Volume 18, Number 5
May, 2012
Single Issue $15.00

In this issue:

• What’s New
• FIRST QUARTER GROWTH SURPRISES MANY
• RECOMMENDED LIST REVIEW
• NEW MANAGEMENT TEAM AT HELM OF TRIMARK FUND

PDF version of this issue

What’s New

 * AGF EMERGING MARKETS MANAGER RESIGNS – On April 9, it was announced that Patricia Perez-Coutts was resigning from AGF. Ms. Perez-Coutts has produced stellar results during her tenure as lead manager of the AGF Emerging Markets Fund. She is being replaced by veteran manager Stephen Way, who has been with AGF for 25 years. Mr. Way will be assisted on the fund by two long standing global team members. Mr. Way has a respectable track record with the AGF Global Dividend Fund and the AGF Global Equity Fund. He is well versed in the investment process that is used within all funds that are managed by AGF. In fact, it was Mr. Way who was instrumental in the development of that process. However, Mr. Way’s successes have been on mandates that are considerably broader than the emerging markets. It is our opinion that managing emerging markets is a different process, and as such, we will require some time under his management to gain a level of comfort with the fund.

* ASSETS IN ETFs CONTINUE TO CLIMB – Strong investor interest in ETFs resulted in net creations of $1.6 billion during the month of March according to Investor Economics. This brought the total assets under management in the Canadian ETF industry to a record high $49 billion. In the past year, assets have grown by more than 18%. Canadian equities were the popular choice with investors, accounting for nearly a third of all new assets. Corporate bonds were the next most popular, accounting for more than 21% of new flows. Not surprisingly, the industry remains fairly concentrated, with the 25 largest ETFs accounting for 75% of the total assets. As of March 31, there were 219 ETFs available to Canadian investors.

In comparison, the mutual fund industry saw $3.45 billion in new money during March. This brings total assets under management to $813 billion. Balanced funds were the popular choice, attracting more than $3 billion in new money. Fixed income funds were the next most popular, attracting nearly $2 billion. Somewhat surprising, equity funds lost nearly $1 billion in the month as investors preferred the perceived safety of balanced funds and bond funds.

Fund of funds were also popular among investors, gaining $2.6 billion in new money, while stand alone funds attracted $871 million.

FIRST QUARTER GROWTH SURPRISES MANY

By Dave Paterson, CFA

Despite strong global equity returns in Q1, investment environment remains very challenging.

 

For the past several months we have been warning investors to expect higher levels of volatility. Yet, when we look at market performance in the first quarter of 2012, one thing we noticed was its absence. Global equity markets rallied sharply higher with the S&P 500 posting a total return of 12.6% in U.S. dollar terms – its best quarterly performance in 14 years.

Most of this rally can be attributed to the positive news coming out of Europe, with the European Central Bank (ECB) pledging more than 1 trillion euros to banks in an effort to shore up liquidity for the banking system. This helped to ease the fears of many investors and allowed them to focus on the positive economic signs that are coming out of the U.S. and other global economies. These signs included stronger than anticipated job growth, signs the U.S. housing market may be bottoming, and a much improved consumer confidence picture.

Much of the headline economic news that emerged during the quarter was positive. However, one quarter of positive economic news does not mean that the global economy is out of the woods. In fact, there are a number of significant risks that continue to overhang the markets and have the potential to bring significant levels of volatility back into the investment markets.

These risks include:

The European Sovereign Debt Crisis – While there have been a number of positive steps taken recently to help reign in this crisis, it is far from being solved. Greece and Portugal have taken measures that will give them some much needed time to help bring their debts under some form of control. However, solvency concerns remain for other countries such as Spain, Italy, and perhaps even France. In the event that any of these countries were to encounter any sort of liquidity troubles, or be put in a position where even the hint of a default is evident, global markets would likely roil in fear, resulting in big drawdowns and heighted volatility while the situations are controlled and investor fears are eased.

The European Banking Crisis – In Europe, it is estimated that more than 80% of corporate financing comes from its banks, which is sharply higher than in North America. This puts significant importance on the willingness of the European banks to lend to businesses. If businesses were unable to secure proper bank financing, there is the potential for a liquidity crisis which could cripple many European companies. Such an event would have a significant impact on not only Europe, but the entire global economy. To help avert this, the ECB is making more than 1 trillion Euros available in the form of low cost loans. This will certainly help, but until the region’s debt issues are under control and the economies are back on a growth trajectory, this risk will remain at the forefront.

