&P/TSX Composite Index return in the first quarter was Barrick Gold, which fell 14%. It was held by 46% of large cap managers in Canada.

Goldcorp, held by 55% of large cap managers, was also among the top five negative contributing stocks.

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Canadian National Railway, which rose 13%, was the top contributing stock in the quarter. The stock is widely held by 68% of large cap managers.

The second-largest contributing stock was Valeant Pharmaceuticals, up 29% in the first quarter, but it was only held by 34% of large cap managers.

In terms of percentage of managers beating the benchmark, dividend-focused managers led the others, with 86% ahead compared to 85% of value managers and 75% of growth managers.

Value managers benefited from having large overweights to the information technology, consumer discretionary and consumer staples sectors, which all outperformed.

Dividend-focused managers were helped by their overweights to the industrials, telecommunication and financials sectors, which also outperformed.

Growth managers have been hurt by their underweights to financials and telecom but helped by their overweight to the energy sector, which outperformed in the quarter.

Although the S&P/TSX Small Cap Index return of 0.6% lagged the S&P/TSX Composite return of 3.3%, small cap managers added value against both their benchmark and large cap managers in the first quarter.

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The median small cap return of 5.4% was ahead of the median large cap return of 4.7%. Small cap managers have notably larger weights in the industrials, consumer discretionary and information technology sectors compared to large cap managers and those three sectors were strong performers in the small cap space, which benefited small cap managers.

In the S&P/TSX Small Cap Index, the energy and materials sectors were the only two sectors that declined, but they account for nearly 58% of the Small Cap Index weight.

Small cap managers, who have outperformed the S&P/TSX Small Cap benchmark for nine consecutive quarters, were 3% underweight energy and 11% underweight materials at the start of the first quarter.

Small cap managers have been outperforming large cap managers by 80 basis points on average per quarter over the last 10 years. “There is definitely more volatility in small cap manager returns compared to large cap managers,” says Wylie, “But investors with a long-term focus should consider a small cap manager allocation given their value-added potential.”

Although the market is struggling so far in the second quarter, with the S&P/TSX Composite down 4% led by materials, including gold, the environment looks favourable for active managers in terms of benchmark-relative performance. Sector breadth is very good with nine out of 10 sectors outperforming.

“It’s too early to call for sure,” says Wylie, “But based on sector performance so far in the second quarter, active managers are favourably positioned in six out of 10 sectors.”

Scott Newman, VP of Global Investment Strategies at Invesco Canada, says there’s never been a better time than now to prove the real value of active investment.

Today’s economic environment, he says, is still fraught with economic uncertainty and betting on grand global recovery may not materialize.

“The beauty of active management in this environment is [that] ultimately you’re buying individual companies you believe are not only going to survive but prosper in spite of broad macroeconomic conditions,” says Newman. “There are times when active management is a lot more rewarding than other times and now is the time, economically, when this style can be extremely rewarding for investors.”

He cautioned active managers to keep an eye out for slowdown in China and its impact on Canada’s economy and its resource sector.

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Detractors have often raised concerns over higher fees and tax implications of active investment strategy, but Newman says results speak for themselves.

“I don’t believe it’s a generic argument,” he says. “You really have to look at the approach, merits and discipline of every active manager and assess what they bring to the table.”

Active management, he asserts, tends to protect capital better than a fully invested passive benchmark.

“The best way to create wealth is to lose less than others,” he adds.