Top Funds Report – February 2014

January was a bumpy ride for investors with global equity markets mixed. In Canada, a strong rebound from the gold sector helped the S&P/TSX Composite Index gain 0.82% for the month. Global markets didn’t fare quite as well, as the S&P 500 lost 3.46% in U.S. dollar terms while the MSCI EAFE Index dropped by more than 4%.

For Canadian investors, these losses were turned into gains, thanks to the falling Canadian dollar. With the signs pointing to stronger economic growth in the U.S., and slower growth here at home, the dollar fell from $0.9402 U.S. to $0.8994. This drop was positive for global funds that don’t hedge currency, as the S&P 500 ended up gaining 1.25% in Canadian dollar terms, while the MSCI EAFE rose a modest 0.34%.

Emerging markets continued to struggle as worries over the impact the U.S. Federal Reserve’s decision to taper their bond purchases weighed on investors. Adding to the turmoil was a currency crisis in Argentina, weaker than expected economic data from China and continuing political troubles in Turkey, Ukraine and Thailand. Many investors began to fear that these events could result in another financial crisis, much like what Asia experienced in 1997. Others feared this could spread to the rest of Asia and Europe, which caused many investors to sell.

With the heightened uncertainty, fixed income did quite well with bond yields dropping both at home and in the U.S. The yield on the benchmark U.S. ten year bond fell from 3% to 2.67%, while the ten year government of Canada bond fell from 2.77% to 2.34%. With the drop in yields, bond prices moved higher, with the DEX Bond Universe gaining 2.60%. Government bonds handily outpaced corporate bonds, and long bonds were very strong. For the month, the DEX Long Term Bond Index gained an impressive 5.0%.

Despite the recent uptick in volatility, my investment outlook continues to favour equities over fixed income. While I favour equities, I am a firm believer that most investors would benefit from having some exposure to fixed income in their portfolios. However, I certainly wouldn’t be overweight in bonds now.

My expectation is that bond yields will be fairly range bound for the near term, as investors digest the true strength of the economy, both in Canada and abroad. In this environment, I favour actively managed bond funds that are defensively positioned with a focus on corporate bonds. Two of my picks would be the Dynamic Advantage Bond Fund and the PH&N Total Return Bond Fund.

With the renewed uncertainty from the emerging markets, I like actively managed funds that have a focus on U.S. equities and place a great deal of emphasis on protecting investors’ capital. Two of my equity picks would be the Mackenzie Ivy Foreign Equity Fund and the Franklin Rising Dividends Fund. Both have a history of strong relative performance in volatile times.

I am reluctant to add any exposure to the emerging markets at the moment. There is far too much uncertainty in the region for me to be comfortable with any significant allocation for anyone except the most aggressive of investors. 

Please send your comments to feedback@paterson-associates.ca.

Funds You Asked For

This month, I take a look at some funds from CI, O’Leary, and Beutel Goodman. 

 CI Global Health Sciences Fund (CIG 201)

This was one of the best performing funds last year, gaining a staggering 61.8%, as investor demand for healthcare stocks continued unabated. That trend is continuing, with the fund gaining another 8.46% so far this year.

I have said it before, and I will say it again, if you have held this fund for any period of time, I implore you to take some money off the table. There is no way that the pace of recent gains is sustainable, and there will be a pullback at some point. I do not know when, but it will happen, and by taking some money off the table, you are protecting those gains. I am not suggesting you completely get out of the fund, because I still believe that the long term outlook for the sector remains intact, and this remains my top pick in the space.

Sentry REIT Fund (NCE 705)

This fund struggled in 2013, losing 3.45% for the year. In comparison, the S&P/TSX Capped REIT Index dropped by more than 5.5%. Investors had fallen in love with REITs, thanks largely to the attractive cash flow that many of them kick out. That all started to change when yields began to move higher in the summer. Many investors got worried and sold their REIT holdings. With an uncertain interest rate outlook expected to continue for the near term, I don’t expect that there will be a short term rally in REITs.

The longer term story remains fairly strong, but I expect that volatility will remain high for the next few quarters. With that as the backdrop, I believe that investors are likely better off avoiding a dedicated REIT fund, and instead focusing on a more diversified monthly income type fund, such as a CI Signature High Income Fund, or Sentry Canadian Income Fund.