A Chinese Hard Landing – There is little debate that China has been one of the largest engines of growth in the global economy in the past decade. There have been recent signs that the economy has become overheated. Steps have been taken to slow the economy, but there is a very real threat that the government may not be able to engineer a “soft landing” to help head off a full on recession. Even with a soft landing scenario, there is likely to be a slowdown in the demand for commodities, which could slow down the materials and energy sector. Given the high weighting of the S&P/TSX Composite in energy and materials stocks, this could have a negative impact on the Canadian equity markets.

A slowdown in U.S. Growth – While recent economic numbers out of the U.S. have been positive, there are worries that the economy could be hit with another slowdown like the one that was experienced last summer. If this were to occur, it is very likely that investor and consumer confidence would be shaken, which could result in many investors running back towards the safe haven investments such as government bonds or even gold.

An oil shock – With the economies of Canada and the U.S. on a slow and steady rebound, a sustained rise in the cost of energy will drain income from consumers. That in turn will reduce consumer spending in other areas which will increase the risk of a slowdown in economic activity. Higher energy costs will also make it more costly for many businesses to do businesses. Many of their raw materials will cost more, which will reduce their profit margins, negatively impacting profitability.

While the year has started off strong, there remain many risks to the global economy and investment markets. As a result, investors should continue to exercise caution when positioning their portfolios.

Portfolio Positioning

There is little doubt that the current investing climate is a very challenging one. Interest rates remain at very low levels but have begun to move higher in recent weeks. As interest rates climb, bond prices will be dragged lower. This was evident in the first quarter of 2012 as the DEX Bond Universe fell by 0.3%. Government bonds took the brunt of the losses losing nearly 1%, while corporate bonds held up well, gaining more than 1.3%.

At current levels, the medium to long term outlook for bonds is generally not favourable. It is our expectation that interest rates will continue to gradually move back towards more normalized levels, which will result in low or even negative returns for many bond funds.

The short term outlook is less clear. Yes, rates have begun to move higher, but not yet in a meaningful or even sustainable way. The Bank of Canada has hinted that they may begin moving rates higher sooner than later. In the U.S. it is expected that the Federal Reserve will keep rates low for the next several quarters unless we see a major uptick in economic growth. In this environment, we don’t foresee significant gains in fixed income investments. It is our expectation that they will be able to maintain their value on a total return basis. We also expect that during periods of elevated market volatility, investors will flock to the safety of fixed income investments, pushing bond prices higher.

Within fixed income investments investors can protect themselves in three ways; focus on quality, shorten duration, or increase the yield. With each of these scenarios the overall impact of a rise in interest rates will be reduced, helping to preserve capital.

For equity investments, the longer term outlook is strong. While the days of double digit returns may be gone, equities will remain one of the best ways to generate capital growth over the long term. Short term, as outlined above, many risks and challenges remain. Given the recent run up in equity prices, some period of consolidation or a minor correction is to be expected. As this happens, it may provide a good entry point for those looking to add to their equity holdings.

Our outlook in Canadian equities is positive. As the U.S. economy continues to improve, Canadian exporters will benefit. Canada is also a very concentrated market, with a significant portion of our index focused on materials and energy. This is a definite risk as these companies will be significantly impacted by the demand and price of the underlying commodities. With the potential for slowing growth in China, the demand for the commodities may soften in the near term which will create increased volatility in share prices of resource focused companies.

To help protect portfolios, investors should focus on high quality, well managed companies that can generate a stable level of free cash flow. These types of companies tend to be less volatile, which should result in less day to day fluctuation in share prices. This strategy will also enable investors to earn decent relative returns when markets move higher.

Within foreign equities, we prefer the U.S. over Europe. Europe, while on a much better footing than they were even a quarter or two ago, still has a long way to go before their debt crisis and economic woes are remedied. Economic growth is expected to slow and the threat of a recession remains very real. Any further negative headline events will result in a very sharp increase in overall volatility in the region.

