Volume 19, Number 4
April, 2013
Single Issue $15.00

In this issue:

• What’s New
• 2013 Budget Impact
• Bank Funds Continue to gain in Popularity
• Understanding ETF Liquidity
• Protecting Against Rising Rates
• Sarbit Activist Opportunities Class
• Readers’ Questions

PDF version of this issue

What’s New

♦ Temporary change in Customer Service Hours – Please   note that for the next few weeks, our Customer Service office will be closed   on Tuesdays. However, you can leave a message on our toll-free line   (1-888-287-8229) and it will be returned the next day. Normal service is   available on all other business days.

♦ BMO Guardian name   is no more – After   more than a decade, BMO announced that it would be rebranding the BMO   Guardian Funds to simply BMO Mutual Funds. This move will allow the funds to   be merged into one group and help reduce duplication.

♦ AEGON winds down   TOP Portfolios –   Launched in 2002, these “fund of fund” portfolios were designed to   be a well diversified, one ticket solution providing access to a wide range   of Canadian mutual funds including offerings from AGF, CI, Brandes, Dynamic,   Fidelity, Mackenzie and TD. Four portfolios were available ranging from the   conservative to the aggressive. Performance has been largely disappointing   and has consistently trailed the peer group. One of the key reasons for this   underperformance would be the high cost, with MERs ranging from 3.23% to   3.45%. Assets in the program were also minimal, with just over $14 million   split between the four portfolios. At this level of assets, the funds simply   aren’t sustainable. They are expected to be closed on June 21, 2013. Until   then, no new purchases are allowed. Investors have the option to switch into   another AEGON fund before June 14, 2013.

♦ Manulife caps   Mawer Managed Funds –   Manulife has capped new purchases into three Mawer managed funds; Manulife Canadian Investment,   Manulife Canadian   Balanced, and Manulife   Diversified Investment. They were capped after the manager,   Mawer Investments, announced that they were closing a number of their   Canadian mandates because they have reached what they believe to be their   capacity limit. While this move is unfortunate to those who have not been   able to invest with Mawer, it is the right move for the funds and their   current investors.

♦ BMO cuts   distributions on a number funds – With the BMO Monthly Income Fund and the BMO Global Monthly Income Fund   offering distribution yields of nearly 10% and 17% respectively, it wasn’t a   matter of if BMO would cut the distributions, but when. Considering their   announcement last week, that time is now upon us. Starting in May, the   distribution on the BMO Monthly Income Fund will be cut from $0.06 to $0.025   per unit. This will bring the yield down to around 4.1%. For the BMO Global   Monthly Income, the distribution will be slashed from $0.055 per unit, to   $0.016 per unit, bringing the yield down to just below 5%. These distribution   levels are much more reasonable given the current yield environment and   expected return of the funds. Distributions were also cut on other funds   including the BMO   Diversified Income Portfolio. For investors who are reinvesting   their units, there will be no change, however those receiving the   distributions in cash will see a big hit in their cash flow.

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2013 BUDGET IMPACT

By Dave Paterson, CFA

Flaherty cracks down on Income Conversion and LSIFs

On March 20, Finance Minister Jim Flaherty delivered the 2013 Federal   budget. By most accounts, it is described as a “modest budget” in   that it contains very little in the way of new spending initiatives and keeps   the government on track to eliminate the $26 billion deficit over the next   two years.

For investors, there were a few changes that will have an impact on their   portfolios. Perhaps the biggest is the plan to eliminate a fund’s ability to   convert interest income into capital gains. Many companies including   Mackenzie, Franklin Templeton, CIBC, and IA Clarington offered these types of   funds with great success. With interest being taxed at an individual’s   marginal rate while only half of capital gains are taxable, it is not hard to   understand their appeal. After all, who doesn’t want to save 50% on their tax   bill? Well, obviously, the Federal government is not too fond of the plan,   and took action to collect more in taxes from investors.

In the coming weeks, the industry will continue to consult with their   legal counsel to determine the best way to move forward. In the interim, many   companies are not allowing new purchases into the affected funds. Regardless   of the outcome, these types of arrangements are done, meaning that investors   in non registered accounts will be hit with higher taxes in the years ahead.

