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Investors Rewarded Despite Mixed Signals
Most markets rally higher, Canadian dollar weakness amplifies gains for Canadian investors.
February was another profitable month for investors with all major equity and fixed income markets moving higher. In Canada, the S&P / TSX Composite Index gained 1.3% on the month.
U.S. equities were higher with the S&P 500 gaining 1.4% in U.S. dollar terms. For Canadian investors, the gain was amplified, as the Canadian dollar dropped from $1.0008 on January 31 to end the month at $0.9723. In Canadian dollar terms, the S&P 500 was up 4.7%. The MSCI EAFE and MSCI World were both higher in Canadian dollar terms, gaining 2.0% and 3.2% respectively.
Canadian bonds were positive, with the DEX Bond Universe gaining 1.0%. Corporate bonds modestly outpaced governments and long bonds outpaced short term bonds. Only real return bonds that were down during the month.
Despite much headline risk bubbling, we favour equities over the perceived safe haven of fixed income, particularly for those who have a medium to long term time horizon. Our reason is quite simple: with yields continuing to hover near historic lows, fixed income investments remain fully valued. There is very limited upside and it will become increasingly difficult to generate any level of meaningful return from most fixed income investments.
We are not suggesting that one sell all of their fixed income holdings. We still believe that fixed income can play a very important role in a well diversified portfolio. Because they tend to move opposite of equities and are a favourite investment in times of extreme uncertainty, some exposure will help to lower the level of volatility in a portfolio. Within fixed income, we continue to emphasize quality, with high quality corporates being our investment of choice. Corporates tend to offer higher yields than governments, which will help to provide higher returns while interest rates remain flat, and will provide better downside protection when rates do begin to rise. Some exposure to high yield and global bonds may also be beneficial in generating returns and protecting capital.
While we favour equities, we still expect that it will be a bumpy ride. To help mitigate this, we favour high quality, higher yielding equities over the more cyclically driven, higher beta stocks. Granted, if the timing is right, returns from the cyclicals can outperform the higher quality names, but longer term, we are looking to balance return with managing volatility. Another factor we are considering is that investors have a very high demand for yield, which will help to put some level of support under the higher quality equities in the near to medium term.
Geographically we favour North America, but with a well managed global fund, there may be great opportunities to add additional return potential while at the same time cutting the overall risk profile of the portfolio. Those looking to do this are advised to go with a high quality actively managed fund, which should provide better risk reward characteristics in the current environment.
Please send your comments to feedback@paterson-associates.ca.
Funds You Asked For
This month, we take a look at Dynamic Value Fund of Canada, Ivy Canadian, and more…
Dynamic Value Fund of Canada – After long serving manager David Taylor left Dynamic in October 2011, Cecilia Mo was handed the reins of the fund. Under her leadership, there have been a few changes to the fund including significant turnover of many of the holdings.
The first change is that she cut the fund’s exposure to commodities. Currently, it is well diversified with energy being the largest sector, representing 17% of the fund, followed by healthcare, industrials and technology. It is underweight in both financials and materials.
Another change was there was a substantial increase in the number of securities held. Under Mr. Taylor, the fund held approximately 25 stocks. As of January 31, it held more than 60 names with the top ten making up a more modest 34% of the fund.
It can invest up to 49% of its assets outside of Canada. Ms. Mo will use this as an opportunity to invest in areas that are underrepresented in the Canadian market, notably in the healthcare and consumer sectors. More than half of the equity exposure is in Canada with the balance in the U.S.
Performance since the change has been strong. For the year ending January 31, the fund gained 10.3%, outpacing the S&P/TSX Composite and finishing in the top quartile.
We expect that volatility, on both an absolute and relative basis will be lower than it was under Mr. Taylor’s leadership because of the broader sector exposure and the increased number of holdings. Given Ms. Mo’s focus on cheap stocks, there still may be periods of higher volatility, but not to the same extent as under the Mr. Taylor.
With just over a year with the new manager, it is too early to make a definitive call on this fund, however, early indications are definitely positive.
Templeton Global Smaller Companies Fund – Martin Cobb took over this fund in March 2011 after longtime manager Brad Radin left the firm. Mr. Cobb follows a multi step, bottom up, value focused process that looks to identify undervalued companies that have a market cap of less than $2.5 billion.
At Templeton, while it is the lead managers who are ultimately responsible for the names in the fund, they are supported by a dedicated team of analysts, as well as the entire 36 member Templeton Investment Management team. On the Global Smaller Companies Fund, there are 7 dedicated analysts involved, including the fund’s back up portfolio manager, Harlan Hodes.
It is well diversified holding close to 90 names, with the top ten making up just over a quarter of the fund. Sector allocations are the result of the bottom up approach. Consumer discretionary stocks make up just under 30% of the fund, followed by financials and industrials, which are about 15% each. The U.S. is the largest country holding, followed by the UK and Canada. Portfolio turnover is expected to be modest. It was 30% for the year ending June 30.