On the other hand, the U.S. has shown encouraging economic numbers which lead us to believe they are on the road to recovery. From a valuation standpoint, equity prices in the U.S. appear to be reasonable which should allow for additional growth in share prices as the recovery continues to takes hold.

While things are on a positive track, it is not unreasonable to expect that we may see the market pause or even pullback in the near term, particularly after the impressive first quarter run. We would use any such pullback as an opportunity to add to our U.S. equity holdings.

For our specific fund picks, please see our Recommended List Review elsewhere in this edition which discusses our favourite funds in detail.

 

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RECOMMENDED LIST REVIEW

By Dave Paterson, CFA

Only three of our picks lost money in the first quarter. Recent changes will help you better position your portfolio for the uncertain investment environment.

 

As discussed elsewhere in this newsletter, the current investing environment is as challenging as we can remember. Interest rates are very low and have begun to rise. It is widely expected that the Bank of Canada may begin moving their overnight rates higher in the next couple of quarters. Rising interest rates will make it very difficult for investors who are heavily weighted in fixed income investments to not only earn a decent return, but in some cases, preserve their capital.

In the equity markets, the North American economies appear to be in the midst of a modest recovery, however, many questions remain the economic health of Europe and Asia. This uncertainty will continue to create headwinds and volatility for investors.

With that investing climate in mind, we have made some changes to our Recommended List of Funds.

New Additions

TD Mortgage Fund (TDB 621) – We are adding this fund to our Recommended List of Funds as a substitute for the National Bank Mortgage Fund, which was removed from our list this quarter. The TD Mortgage Fund invests in high quality Canadian residential mortgages that are purchased from and administered by TD Bank. It also has the ability to invest in bonds that are issued by Canadian governments and corporations. As of March 31, the fund held 94% in mortgages, 5% in bonds with the balance in cash. It pays investors a variable monthly distribution which has ranged between $0.095 per unit and $0.183 per unit. Based on the distributions paid in the past 12 month and the current price, the distribution yield to investors is 2.7%. This is significantly higher than the 1.8% paid by the National Bank Mortgage Fund. We like this fund because it holds a much higher proportion of the fund in mortgages when compared to the National Bank Mortgage. The credit quality of the underlying investment portfolio is also higher with 93% of the fund invested in AAA rated securities compared with 48% for the National Bank Fund. It also has a shorter duration relative to the National Bank Mortgage Fund. The duration of the TD Mortgage Fund is 2.5 years compared with 2.9 years for the National Bank Mortgage Fund. This shorter duration will help protect capital better in a rising rate environment. Costs are slightly higher with TD, but for the quality of the portfolio and the higher exposure to mortgages, we feel that this is a better option for investors looking for mortgage exposure in their portfolios.

Funds to Sell

National Bank Mortgage (NBC 816) – As mentioned above, we are removing this fund from our Recommended List. In recent months, we have noticed that the performance has begun to consistently underperform the TD Mortgage Fund. We are also somewhat troubled that the fund has a higher exposure to more traditional bonds than TD. While this may add incremental return in a falling rate environment, we believe it will be a detriment in a rising rate environment. For those looking for a fund that is a mix of mortgages and short term bonds, the PH&N Short Term Bond and Mortgage Fund is a great pick.

Fidelity Northstar Fund (FID 253) – Despite having the very capable management team of Joel Tillinghast and Daniel Dupont at the helm, this fund has failed to perform at a level which allows us to recommend it as one of our best fund ideas. This is particularly true in the current market environment.

Funds to Buy

Fidelity Canadian Large Cap Fund (FID 231) – In the past several months one of the themes we have been focusing on is quality. Our belief is that in periods of uncertainty and volatility, quality will reward investors on a more consistent basis. Daniel Dupont, the manager of the Fidelity Canadian Large Cap Fund shares this view. Using his bottom up, value driven approach, he looks for high quality companies that are trading at reasonable valuations. His primary goal is to preserve capital and looks to avoid major blowups in the portfolio. To date, he has been very successful in doing this and in the process has rewarded investors handsomely with top quartile returns. Looking at his current portfolio, we believe that he can continue to deliver strong risk adjusted returns for investors for the near to medium term. He is worried about the potential impact of a slowdown in China, and as a result has no exposure to materials and is significantly underweight in energy. Further, he is concerned about the growing level of debt that many Canadian consumers are carrying and has reduced his exposure to the Canadian banks. Both of these measures should help to keep overall levels of volatility in check. The fund also holds approximately 40% in foreign equities, the bulk of which are in the U.S. We would also expect that the fund will lag the markets in a sharply rising environment, but will provide strong relative returns in periods of volatility.

