Relief. That’s the feeling that many months of solid gains across the asset-class spectrum has produced for investors and their advisors alike. That feeling of relief has likely placated investors to the point where they may be spending less time than normal scrutinizing their managers’ performance. But it won’t be long before those very same investors start playing the relative return game once again, chasing what was hot, and soon-to-be-not. Wealth managers may be questioned as to why their recommended large-growth, separately managed account or mutual fund manager was up “only” 14% during the third quarter, while the top-performing managers in the category were up 22% or more.

In order to judge and explain performance at any particular point in time, wealth managers must understand the factors which drive returns of the market as a whole, and how those factors affect the performance of the managers that they recommend to clients. Given the speed and strength of the rally since the market lows of early March, and the large performance differential between top and bottom quartile managers so far this year, we delve into the question: What has driven performance? And we attempt to gauge whether or not those factors are likely to outperform in the future.

Quality. In a word, that is what is behind the performance differential so far this year–or perhaps more correctly: low quality. Through conversations with money managers and market strategists, as well as our own research, it is clear that lower-quality companies have led this rally, and as a result, managers that focus on (or willing to take a chance on) lower-quality companies have benefitted tremendously, leaving their high-quality peers in the dust. Consider the following:

  • Baird found that companies with negative earnings gained 92% from the March 9 lows through the end of August, compared with a 47% rise for companies that had the highest profit margins. Further, companies with the lowest return on equity outperformed those with the highest by more than two-to-one.
  • In a research note dated September 3rd, Morgan Stanley indicated that the performance of stocks rated B, B- and C by Standard & Poor’s have generated returns of 21%, 21% and 35%, respectively, since the beginning of the year through September 2nd, whereas stocks rated A- and A produced paltry returns of 4% and 6%, respectively, and stocks rated A+ actually declined by 3%. Morgan Stanley went on to say that “Cash has gone into corporate clunkers.”
  • Todd-Veredus Asset Management noted that the average stock priced under $10 as of June 30th returned almost 40% during the third quarter, and that stocks priced under the $10 mark as of January 1st are up almost 85% through the second week of October.

Prima’s own research confirms the findings presented above. We examined the returns of stocks within S&P’s quality rankings for the third quarter and found that in all nine domestic equity style boxes (i.e. large growth to small value), stocks with a rating of A underperformed stocks with a rating of C by a meaningful margin. Further, those companies falling into the fourth quartile based on ROE outperformed first quartile companies by large margins during the quarter.

In addition, Prima reviewed the best- and worst-performing characteristics of stocks in the S&P 500 Index for the year-to-date period ending September 30, 2009. Of the 17 characteristics that Ford Investor Services tracks, beta (high) had the largest positive attribution, meaning the higher a stock’s beta, the better it has performed. As you might expect, the opposite has been true for dividend yield. High-yielding stocks have underperformed the S&P 500 Index.

As you can see, various research suggests that low quality has led to outperformance. While this is helpful in explaining the performance differential across actively managed strategies to date, the bigger question now is, will the payoff for low quality continue? The answer would seem to be no. As Morgan Stanley put it, there has been a compression of value spreads and at this time there is no premium to growth. More specifically, the P/E ratios of top quintile companies, based on long-term earnings forecasts, are now roughly the same as the P/E ratios of the bottom quintile companies. Quality, it would seem, is relatively cheap, and those managers with a quality bias won’t likely trail for much longer.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital, which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.