Mutual Fund Recommended List Review

Central bank easing pushes global equities higher

Market Recap

Late in the quarter U.S. Federal Reserve Chairman Ben Bernanke announced a $40 billion per month plan to buy up mortgage backed securities indefinitely, and a pledge to keep interest rates extremely low until at least mid 2015. Also in September, European Central Bank President Mario Draghi announced his plan to inject liquidity into the Eurozone economy by buying up bonds indefinitely. Other countries announced similar plans including China, Japan and Brazil.

The market reaction was extremely positive, driving virtually all equity markets higher. With more stimulus set to hit the system, the main benefactors were the more economically sensitive sectors such as energy and materials. Gold was given an extra boost as some feared that these massive stimulus plans would further fuel the inflation fears. In a somewhat overdue reversal of fortune, gold companies finally outpaced the bullion.

Beyond the announced stimulus plans, there are many reasons for investors to be optimistic. Corporate profitability, one of the key drivers of stock price appreciation over the long term, has remained positive in both Canada and the U.S. The U.S. housing market, which has been a drag on the economy since 2008 appears to have finally hit bottom. Housing prices have risen four months in a row and the year over year comparisons are also positive in an overwhelming number of states. Housing starts have also been strong, which is critical to the U.S. recovery since it is estimated that housing and related expenditures can make up around 17% to 18% of the total U.S. GDP. With this on the upswing, it is likely that some level of meaningful economic recovery can continue.

The European debt crisis has been a headwind to the global equity markets for some time. Left alone, the probability of a major blow up is huge. However, with the ECB’s bond buying announcement, they have essentially provided a backstop that will help to prevent a major catastrophe. With this likelihood reduced dramatically, much of the headline risk has been taken out of European equities.

Add in the expectations that interest rates in developed nations are to be kept artificially low for the near to mid-term, and it is no wonder that both investor and consumer confidence has rebounded.

While there are many reasons for optimism, there are also reasons for concern. Signs of improvement abound in the U.S., but there is much uncertainty surrounding the outcome of the election and what actions the president will take to avoid the “fiscal cliff”, a mix of spending cuts and tax increases that are widely expected to severely affect the economic recovery.

In Europe, while the risk of a blow up has been greatly reduced, the main problem of the debt crisis that cripples many countries remains. Add to that many countries in the Eurozone are in recession and others are implementing austerity measures, much risk remains. Many emerging markets, particularly China are embroiled in a slowdown, with many experts expecting it to be much worse than originally expected. This may result in a prolonged downturn in energy and materials, which will drag the Canadian market.

Investment Outlook

Considering this, we remain cautiously optimistic, particularly with respect to equities. Valuations, while increasing, are still more favourable than bonds. We believe that recent policy actions in Europe will help to at least contain the crisis and buy more time for policy makers to determine an appropriate solution.

We are also optimistic that whoever is elected in the U.S. will find a way to avoid the fiscal cliff. There is far too much at stake for even a partial solution not to be found, helping to reduce the potential damage. We are also optimistic that as we enter the final months of the year that the traditional Santa Claus rally will take hold and push markets higher.

Fixed Income Outlook

Our outlook for fixed income has not changed from last quarter. With interest rates likely to be on hold for the foreseeable future, bonds aren’t likely to produce any major gains. In this environment, we favour corporate bonds over government bonds for their higher yield potential. We still believe that some government bond exposure is needed to act as a safe haven should markets become very volatile. Going forward, we need to adjust our return expectations for fixed income investments. No longer can we expect them to be a major contributor to portfolio return, but instead, their main purpose will be to help reduce volatility in periods of uncertainty.

We favour actively managed funds that can tactically manage the portfolio and position it to take advantage of the expected environment.

Equity Outlook

We expect that equities will continue to be driven more by macro events than by the quality of the individual investments. With the economic slowdown in China, we have concerns that commodity and energy prices may be under pressure, which may hold back the broader market. Because of this, we are favouring actively managed funds that are not heavily weighted towards those sectors. We are willing to forego some of the upside should investors’ appetite for gold stocks continue, in return for much lower volatility on the downside. We also favour higher quality, large cap companies over the small cap companies.

We remain cautious on the U.S. in the immediate term while the uncertainty surrounding the election and the fiscal cliff are dealt with. We are not suggesting that exposure to the U.S. be reduced, rather we are reluctant to add any additional exposure at the moment.

Europe is still an area of concern, but with the European Central Bank stepping up to backstop Eurozone bonds, there may be some opportunity for high risk, contrarian investors to begin to dip their toes into the region. Within Asia and the emerging markets, it is our view that there is far too much uncertainty to be adding to any positions at the moment.

Recommended List Review

Funds to Sell

CIBC Canadian Short Term Bond Index (CIB 489) – This fund is designed to track the DEX Short Term Bond Index Fund and does a decent job at it. With an MER of 1.07%, it is cheaper than many other short term bond funds. However, given our outlook for a challenging fixed income environment and our current preference for active management, we felt that it was time to make the change. In its place, we are adding the TD Short Term Bond Fund (TDB 967). As you would expect, it invests in bonds issued by Canadian governments and corporations with maturities of less than five years. It is more heavily weighted towards corporate bonds, which will help to boost returns in a flat or rising interest rate environment. All of the bonds in the fund are rated BBB or higher, so there is very little credit risk. The MER is slightly higher than CIBC, coming in at 1.11%. Despite this, performance has been stronger in most time periods and we expect that with a flat to rising rate environment, this trend will continue.

