Less than 20% of large cap Canadian equity investment managers beat the benchmark in the first quarter of 2008, according to new data from Russell Investments Canada.

That was down from 41% in the fourth quarter of 2007 and was the lowest level since 1999, when Russell began to closely monitor such data. As a result, the median large cap manager’s return of -3.9% lagged the S&P/TSX Composite return of -2.8%.

“I would describe this environment as the most hostile I’ve ever seen. Two things really hurt active managers in the first quarter. First, the only two sectors with positive returns were energy and materials, but large cap Canadian equity investment managers were underweight those sectors on average,” says Kathleen Wylie, a senior research analyst at Russell.

“The other issue that hurt active managers was that companies with strong fundamentals trading at reasonable prices were not the most rewarded in the quarter. It reminded me a bit of 2003 when lower quality companies generally were sought after, which was a challenge for active managers that focused on quality companies. In the long run, I believe that good companies with sound fundamentals at reasonable valuations will come back in favour and managers with skill at finding those companies will outperform.”

Wylie notes that he energy sector is now a larger weight in the S&P/TSX than financials and that resources (energy and materials) account for almost half the index weight. That makes it even more challenging for active managers to outperform the benchmark when those sectors are outperforming and makes peer relative assessments even more important in periods such as this. For instance, within materials, gold stocks rose 8.4% compared to the S&P/TSX composite decline of 2.8%.

“Most active managers are underweight gold and many do not own any gold stocks at all in their portfolios — that significantly hurt their benchmark relative performance in the quarter. But the good news is that gold stocks are down significantly so far in the second quarter. As a result, the active manager environment looks more favourable,” says Wylie.

After experiencing the worst back-to-back performance since 1999, value managers showed improvement and held up better than growth managers in the first quarter of 2008. In the quarter, 27% of value managers beat the S&P/TSX composite, which was up from 16% in the fourth quarter and only 9% in the third quarter. In contrast, 24% of growth managers beat the benchmark in the first quarter down from 53% in the fourth and 75% in the third.

Wylie points to the improved performance of value managers stemming from the recent rebound of the financials sector, and the underperformance of materials stocks as reasons for optimism going forward.

“A number of value managers that I’ve spoken to report that April has been a strong month for them. Although it’s too early to say that the tide has completely turned, there are signs of optimism so far in the second quarter,” Wylie says.

Wylie also points out that over the long run, active managers have historically added value, even after fees, and that the managers in this survey are institutional rather than mutual funds with a focus on non-taxable investors. Institutional investment managers generally tend to hold less cash and hold a smaller allocation to foreign equities compared to mutual fund managers. In the last 10 years, the median large cap manager has beaten the S&P/TSX composite on average by 27 basis points per quarter.