Defensive active managers struggle to beat benchmark in the second quarter: Latest Russell Canada Active Manager Report

• 41% of large cap managers outperform benchmark, a 10% increase from last quarter
• Growth managers fared better than defensive dividend and value managers during the quarter
• Active manager environment appears to be mixed so far in the third quarter

TORONTO, July 31, 2014 /CNW/ - The active management environment in Canada improved in the second quarter with 41% of large cap managers beating the S&P/TSX Composite Index, a 10% increase from the first quarter. The median manager return was 6.2%, slightly behind the S&P/TSX Composite Index return of 6.4%. These and other notable observations are included in the most recent Russell Investments Canadian Active Manager Report, which is based on a quarterly survey of roughly 150 institutional money manager products (all data cited is gross of fees).

"Although the stock market started the year on a strong note, with the S&P/TSX Composite Index up 12.9% in through the end of June, the first half has not been as strong for active managers," noted Kathleen Wylie, Head of Canadian Equity Research at Russell Investments. "Large cap managers struggled to beat the benchmark in the first six months of the year after a string of five consecutive quarters of favourable active management environments." Wylie defines a favourable active management environment as when 50% or more investment managers beat the benchmark. Wylie noted that in the last 10 years an average of 54% of large cap managers have beat the S&P/TSX Composite Index per quarter. That number increases to 58% in the last five years.

Environment Improves for Canadian Large-Cap Equity Managers

During the second quarter, only two of 10 sectors outperformed the benchmark, but large cap managers were favourably over- or underweighted in six of the 10. "Typically, narrow sector breadth can lead to a difficult environment for investors. I was surprised it wasn't more of a struggle for managers to beat the benchmark. However, managers were underweight five sectors that underperformed and overweight one of the two sectors that outperformed. In addition, within certain sectors stock selection played a role," states Wylie.

The only two outperforming sectors were Energy and Industrials. Large cap managers were almost 2% overweight Industrials on average, which helped their benchmark-relative performance. Within Industrials,  railroad stocks were key contributors but manager positioning at the start of the quarter was mixed. Canadian National Railway, up 12.2% during the quarter, was owned by 70% of large cap managers. Canadian Pacific Railway, up 16.9% in the quarter, was only owned by just 32% of large cap managers.

Large cap managers were underweight Energy slightly more than 2%, which would have hurt their benchmark relative performance. However, if the pipeline stocks, specifically Enbridge Inc. and TransCanada Corp, are excluded from the Energy sector, large cap managers on average would be overweight Energy. Each stock has a large weight in the sector, yet was owned by less than half of the managers surveyed. Enbridge has a 2.4% weight in the Index and is only owned by 41% of large cap managers, while TransCanada has a 2.0% weight and is owned by 49% of large cap managers. Both stocks underperformed in the quarter. "Of the pure Energy companies, managers benefited from owning Suncor Energy, which was the top-contributing stock to the Index gain in the second quarter, up 18.5% and owned by 74% of large cap managers in Canada. Canadian Natural Resources also helped, up 16.3% in the quarter and owned by 80% of large cap managers," says Wylie.

The largest sector in the Index is now Financials, which started the second quarter at a 34% weight. Overall positioning of the Financials sector helped large cap managers in the quarter since they are over 2% underweight on average and the sector underperformed. "However, within Financials, diversified bank stock performance was strong at 7.2% and large cap managers tend to be overweight," highlights Wylie. "In fact, the most widely held stock by large cap investment managers in Canada at the start of the second quarter was TD Bank, held by 89% and among the top contributing stocks in the quarter with a return of 6.9%. Bank of Nova Scotia, held by 88%, was the second top contributing stock, up 12.1% in the quarter. Overall, large cap managers in Canada were 3.4% overweight diversified banks at the start of quarter."

Growth managers fared better than defensive dividend and value in the quarter

Growth managers fared better than defensive managers in the second quarter, with 50% beating the benchmark compared to 34% of value managers and 27% of dividend-focused managers. The median growth manager return was in line with the benchmark return of 6.4% but the more defensive value and dividend-focused manager medians lagged the benchmark, with 6% and 5.6% returns, respectively. Growth managers benefited from a large underweight on average to the underperforming Telecommunication and Utilities sectors.

Gold stock performance also helps explain differences in investment manager style performance during the quarter. Gold stocks were up almost 10% in the quarter, which hurt value and dividend manager performance most since they have larger underweights. On average, value and dividend managers were underweight gold stocks by 3% and 4%, respectively, while growth managers were less than 2% underweight at the start of the quarter. "The good news is that gold stocks are having less of an impact on benchmark relative performance now, compared to 2011 when they were 14% of the Index and large cap managers were 6% underweight," points out Wylie. Large cap managers on average were 2.6% underweight gold stocks at the start of the quarter.

"This was the first time in a year that growth managers have fared better than value and dividend managers," highlights Wylie. "Their style was largely out of favour throughout most of the financial crisis with growth managers lagging the more defensive styles in all but five quarters since the third quarter of 2008. We know that styles come in and out of favour and that the performance differences in some periods can be quite extreme. A well diversified, actively managed multi-asset portfolio, which includes multi-style managers as well as multi-factor exposures, will help smooth out some of those swings," states Wylie.

Environment not so clear so far in the third quarter

In the first four weeks of the third quarter sector breadth has improved with four of the 10 sectors outperforming, up from only two in the second quarter. However, active managers are favourably positioned in six out of 10 sectors, the same as in the second quarter. Overweights to Industrials and Consumer Staples are helping benchmark-relative performance for active managers since those sectors are the top performing sectors. Strong performance in  diversified bank stocks is continuing, which is also benefiting large cap managers. Gold stocks are underperforming slightly, which is also positive for large cap managers.

"There is no clear indication which style may be leading so far in the third quarter", states Wylie, "with the situation changing daily. However, it appears that growth managers may be lagging." Growth managers have their largest overweights to Consumer Discretionary stocks and Information Technology stocks, which are both underperforming. Value managers have the largest overweights to Industrials and bank stocks, which would be helping their relative performance. Dividend managers would benefit most from the underperformance of gold stocks and the largest overweight to the Consumer Staples sector.

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