Investment managers have faced a challenging environment of late, with only 45% of large cap Canadian equity investment managers beating the S&P/TSX composite total return index in the third quarter of 2007, according to a report from Russell Investments Canada.

That was down from 53% in the second quarter and 65% in the first quarter of this year. It was the lowest number since the second quarter of 2006. The median large cap manager return was 1.8%, which lagged the S&P/TSX composite return of 2%.

Russell notes that the managers in the survey tend to be institutional rather than mutual fund managers with a focus on non-taxable investors. Institutional managers generally tend to hold less cash and have a smaller allocation to foreign equities compared to mutual fund managers.

There was less breadth in the market in the third quarter with only three out of 10 sectors beating the benchmark (down from six out of 10 in the second quarter) and given that active managers on average were underweight two of the three top-performing sectors, that made it difficult for them to beat the benchmark, Russell says.

Large cap managers on average were slightly overweight the top-performing information technology sector, which was up 14% and that helped their relative performance. However, they tended to have a significant underweight in the materials sector, which was up 13%, the second strongest sector in the quarter. What also hurt was that large cap managers had their largest overweights to the industrials and consumer discretionary sectors on average, which both underperformed in the quarter.

The biggest story in the quarter was the divergence between the performance of growth and value managers. Only 9% of value managers beat the S&P/TSX composite return in the third quarter. In contrast, 75% of growth managers outperformed the benchmark.

The median value manager return was only 0.5% compared to the median growth manager return of 2.4%.

What made it tough for value managers was that, on average, they were more than 1% underweight the top-performing information technology sector. In contrast, growth managers were roughly 3% overweight. In addition, value managers had notably larger underweights to the strong performing materials sector.