- Only 17% of Canadian large-cap equity managers beat the benchmark
- Early look at Q3: Active manager environment rebounded in first three weeks of July
- Five-year view shows 61% of active large cap managers beat the benchmark
TORONTO, Aug. 4, 2016 /CNW/ - It was a "good news/bad news" story for investors in the second quarter of 2016. The good news: the benchmark S&P/TSX Composite Index rose 5.1% in the period and marked its largest quarterly gain in two years. The bad news: only 17% of large cap equity managers in Canada beat the benchmark—down from 41% in the first quarter of 2016 and the lowest percentage seen in available data since Q3 1999. In addition, the median large cap manager return was 3.4%, which was well behind the benchmark Index return. These and other notable observations are included in Russell Investments Canada Limited's ("Russell Investments Canada") most recent active manager report, which is based on a quarterly survey of 142 Canadian institutional money manager products.
"The first half of 2016 presented Canadian large cap managers with considerable challenges to beat the benchmark, particularly due to the strength in the Energy sector and gold stocks," highlights Kathleen Wylie, Head of Canadian Equity Research at Russell Investments Canada.
Wylie added that gold stocks surged a record 41% in the second quarter with large cap managers roughly 3% underweight on average. That followed a 39% increase in gold stocks during the first quarter. Four of the top 10 contributing stocks within the Index in the second quarter were gold stocks accounting for more than 25% of the Index gain, including Barrick Gold, which was the top contributing stock but held by less than 20% of large cap managers.
"With the strength in gold stocks in the first two quarters of the year, their weight in the Index has doubled since the end of 2015; and since most managers are generally underweight this sector, gold has become the latest concentration issue," says Wylie. "Still, it's not as much of an issue as it was in 2011 when the weight of gold stocks peaked at 14% in the Index and managers were underweight by 6% on average."
Strength in the Energy sector also presented challenges for Canadian large cap equity managers who are 3% underweight on average.
"Within Energy, managers generally were hurt by strength in TransCanada Corporation and Enbridge, which rose 15.6% and 9.4% in the second quarter, respectively," explains Wylie. "Those two stocks started the quarter with a combined weight of nearly 5% in the Index with TransCanada Corp. held by only 49% of large cap managers and Enbridge held by only 54%."
On a positive note, large cap managers have relatively heavy exposure to Canadian Natural Resources, which rose 15.7% in the second quarter and ranked as the second top-contributing stock in the Index. The stock is held by 67% of large cap managers, so its gains did help their benchmark-relative performance.
Active managers still added value over the longer term
While this marks the second consecutive quarter that active managers have struggled to beat the benchmark, we saw six consecutive highly favourable quarters for active managers through the end of 2015. "There will be periods where active management struggles, particularly in Canada with such a concentrated index. But over the last five years, including these challenging periods, an average of 61% of large cap managers have beaten the benchmark by an average of roughly 50 basis points per quarter," Wylie noted. "Even more interesting is that the first quartile managers' median return has outperformed it by 175 basis points per quarter. This reinforces that skilled investment managers can add value over the long run."
Narrow sector breadth a key factor
Sector breadth narrowed in the second quarter with only three sectors beating the benchmark for the period, down from five in the first quarter. In addition to Materials and Energy, Utilities outperformed. Large cap managers on average were overweight Utilities, which helped, but they also had notable overweights to Information Technology, Consumer Discretionary, Industrials and Consumer Staples, which all underperformed. Underweights to Telecom and Financials were beneficial to active managers overall since those two sectors were among the underperformers. Overall, large cap managers were favourably positioned in only three of 10 sectors.
Wylie added that the experience in the second quarter reminded her of the third quarter of 2012, which was the second-worst quarter for active managers since available records in Q3 1999. She explains, "Back in 2012, 18% of managers beat the benchmark (compared to 17% this past quarter) and the situation was similar in that sector breadth was narrow with only three ahead and Energy and Materials among the outperformers. Gold stocks jumped 18% in the third quarter of 2012; not nearly as extreme as the 41% jump in the second quarter of 2016, but they represented a larger weight in the Index at the time so they had more of an impact."
All styles lag the benchmark
All investments styles in the active management report struggled to beat the benchmark return of 5.1% in the second quarter of 2016, with a nominal difference in median returns. Dividend managers fared slightly better with a median return of 3.5%, compared to 3.4% for growth managers and 3.2% for value.
Dividend managers would have been hurt most by the strength in Canadian gold stocks since they were underweight by nearly 5% on average. Value managers were just over 4% underweight gold stocks while growth managers were less than 1% underweight.
Dividend managers on average were less overweight the Industrial and Consumer Discretionary sectors, compared to value and growth managers, which helped them since those sectors underperformed. Dividend managers also have an underweight to Information Technology, which underperformed, punishing growth and value managers who have significant overweights to these stocks.
Growth managers benefited from an overweight to the Energy and Materials sectors and notable underweights to the underperforming Telecommunication and Financial sectors.
Within Financials, diversified banks underperformed, rising 2.2% in the quarter. That would have helped value managers most since they were roughly 8% underweight on average heading into the quarter compared to growth managers who were roughly 5% underweight and dividend managers who were only 2% underweight. The most widely held bank stocks by large cap managers overall are Toronto Dominion, Royal Bank and Bank of Nova Scotia—and all three underperformed. Those bank stocks were less widely held by value managers than by growth or dividend managers.
"The second quarter displayed little variation in the performance of the styles, but looking back, there are more quarters when one style significantly outperformed others, so maintaining a multi-style approach in a multi-asset portfolio will help to weather swings," says Wylie.
Early look at Q3: Active management environment looked notably better in early July
The third quarter of 2016 through July 22 looked significantly better for active managers. In the first three weeks of the quarter, the S&P/TSX Composite Index was up 4.0% and gains were broad, with six out of 10 sectors ahead, compared to only three in the second quarter. Large cap managers are favourably positioned in eight sectors with overweight positions in five of the six outperforming sectors and underweight positions in three of the four underperforming sectors, including Energy and Materials.
In terms of style, the picture was less clear. Dividend managers may have the early edge given strength in bank stocks through July 22 and the underperformance of gold. Dividend managers have larger weights in banks and a lower weight in gold stocks, compared to value and growth managers.
"It's still early in the third quarter, but the investing environment looks significantly better for large cap managers to beat the benchmark," highlights Wylie. 'For the Index to be solidly higher and managers able to outperform is the best of both worlds."
For more information on this report and findings from previous quarters, please visit https://russellinvestments.com/ca/insights/active-manager-report.
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