In our conversations with a number of industry participants, there was   some concern that corporate class funds may be next on the government’s hit   list. Given their desire to close as many tax loopholes as possible, that   certainly makes sense. Corporate class funds can help reduce the total tax   paid by non registered investors through their ability to lower the   likelihood of an interest distribution and the ability to switch between   funds, without incurring a taxable event.

Another change in the budget is that the Federal government will be   phasing out the tax credit on Labour Sponsored Investment Funds, much like   the Ontario government did in 2008. For 2013 and 2014, the Federal Tax Credit   for LSIFs will remain 15%, falling by 5% in 2015 and 2016, after which the   credit is eliminated. When this happened in Ontario, many LSIFs were hit with   a run on redemptions and a resulting liquidity crisis. Because of that, many   funds have suspended redemptions, leaving investors holding the bag.

We expect that this move will have a similar effect on LSIFs right across   the country. This is likely the death knell for the program. Worse things   could happen. We have never been a fan of LSIFs. They were expensive and in   the end, just didn’t live up to the promise. For most investors and advisors,   they were a tax solution, not an investment solution. As a result, some poor   choices were made, and many have lost money even when the tax credit is   considered.

They will not be missed.

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BANK FUNDS KEEP GAINING POPULARITY

By Dave Paterson, CFA

A number of quality funds available from the big six banks!

Mutual funds offered by the big six banks remain some of the favourites   among Canadian investors. From being small players a just a few years ago, to   major players today, there is no denying that the banks are now forces to be   reckoned with in the Canadian mutual fund landscape.

The banks have done this by using their vast network of bricks and mortar   branches to focus on the small investors, and by working to build awareness   of their funds within the advisor channel. Perhaps the most surprising part   of this is how much acceptance the banks have been able to find with   independent financial advisors right across the country. They did this the   old fashioned way; by building one on one relationships with advisors and   having a decent stable of investment products.

While there has been strong growth in their assets, the question remains:   are bank funds any good? In the “olden days” their funds were   mostly very conservatively managed, index-like funds that played it safe and   were lucky to finish in the middle of the pack when measured against their   peers. Today, at least at some of the banks, that appears to have changed.

To get an idea of the relative quality of the bank funds, we looked at   their performance over the most recent one, three, five and ten year periods   and tracked the number of funds that were above average for each bank in each   of the various time periods. We excluded any advisor focused offerings   offered by the banks, and for RBC we excluded PH&N. We also excluded   multiple versions of the same fund and focused on the main series. The   results are in the table on the right.

As you can see, Royal and TD were leading the pack, each with more than   50% of their funds finishing in the upper half of their respective   categories. Perhaps coincidentally, these are also two of the banks that have   made the biggest inroads within the advisor channel. For comparison purposes,   we put three of the larger fund advisor focused fund companies, CI, Mackenzie   and Fidelity, through the same screen. They all fared somewhat better than   the banks with Mackenzie having 52% of their funds in the upper half, while   CI and Fidelity had 64% and 65% respectively finishing above average.

Next, we set out to identify the best bank offered funds in a number of   categories including core fixed income, Canadian equity, U.S. equity, Global   equity and sectors. Our list of the top bank funds follows:

Percentage of Funds   with Above Average Returns

Returns to February 28, 2013
Source: Fundata

Fixed Income Funds

TD Canadian Bond Fund (TDB 162) – This has been one of   our favourite bond funds since we started analyzing mutual funds more than a   decade ago. It is run by a great team and is very focused on corporate bonds,   has a yield higher than the benchmark and a duration that is lower. This   positioning will help it to outperform while interest rates remain stable,   and to provide better downside protection when they begin to move higher.

TD Canadian Core Plus Bond Fund (TDB 694) – This is very   similar to the TD Canadian Bond Fund with its focus on investment grade   Canadian bonds. The difference is this fund can invest up to 30% in tactical   strategies such as global bonds and high yield debt. Because of this, we   consider it to be a bit higher risk, but we believe that this tactical   overlay will allow for improved returns in both a flat and rising interest   rate environments.

Some may be wondering how the PH&N Bond Fund and PH&N   Total Return Bond Fund would rank if they were considered. The   simple answer is it depends on what series you are buying. If you are buying   the Series D units directly from PH&N, then they would rate as our top   picks. However, if you must buy the higher cost units through an RBC branch   or an advisor, then the higher MER erodes any excess return, leaving the TD   offerings as our top picks.

