Small cap, growth the places to be in Q1

Small cap fund managers posted better performance than their large cap colleagues in the first quarter of 2009, according to the latest Russell Active Manager Report.

Small cap funds posted a median return of -1%, while large cap managers posted a median return of -2.7%. The outperformance can be largely attributed to the business sectors that make up each of the capitalization brackets.

Large cap managers tend to be more heavily invested in financials and industrials, while the small cap space is dominated by the resources and technology sectors, and returns were dependent on the fortunes of those sectors.

“That was the strongest outperformance of small cap managers relative to large cap in two years,” says Kathleen Wylie, senior research analyst at Russell Investments Canada Limited.

Only 36% of large cap managers beat the S&P/TSX Composite Index, compared to 72% in the final quarter of 2008.

“It was a tough quarter overall in terms of beating the benchmark. Within the quarter, it’s worth noting that 68% of managers outperformed in February when the S&P/TSX was down 6.3%,” says Wylie. “With seven out of 10 sectors beating the benchmark during that month, managers found it a more favourable environment to beat the benchmark.”

But for the full quarter, only four market sectors beat the index, making it difficult to pick winners. The IT sector was the top performer, followed by materials, both of which assisted the small cap managers.

Active managers, in general, tend to overweight tech as a means of gaining some variance from the index, because the sector is so small in Canada. Conversely, energy and materials make up a large portion of the index, and tend to be underweighted by active managers.

“Active managers tend to have their largest overweights in consumer discretionary, industrials and consumer staples and these three sectors all underperformed in the first quarter, which hurt their benchmark relative performance.”

Active large cap managers were hurt by their exposure to Barrick Gold, which failed to join a rally by gold stocks. Precious metals miners were one of the key growth drivers within the materials sector.

Leaving capitalization preference aside, growth managers outperformed value managers, with a median return of -2.0%, compared to -3.4%.

Nearly half of growth managers (47%) beat the S&P/TSX Composite in the first quarter, compared to 60% in Q4 of 2008. Just 37% of value managers beat the index in Q1, compared to 67% in Q4, 2008.

“The switch from value back to growth highlights how quickly styles can come in and out of favour, and that the best approach to weather these swings is multi-style diversification,” says Wylie. “Our data shows that on average the median value manager was ahead of the median growth manager by only 10 basis points per quarter during the last 10 years and even less of a difference over 20 years.”

Again, the rising IT sector fueled the outperformance, as growth managers typically have larger exposures to tech than their value counterparts. Almost three quarters of growth managers held Research in Motion in Q1, which gained 10% over that period. Only 25% of value managers had a stake in the company.

“As well, value managers tend to be more underweight gold stocks compared to growth managers so that would have hurt performance,” says Wylie. She points out that growth managers also tend to be underweight in financials, which were a drag on the market in the first three months of the year, falling 6% as a sector.

“It’s been interesting to watch how active managers have been repositioning their portfolios in this environment,” she says. “Value managers have been actively reducing their overweight in financials during the latter half of 2008 while growth managers have been reducing their underweights. Value managers remain overweight while growth managers remain underweight but the gap has certainly narrowed.”

“Although the first quarter was challenging 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 30 basis points per quarter over the last 10 years.”

(04/29/09)