The fund had a rough 2011, losing 23% during the year, trailing both the Index and its peer group. In 2012 it gained 11.5%, again lagging the index, which rose 16.5%. Still, this was strong enough to finish in the top half of the category.
While there have been some growing pains because of the manager change, there have been recent signs of improvement, but not enough to give us the comfort level we require. It is still too early to make a definitive call on Mr. Cobb’s management and we would suggest that investors remain cautious with this fund.
Aston Hill Growth & Income Fund – This fund is listed as an alternative strategies fund, but is really more of a global neutral balanced fund that can engage in a bit of shorting and derivatives, which gives it that alternative strategies flavour.
It invests in a mix of stocks and bonds with the goal of providing a fixed distribution without any capital erosion. It pays a monthly distribution of $0.03 per unit, which is an annualized yield of around 5.5% at current prices. The current asset mix is about 40% bonds, 50% equities, 15% cash and about 3% in shorts. It has a go anywhere mandate, but will invest primarily in Canada and the U.S.
The equity focus is on the small and mid cap growth space while the fixed income sleeve focuses on high yield.
Long term performance has been solid. It was pummeled after its launch in 2008, but since the market bottom in February 2009 has delivered strong returns with modest volatility. The managers are very active, with portfolio turnover levels well in excess of 200%. Costs are a bit high, with an MER of 2.49% in 2011, which is down from well above 3% in 2010 and 2009.
Looking at the asset mix, with its mid cap and high yield focus, we expect that it has the potential be more volatile than other funds in the category. In calm markets, we expect it to provide good risk adjusted returns that will likely be in the upper half of its category. However, at the first whiff of trouble, we expect it will sell off as people head towards the stability of large cap dividend payers and government bonds.
This is not a fund for everybody. It should only be considered by those with an above average appetite for risk.
Fidelity Canadian Growth Company Fund – Since taking over the reins in March 2011, Mark Schmehl has done a good job in turning this fund around. For the three years ending January 31, it gained an annualized 11.4%, outpacing the S&P/TSX Composite which rose 7.5% during the same period. Much of this outperformance can be attributed to the significant U.S. based holdings, which currently make up approximately 35% of the fund. Still, it managed to outperform a blended benchmark that includes U.S. stocks and finish in the top quartile, outpacing its peer group.
It invests in medium and large sized companies that the manager believes have a sustainable competitive advantage and a growth rate that is substantially higher than their competitors. To find these companies, they use a fundamentally driven, bottom up investment process that looks for well managed companies that have strong free cash flows, healthy balance sheets, and a clearly defined growth driver in place.
They are very active managing the fund with a portfolio turnover rate that has been well above 200% in the past two years.
It is a well diversified fund with more than 80 holdings. It can invest up to 49% outside of Canada and they are taking full advantage of that. As of January 31, the fund was invested 50% in Canadian equities and 49% abroad. It is very heavily weighted towards technology, which currently makes up 22% of the fund. Financials and materials are also well represented.
Volatility is roughly in line with the broader market, but has increased slightly since the new manager took over. Despite this increase, we are not too concerned, but will continue to monitor it.
Thus far, we like the direction that this fund is heading. It is not a bad choice for those looking for a more aggressive growth focused option within the Fidelity family. We still feel that more conservative, valued focused investors are better served through the Fidelity Canadian Large Cap Fund than with this offering.
CIBC Managed Income Plus Portfolio – Set up as a fund of funds that invests in other CIBC managed products, it has a static asset mix that is currently targeted at 3% cash, 62% bonds and 35% equity. The fixed income exposure is equally split between the CIBC Canadian Bond Fund and the CIBC Canadian Short Term Bond Index Fund. Combined, these two funds represent approximately 57% of the fund. There is a small exposure to global bonds. Equity exposure is predominantly focused on large cap stocks.
The short term performance numbers have been good, with a one-year return of 5.3% compared with a 3.2% return for the benchmark. Longer-term numbers however, are less impressive with a five year return of 3.2%, dramatically underperforming both the index and the category average.
Costs for the fund are a touch high with an MER of 2.18%, which is above the category average. For those looking for cash flow, there are two T-Series options available which offer annualized payouts of 4% and 6%. The MERs of those series are slightly higher, coming in at 2.19% for the T-4 series and 2.22% for the T-6 series.
We expect that this portfolio, with its emphasis on fixed income, will see returns that are more modest going. Half of the fixed income exposure is invested in short-term bonds, which should hold up relatively well in periods of rising rates. The downside is that they will do little to add to return during a flat rate environment, as we are expecting for the near term. Within the traditional fixed income component, about 60% of the bond exposure is in corporates, which should help to add some level of return while rates hold steady and downside protection when they rise.