Balanced Funds

RBC Monthly Income Fund (RBF 448) – This conservatively   managed balanced fund has a proven track record of delivering above average   returns with lower than average risk. It has a target asset mix of 55% bonds,   40% equity and 5% cash. It pays a monthly distribution of $0.0425 per unit,   which works out to an annualized yield of around 3.8%. The biggest drawback   to this fund is it is not available in registered plans.

TD Monthly Income Fund (TDB 622) – With just under 37%   invested in fixed income, this balanced fund is more aggressively positioned   than the RBC offering. As a result, volatility has been higher, and we expect   that to be the case going forward. To date, investors have been rewarded for   taking on this additional risk with better long-term returns. Further, with   the higher equity weighting, we expect this fund to outperform as rates begin   to rise.

Canadian Equity Funds

RBC Canadian Equity Income Fund (RBF 591) – This actively   managed Canadian dividend and equity income fund has consistently delivered   above average returns with an MER that is in the lower half of the category   average. While we don’t expect it to deliver the same level of absolute   returns that it has historically, we believe that it can deliver above   average risk adjusted returns for investors.

RBC North American Value Fund (RBF 554) – There are many   reasons to like this Canadian focused equity fund including a strong   management team, a solid investment process and a reasonable MER. The fund is   also at a size that the managers should not have any difficulty implementing   their process. All things considered, this is a great core fund for most   investors.

U.S. Equity Fund

TD U.S. Blue Chip Equity Fund (TDB 977) – As the name   suggests, this fund invests in some of the best and biggest companies in the   U.S. such as Google, Amazon, and Apple. An interesting bent to this fund is   that unlike other blue chip focused funds which tend to be more value driven   in approach, it is more growth oriented. As a result, it tends to be a bit   more volatile than the S&P 500. Its biggest drawback is the 2.55% MER.

TD U.S. Equity Portfolio (TDB 962) – This is a fund of   funds that holds a number of U.S. equity funds that are managed by TD. It   provides exposure to both growth and value styles. While the focus is on   large caps, there is some exposure to small and mid caps, which currently   make up about 15% of the fund. Volatility has been in line with the Index.   Performance has consistently been in the upper half of the U.S. equity   category. Again, cost is the main drawback, with an MER of 2.59%.

Global Equity

Scotia Global Growth (BNS 374) – The only Scotia offering   on our list invests in a diversified portfolio of companies located around   the world. The focus is on big companies, but it does have some exposure to   mid-sized names as well. It is more growth focused in approach, meaning that   it is likely to be more volatile at times. Performance has been in the upper   half of the global equity category for the past five years. The MER is a bit   high at 2.57%.

TD Global Dividend Fund (TDB 231) – With its emphasis on   dividends, this global equity fund has more of a value tilt than the Scotia   offering. It looks for well managed companies anywhere in the world that pay   a dividend. Not surprisingly it is heavily weighted towards the more   defensive sectors such as consumer staples and healthcare. Performance,   particularly the shorter term numbers, has been strong on both an absolute   and relative basis. It’s not a cheap fund with an MER of 2.57%.

Specialty / Sector   Funds

TD Health Sciences (TDB 976) – This is without a doubt,   one of the best healthcare funds in the country. It focuses on companies of   any size that are operating in the healthcare sector, with about half the   fund invested in large caps. The manager has done a great job of keeping   volatility in check, and returns have consistently been above the category   average.

CIBC Real Estate Fund (CIB 506) – Investing in a mix of   real estate companies and REITs, this has been one of our favourite real   estate funds for a while now. Despite lagging both the index and its peers   last year, the longer term numbers remain quite strong. Volatility is in line   with the average. The biggest drawback is the MER, which is 2.96%.

Bottom Line: There is little doubt that the banks are now   a force to be reckoned with in the mutual fund industry. In recent years, a   number of banks have shown a marked improvement in their product lineup.   Specifically, RBC, TD, and BMO now have a product lineup that can rival many   of their advisor sold peers for selection, performance and overall quality.   As with all mutual funds, investors are wise to do a bit of research before   investing, since not all funds are created equally.