Trimark Floating Rate Income Fund (AIM 1233)

Floating rate funds are a great way to help protect against rising yields. They invest in bonds and loans that pay a coupon that is based on some underlying benchmark rate like LIBOR, which tends to move similarly to the overnight rates charged by the various global central banks. With these rates expected to remain on hold for most, if not all of 2014, I don’t expect that we will see big gains from these funds. Still, they are very likely to outperform more traditional fixed income investments. I would not be surprised to see another year like we saw last year, with this fund generating low to mid single digit gains.

AGF Monthly High Income (AGF 766)

Along with being a pretty solid balanced fund, this is also a good way to generate cash flow. It pays a variable monthly distribution that in the past year has ranged from a low of $0.0341 per unit to a high of $0.0626 per unit. At current prices, the fund is yielding approximately 6.5%. Manager Peter Frost is favouring equities over fixed income with an asset mix that is 63% equity, 28% bonds, and 9% cash. With this positioning it is likely to be the most volatile fund on the list, but I would also expect it to deliver strong levels of risk adjusted returns.

Steadyhand Income Fund (SIF 120)

A few years ago, when talking with Tom Bradley, the President of Steadyhand Funds, he referred to this fund as his “bond beater”. I have to admit it is a handle that fits this balanced fund nicely, with a five year gain of 10.1%, more than doubling the return of the DEX Bond Universe Index. To do this, it invests approximately 70% in predominantly corporate bonds, with the balance in high yielding equities and REITs. While I don’t expect it to deliver the same level of gains that it has of late, I do think it will handily outpace traditional bond funds, and provide solid risk adjusted returns for investors. If you have a higher risk tolerance, you may want to consider using this as part of your fixed income allocation.

Trimark Canadian Small Companies Fund (AIM 1683)

With its concentrated, high conviction portfolio, it is more likely to experience periods of higher volatility than many other small cap funds. The managers stick to a disciplined stock selection process, and will hold high cash balances when they cannot find suitable investment opportunities. At the end of December, with valuations getting a bit rich, they held 25% in cash. This helps explain why they lagged in the fourth quarter. Longer term, I believe in their process and expect the fund to deliver above average risk adjusted returns over the long term.

IA Clarington Sarbit U.S. Equity Fund (CCM 150)

I will admit that this is a fund that can be a tough one to hold. Manager Larry Sarbit invests in an ultra-concentrated portfolio of what he calls “terrific businesses”. At the end of December, it held just ten equity holdings that made up 70% of the fund, with the balance in cash. His focus is the U.S., and will invest in companies of any size ranging from the tiny to the very large. Performance has been very different from what you would expect from other U.S. equity funds, and has largely underperformed. His long term track record has been very solid and he has a very unique approach. I would never suggest this be used as a core holding, but I do think it can play a role in an otherwise diversified portfolio. It is only suitable to those who are in it for the long term and are comfortable with periods of underperformance, knowing that if he gets it right, you will be handsomely rewarded.

CI Black Creek Global Leaders (CIG 11106)

With a go anywhere mandate, this global equity fund looks for high quality and unique companies that have the ability to grow their market share, that are trading at favourable valuations. Except for 2011, it has consistently outperformed its competition and last year, it gained more than 40%. Given this run up, manager Bill Kanko is becoming worried that a correction is coming. He still favours equities over fixed income and cash, but remains vigilant. When you get the fund manager telling you he is worried about a correction, there aren’t many signals that are more clearly suggesting you should take some profits and reduce your exposure to the fund.

CI Harbour Fund (CIG 690)

Until December 2012, this fund had been managed by respected veteran, Gerry Coleman, when he handed over the reins to longtime associate, Stephen Jenkins. Despite the change in manager, there hasn’t been any major changes to the investment process used in the fund.

It is still It is managed using a patient, bottom up and research intensive approach that invests in concentrated portfolio of 30 to 40 names. They look for industry leading companies with strong balance sheets and sustainable competitive advantages that can generate significant free cash flows. They look for good management teams who have proven that they are good allocators of capital with an eye for creating shareholder value. Once they find these opportunities, they must be trading at an attractive discount to their estimate of intrinsic value, so there is a margin of safety for investors. Ideally, they are looking for a discount of at least 50%.