IA Clarington Canadian Conservative Equity Fund (CCM 1300) – Perhaps the best way to describe this fund is that it is boring. That is not a bad thing. It is just that there isn’t a lot of excitement or sizzle to it. But that is also why I like it. What it does have is a disciplined management approach that looks for high quality companies that have a demonstrated history of paying and growing dividends over time. The end result is a concentrated portfolio of Canadian blue chip companies. If you are looking for a fund that will keep pace with the markets when they move higher, then this isn’t a fund for you. But if you are looking for a fund that will deliver relatively consistent returns, then this is definitely worthy of consideration. In our opinion, it is best suited for conservative or medium risk investors who are looking to gain some Canadian equity exposure but don’t want to take on too much risk. Those with a higher risk tolerance may want to consider one of our other Canadian equity picks.

RBC North American Value Fund (RBF 554) – On our Recommended List since June 2011, we recently upgraded the fund from a Hold to a Buy based on a number of factors including recent risk adjusted returns, portfolio positioning and manager process. The manager uses a mix of top down quantitative screening and fundamentally driven, bottom up analysis. The end result is a very well diversified portfolio of more than 100 individual stocks. The manager can invest up to 49% of the fund outside of Canada, and has been taking advantage of that recently, increasing the U.S. exposure in the fund to 41%. The fund is currently underweight in both energy and materials which should help keep overall volatility in check. Performance has continued to outpace not only the index but the majority of its peer group. All of this leads us to believe that the fund is well positioned for the current market environment.

Steadyhand Income Fund (SIF 120) – Having just celebrated its fifth anniversary, Vancouver based Steadyhand continues to deliver strong risk adjusted returns for investors in the Steadyhand Income Fund. This fixed income balanced fund has a target asset mix of 75% bonds and 25% dividend paying securities such as stocks and REITs. As of March 31, the fund was slightly underweight bonds, holding 71%, while equities and REITs made up the balance. Within the fixed income portion of the fund, nearly two thirds was held in higher yielding corporate bonds. We see this as a good fund for conservative investors who want a little exposure to equities while knowing the majority of their money is invested in bonds. The other use we see for this fund is as a core fixed income holding within an otherwise well diversified portfolio. Given the fund’s exposure to equities and REITs, combined with its high exposure to corporate bonds we believe that this fund will likely hold its value better than a traditional bond fund in a rising interest rate environment.

CI Signature High Income Fund (CIG 686) – With a modest 3.2% return in the first quarter, this Eric Bushell managed fund remains one of our favourites in the global balanced and income categories. The asset mix of the fund is relatively conservative, holding nearly 40% in corporate bonds and 17% in cash. The equity exposure of the fund is focused on Canada. It pays a monthly distribution of $0.07 per unit, which equals an annualized yield of 6.1%. Factor in a relatively low MER and below average volatility and you have a good fund for investors looking for a mix of income and capital growth over the long term.

PH&N Total Return Bond Fund (PHN 340) – With interest rates potentially moving higher sooner than later, our preference is for bond funds that allow the managers a certain degree of leeway in the strategies they can employ. One of our favourites in this category would be the PH&N Total Return Bond Fund. It is run by one of the best fixed income teams on the street, and is quite similar to another one of our favourite funds, the PH&N Bond Fund. The key difference is the managers have the ability to be fairly tactical in their approach and can access a number of strategies that are not available with the PH&N Bond Fund including high yield bonds, mortgages and derivative strategies. This additional flexibility should allow the fund to outperform a more static bond fund in a rising rate environment, making it our top pick for traditional bond funds at the moment.