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UNDERSTANDING ETF LIQUIDITY

By Dave Paterson, CFA

ETF Liquidity not as simple as it appears

A few weeks ago, I was having a conversation with an advisor about ETFs.   We were talking about one in particular that I thought was interesting, the PowerShares   S&P/TSX Composite Low Volatility Index ETF (TSX: TLV). While he   agreed that the idea of low volatility investing was interesting, he said   that he was a bit wary about using this ETF because the average daily trading   volume was only a couple of thousand shares. He was worried that this low   level of volume may affect his ability to get clients in and out of it if   easily.

His viewpoint certainly made sense. After all, with equities, the ability   to get in and out of a position easily is a function of the daily trading   volume. If there is a lot of volume, it is quite easy to get in and out.   However, with little trading volume, it becomes much a much more difficult   proposition to get your orders filled. Intuitively, this same logic should   also apply to ETFs.

However, after doing a little bit of research on the topic, it turns out   that is not quite the case. Speaking with Michael Cooke, the head of   distribution for PowerShares Canada, he said, “The daily trading volume   of an ETF is really only one aspect of its true liquidity. To fully   understand the liquidity, you have to look at the mechanics of the ETF   creation and redemption process. Market makers are pricing the underlying   basket of securities of each ETF in real time and it is their job to issue or   redeem ETF shares as necessary to keep the market in balance. So in reality,   the true liquidity of an ETF is the liquidity of the underlying   securities.”

In other words, if an ETF trades in larger, more liquid securities, market   makers should have very little difficulty filling any trade orders that may   be placed. Mr. Cooke also pointed out that on these types of ETFs, the   bid/ask spread is often quite narrow. However, for ETFs that invest in   illiquid securities, like some of the small cap focused or sector specific   ETFs, liquidity is more of a concern. Mr. Cooke said that with these ETFs you   will quite often see bid/ask spreads that are much wider than with other   ETFs, since market makers may keep the spreads wider as a way to hedge the   liquidity risk of the underlying securities.

Looking at the bid/ask spreads on the iShares S&P/TSX 60 Index   Fund (TSX: XIU), the most actively traded ETF in the country, we   find that the spread is typically only a penny or two. However, with a highly   specialized ETF, for example the iShares S&P Global Water Index   Fund (TSX: CWW), the bid ask spread was more than $0.20 on March 27.

This wider spread is not unexpected for two reasons. First, its average   daily trading volume is only 2,500 shares, indicating that there is not a lot   of investor interest in the product. Second, and perhaps most importantly, it   invests in a very narrow band of securities that are involved in water   related businesses. It isn’t exactly filled with household names and none of   the stocks seem to have a significantly high trading volume.

There are a number of ways that you can protect yourself while trading   relatively illiquid ETFs. The first is to use limit orders. “Market   making is very strong in Canada” says Mr. Cooke, which means that it is   likely that your order will be filled if you set a limit price somewhere   between the bid and the ask. This will help you to get much better trade   execution than by simply using market orders.

Other strategies that may help to help you get better execution include   paying attention to the time of day that you place your order. For example,   at the market open, there may be stocks that are not open for trading because   of news, a corporate action or some other delay. When this happens, it is   likely that you will see a widening in bid ask spreads because of the   uncertainty caused by this delayed opening.

Another thing you will want to watch is ETFs that trade in overseas   markets or in fixed income instruments. The Canadian stock markets where the   ETFs trade are open between 9:30 a.m. and 4:00 p.m. Many overseas markets are   closed when Canadian markets are open, and trading in the bond market stops   at 2:00 p.m. If you are trading in ETFs in these markets, you may see wider   bid/ask spreads because of the higher uncertainty resulting from the markets   where the underlying securities are traded being closed.

Bottom Line: The daily trading volume of an ETF is only   one aspect of its true liquidity. To get the full liquidity picture of an   ETF, you must consider the liquidity of the underlying investments, which is   a more accurate determinant of its liquidity. By using limit orders, you can   protect against the potential of wide bid ask spreads sometimes found with   the more illiquid ETFs.

