Resource-driven market tough for managers to beat: Russell

“The median large cap manager returned 5.8% in the third quarter, which was a strong return,” highlights Kathleen Wylie, head, Canadian equity research at Russell Investments, “but that return was notably behind the S&P/TSX Composite Index’s return as most managers struggled to beat the benchmark. For that reason, we describe it as a challenging active management environment.”

With only three out of 10 sectors beating the S&P/TSX Composite Index in the third quarter, the narrow sector performance, led by energy and materials, made it challenging for active managers to keep up with the benchmark return. “Large cap managers on average are 5% underweight materials and nearly 2% underweight energy stocks, so when those two sectors run, these managers struggle to beat the benchmark,” says Wylie. The energy and materials sectors combined accounted for 2/3 of the S&P/TSX Composite Index’s return in the quarter.

Gold stocks rose 18% in the third quarter, the largest quarterly gain since the second quarter of 2010 and following three consecutive quarterly declines. This explains much of the underperformance by active managers.

“Large cap managers on average are more than 4% underweight gold stocks so when these stocks surge, active managers tend to struggle relative to the benchmark since gold stocks have such a large weighting in the Index,” says Wylie.

At the start of the third quarter, gold stocks, a sub-sector of the materials group, accounted for 10% of the S&P/TSX Composite Index, which is down from a peak of 14% three quarters earlier. Dividend-focused managers on average were almost 8% underweight gold stocks, so they were most negatively impacted. That compares to value managers who were roughly 6% underweight and growth managers who were only 1% underweight at the start of the third quarter.

“All styles lagged the benchmark in the third quarter,” highlights Wylie, “but growth managers lagged by less. They were helped by having a slight overweight to energy and less of an underweight to materials stocks, including gold.” In the quarter, 27% of growth managers beat the benchmark with a median return of 6.1% while only 16% of value managers beat the benchmark with a median of 5.7%.

Not one dividend-focused manager was able to beat the S&P/TSX Composite Index’s return in the third quarter. The median return of 4.5% was well behind the S&P/TSX Composite Index’s return of 7.0%. Dividend-focused managers tend to have large underweights to resources so the strength in energy and materials hurt their relative performance. On average dividend managers were 12% underweight materials and nearly 4% underweight energy at the start of the quarter.

“The magnitude of underperformance of dividend-focused managers may come as a surprise to many,” suggests Wylie, “but keep in mind that these managers tend to have larger sector bets compared to other styles, which can result in larger swings in performance relative to the benchmark. As well, they have performed extremely well since the start of 2011 as investors favoured more defensive strategies.”

The first four weeks of the fourth quarter appear to be more favourable for active managers, with more sector breadth as six out of 10 sectors are ahead. The energy and materials sectors are lagging so far in the quarter.

“Large cap managers have their largest underweight to Energy and Materials so it helps that these sectors are underperforming,” says Wylie.

As well, large cap managers on average are overweight the top-performing industrials, consumer staples and consumer discretionary sectors so that positioning is benefitting their benchmark-relative performance.

“It’s too early to make a call on the environment,” cautions Wylie, “but with resources, including gold, lagging, it’s promising for active managers.”

In terms of style, since dividend-focused managers have significantly larger underweights to resources, the environment may be tilted back in favour of their style again. As it stands, they are favourably positioned in eight out of the 10 sectors.

The Russell Active Manager Report is produced quarterly and is based on recently released data from more than 140 Canadian institutional equity manager products.