The strong returns from the recovering Canadian stock market have benefited small cap investment strategies in a big way, suggests a new report from Russell Investments Canada Limited.

According to the latest 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 Toronto-based Russell Canada.

“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.”

TSX materials sector boosts small cap funds

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 Small Cap Index, due to their underweight to materials, compared to the benchmark,” says Wylie.

“The S&P/TSX Small Cap 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 Small Cap 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 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.

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.

Favourable active management environment kicked off Q4

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.

IE