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PROTECTING AGAINST RISING RATES

By Dave Paterson, CFA

Floating rate notes can help cushion the impact

There is no doubt that bonds have had an unprecedented run over the past   30 years or so, as falling interest rates drove bond prices higher, rewarding   investors with outsized returns along the way. Returns have moderated of   late, with the majority of central banks keeping short-term interest rates on   hold. Recent bond returns have been more in line with the average coupon   rate, with the DEX Universe Bond Index gaining 3.6% in 2012. Barring any   major movements in interest rates, we expect that we will see similar returns   in 2013.

At the risk of sounding like a broken record, interest rates cannot remain   at their current levels indefinitely. It is not a question of if interest   rates will rise, but when. Unfortunately, predicting when the rates will   start increasing has become a very difficult task.

While the economy continues to slog along, it is not growing at a pace   that would require moving rates higher. Still, some signs of life are   emerging. In the U.S., the housing market is improving, consumer spending is   on the rise, jobs are being created, and economic growth is on the upswing.   In Canada, growth is positive, but slowing to a more modest pace.

When rates do begin to rise, traditional bonds, particularly the safe   haven government bonds, will be hit the hardest, taking on the full brunt of   the losses. As we know, bond prices move in the opposite direction of   interest rates, so if interest rates move higher, bond prices move down.

There are a few ways to help protect against this. One way is to invest in   short term bonds, which aren’t affected as much when rates move. Another   option is to invest in bonds that offer higher yields, for example corporate   or high yield bonds, since the higher coupon payments help protect them from   rising rates.

One often overlooked option to help protect against rising rates are   floating rate notes. In very simple terms, floating rate notes are issued by   large corporations with the coupon payment based on the prevailing rate of   interest in the economy. Usually these loans are senior debt and they can be   secured or unsecured. Secured notes are typically collateralized by such   things as accounts receivable, inventory, property, plant and equipment. They   will typically have a maturity of between 5 and 9 years.

There are a number of reasons to consider investing in floating rate   notes. Because the coupon payment moves with the prevailing rate of interest,   there is virtually no duration risk. Unlike other bonds, their prices won’t   be negatively affected when interest rates rise. They also tend to be a good   hedge against inflation.

Within the context of a portfolio, funds that invest in these notes tend   to have low or even negative correlation to the traditional asset classes.   For example, looking at the Trimark Floating Rate Income Fund, it has low   positive correlation to the main equity indices, and is negatively correlated   to the DEX Universe Bond Index. This correlation profile will help to reduce   overall volatility when used as part of a well diversified portfolio.

They are not without their risks. Many of the floating rate notes   available are not rated as investment grade debt by the major ratings   agencies. As a result, they can carry a high risk of default. Because of   this, you will want to make sure that any floating rate investment you   consider is well diversified, and that the managers have a sound investment   process in place.

While recent performance has been decent, these funds were hit very hard   during the credit crisis of 2008. Between May and December 2008 these funds   dropped precipitously with the BMO Guardian Floating Rate Income Fund   dropping by 46% while the Trimark Floating Rate Income Fund fell by 27%.   While nothing on the horizon suggests a similar event to be occurring, these   products are likely to be hit hard again if there are any issues with   liquidity in the corporate bond markets.

Floating rate notes are a fairly small segment of the investment universe   and there are only a handful of ways to invest in the sector.
As of February 28, 2013, the main floating rate note funds include:

Returns at February   28, 2013

Source: Fundata Canada

AGF Floating Rate Income Fund (AGF 4076) – AGF hired   Boston based Eaton Vance to bring their successful floating rate fund to   Canada. With this fund, foreign currency is hedged 100% back to Canadian   dollars. Looking at the performance of the U.S. version, even accounting for   the higher fees, we expect that it should be a solid performer going forward   on both an absolute and risk adjusted basis.
BMO Guardian Floating Rate Income Fund (GGF 626) – One of the first funds in   the floating rate space, this has rebounded nicely since taking a 46% drop in   2008. Credit quality looks strong, with more than 31% invested in notes that   are rated “A” or higher. However, it has one of the more   concentrated portfolios, holding around 50 names. Shorter term performance   has been strong, but still the longer term numbers lag. It is also the   smallest fund in the category with slightly more than $16 million in assets.   Given the above, we would likely shy away from it for now.

iShares DEX Floating Rate Note Index ETF (TSX: XFR) – This   is the most conservatively positioned of the floating rate products   available. It is solely invested in Canadian floating rate notes. Unlike the   other funds, it is heavily concentrated in government floating rate bonds,   with only a modest 7% weighting in corporates. While this positioning may   help in periods of uncertainty, we believe that over the long term, it will   underperform its more diversified peers, even with its significant cost   advantage.