PH&N Short Term Bond and Mortgage Fund (PHN 250) – Another strategy that will help reduce the impact of rising interest rates is to shorten the duration of your fixed income portfolio. The best way to do this is to increase your exposure to short term bonds. On our Recommended List for more than 11 years, our favourite in the category is the PH&N Short Term Bond & Mortgage Fund. As the name suggests, it invests in a mix of bonds and mortgages that will result in an average term to maturity that is three years or less. As of March 31, 96% of the fund was invested in bonds or mortgages that had a term to maturity of less than five years. Factor in a high quality management team and a low MER, and you have a great choice for investors looking for short term bond exposure.

IA Clarington Sarbit U.S. Equity Fund (CCM 150) – In early April, it was announced that David Fingold, longtime manager of the Dynamic American Value Fund was temporarily stepping down to deal with a personal medical issue. As a result, we have temporarily pulled our BUY recommendation on the fund until his return. When looking for a substitute fund that follows a disciplined, value driven approach, the IA Clarington Sarbit U.S. Equity Fund was one that jumped out at us. Mr. Sarbit runs a very concentrated portfolio of what he considers to be “terrific businesses” which are high quality, easy to understand companies that generate a high level of free cash flow for investors. Unlike Mr. Fingold, he is a less active manager and will make dramatic asset mix calls when he is unable to find quality investments. This is a fund to consider for those investors looking for U.S. equity exposure and who have a time horizon of at least five to seven years, and who can accept a higher than average level of portfolio volatility. If that is not your situation, then we would strongly suggest that you avoid this fund.

Dynamic Power American Growth Fund (DYN 1244) – And speaking of higher than average levels of portfolio volatility, allow me to introduce you to the Dynamic Power American Growth Fund. Managed by Noah Blackstein since its 1998 launch, this U.S. focused growth fund has rewarded investors who have the risk tolerance to ride out the fund’s wild ride. The portfolio is a very actively managed one where the manager will take very concentrated positions in a small number of stocks and sectors. The stock selection process is very growth oriented and the portfolio is currently very heavily weighted in technology, consumer discretionary and health care. The fund is significantly more volatile than both the index and its peer group. It also carries a performance fee which rewards the manager for performance in excess of the S&P 500, which can make this fund very expensive relative to its peer group. However for investors who don’t mind paying for performance and are comfortable significant swings in the value of their investment, this is a good fund to consider. However, if you are at all bothered by high levels of volatility, this is not a fund for you.

 

 

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NEW MANAGEMENT TEAM AT HELM OF TRIMARK FUND

By Dave Paterson, CFA

Investment process remains the same, but the people have changed.

 

One of the biggest challenges to being a mutual fund analyst is staying on top of all of the portfolio manager changes that seem to happen on a far too frequent basis. One company that has been keeping us busy in the past few years has been Invesco Trimark, which has seen more than its fair share of manager departures in the past five years.

One of the more recent departures occurred in early March, when long time manager of the Trimark Fund, Dana Love, left the company. Replacing Mr. Love on the Trimark Fund is Michael Hatcher, who has served as the fund’s co-manager for the past year or so. Stepping into the co-manager chair are Darren McKiernan and Jeff Feng. The trio has worked together for the past nine years. They joined Invesco in 2009 after working together at Burgundy Asset Management, a privately owned, deep value shop that manages money on behalf of institutions and high net worth individuals.

“There are probably no two firms on Bay Street that are as closely related” says Mr. Hatcher. “The main reason for that is that there has been a real cross pollination of people and talent between the two firms.” Both Burgundy and Trimark use a very similar investment approach where they run concentrated portfolios of high quality, well managed businesses that have competitive advantages and the ability to generate strong levels of free cash flow.

This is not expected to change. According to Mr. Hatcher, “There is absolutely no change to how the Trimark Fund is structured or how it is run.” The team will continue to run a concentrated portfolio of global companies.

That is not to say that there hasn’t been significant turnover within the holdings since they took over the fund. When they first took over the fund, it held 38 names. Today, it holds 41. But within those 41 names, there are only 13 names that remain out of the inherited holdings. In other words, 25 names were sold, and 28 new names were purchased. No matter how you slice it, that is a significant turnover.

“We believe that right from the get go, the fund needs to immediately reflect the businesses in which we have the highest conviction and it has to be a portfolio of businesses that we want to own” said Mr. Hatcher. He goes on to say “There is absolutely zero value in holding a bunch of names in a portfolio and then six months later if they blow up saying to investors that we’re sorry, but those weren’t our picks.” “WE have to own every name in the fund” said Mr. McKiernan.