While this is not a bad fund, we do believe that there are better options available for most investors. We also believe that with interest rates expected to rise over the next few years, investors will need to begin to take on additional equity exposure if they are to earn a level of return that will keep pace with inflation. A static asset mix which heavily favours fixed income will likely not allow that to happen.
Mackenzie Ivy Canadian Fund – Like all Ivy branded funds, the focus of this fund is capital preservation. To do this, it invests only in high quality, large cap companies. To build the portfolio, the mangers use a fundamentally driven, bottom up process with no fixed sector allocations, allowing them significant freedom to build a concentrated and very conservative portfolio. The top ten holdings make up 45% of the fund.
With its focus on capital preservation, it is not surprising to see the fund heavily weighted in the more defensive financial and consumer focused sectors. Financials make up 24%, while the consumer focused holdings represent 44%. It is underweight in both energy and materials which is not surprising, given the lack of earnings visibility with most companies in those sectors. The focus is on Canada, where 60% of its companies trade, followed by the U.S. which makes up 24% of the portfolio with the balance in Europe.
The longer term performance has been less than stellar, with an annualized ten year return of just 3.6%, compared with a 9.5% gain for the S&P/TSX Composite Index during the same period. Where this fund really earns its stripes are in periods of extreme market volatility. For example, in 2008, the market was down 33%, yet this fund was down by less than half of that. In 2011, the market fell by 8.7%, yet this fund was up 1.5%.
It offers one of the lowest downside capture ratios of any Canadian equity fund available today. Unfortunately the downside to this is that it also offers one of the lowest upside capture ratios, meaning that when markets are moving higher, it tends to leave much money on the table. For example in 2009 the market shot higher by 35%, yet this fund gained only 4.9%.
This is a great fund to own in highly volatile time and when you expect that markets will fall. However, looking at the current environment, while we expect some periods of elevated volatility, it is certainly not high enough to warrant this fund for most investors. However, it may be a good option for very conservative investors who are looking for a relatively low risk way to dip their toes into the equity markets. Those with average or higher risk tolerances are likely to want to look elsewhere.
Is there a fund you would like us to review?? Please send any requests for fund reviews to feedback@paterson-associates.ca.
March’s Top Funds
IA Clarington Tactical Income Fund
| Fund Company | IA Clarington Investments Inc. |
| Fund Type | Tactical Balanced |
| Rating | B |
| Style | |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Ben Cheng since June 2009 |
| MER | 2.48% |
| Code | CCM 550 – Front End Units CCM 551 – DSC Units |
| Minimum Investment | $500 |
ANALYSIS: Manager Ben Cheng has a solid reputation and a track record to match. Before joining Aston Hill he was the lead manager on one of our favourite funds, the CI Signature High Income Fund.
The fund is a “best ideas”, “go anywhere” fund. There are no firm asset mix constraints, but the target will be in the 60% equity, 40% fixed income range depending on their outlook. Because it is an income fund, the focus is on generating cash flow from investments, whether it is as income or dividends.
As the name suggests, it is tactically managed. They are active in their approach and are not afraid to go heavily into cash when they cannot find quality companies that meet their investment criteria.
All the fund’s fixed income exposure is in corporate and high yield bonds. Geographically, it is focused in Canada, with nearly 60% invested domestically, followed by the U.S. where 30% of the fund is domiciled. With the focus on yield, it is not surprising to see that it is concentrated in the high yielding financial and energy sectors.
Looking at the current environment, they are beginning to shift the fund more into equities.
Performance has been decent with a three year return of 6.6% as of January 31, compared to the 5.7% rise in the benchmark during the same period. Shorter term, with equity markets posting decent rallies, it has lagged. Given the underweight position in equities, this is not unexpected. Volatility has been higher than both the index and peer group.
The cost is right in line with the category average with an MER of 2.39%. For those looking for yield, it is available in a couple of different series, one that pays out an annualized 6% distribution and the other an 8% yield.
PH&N Monthly Income Fund
| Fund Company | Phillips, Hager & North Investment Management |
| Fund Type | Canadian Neutral Balanced |
| Rating | B |
| Style | Blend |
| Risk Level | Low Medium |
| Load Status | No Load / Optional |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | Scott Lysakowski since December 2009 Scott Lamont since December 2009 |
| MER | 1.12% |
| Code | PHN 660 – No Load Units PHN 6660 – Front End Units |
| Minimum Investment | $5,000 |
ANALYSIS: As the name suggests this fund provides investors with a monthly distribution. The current distribution was increased to $0.045 per unit in January, giving an annualized yield of 5.0%.
To generate this income, it invests in a diversified portfolio with a target asset mix of 50% fixed income and 50% equities. There is some flexibility around these targets based on their outlook. The asset mix can range between 40% to 60% fixed income at any time.
