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Fewer than one in five actively managed Canadian equity funds beat the Morningstar Canada Index between June 2007 and September 2024, according to The Canadian Conundrum, a study published by the firm. When a 1% management fee was applied to those funds, a little better than one in 10 added value relative to the Morningstar index.

“What we find here is consistent with what we’ve found in other markets,” said Michael Dobson, manager, research analyst with Morningstar Canada, in an interview with Investment Executive. “Active equity managers in general struggle to beat their respective indexes over long periods of time.”

Dobson emphasized that the findings do not suggest active management is a poor choice. “I don’t think it’s wise to rule active management out entirely.”

One reason stock picking is difficult in Canada is the preponderance of financial, energy and materials companies. Sixty-three per cent of the Morningstar Canada Index is made up of companies in those sectors as of September 2024. Compare that to just 25% of the Morningstar Global Markets Index. Energy accounts for 17% and materials make up 12.7% of the index as of September 2024.

“The excess returns in actively managed funds were negatively correlated with the excess returns of the commodity sectors over the period studied,” Dobson said.

Most actively managed Canadian equity funds were underweight energy and materials, and overweight consumer stocks relative to the Morningstar index during the 17-year study period. That served them well in the first half of the 2010s — by the end of 2015, more than half of these funds were besting their index by more than four percentage points, annualized over the prior three years. But the winning streak didn’t last.

“Materials had a significant underperformance at the start of the decade,” Dobson said. “So being underweight that sector was probably a tailwind for active management. And the reverse has been true about energy exposure.”

The materials sector underperformed relative to the S&P/TSX Materials sector index dramatically from 2010 to 2016 — by up to 25% over three-year rolling periods.

Canadian equity managers exited energy stock positions in large numbers as the S&P/TSX Energy sector index fell 3.6% annualized between June 2007 and September 2020. By September 2024, just 14.8% had overweighted the category relative to the Morningstar Canada Index. They’ve been on a tear since October 2020, gaining 28.8% annualized between then and September 2024. But stock pickers have been slow to respond.

Market concentration is another challenge facing Canadian equity fund managers. Whereas the 10 largest investments constitute less than a fifth of the Morningstar Global Markets Index, Canada’s top 10 stocks count for more than a third of the Morningstar Canada Index.

“Every country has certain characteristics and traits that make it stand out,” Dobson said. “For us in Canada, it’s commodities exposure.”

The study did not examine why these managers made the choices they did. Many have mandates that dictate investment selections. Still, the message is investor beware — especially when it comes to commodities.

“Investors in Canadian equity should pay special attention to how their funds allocate to commodity sectors given how significant energy and materials stocks are in the index,” according to the report. “Perpetual sector tilts away from these areas can overshadow stock-picking for many funds.”