Active portfolio management outperformed the benchmark S&P/TSX composite index last year for the fourth consecutive year, effectively outpacing passive investing.
“A lot of people say that active management cannot add value,” says Kathleen Wylie, head of Canadian equities research with Toronto-based Russell Investments Canada Ltd. and author of the Active Manager Report, which is based on a quarterly survey of 111 institutional portfolio managers. “[But] our data show that active management can add value.”
It’s a notable event whenever more than 50% or more of large-cap, active portfolio managers beat both the benchmark and the median, says Wylie. In 2014, the median portfolio manager beat the benchmark by 77 basis points (bps), she adds.
“In 2013, the median manager outperformed [the benchmark]by 659 bps,” Wylie adds. “In 2012, the outperformance gap was 219 bps and, in 2011, it was 42 bps. The average over the 10 years ended 2014 was 83 bps a year.”
In the past decade, she says, top-quartile active portfolio managers outperformed the benchmark by an average of 394 bps a year.
A tale of two halves
The active portfolio management environment improved as 2014 progressed: 65% of Canadian large-cap portfolio managers beat the benchmark in the fourth quarter (Q4); 53% of fund portfolio managers in the third quarter did so, as did 41% in the second quarter and 31% in the first quarter, according to Wylie’s analysis. The median portfolio manager’s return was 11.3% in 2014, ahead of the index’s return of 10.6%.
“[Last year] was a tale of two halves,” Wylie says. “Only two sectors beat the benchmark in the first half: energy and materials. On average, most managers are underweighted in energy and materials, which makes it very difficult to beat the benchmark when those sectors outperform.”
The second half of 2014 was a reversal of the first: eight sectors beat the benchmark while energy and materials underperformed.
“That was generally good for large-cap managers,” says Wylie, noting that the energy positions held by portfolio managers ranged widely from a 25% overweighting to a 24% underweighting.
“The managers who were quite overweighted in energy had pretty poor performance when the sector fell by 16% in Q4,” says Wylie, adding that the top-performing portfolio manager gained by 15.9% in Q4 while the bottom performer lost 9.3%.
“We haven’t seen that wide disparity in performance since the third quarter of 2008,” she says. “We had an extreme environment back then, and the fourth quarter of 2014 was also an extreme environment.”
Active portfolio management does not shine in every period, Wylie notes, as 2009 and 2010 were extremely challenging for active portfolio managers who either avoided low-quality stocks that garnered a lot of attention or were defensive and held cash.
“When you have a big dispersion of returns, as we saw in Q4 and, indeed, throughout all of 2014, [the outperformance of active portfolio management] doesn’t surprise us at all,” says Bruce Cooper, chief investment officer with Toronto-based TD Asset Management Inc. (TDAM).
“This shows that intelligent selection of securities can make a difference,” he adds. “If you can uncover securities that have better risk/reward trade-offs than the index, that’s the benefit of active management. We’re seeing over the past few years that active management can pay off.”
Controlling risk
But risk controls are vital, too, says Cooper, and they should go hand in hand with generating alpha-like returns, especially in an environment in which investors are looking for equities alternatives to fixed-income vehicles that produce paper-thin yields.
“We believe that we can do a great job controlling risk,” says Cooper. “This is something that passive funds cannot do. It’s one of the main strengths of active management.”
TDAM’s equities investments generally fall into three so-called “buckets”: dividend investing; low-volatility investing; and core portfolios that emphasize companies with strong balance sheets and consistent cash flows.
Low-volatility funds, says Cooper, “performed best in 2014, mainly because these funds [were] underweighted in energy and materials.”
Conversely, the $2.9-billion TD Canadian Equity Fund, regarded as a core holding, underperformed the benchmark because of the fund’s heavy energy exposure.
One of Wylie’s key findings is that defensive strategies were favoured between 2011 and 2013, although 2014 marked a turning point as growth investment styles began to shine.
“In 2014, everything switched and growth managers outperformed [against dividend and value portfolio managers], for the first time since 2010,” says Wylie, attributing the strong performance to growth portfolio managers’ heavy weightings in stocks such as Canadian National Railway Co. and Enbridge Inc.
“This year is shaping up to be challenging,” she says, “as large-cap managers appear to be positioned favourably in only four of the index’s 10 sectors as of early February. Health care and materials are the top-performing sectors so far this year and are likely to hurt large-cap managers who, on average, are underweighted in these two sectors.
“It looks like a challenging environment for active managers to beat the benchmark,” Wylie adds. “There is less sector breadth -only five of 10 sectors are outperforming the benchmark. It doesn’t look great. But things change every day.”
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