ALTHOUGH THERE ARE MANY critics who question the value of active fund portfolio management, recent research by Toronto-based Russell Investments Canada Inc. shows the majority of 154 Canadian small- and large-capitalization institutional fund managers surveyed are trouncing index returns – and have done so for the past decade.
Canadian research team, headed by Kathleen Wylie, focuses on institutional portfolio managers, although many of such managers also manage funds for retail investors. The survey compares the stock portfolios of the managers to their benchmark indices – either the S&P TSX composite index or the S&P TSX small-cap index – in terms of sector exposure and individual stock weightings.
The third quarter (Q3) of 2013, ended Sept. 30, was the fourth consecutive quarter in which the majority (74%) of the 115 large-cap portfolio managers in the survey beat their benchmarks, following a record 96% in the previous quarter. In Q3, the median large-cap portfolio manager’s return was 7% vs 6.2% for the S&P TSX composite index. (Institutional returns are not net of fees.)
Last year, 76% of large-cap portfolio managers beat the benchmark on an annual basis, the most since 2002. The median return was 9.4%, more than two percentage points higher than the 7.2% gain shown by the index. Over the past 10 years, says Wylie, large-cap managers have averaged a 20 basis point (bps) outperformance per quarter, adding up to an average 80 bps advantage per year.
Small-cap portfolio managers have been doing even better. Q3 was the 11th consecutive quarter in which the 39 small-cap portfolio managers beat their benchmark, boasting a median 9.6% return during the quarter compared with the S&P TSX small-cap index’s return of 8%.
Over the long run, small-cap portfolio managers have done the best of all, beating both their benchmark and their large-cap peers. For the past 10 years, the median small-cap portfolio manager was ahead of the small-cap benchmark by 165 bps per quarter, or 6.6% annually, on average.
“It’s been a favourable environment for active managers,” Wylie says. “In environments where the majority of stocks are moving in the same direction, it’s hard for managers to differentiate themselves and even the good managers can’t add value. Right now, it’s a good stock-picker’s environment.”
As with the performance of retail mutual funds, the performance of institutional portfolios is affected by fees, but to a lesser degree. Generally, institutional portfolio managers charge fees of 1% or less of assets under management. If you factor in the impact of these fees, many institutional portfolio managers still outperform their benchmark.
However, the majority of mutual fund portfolio managers underperform their benchmarks. A key differentiator is that their performance often is eroded by management fees (2%-3% on equity funds, for example), making it harder for these portfolio managers to outperform their benchmark and competing products, such as low-fee, index-based exchange-traded funds.
“Costs are important, and there’s a natural advantage for low-fee index funds,” says Rudy Luukko, investment funds and personal finance editor with Morningstar Canada. “But, that said, our research indicates that not all fund managers are created equal. Some have superior skill, discipline and a repeatable investment process. The challenge for advisors is to find funds and managers that achieve superior performance over long time periods, and that can be helped by lower fees.”
Most fund portfolio managers surveyed by Russell did not perform well during the 2008 financial crisis and the couple of years afterward, Wylie says. Generally, they were underweighted in the few areas that were outperforming, particularly gold stocks.
One thing all the outperforming managers have in common is a large “active share” in their portfolios. “Active share” measures how a mutual fund differs from the index, in terms of both names in the portfolio and the percentages held in those names.
A portfolio manager with an active share of more than 80% is considered a truly active manager, while a manager with an active share of less than 20% is considered to be a “closet indexer.” Research has shown that managers who truly are active and whose portfolios deviate from the index are the ones who are able to outperform and therefore earn their fees.
Says Alex Sasso, CEO of Calgary-based Hesperian Capital Management Ltd. in Toronto and lead manager of Norrep Fund: “It’s important to choose an active manager who employs a proven and repeatable investment process and has built a track record over a long period of time and through various market cycles.”
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