Download the PDF Version of this report
Canadian Equities Lead the Way
Second quarter starts much like the first ended – bonds higher, global equities mixed.
After a solid first quarter, April offered a bit of everything for investors. Fixed income and Canadian equities provided modest gains, while global equities were mixed.
Directionless economic data combined with modest inflation pressures helped push bond yields lower in the month. The yield on the benchmark Government of Canada ten year bond ended the month at 1.67%, down from 1.71% at the end of March. Because bond returns move in the opposite direction of yields, bonds rose, with the DEX Bond Universe gaining 0.5%. Long term bonds outperformed short term bonds, and corporate and high yield outpaced governments.
Worries over the Ukraine provided incentive for some safe haven bond buying, keeping yields in check. It also helped to support other safe haven assets, including gold, which is up nearly 8% so far this year. Energy was also stronger in the month, helping push Canadian equities higher, with the S&P/TSX Composite rising nearly 2.5%.
Global equity markets were a mixed bag. The S&P 500 gained 0.74% in U.S. dollar terms, but a rise in the Canadian dollar resulted in losses for those funds that do not hedge their currency exposure. Factoring in currency, the S&P 500 was actually lower by 0.14%. It was a similar story with other indices with the MSCI EAFE Index gaining 1.5% in U.S. dollar terms, but was only up 0.6% in Canadian dollar terms.
China struggled yet again as worries over the pace of economic growth weighed on sentiment. Until we see some clear signs that the economy is firmly on the mend, I expect there to be continued volatility, not only in China, but most of the other emerging market countries.
Looking ahead, I continue to favour equities over fixed income. I am favouring North American equities over Europe and Asia, although I expect there may be some heighted volatility in the U.S. over the summer months on valuation worries. I still expect better growth out of North America in the near to medium term.
Please send your comments to feedback@paterson-associates.ca.
Funds You Asked For
This month, I offer up some quick hits on some of my recommended list funds….
TD Short Term Bond Fund (TDB 814 – Front End Units, TDB 870 – DSC Units) – As the name suggests, it invests in a mix of government and corporate bonds that have a term to maturity of less than five years. The current mix favours corporate bonds, which make up nearly 60% of the fund. It has a duration of 2.7 years which is considerably shorter than a traditional bond fund, which would be in the ballpark of 6.8 years. It pays a variable monthly distribution that has yielded approximately 1.6% in the past 12 months. While there is the risk it will experience a loss when short term yields move higher, I still expect that over the medium to long term, it will provide returns that outpace its peer group. If you are looking for a way to shorten the duration of your fixed income holdings, this is a great fund to help you do that.
Dynamic Advantage Bond Fund (DYN 258 – Front End Units, DYN 688 – DSC Units) –With the potential for the interest rate environment to once again become rather choppy, this fund, with its actively managed portfolio, and duration management strategy remains my top pick. I would expect that it will lag during a bond market rally, but will outperform during periods of higher than normal bond market volatility.
CI Signature Select Canadian Fund (CIG 677 –Front End Units, CIG 777 – DSC Units) –This was the top performing Canadian equity fund in the first quarter, with a gain of 4.97%, outpacing both the category average and the S&P/TSX Composite Index.
It has about half the fund invested outside of Canada, which helped boost performance, thanks in part to a falling Canadian dollar. It is fairly defensively positioned, underweight materials and energy, and overweight more defensive sectors like healthcare and consumer defensives. A recent selloff in healthcare may weigh on returns in the next few weeks.
Looking ahead, I expect that it will continue to do what it has always done – deliver solid risk adjusted returns to investors.
Trimark U.S. Companies Fund (AIM 1743 – Front End Units, AIM 1743 – DSC Units) – This is a concentrated portfolio of attractively priced U.S. companies that have distinct proprietary advantages, strong management, industry leadership and a history of strong capital allocation policies.
During the first quarter, it gained more than 6.9%, handily outpacing the S&P 500 and most of its peer group. The main reason it outperformed were its technology and financial holdings, which posted strong gains. The fund’s currency exposure remains unhedged, which helped to boost the overall performance.
