Stock pickers’ pain turning to gain: report

“Bottom-up stock fundamentals did not seem to matter in the quarter, as macro concerns such as the on-going debt crisis in Europe, dominated,” says Kathleen Wylie, senior research analyst at Russell Investments. “As well, we observed a significant spike in the correlations of stocks, and when that happens it is very challenging for active managers to add value. There were few places to hide, when 74% of the stocks in the index declined in the quarter. For many investment managers, benchmark-relative performance in the quarter was their worst on record.”

Wylie, who has interviewed hundreds of investment managers during her career, went on to add that the fourth quarter is off to a positive start. “Many of the hardest hit stocks in the third quarter rebounded in October from the lows, and this is already translating into significantly stronger performance for many of those investment managers who struggled so much in the third quarter.”

“Examples of stocks rebounding include Suncor Energy Inc, which was down 29% and the top negative contributing stock in the third quarter, and is up 19% in October. Almost 80% of investment managers hold the stock so the performance has a notable impact on performance,” says Wylie. Other widely held stocks that hurt manager performance in the third quarter but are now rebounding include Canadian Natural Resources, down 24% but up 14% in the fourth quarter; Manulife Financial, down 29% in the third quarter but up 10% so far in the fourth; and Teck Resources, which was down 37% in the third quarter but up 29% so far in this quarter.

Wylie also notes that gold stocks underperformed in October after strong performance in the third quarter. Large cap managers in Canada are underweight golds by almost 5% on average.

Seventy-four per cent of dividend-focused investment managers beat the S&P/TSX composite in the third quarter. This compares with 100% of dividend managers beating the benchmark in the second quarter. “The only two sectors to post positive returns in the third quarter were Telecommunications and Utilities and dividend managers are overweight both those sectors,” says Wylie. Overall dividend-focused managers were favourably positioned in seven out of 10 sectors.

“What I found particularly interesting is how well dividend managers performed in the third quarter despite the strength in gold stocks.” In the quarter, six of the top 10 contributing stocks were golds. Dividend managers on average were almost 8% underweight gold stocks at the start of the quarter, but those positions were offset to a certain extent by their significant overweights to BCE and Enbridge, which were also among the top contributing stocks.”

Growth managers struggle most in Q3

Growth managers were hit hardest in the third quarter with only 12% able to beat the benchmark, down from 67% in the second quarter and the lowest on record. Value managers were slightly better with 30% beating the benchmark, down from 66% in the second quarter.

“Growth managers were underweight the five sectors that outperformed and overweight the five that underperformed, so nothing went right for them in terms of sector positioning,” says Wylie. “As well, their stock positioning was not favourable due to large negative contributors such as Royal Bank, Potash Corp, Teck Resources and Suncor Energy, which were all more widely held by growth managers and at overweight positions. On a positive note, top-contributing stocks such as Barrick and Goldcorp tended to be more widely held by growth than value managers and at larger weights.”

So far in the fourth quarter, performance looks like it might be rewarding growth managers, who are more favourably positioned in eight out of 10 sectors compared to value managers. Energy is among the top performers and the largest contributor to the S&P/TSX composite return. Growth managers have a slight overweight to energy while value managers are underweight. As well, the stocks that have rebounded most in October tend to be more widely held by growth managers.

“With only three sectors outperforming so far in October, sector breadth is narrow, which often makes for a challenging active management environment. However, stock selection was the key driver in October based on the returns I’ve seen,” says Wylie. “While it is early in the quarter, the tone has certainly improved compared to the third quarter, even though the last couple of days have been challenging. Although the volatility continues, the market is in positive territory and fundamentally strong companies that are trading at good valuations were rewarded in October.”

The Russell Active Manager Report, which is produced quarterly, is based on recently released data from over 140 money manager products.