Canadian managers protect the downside

It certainly appears that Canadian active managers were able deliver on their value proposition, mitigating the downside risk of their portfolios during one of the worst market downturns ever — the final quarter of 2008.

According to Standard & Poor’s Indices Versus Active Funds Scorecard (SPIVA) for Canada, 53.2% of Canadian Equity active funds outperformed the S&P/TSX Composite Index in the final three months of 2008.

“On an equal-weighted basis, Canadian equity mutual funds had -21.67% in fourth-quarter performance compared to the index, which was down 22.71% — not a lot of difference,” says Jasmit Bhandal, director at Standard & Poor’s.

It’s a contrast of data for SPIVA, which had been consistently showing the index trouncing Canadian equity managers for some time. Over longer periods, this has certainly been the case. In three-year and five-year periods, only 21.0% and 11.2%, respectively, of actively managed Canadian Equity funds have outperformed the S&P/TSX Composite Index.

“On an equal-weighted basis, the active Canadian equity funds had three-year returns of -7.08%, and their five-year returns were 0.87%. For the index, either capped or composite, returns were -4.80% for three years and +4.16 for five years,” Bhandal says.

This latest report gives some ammunition to active management proponents who argue that active management proves its value by protecting downside risk. Usually the one-quarter performance would be considered an aberration, but the losses in the Canadian stock market were horrendous and protecting capital has been essential.

The outperformance held true only for the domestic marketplace, as Canadian funds still underperformed foreign markets.

In Q4 2008, only 21.3% of active managers in the International Equity category, 25.2% in the Global Equity category and 36.7% in the U.S. Equity category have outpaced S&P EPAC LargeMidCap, S& amp;P Developed LargeMidCap and S&&P 500 indexes respectively.

On the institutional side, Canadian managers did even better, with a whopping 72% beating the S&&P Composite.

“How managers performed during the fourth quarter really depended on their cash levels and their gold weighting,” says Kathleen Wylie, senior research analyst at Russell Investments Canada Limited. “Being underweight, energy and financials (the two largest sectors) would have been positive since those two sectors underperformed the index. The top-performing sector was consumer staples, but at a weight of less than 3% in the index, the impact of this sector was not as significant.”

Wylie adds that active institutional managers have been able to add value over the long run in Canadian equities.

“Although some market environments are more difficult than others for active managers, our data confirms that over the long run, active management does add value, with large cap Canadian equity investment managers beating the benchmark by roughly 140 basis points per year over the last 10 years,” she says.

Part of the reason active management shines in Canada could have something to do with the narrowness of the market itself. Until the summer, resource sectors accounted for roughly 50% of the market’s value — an asset allocation most diversified funds were not going to chase.

“Did you really want to have half your portfolio in resources? That was great strategy while they were going up. As soon as resource prices turned in the third quarter, all of those managers who had been underweight in resources and materials did really well,” Wylie says. “That’s why 65% of managers beat the benchmark in the third quarter.”

In the final, and more disastrous quarter, cash and gold helped managers outperform, Wylie notes. Again, the narrowness of the benchmark revealed itself, because while gold stocks increased to represent nearly 11% of the Canadian index’s value, most managers were actually underweight in gold as a sector. Merely holding one of two gold stocks — Barrick Gold or Goldcorp — helped the managers keep pace with gold’s rise.

“Gold stocks were up 15.5%, almost 40% above the benchmark. That normally would have really hurt active managers because they tend to be underweight in gold. What was interesting is that Barrick and Goldcorp were the two top contributors to the index, and the majority of active managers held those two stocks overweight. While they were underweight in the sector, they had the right stocks within the sectors to help them,” she says. “When I talked to managers, I found they have been holding Barrick for ages. It’s a popular name for value managers. It didn’t pay off for a long time, and now it’s paying.”

The S&P Composite Index accurately reflects the market-cap weighting of the Canadian stock market, but because the breadth of the market is so narrow, it may not be the most accurate measure of determining manager alpha.

Data provided by Pro-Financial Asset Management, a provider of fundamental indexing funds, shows the Research Affiliates Fundamental Index methodology may tell a different story.

FTSE RAFI Canada Total Return Index outperformed the TSX Composite Index by 1.85% on a year-to-date basis in 2008. The S&P/TSX Composite Index outperformed active equity fund managers by 1.4%, according to S&P. This creates a significantly larger gap for active managers to outperform.

Preet Banerjee, senior vice-president of Pro-Financial, points out the fundamental Canadian index does not get dragged down by the tendency of a cap-weighted index to overweight stocks in comparison to their intrinsic or fundamental value to the broader market.

“Cap weighting is always overweighting overpricing errors and underweighting underpricing errors,” Banerjee says. “Our Pro-Financial fundamental index uses four metrics: cash flow, book value, dividends and sales. None of those four metrics has anything to do with the stock’s price. People bid up the P/E ratio ridiculously high. We don’t care.”

(02/04/09)