Canadian small cap managers deliver big returns versus large cap managers

Russell Active Manager Report Highlights

• Small cap managers have outperformed large cap managers in 6 out of the last 7 quarters
  
  
• Growth investment style back in favour
  
  
• Fourth quarter started on a positive note for Canadian active managers

TORONTO, Nov. 3 /CNW/ - The strong returns of late from the recovering Canadian stock market benefited small cap investment strategies in a big way. According to the latest results of the Russell Active Manager Report, the median small cap manager in Canada posted a return of 12.7%, well ahead of the median large cap manager return of 9.9%. 

"Small cap managers have outperformed large cap managers in six out of the last seven quarters after lagging large cap managers for most of the previous four years," says Kathleen Wylie, Senior Research Analyst at Russell Investments Canada Limited (Russell), who has interviewed and evaluated hundreds of investment managers during her career. 

"Over longer periods, the median small cap manager outperformed the median large cap manager by over 115 basis points per quarter on average over the last 10 years."

The strong performance of the Materials sector was the key difference maker between small cap managers and large cap managers. Small cap managers in Canada have an average weight of over 21% of their portfolios in the Materials sector compared to large cap managers who have roughly 15% on average.  That was good news for small cap managers relative to large cap since Materials stocks surged in the third quarter.

"However, small cap managers struggled against the S&P/TSX SmallCap Index, due to their underweight to Materials, compared to the benchmark," says Wylie.

"The S&P/TSX SmallCap Index has a weight of almost 32% in Materials stocks, compared to 21% for small cap managers. As a result, only 29% beat the S&P/TSX SmallCap Index's return of 14.2% in the third quarter."

For active large cap managers, the strength of Materials stocks in the third quarter also made it difficult to outperform the S&P/TSX Composite Index.  Large cap managers were almost 6% underweight the top performing Materials sector at the start of the quarter, which returned 18.2% in the third quarter.  That sector alone accounted for almost 37% of the S&P/TSX Composite Index's positive return during the quarter.  As a result, only 34% of large cap Canadian equity managers were able to beat the S&P/TSX benchmark in the third quarter of 2010.

"To really understand what happened in the quarter, you need to look at each month.  In July and September, the active management environment was favourable with 63% and 56% of large cap managers beating the benchmarks, respectively.  In August, as concerns about the U.S. economy sent gold prices and gold stocks soaring, only 19% of large cap Canadian equity managers were able to outperform the benchmark.  Large cap managers on average are almost 5% underweight the gold stocks in Canada so when gold outperforms, it's difficult for active mangers to beat the benchmark since gold stocks now account for roughly 13% of the S&P/TSX's weight," explains Wylie. 

Despite the recent underperformance versus small cap managers, the median large cap manager has been able to outpace the S&P/TSX benchmark by 40 basis points on average per quarter over the last 10 years. 

"Keep in mind that's a median return. Therefore half the universe of large cap managers beat the benchmark by more than 40 basis points per quarter," says Wylie. 

"Historically, managers with skill in stock research and portfolio construction have been proven to add significant value above the benchmark over long periods of time."

Growth style of investing back in favour

After lagging value managers for five consecutive quarters, the growth style of investing was more in favour in the third quarter, as 47% of growth managers outperformed the S&P/TSX Composite benchmark compared to 31% of value managers.  That compares to only 24% of growth managers and 45% of value managers in the second quarter of 2010. 

"Generally, the factors that growth managers tend to emphasize in their stock selection process, such as earnings growth, earnings estimate revisions and earnings surprises were rewarded in the third quarter. However, the major difference in returns was stock specific. If you look at the top five contributing stocks, Potash, Bank of Nova Scotia, Toronto Dominion Bank, Teck Resources and Royal Bank, a smaller percentage of value mangers owned these stocks and they tended to own them at lower weights compared to growth managers," explains Wylie. 

"Value managers struggled from 2005 to the first half of 2008 but have outperformed growth managers in most quarters since then. Early indications were that the value style was coming back in favour in the fourth quarter of 2010 based on sector performance, but that keeps changing daily so it's not clear which style is outperforming now. " 

Favourable active management environment kicked off fourth quarter

The active management environment in the fourth quarter of 2010 started off on a positive note in the first three weeks as Energy and Materials stocks underperformed.  However, sector leadership is changing quickly.

"Active managers have their largest underweights to the Energy and Materials sectors, particularly golds, so performance of those sectors will determine how favourable the environment ends up in the quarter," says Wylie.

In October, the top-performing sector was Information Technology, led by Research In Motion (RIM), which was the top-contributing stock in the index. 

"Interestingly, active managers have been busy repositioning their portfolios and value managers now have roughly the same weight in technology stocks as the average growth manger.  However, given that 77% of growth managers hold RIM compared to 45% of value managers, the strength in RIM is more of a positive for growth managers," says Wylie.

"If you look back to early 2008, less than 1% of value managers held RIM so the increase to 45% is a significant change. In early 2009, value managers took advantage of lower valuations in RIM when the market bottomed.  This highlights that managers should not be dogmatic about where to find growth or value in the Canadian market but be responsive to the market environment. Going forward, we can't predict which style of active management will outperform on a quarter-to-quarter basis but we do know that over the long run, there is not a significant difference in the performance of value and growth managers in Canada. As a result, holding a diversified portfolio of managers with different styles will help you weather the swings."

For access to the full Russell Active Manager Report, please contact Thien Huynh at 416-640-2529.

About Russell Investments

Founded in 1936, Russell Investments is a global financial services firm that serves institutional investors, financial advisers and individuals in more than 40 countries. The firm has C$153.2 billion in assets under management (as of September 30, 2010) in its mutual funds, retirement products, and institutional funds.

Russell Canada was recently named the #1 fastest growing money manager in Benefit Canada's 2010 Top 40 Money Managers Report. For more information about how Russell helps to improve financial security for people, visit us at www.russell.com/ca.

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For further information:

Thien Huynh	416-640-2529
Katita Stark	416-929-9100