Bad quarter for active managers, but the future could be bright

Despite faltering in Q2, active managers could see their returns rise over the next three months.

The Russell Investments Q2 Active Management Survey reported that only 53% of Canadian investment managers beat the S&P/TSX Composite Index, down from 65% in Q1. However, Philip Lee, a fund analyst with Morningstar Canada says the market’s current volatility could push these numbers upward.

“It will be interesting to see what comes out in Q3 because of market turmoil right now,” he says. “Managers that have the ability to hold cash and pick stocks might do a little better in this type of environment.”

But, adds Lee, high fees could continue to prevent active managers from beating their benchmark. “Managers with higher fees would have to take more risk to beat the index,” he says.

Kathleen Wylie, a senior research analyst at Russell Investments Canada, says while the numbers are down, things are looking much better than they did in 2005. “It was a particularity challenging environment then. Things were very narrow and dominated by resources. Now you’ve got good breadth in the market.”

She adds that as long as sectors are beating the benchmark, and right now seven out of 10 are, the next quarter should be a healthy one. “If you have one sector really leading by a lot – like materials is now – then I think active managers will still do better than they’ve done in the last couple of years.”

As for Q2’s numbers, the median large-cap manager return just beat the S&P/TSX Composite’s return of 6.3% by a mere 0.1%.

The slightly better return was due to large-cap managers’ overweighting the three top-performing sectors — telecommunications, IT and industrials — but they could have done better if they didn’t underweight the energy and materials sectors, which beat their benchmark return.

“It was more challenging in terms of sector returns,” she says, explaining why Q2’s numbers were lower. “Energy and materials accounted for over 40% of the index, and both beat the benchmark. On average large-cap Canadian equity managers underweight those sectors.”

When it comes to investment styles, both value and growth managers had trouble beating the benchmark, with 42% of value managers passing their target, and 41% of growth managers outperforming the S&P/TSX Composite Index.

Wylie points out that these numbers are “significantly lower” from Q1. At that point, 71% of value and 61% of growth managers outperformed the benchmark. When taken individually, neither value nor growth returns beat the benchmark, coming in at 6% and 6.2% respectively, just off the 6.3% S&P/TSX return.

The reason value managers were more successful than their growth counterparts was because they overweighted telecommunications while growth managers underweighted the top-performing sector. Value managers also put more emphasis on the industrials sector but paid less attention to energy. Hurting them even further was the financial sector — the second-worst performer — which they overweighted, while growth took a more cautious approach.

Russell Investments also found that small-cap managers fared better than large-cap managers, with the median small-cap manager seeing a 7.1% return.

The positive results are due to small-cap managers’ underweighting the financials sector and having double the weight in the industrials sector.

Disparity between the top- and bottom-performing managers also improved for the small-cap set, with the range in returns at 10.3% as opposed to 12.5% in Q1.

“Generally, during the rally in resource prices in 2005 and 2006, small-cap managers lagged large-cap,” says the report. “It is encouraging that they have outperformed for three straight quarters.”

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

(08/01/07)