The equity portion is invested in predominantly income producing equities, such as dividend paying common stocks, income trusts. Not surprisingly, the top names in the equity component are big, blue chip names like the banks, TELUS, and Enbridge. More than half is invested in financials and energy.
The fixed income portion invests in a mix of government bonds, corporate bonds, and preferreds. Currently, about half of the bond exposure is in corporate bonds. Credit quality is high, with all the bond holdings in investment grade debt. It also has some exposure to high yield bonds.
Performance has been strong, gaining 7.7% for the three years ending January 31, handily outpacing both the benchmark and the peer group. Volatility has been quite modest, with a standard deviation that has been lower than the index and peer group.
Looking ahead, we believe that it may be a challenge for the managers to continue to deliver returns at the level they have, given that they must maintain at least a 40% weighting in fixed income. They have positioned the fixed income portion quite defensively, with a duration that is shorter than the benchmark and significant exposure to corporate and high yield bonds, which will help provide better downside protection. The equity focus on dividend payers will likely result in underperformance in hot markets, but will provide stable, decent risk adjusted returns over the long term.
NEI Ethical Special Equity Fund
| Fund Company | NEI Investments |
| Fund Type | Canadian Small / Mid Cap Equity |
| Rating | B |
| Style | Value |
| Risk Level | Medium High |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Joe Jugovic since March 2005 |
| MER | 2.84% |
| Code | NWT 067 – Front End Units NWT 167 – DSC Units |
| Minimum Investment | $500 |
ANALYSIS: This fund has been managed by Joe Jugovic at QV Investors since 2005.
The manager looks for attractively valued companies that are managed by capable, honest management teams. Characteristics they look for include balance sheet discipline, a solid business plan and the potential to see growth in the company’s book value, sales and earnings, which they believe can help the company to sustain difficult periods.
Quality of management is a critical factor in their evaluation process and they look for managers who hold a significant stake in the business.
Once the companies have been identified, they are put through Ethical’s rigorous ESG screening criteria. Additionally, NEI Ethical is very active in engaging companies to improve their environmental, social and governance policies.
The concentrated portfolio is fully invested in approximately 40 Canadian equities. Sector mix is the byproduct of the bottom up stock selection process.
With their focus on quality, it tends to perform well in flat and falling markets, but often lags in a sharply rising market. This is because in that type of market, the quality companies tend to lag while the higher beta, more leveraged companies shine. Over the long term, quality should outperform.
Judging by the performance, this appears to be true. For the 10 years ending February 28, the fund gained an annualized 11.4%, outpacing both the index and its peers. Equally impressive is the fund’s volatility has been lower than average.
The biggest drawback to this fund is that it is fairly expensive, with an MER of 2.84%, which is in the upper half of the peer group.
This fund and it’s nearly identical “un-ethical” peer, the IA Clarington Canadian Small Cap Fund are two of our favourites. Both offer investors great management and a disciplined process that should reward investors over the long term with above average risk adjusted returns.
Dynamic Global Infrastructure Fund
| Fund Company | Dynamic Funds |
| Fund Type | Global Equity |
| Rating | B |
| Style | Growth |
| Risk Level | Medium High |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Oscar Belaiche since July 2007 Jason Gibbs since July 2007 |
| MER | 2.60% |
| Code | DYN 2210 – Front End Units DYN 2212 – DSC Units |
| Minimum Investment | $500 |
ANALYSIS: The longer term outlook for infrastructure is quite positive, and the Dynamic Global Infrastructure Fund is our top pick for mutual fund investors looking for exposure to the sector.
It invests in publicly traded companies that hold infrastructure assets directly or are involved in the building or maintenance of these assets. The fund has a go anywhere mandate and can invest in companies of any size. Not surprisingly, the utilities and energy infrastructure sectors are the biggest components, making up more than 60%. It is fairly concentrated, holding about 35 names with the top ten making up just under 40% of the fund.
Despite the fund’s recent underperformance, the medium term numbers are impressive. As of February 28, the three year return was 12.8%, outpacing the peer group and the broader equity markets. Volatility has remained in check and is slightly below the volatility of the MSCI World Index. Given the yield characteristics of many infrastructure plays, this is not surprising.
The cost of this fund is reasonable, with an MER of 2.60%, which is about average for the category. The currency exposure is actively managed.
The managers remain very bullish on the prospects for infrastructure. In a recent commentary they noted that many institutional investors have publicly stated that they are planning to significantly increase their investments in real estate, infrastructure and private equity. Further, valuations appear to be reasonable, despite a recent rally in the sector. The Fund continues to have a major focus on energy infrastructure, utilities, wireless towers and toll roads.
Given the narrowness of the sector, it could be quite volatile in certain periods. Because of that, it is not for everybody. It is probably best suited to medium to high risk investors looking for some diversification potential without sacrificing yield or return potential.