All that glittered was gold and dividend stocks in the second quarter of 2010 as a majority of Canadian active managers struggled in an environment where investors were more risk-averse, amidst market volatility stemming from the European debt situation.

According to the latest results of the Russell Active Manager Report, only 37% of Large Cap Canadian active managers outperformed the S&P/TSX Composite Index in the second quarter of 2010, down from 75% in the first quarter and the lowest percentage of active managers to outperform the S&P/TSX benchmark since the first quarter of 2009.

“Despite the difficult investing environment for Canadian active managers, those that emphasized dividends or gold in their stock selection process had a better chance of outperforming since risk-averse investors rewarded dividend paying companies and gold stocks,” says Kathleen Wylie, senior research analyst at Russell Investments Canada Limited.

During the second quarter, 60% of dividend-focused managers were able to beat the benchmark. Wylie points out that those managers benefited from holding significant weights in companies such as BCE Inc. and Telus, which were among the top contributors in the quarter.

Meanwhile, seven of the top 10 positive contributing S&P/TSX stocks in the quarter were gold companies. Canadian gold stocks rose 21% in the second quarter, the highest increase since the first quarter of 2002.

“The rise of gold stocks was a significant challenge for Canadian active managers, who tend to be underweight gold. Large cap managers in Canada on average are more than 4% underweight gold stocks. Only five active managers of the 101 Russell receives data on were overweight gold stocks at the start of the quarter. Since gold stocks account for roughly 10% of the index weight, that makes it very difficult for active managers to beat the benchmark when those stocks surge,” explains Wylie, who has interviewed and evaluated hundreds of investment managers during her career at Russell.

Value managers hold up better than growth

Value managers fared better than growth managers in the second quarter of 2010, with 45% of value managers beating the S&P/TSX Composite Index compared to just 24% of growth managers. In comparison, 81% of value managers and 76% of growth managers outperformed the S&P/TSX in the first quarter of 2010. Median returns of both styles lagged in the second quarter with the median value manager posting a return of -6.0% and the median growth manager declining -6.9%.

“Stock selection really drove performance this quarter. For instance, growth managers were hurt by owning underperforming stocks such as Royal Bank, Research in Motion, Potash and Teck Resources,” says Wylie.

“Value managers outperformed growth for five consecutive quarters and are on track to outperform again in the third quarter. Their overweights to consumer staples and, Industrials, as well at their significant underweight to Materials, were rewarded in the month of July. Overall sector positioning is favouring value managers compared to growth managers in six out of the 10 sectors. This is one of those periods when one style is dominating over another. But keep in mind that over the long run, their returns are similar. Styles come in and out of favour and it’s impossible to consistently forecast which will be the most rewarded.”

Small cap managers lag large cap

After five consecutive quarters of outperforming large cap managers, small cap managers slightly lagged in the second quarter of 2010. The median small cap manager return was -6.8% compare to -6.2% for the median large cap manager. Over the long run, small cap managers have outpaced large cap managers by roughly 115 basis points per quarter over the last 10 years.

“There were few places to hide in the small cap space during the quarter, with Health Care being the only sector to post a positive return. Small cap managers on average are underweight health care, with less than 3% of their portfolios in the sector. As a result, that positioning hurt their performance compared to large cap managers,” says Wylie.

“More significantly, small cap managers on average have roughly 22% of their portfolios in the materials sector compared to 15% for large cap managers. Materials declined 2.2% in the small cap space, which further took away from the performance of small cap managers.”

Market outlook

Although the second quarter was challenging for many active managers in Canada, Wylie stresses that the median large cap manager in Canada has outperformed the S&P/TSX benchmark by 51 basis points on average per quarter over the last 10 years.

“Keep in mind that the 51 basis point outperformance only represents the median. This means that half of the managers in the Canadian active management universe were able to outperform the benchmark beyond 51 basis points over the past decade. Active managers with skill in stock research and portfolio construction should add significant value above the benchmark over long periods of time,” says Wylie.

“The active management environment has already improved so far in the third quarter, with the focus back on company fundamentals and less on the macroeconomic picture. Sector breadth was strong in July with six out of 10 sectors beating the S&P/TSX benchmark and gold stocks underperforming. Among the top-performing sectors are consumer staples and industrials, which is positive for large cap managers, who historically have large overweights in those sectors. The only sector to post a negative return in July was materials, which is also a positive for active managers, since their largest average underweights are in that sector.”

IE