Manulife Floating Rate Income Fund (MFC 4573) – One of   the newer entrants in the space, it has also been the strongest performer   since its launch. It is currently invested primarily in notes that are rated   BBB or lower, but is very well diversified with more than 140 names to help   offset this higher credit risk. Despite this greater diversification, it has   been more volatile than the other funds. But, if you are comfortable with the   higher risk, then this may be a good fund to consider.

Trimark Floating Rate Income Fund (AIM 1233) – This is   our top pick in the space. It is the oldest fund in the category and has   delivered modest longer term returns. It has also been the least volatile.   It, like the BMO Guardian offering was hit hard in 2008, dropping by 27%, but   has since more than made up for that decline. We believe that it should   continue to be the leader in the space on a risk adjusted basis, although the   Manulife fund may do better on an absolute basis.

Bottom Line: Floating rate notes can be a good way to   help protect your portfolio against the impact of rising interest rates. They   are not without risks, and should not be used as a core holding. Instead, use   them in a way that is similar to how you would use high yield in your   portfolios, keeping their exposure to a reasonable level given the total risks.

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SARBIT ACTIVIST OPPORTUNITIES CLASS

By Dave Paterson, CFA

Activist fund the first of its kind in Canada

Larry Sarbit is one portfolio manager that has never been accused of   following the crowd. He has always done things his own way, following a very   disciplined, high conviction style from which he has never strayed. He sticks   with it through thick and thin and stands up for what he believes in. That is   probably why it is not a big surprise that the first activist driven fund in   Canada was launched by him and IA Clarington.

The IA Clarington Sarbit Activist Opportunities Class   will invest in a concentrated portfolio of companies that are being targeted   by activist investors. Loosely defined, an activist investor is one that has   an interest in changing or influencing the management of a company. Activist   tactics can include proxy battles, shareholder resolutions, litigation,   management negotiations, or publicity campaigns. The reasons for activism are   varied, but can include purely financial motives such as changing corporate   policy, altering the financial structure, and implementing cost cutting   programs to help unlock the company’s true value. Activism may also have more   altruistic reasons including divestiture of assets in specific countries,   adopting stronger environmental policies, or improving working conditions.

Regardless, there is compelling evidence that activist investor situations   can lead to outsized performance. According to the report “Investors   Activism & Takeovers”, which was published in the June 2009 Journal   of Financial Economics, it was shown that activist investor situations added   an average of more than 10% over traditional buy and hold investing. In the   December 2012 report on Shareholder Activism Review published by Activist   Insight, activist funds were shown to deliver stronger returns than a passive   index. Between the start of 2008 and September 2012, activist funds generated   an average annualized return of 3.1%, compared to an annualized loss of 2.8%   for the MSCI World Index during the same period (all returns in U.S. dollars).

While the lure of excess returns is strong, Mr. Sarbit has promised that   he will stay true to his Warren Buffett inspired, value focused approach. It   will take more than an activist investor being involved with a company to be   considered for the fund. Investment candidates must have the potential to be   quality businesses that they can understand, but that have experienced some   issues which have resulted in their value not being fully reflected by the   markets. The activist investor will be viewed more as a catalyst to help   unlock that value. If Mr. Sarbit and his team do not see the potential for it   to be a “terrific business”, they will not invest.

One of our initial concerns was that there would not be enough of these   opportunities available that would fit within Mr. Sarbit’s investment   criteria. After all, he is the manager who famously held three stocks and 92%   cash back in the early 2000’s.

To identify potential investment candidates, Mr. Sarbit and his team will   comb through the publicly available 13D filings in the U.S. These filings   must be made by any investor who acquires more than 5% of a company’s stock   with the intention of influencing management or control of the company. They   will also look for companies where there has been significant trading   activity by management or other insiders. Given that in most years there are   around 2,000 13D’s filed, there should be at least 15 to 25 decent investment   opportunities to be found.

The fund will be completely benchmark agnostic and can invest in companies   of any size. Given Mr. Sarbit’s preference for the U.S., we expect it will be   heavily invested there.

