Active managers beat the benchmark

The ongoing debate over active versus passive returned on Monday with Russell Investments Canada saying that active Canadian equity managers have had a great Q1.

In the Russell Investments Canada 1st Quarter 2007 Active Management report, 65% of large cap equity managers fared better than the S&P/TSX Composite Index, the highest number in three years. In Q4 2006 only 51% outperformed the benchmark.

This quarter also saw the median large cap manager post a 3% return, besting the S&P/TSX Composite’s return by 0.4%.

“It’s been a challenging environment for active managers with the run in resources,” says Kathleen Wylie, senior research analyst for Russell Investments Canada. “This quarter you didn’t have one sector that really dominated.” Wylie says in years past, energy — a sector active managers tend to underweight — was up more than 60%. “So it was really hard for them to beat the benchmark.”

This year telecom, a sector that many large cap managers overweight, has been the top performer, while utilities — which many managers underweight — was the worst performing sector in Q1. The result was that more managers beat their benchmark. “For a while, when you had energy and materials, you had a huge range in sector returns from the top to the bottom performing,” says Wylie. “In this quarter, that range was really narrow. More breadth in the market made it easier.”

When it comes to individual stocks, Wylie says there was more breadth here too, with half the names in the S&P/TSX Composite outperforming the index return of 2.6%. The lack of disparity between stock returns was both a blessing and a curse for active managers. “The range between the top-performing investment manager and the bottom-performing is tighter than we’ve seen in a long time,” says Wylie. “So it’s easier for managers to beat the benchmark, but it’s harder for them to differentiate themselves or stand out relative to their peers.”

Despite the relative improvement, a couple headwinds continued for active managers. Mergers and Acquisitions was one challenging area for managers near the end of 2006, and so was private equity, though it didn’t pose as many problems as Wylie initially anticipated. “I thought it was going to be a more challenging quarter for investment managers than it turned out to be,” she says. “You still have these private equity firms targeting a number of public companies, and they’re not necessarily the highest quality company. That makes it tough as they may not be companies that are widely held by investment managers.” Any problems, though, were offset by the breadth of sectors and stock levels.

For value managers, Q1 2007 was a great three months, with 71% of them beating the benchmark. Only 61% of growth managers outperformed the S&P/TSX Composite. This is a marked shift from the past two years, where growth managers consistently fared better than value managers; in Q4 2006, only 27% of value managers outperformed the benchmark.

“It was a slightly more favourable sector positioning,” says Wylie, explaining why value managers did so well. “Value had larger overweight in industrials, consumer discretionary and financials, which were three of the top-performing sectors in the quarter.”

As good as large cap stock returns were, small cap did even better, posting a return of 6% in Q1 compared to a 2.6% return for the Composite. The median small cap manager enjoyed a 6% return, doubling the median large cap manager return. Still, small cap managers had difficulty beating their benchmark. “Only 50% beat the BMO small cap index,” says Wylie. “That index is heavily dominated by materials. That hurt them relative to the benchmark, but a return of 6% is great.”

As for Q2 2007, Wylie says it’s hard to predict how well active managers will do. “The outlook is positive, but things can change very quickly.”

Stay tuned to Advisor.ca for analysis on Standard & Poor’s report on active managers, due out at the end of this week.

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com