Cash will still be used tactically when no investment opportunities that meet the manager’s criteria are available. At the end of November, it held 15% in cash. This will act as a buffer in volatile markets, but will drag performance when markets are rising.

Traditionally, the portfolio has been focused on quality, and that is still the case, however under Mr. Jenkins’ watch, valuation has become a slightly more important factor. This may result in underperformance in sharply rising markets, but over the long term, should not have a meaningful impact on performance.

At the end of the year, longer term numbers remained quite strong, however shorter term, it has underperformed. It gained 12.3% in 2013, slightly lagging the S&P/TSX Composite, but trailing its competition by a significant margin.

This fund remains on my Rec list for now, but the shorter term performance has become a bit of a concern. I will continue to watch it closely for any further erosion in the risk reward metrics of the fund.

Beutel Goodman Balanced Fund (BTG 772)

This equity focused balanced fund really struggled in 2009 and 2010, but has been very strong since then. For the year ending January 31, it gained 14.1%, leading both the benchmark and its competitors.

The portfolio is really just a mix of other Beutel managed funds including the Beutel Goodman Income Fund, Beutel Goodman Canadian Equity, Beutel Goodman International Equity and Buetel Goodman American Equity.

The asset mix is weighted towards equities, with a neutral mix set at 40% bonds, 60% equities. At the end of January, it had 28% invested in bonds, 6% in cash with the balance in equities. They are pretty consistent with this asset mix, and it hasn’t changed considerably in the past few years.

On the equity side, they look for companies that have a history of generating above average free cash flows that are trading at a discount to their estimate of intrinsic value. They tend to favour companies that are more defensively positioned. They are currently overweight consumer focused names, and communication stocks, and are significantly underweight in energy, materials and real estate.

Within the fixed income portion of the fund, they focus on building a portfolio of high quality corporate bonds that has a yield that is higher than the DEX Universe benchmark. The team determines an overall outlook for the economy, including the direction of interest rates, credit spreads and the yield curve and positions the portfolio opportunistically to benefit from this outlook.

While the five year return has been largely disappointing, I am somewhat encouraged by the shorter term numbers. Another very positive attribute of this fund is its 1.21% MER, which is one of the lowest in the category.

Still, I believe that there are better balanced funds available. There are some concerns with a couple of the underlying funds, particularly the International Equity and the Income Fund. I would recommend the Mawer Balanced Fund over this offering.

O’Leary Canadian Dividend Fund (OLF 301)

Managed by Connor O’Brien and Steve DiGregorio of Stanton Asset Management, this Canadian dividend fund uses a mix of top down macro analysis and bottom up security selection. The top down macro analysis is used to help zero in on most attractive sectors and security types. Once this is determined, they then use a fundamentally driven, bottom up security selection process with the goal of finding high quality companies with strong balance sheets and cash flows that are trading at a discount to their estimate of its true worth.

They can invest in companies of any size, but tend to focus on large and medium sized companies. They can invest up to 30% outside of Canada, and at the end of January, there was just under 20% invested abroad. It was also nearly fully invested, holding just under 2% in cash. Their investment process is quite active, with annual portfolio turnover averaging more than 100% since its launch.

Performance has been decent, with a three year gain of 7.49%, outpacing the S&P/TSX Composite Index, but lagging the Dow Jones Canada Select Dividend Index. Shorter term numbers have been stronger, gaining 13.4% in the past year, outperforming both indices, and finishing in the second quartile. Volatility has been slightly lower than the category average. It is a good source of cash flow, paying a monthly distribution of $0.0315 per unit, which works out to an annualized yield of more than 3%.

The costs are reasonable with an MER of 1.73%, largely because O’Leary is absorbing a large portion of the expenses. Without them picking up some of the tab, the MER would have been in the 2.7% range.

This isn’t a bad fund per se. Based on my analysis, I would expect it to produce average returns with slightly below average risk. It’s just that I believe that there are better dividend income funds available, including RBC Canadian Equity Income, Sentry Canadian Income or Mackenzie Canadian All Cap Dividend.

If there is a fund that you would like reviewed, please email it to me at feedback@paterson-associates.ca.

February’s Top Funds

Sentry Conservative Balanced Income Fund