Active management proving its worth

It’s been a while since active investment managers had such a good year. The last time they beat the benchmark in four consecutive quarters was 2007, and market conditions were stronger then. Still, when the bigger picture is considered, the impressive performance of active investment managers over the past 12 months is not an anomaly, says Kathleen Wylie, head of Canadian equity research with Russell Canada in Toronto: “The 10-year average is 55% above the benchmark.”

BANK STOCKS DRIVE GROWTH

The current results occurred despite greater concentration of firms, with only four of 10 sectors — health care, consumer discretionary, financials and energy — beating the benchmark S&P/TSX composite index. This compares to seven of 10 sectors beating the benchmark in the previous quarter. “When you have broad-based gains,” says Wylie, “it’s easy to be in the right sector. There was less breadth in this quarter.”

She attributes the gains achieved by active investment managers in this quarter to the individual stock selections they made. Bank stocks, in particular, were a popular and productive investment. “Of the top 10 contributing stocks,” notes Wylie, “five were banks.”

The Russell Canadian Active Manager Report, which is produced quarterly and based on recent data from more than 150 Canadian institutional-equity investment manager products, found that bank stocks tend to be the most widely held in Canada at “overweighted” positions on average. For example, as of the fourth quarter of 2012, the most widely held stock was Toronto-Dominion Bank, with 88% of large-cap active investment managers holding it at an average overweighting of 1.3%.

“Given how managers are positioned and the weighting of financials in the index, clearly the performance of the sector — particularly, the banks — will have a notable impact on the benchmark-relative performance of investment managers,” Wylie concludes in an accompanying 17-page special report entitled Equity Active Management In Canada: The changes and the challenges, which looks at the active investment management environment in Canada more closely

Performance also was enhanced by what active investment managers opted not to buy. For example, BlackBerry Ltd.’s stock fell by 27% in the quarter ended Sept. 30, but was held by only 31% of large-cap active investment managers. Cameco Corp., one of the world’s largest publicly traded uranium companies, also did not contribute to active managers’ success; that stock fell by 14% in the same quarter, but was held by only 34% of active investment managers.

Concentration is a significant issue for active investment managers, according to Wylie’s report. In fact, three sectors — financial services, energy and materials — account for 75% of the S&P/TSX composite. This lack of diversity sets Canada apart.

CONCENTRATION IS AN ISSUE

“Compared with other indices, there is a huge difference in weighting,” Wylie says. “That makes it harder to be above the benchmark.”

This situation is unlikely to change, she adds: “Concentration is likely to impact the Canadian market, probably forever.”

Gold stocks reflect the issues that greater concentration can bring for active investment managers. Prior to 2007, gold stocks were a relatively small portion of the index, hovering at around 5%, Wylie’s report states, but this began to change “notably” toward the end of 2007.

From 2003 to 2011, the weighting of gold stocks almost tripled, reaching a peak of 14% of the S&P/TSX composite. In the third quarter of 2011, the materials sector overall accounted for 23% of the S&P/TSX composite index, and gold stocks composed the majority of that. States Wylie’s report: “That made gold the third-largest ‘sector’ behind financials and energy, which was problematic for investment managers who have been underweighted on average.”

Sector breadth has improved so far in this, the final quarter of the year, which will end on Dec. 31. Six of 10 sectors are ahead of the benchmark thus far, and large-cap active managers are positioned favourably in five of those sectors. The greater breadth bodes well for active investment management, says Wylie: “We’re in a period now that is better because it’s not quite so concentrated.”

The findings of the report and the trends that have emerged over time indicate the value of active management, despite the detractors of this strategy. From 2009 to 2012, Wylie notes, active investment management was not doing well, leading to resistance to using this approach.

But that’s shortsighted, she feels: “There will be periods in which active investment managers don’t do well. But that doesn’t mean active investment management isn’t valuable. Man-agers can add value.” IE