The management fee is set at 2.0%. Looking at other IA Clarington funds,   we expect that the MER will be in the 2.35% to 2.50% range, once operating   expenses and HST are taken into account.

While this is a unique and interesting mandate run by a very highly   respected manager, we would approach it with caution. First, it is a brand   new strategy and we do not yet fully understand its risk/reward profile.   While historically activist situations have delivered above average returns,   there is no assurance that they will continue to do so. Also, the   concentrated portfolio, combined with Mr. Sarbit’s investment style, lead us   to believe that it will be very volatile at times, and in most cases, will be   more volatile than the broader U.S. equity markets.

It is our opinion that this fund should not be considered a core holding.   Instead, we would suggest that investors view this fund much the same way   that they would view a U.S. small cap fund. Portfolio exposure should be kept   at a modest level to protect against the potential volatility.

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READERS’ QUESTIONS

Q – What is your opinion of the Cundill Recovery   Fund?

A – The timing of this question couldn’t be better, given   that elsewhere in this edition we highlighted the new IA Clarington   Sarbit Activist Opportunities Class. This fund is in a similar space   in that it has the mandate to invest in companies that are undergoing some   sort of recovery situation such as reorganization, coming out of bankruptcy   protection, a change in ownership or other crisis. The company must also meet   the very disciplined Cundill investment criteria. The big differences would   be that with the Cundill Recovery Fund, there is no requirement for an   activist shareholder to be involved, and the Cundill offering will be much   more global in scope.

In building the portfolio, manager James Morton uses a very disciplined,   bottom up, value approach to evaluate companies and determine their true   value. He must see a near term catalyst in place that will unlock the true   value of the company. Ideally, there will be at least a discount of 30% or   more from his estimate of its worth. He also looks for companies that have   growing intrinsic values and companies with tangible resources.

It has a go anywhere mandate, but tends to focus in small and mid cap   issues and tends to favour Asia and developing Eastern Europe. The portfolio   itself is quite diversified, holding around 60 names. Still, it is rather   concentrated in the top ten holdings, which make up 42% of the fund. When   adding a new company, he will typically take a small position first and   gradually add to it as he becomes more comfortable with it.

Long term performance has been strong, gaining an annualized 10.4% per   year over the past ten years, compared with a 7.7% gain for the Dow Jones   Global Small Cap Index during the same period. However, the fund is volatile   and prone to periods of significant underperformance. For example, in 2008   and 2011 it lost 54% and 26% respectively. That said, it does tend to bounce   back strongly, typically outpacing the index and category in rising markets.

From a regional standpoint, Mr. Morton likes Europe and Russia from a   valuation perspective. Despite that, he is reluctant to add much to Europe because   of issues with the euro, but is on the lookout for statistical bargains.   Russia is by far the most attractively valued country, but not without its   risks. Asia and the Pacific Rim make up 54% of the fund, followed by Europe   with about 31%.
In Asia, he favours Chinese property stocks feeling that current valuations   support a strong rebound in the sector. Because of this view, real estate   makes up about 32% of the fund, followed by financials at 21%.

This is a good fund for investors who have a very high risk tolerance.   Before considering an investment in it, you must be willing to stomach some   pretty jaw dropping selloffs in return for strong longer term returns.   Overall volatility is expected to be much higher than other small and mid cap   funds. We expect that longer term performance will be strong, but there will   be periods of extreme underperformance.

Mutual Funds / ETFs Update
Editor and Publisher: Dave Paterson
Circulation Director: Kim Pape-Green
Customer Service: Katya Schmied, Terri Hooper

BuildingWealth’s   Mutual Funds / ETFs Update is published monthly.

Copyright   2013 by Gordon Pape Enterprises Ltd. and Paterson & Associates

All rights   reserved. Reproduction in whole or in part without written permission is   prohibited. All recommendations are based on information that is believed to   be reliable. However, results are not guaranteed and the publishers and   distributors of Mutual Funds Update assume no liability whatsoever for any   material losses that may occur. Readers are advised to consult a professional   financial advisor before making any investment decisions. Contributors to the   MFU and/or their companies or members of their families may hold and trade   positions in securities mentioned in this newsletter. No compensation for   recommending particular securities or financial advisors is solicited or   accepted.

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