But despite the significant short term changes, the team expects that level of portfolio turnover will be relatively low on an ongoing basis. “If you look at the funds we have managed in the past, you will see that portfolio turnover has typically been somewhere around 20%” according to Mr. Hatcher. He goes on to say “I don’t see any reason why you wouldn’t expect to see that going forward, but that will all depend on what the markets are going to throw us.”

Historically, the Trimark Fund has shown a level of volatility which has been lower than the average global equity fund. Under the new team, this trend is expected to continue. One of the reasons for this has to do with the maximum weighting of a stock within the portfolio. Under the previous manager, it was not uncommon to see a stock have a maximum weight of nearly 10%. Under the new team, it is likely that the portfolio will be much more equally weighted.

Mr. Hatcher says “I feel I can do a really good job at picking great stocks for the portfolio, but not at telling you which of those stocks are going to do the best over the next one or two years.” Within a concentrated portfolio, each stock has the potential to impact the portfolio’s return. But the flip side is that the team must ensure that there are very high quality stocks within the portfolio. To do this, the team will focus on well run businesses that are trading below their estimate of what the company is really worth. This helps to provide a margin of safety and will help to protect the downside for investors.

The concept of downside protection is one which cannot be overlooked. As Mr. Hatcher points out, “If you lose 50%, you will need to gain 100% just to be back at even.” In other words, the easiest way to make money over the long term is to not lose money.

Historically, their approach has done well. According to Jeff Feng, “If you look at our individual funds since we have arrived, we’ve been able to capture about 80% of the upside and only 45% to 65% of the downside”. Mr. McKiernan goes on to say “If things really take off, this fund is going to lag. In a strong market, this is going to be a good absolute return product, but in a rough market, we have historically outperformed. I don’t see why that would change given the defensive nature of the businesses that we own.”

While downside protection is important, the team will not make a tactical call on cash as a way to achieve it. Any cash balances will be the byproduct of the stock selection process. The current cash weighting in the fund is approximately 12% providing the team with some dry powder should they identify suitable investment candidates.

Looking ahead, Mr. McKiernan is optimistic. “In my opinion, we are at a point in the market where there isn’t a lot of differentiation between the higher quality and the lower quality businesses. This is much different than it was in the late 90’s. You couldn’t buy Pepsico at 15 times earnings. It was all 20 or 25 times earnings. This is what has really been great for us in the past several years. So far, there has been no real dichotomy between high quality and low quality businesses. As long as that remains to be the case, I think that we are going to have a pretty ripe hunting ground to find superior investments and generate acceptable returns.”

“We have the whole world to look for these things (quality management, competitive advantages, and strong cash flow), and we’re only looking for 40 companies. So we can have a pretty high standard to what actually makes it in the portfolio” adds Mr. Hatcher.

While performance of the fund under Dana Love’s management was decent and had been fairly strong of late, there is reason to be optimistic with the new team at the helm. Each of their individually managed funds has posted stellar results since their arrival. As of March 31, 2012, each of the managers had posted the following results in their individually managed funds.

 

Lead Manager	Fund	1 Year	2 Year
Michael Hatcher	Trimark Europlus Fund	8.35%	7.43%
	MSCI Europe Index C$	-4.38%	1.91%
Darren McKiernan	Trimark Global Dividend Fund	14.08%	9.46%
	MSCI World Index C$	3.98%	6.52%
Jeff Feng	Trimark International Companies Fund	3.17%	2.97%
	SCI EAFE Index C$	-2.65%	1.64%

 

Bottom Line: We are encouraged by what we have heard from this team. They are following a disciplined process that is very similar to how the fund has been managed in the past. The results that they have been able to achieve in their individually managed funds are also encouraging. However, we remain cautious. There has been significant turnover within the fund and we will need to see a few quarters of data under the broader mandate of the Trimark Fund before we can make a more definitive call on the fund.

 

 

 

Mutual Funds / ETFs Update
Editor and Publisher: Dave Paterson
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Gordon Papes Mutual Funds / ETFs Update is published monthly.

Copyright 2012 by Gordon Pape Enterprises Ltd. and Paterson & Associates

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