The Best & Worst of 2013

Looking at last year’s winners and losers and how they should fare this year

With 2013 now just a memory, I thought I might be interesting to take a look back at the best and worst of the year.

Best of the Year

According to fund research firm Morningstar, the best performing fund categories last year were:

Health Care Equity

Health care was the best performing category in the year, with drug makers and biotech leading the way. In the past two years, the sector has risen by more than 80%. There are a number of reasons to remain positive on the sector, including the increased demand for new drugs caused by the aging of the baby boomers, combined with the development of the emerging markets, which has increased demand for health care products. While the long term looks good, the recent run-up causes me some concern and I would expect that we will likely see some sort of a correction soon. If you have held health care in your portfolio for any length of time, you may want to consider taking some profits, to protect against any potential selloff. My favourite fund in the category remains of the CI Global Health Sciences Fund (CIG 201). Manager Andrew Waight has done a stellar job generating amazing returns, and has also kept risk well in hand.

U.S. Small / Mid Cap Equity

I was a bit surprised to see small caps lead the way in 2013. This time last year, I felt there was far too much uncertainty, and expected that quality focused large caps would be the stronger performers. In hindsight, I was wrong. As we enter 2014, I see a similar market environment to what we experienced last year. While I do not expect another 40% year out of U.S. small caps, I think it likely that we will see another strong year. In the category, my favourite would be the Fidelity Small-Cap America fund (FID 261), managed by Steve MacMillan. Since taking over this fund, he has done a great job focusing it on high quality names, and to date, investors have been rewarded.

U.S. Equity

With signs that a sustained improvement in economic conditions is underway, U.S. equities responded favourably with their best year since 1997. For Canadian investors, the gains were even more impressive, thanks to a 7% drop in the Canadian dollar. For the coming year, I expect that we will see further signs that the economy is on the right track. The Federal Reserve’s tapering of their bond purchases that started in January is likely to continue over the course of the year. Still, it is very unlikely that the Fed will move overnight rates higher until at least 2015. U.S. equities should have another strong year, although I doubt that they can repeat the strong gains of 2013. The U.S. is always one of those markets where it is very difficult for any manager to consistently outperform. At the moment, I am struggling to find a U.S. equity fund that I have strong conviction in for the coming year. I would favour a low costs U.S. focused ETF or index fund over an actively managed fund.

Japanese Equities

Investors celebrated the economic reforms brought forward by Prime Minister Abe by pushing the Nikkei up by 57%. Many are expecting a continuation of 2013, with both economic and earnings growth rising. Still, I remain very cautious on Japan. I am not currently recommending any Japanese equity funds. If would you like exposure to the region, your best bet is to invest in a more diversified Asia-Pacific equity fund. My pick in the category would be the BMO Asian Growth and Income Fund (GGF 620), which is a more conservative way to play the area. It invests in a mix of equities with some exposure to fixed income, largely convertible bonds. While it may lag a pure equity fund when markets are rising, the lower overall risk profile make it a more attractive option.

Global Small / Mid Cap Equity

Global small caps had a very strong year gaining 32.3% compared with the still respectable 29.9% rise of their large-cap brethren. This year should be quite similar to last, providing the potential for another strong showing for global equities, both small and large cap. In the small cap space, my pick would be the Trimark Global Endeavour Fund (AIM 1593). It is a concentrated portfolio of high quality names that trade at a discount to the manager’s estimate of intrinsic value. It is very different from its benchmark, which may cause it to perform much differently than the index at any given point in time. Over the long term, risk adjusted returns should be above average.

Worst of the Year

While the above highlights the winners for the year, there were also a number of losers. According to Morningstar, the worst performing fund categories were:

Precious Metals Equity

The fall in gold continued in 2013 as the outlook for inflation remained well contained, and the geopolitical climate was relatively calm. While there is evidence that economic activity is picking up around the world, the outlook for inflation remains fairly muted. I certainly don’t see anything on the near-term horizon that may change this outlook. While I don’t expect another 48% drop, I don’t think a sharp rebound is imminent. Those worried about inflation who would like some gold in their portfolio, may want to use any pullbacks as a buying opportunity. I would not recommend a significant overweight in the sector as there are far too many unknowns and too much risk for gold to be a significant component of any portfolio.

Canadian Inflation Protected Fixed Income

It was very tough year for real return bonds for a couple of reasons. First, most real return bonds are long term. Long bonds tend to be more sensitive to movements in interest rates, so when yields spiked in the summer, real return bonds were punished. Second, inflation has remained well contained, and has in many countries below the inflation targets set by central banks. This further limits the appeal of real return bonds. Looking ahead, at least in the near to medium term, there is nothing on the horizon that changes the inflation outlook. Under these circumstances, I expect that it will be another rocky year.

Canadian Long Term Fixed Income

Canadian long-term fixed income was hit hard this year, dropping 7%. Most of this can be attributed to the comments made by U.S. Federal Reserve Chairman Ben Bernanke in May that hinted that the Fed would be scaling back their bond buying program sooner than many had expected. Market reaction was swift, pushing yields up significantly, punishing bonds, particularly those with longer durations. Looking ahead, short term rates will likely remain near current levels, however, I see upward pressure on yields for medium to long-term bonds. This makes losses in long-term bonds likely in 2014.

Real Estate Equity

Another casualty of the rising yield environment was real estate, particularly REITs. Over the past several years, investors have viewed REITs mainly as income producing vehicles. When yields started to move higher, investors sold out many of their REIT holdings, pushing prices down. While some correction may have been necessary, yields on many REITs are starting to look very attractive, with the potential for capital gains. It won’t be smooth sailing, and I fully expect more turbulence in the sector in the early part of the year. Looking out a couple of years however, the REIT story looks pretty attractive, providing lots of room for growth. For mutual fund investors, my real estate pick would be the Sentry REIT Fund (NCE 705), which provides exposure to both Canadian and global REITs. Performance has been underwhelming of late, however longer term, it is as solid as they come. For ETF investors, my pick is the BMO Equal Weight REITs Index (TSX: ZRE). I like this one over the iShares offering because it has a more diversified portfolio, which should provide better risk-adjusted returns over the long term.