Funds to Buy

Steadyhand Income Fund (SIF 120) – With interest rates expected to remain flat for the near term, this fund is a great alternative to a more traditional bond fund. With a target asset mix of 75% bonds and 25% high yielding equities, it is well positioned to provide investors with higher returns. Nearly two-thirds of the bond sleeve is invested in corporate bonds, which typically offer a higher yield than government bonds. This will no doubt add additional return in a flat or rising rate environment. A word of warning, there is the potential for higher levels of volatility, particularly if we enter into a period of unexpected volatility in the markets.

CI Signature High Income Fund (CIG 696) – As of September 30, this fund has gained 9.8%, outpacing most of its peers and its benchmark. Equally impressive, it has matched the performance of the MSCI World Index, but with considerably less volatility. Looking ahead, we believe that it is well positioned to continue to deliver strong relative returns. It holds about 45% high yielding equities, 42% bonds and 10% in cash. All the fixed income holdings are corporate bonds, and many of them are high yield bonds. While this will generate strong returns and downside protection in a flat or rising rate environment, it does have the potential to underperform in very volatile markets.

RBC Canadian Equity Income Fund (RBF 591) – Using a very active management approach, the team of Jennifer McClelland and Brahm Spilfogel scour the investment universe looking for stocks that have shown positive rates of change in their proprietary valuation model. When markets are volatile, they view it as an opportunity to actively trade and book profits. For example, in 2008 and 2009 portfolio turnover skyrocketed to nearly 500% for the year. Their process has worked, with the fund consistently being at or near the top of our proprietary valuation model. We expect that it will continue to deliver returns that will beat its peer group, but we don’t believe that their absolute numbers are sustainable going forward. Still, for investors looking for decent returns, modest volatility and a decent cash flow, this is one to consider.

Fidelity Canadian Large Cap Fund (FID 231) – Despite struggling in the second quarter, we still believe that this fund is well positioned for the current environment. With a significant underweight position in energy and virtually no exposure to materials it looks nothing like the heavily concentrated S&P/TSX Composite Index. Nearly half is invested outside of Canada, with the bulk of that being invested in the U.S. Further, it offers a dividend yield that is above the broader market. Given the conservative nature of this fund, we believe that it will continue to hold up well for the next few months, but could lag if cyclical stocks rally sharply.

IA Clarington Canadian Conservative Equity Fund (CCM 1300) – Despite the announcement of QE3 driving material stock prices higher, this dividend focused fund held up relatively well, gaining 2.3% in September and 4.5% for the quarter. While this lagged the index, it outpaced most of its peer group. Looking at the current environment, its focus on high yielding dividend paying stocks put this fund in a good position to continue to provide strong risk adjusted returns for investors.

RBC North American Value Fund (RBF 554) – On our last Recommended List Review, we said that we liked this fund for its large cap positioning and relatively high cash balance to take advantage of attractively valued opportunities when they arise. Those, combined with the valuation of the underlying portfolio only reinforce our view of this fund as one which we believe has the potential reward investors over the next several months with above average returns.

Beutel Goodman Small Cap Fund (BTG 799) – While our bias is generally towards large caps for the current environment, the Beutel Goodman Small Cap Fund is an exception. While the name suggest small cap, it is in fact more concentrated in the mid cap space and the management team tends to focus on companies with proven cash flows and strong business fundamentals. This, combined with an MER of 1.43% makes this our top pick for investors looking for high quality small cap exposure for their portfolios.

Mawer International Equity Fund (MAW 102) – In general, we have been avoiding Europe for several quarters in favour of North America. However, with the European Central Bank’s bond buying program essentially taking the risk of a major blow up off the table, those with an above average for risk may want to consider dipping their toes in the region. A great way to do that is with an international equity fund and in our opinion, there aren’t many better than this one. It is managed using a growth at a reasonable price approach and looks for companies that have great management teams, improving business fundamentals and a history of generating high returns on equity. It currently has 40% invested in Europe, 31% in the UK, 5% cash and the balance invested in Asia.

Sentry REIT Fund (NCE 705) – Despite lagging the index on a year to date basis, we believe that the outlook for REITs remains positive for a number of reasons including strong property fundamentals, low cost debt, increased foreign activity and an uptick in takeover activity in the sector. Combined with investors’ insatiable demand for income, we believe that this fund is well positioned to reward investors. Given that this is one of the few funds in the country to focus solely on REITs and it has a great management team behind it, we believe that investors will be rewarded.

CI Signature Global Health Sciences Fund (CIG 201) – Health care, and this fund specifically have been on a tear this year. Year to date the fund has gained 27% outpacing not only the index but every other health care fund except the TD Health Sciences Fund. Despite this impressive rise, it appears that there may be more upside in the sector in the near term. According to data provided by Morningstar, the weighted average Price to Earnings multiple for the stocks in this fund is just over 12 times, compared to 15.6 for the index. As with any sector play, caution is warranted as there is the potential for period of high volatility. Portfolio exposure should be limited to no more than 10% for the most aggressive investors and adjusted downward according to an individual’s risk tolerance.

NOTE

ABC Fundamental Value Fund – Effective immediately we are removing the ABC Fundamental Value Fund from our Recommended List. First, this is not being done in reaction to the performance or the volatility profile of the fund. It is a very deep value, high conviction portfolio that over the long term has performed quite well and of late has been performing very well. The reason we are removing the fund from the list is that it carries a minimum initial investment of $150,000 which puts it out of reach for many investors. It is also not available through any discount broker or investment advisor. Based on these factors, we have decided to remove the fund from our Recommended List. We will continue to follow the fund and will provide commentary and analysis for it on an ongoing basis.