Active managers turn in dismal results

Active managers are likely feeling a bit down today, and it has nothing to do with the weather. Russell Investments Canada revealed on Wednesday that only 41% of active managers beat the S&P/TSX Composite Index in Q4, their worst performance in more than two years.

Kathleen Wylie, senior research analyst at Russell, says the poor performance can be chalked up to the last two quarters, which saw many sectors relevant to active managers underperform. “If you look at the year, it started off beautifully,” she says. “There were 65% of managers beating the benchmark; it’s just gotten worse as the year went on.”

While market volatility might seem like the obvious reason for active managers’ troubles, Wylie says that’s not the case. She says this type of managing relates most to how sectors fare, and in this quarter, energy and materials, which active managers tend to underweight, outperformed the benchmark.

Instead of hurting active managers, volatility could be exactly what they need. “The increased volatility in the stock markets allows active managers with skill to add more value over the benchmark,” says Wylie. “For instance, the range in returns between the top- and bottom-performing stock in the fourth quarter of 2007 widened out to the highest level in almost two years, stemming from the volatility. This led to a wider dispersion of returns between the top- and bottom-performing large-cap manager of almost 20%.

“The expectation is for that volatility to continue this year, which could make 2008 a more favourable environment for active managers. This means that portfolios that feature highly skilled managers that are able to add value over the benchmark could see impressive returns. The key is having the expertise and resources to identify and research these superior managers.”

Value managers especially will have a lot of ground to gain, as they had their worst performance since 1999.

For the entire year, value managers lagged the benchmark by 3.1%, while Q4 saw just 16% of them beat the S&P/TSX composite index. That was better than the 9% that succeeded in the third quarter, but not enough to stave off their dismal full-year results.

In contrast, 53% of growth managers outperformed their benchmark. Wylie reiterates that it was the second half of the year that threw things into turmoil for value managers.

“The year started off with value ahead of growth, so this shows how quickly things can turn,” she says.

She points to the financial sector for much of the value managers’ losses, as they tend to overweight these stocks, which took a huge hit in the last two quarters. Growth managers, on the other hand, tend to underweight financials.

Information technology also hurt value managers, as on average they underweight the sector by 2%, while the average growth manager overweights it by 3%.

“Overall, if you look at what hurt value managers in the fourth quarter, the story is remarkably similar to what we saw in the third quarter,” says Wylie. “This is the worst back-to-back performance of value managers that I have seen since we officially started tracking the quarterly data in 2000.

“Fortunately, the market in the first quarter of 2008 is looking different in terms of sector returns and might possibly be a better environment for value managers.”

Already, energy and information technology are underperforming, which is good news for value managers. However, materials are still going strong, and that can hinder performance. “If I were to predict right now, I’d say it’s a slightly better environment, but it’s tough to tell,” she says.

As for small-cap managers, their results were somewhat deceiving. Russell found that 85% of them outperformed their benchmark, but the S&P/TSX Small Cap Index was actually down 4.9%, so an average return of -1.9% ends up looking good.

How can managers improve? By sticking it out and focusing on the long-term, says Wylie. And a little volatility never hurts. “In a perfect world, we want volatility in stock returns,” she says. “But it’s not a perfect world.”

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

(01/30/08)

Bryan Borzykowski