Looking ahead, the managers believe that the economic recovery in the U.S. is continuing, and that the recent market selloff was the result of investors once again reevaluating their view on risk. It is expected that earnings growth, which the companies in the fund have plenty of, will take on a greater importance in the weeks and months ahead.
While I expect that this fund can continue to deliver above average returns, I am beginning to get very concerned with its cost. The MER is now nearly 3%, which is likely to be a big drag should we encounter a period of single digit returns for U.S. equities. I am continuing to monitor the fund closely.
Brandes Global Small Cap Fund (BIP 152 – Front End Units, BIP 252 – DSC Units) – This deep value offering from Brandes had a very strong quarter, gaining nearly 9%, outpacing both the index and its peer group.
The management team follows a very disciplined and repeatable process that looks to buy companies that are trading a significant discounts to their true value. While this process may result in periods of underperformance, over the long-term, I expect it can to deliver strong returns for investors.
On the surface it appears to be more volatile than its peers, with a standard deviation that is considerably higher than both the index and its competition. However, looking at upside and downside capture ratios, the fund still manages to do a good job at protecting investors’ capital.
The fund has been on a solid run since mid-2011, and I would expect that we will see more of a pullback in the next few months. However, I do believe that over the long term, the focus on value names will help to provide above average returns to investors, both on an absolute and risk adjusted basis.
CI Global Health Sciences Corporate Class (CIG 201 – Front End Units, CIG 701 – DSC Units) – After a heck of a run, the fund has been selling off in the past month or so. If you have held this fund for a while and haven’t taken profits recently, I would strongly urge you to do so, as valuations have certainly become very rich. I expect that we will see more downside in the coming weeks. By taking some money off the table, you can help protect some of the gains you’ve seen in the past several months.
Longer term, I still like the healthcare story. As the populations in the developed world continue to age, the demand on healthcare products and services are likely to continue to increase. The development of the emerging markets will also help to drive demand for the sector, all of which paints a strong picture for the medium to long term.
However, given the strong run and the level of valuation, I expect more volatility in the coming weeks and possibly months.
AGF Canadian Asset Allocation Fund (AGF 280 – Front End Units, AGF 980 – DSC Units) – With roots dating back to 1931, this is one of Canada’s oldest mutual funds. Today, it is managed by the team of Michael White and Brian Madden using a mix of top down macro analysis and bottom up security selection.
The first step in the process is to determine the health of the global economy and the investment markets. To do this, they look at a number of factors including bond yields, job numbers, leading economic indicators, and investor sentiment. They also look at the fundamentals of the equity markets.
With this information, they will set the fund’s broad based asset mix. Using their real time monitoring process, they will adjust the asset mix based on what risks they see. The more risks identified, the lower the allocation to equities. They have a great deal of flexibility and can invest up to 80% of the fund in any one asset class.
At the end of April, they were rather positive on the equity markets, with more than 70% invested in equities. Once they have the asset mix set, they will also use macro analysis to set the sector mix of the fund. Individual securities are selected using a fundamentally driven, bottom up stock selection process. They focus on profitable companies with excellent earnings growth visibility and solid balance sheets that are trading at what they believe to be reasonable valuations.
Of late, they have been finding opportunities outside of Canada, particularly in growth and non-resource cyclical names. The fund is overweight in healthcare and consumer names, and is underweight financials, energy and materials. This positioning helps to explain the fund’s underperformance so far this year, after a very strong 2013.
While I have been encouraged with the results of late, I would like to see a longer track record before I can recommend it. The managers have been making a number of refinements to their investment process, which appear to be working, but I will need more time to evaluate. Another concern I have with this fund is its cost. The MER is 2.70%, which is high compared to many other balanced funds, and is significantly higher than any of the balanced offerings on my Recommended List of Funds.
Dynamic Global Real Estate Fund (DYN 085 – Front End Units, DYN 785 – DSC Units)– As the name suggests, this fund is very global in nature, with nearly two-thirds invested abroad. It is managed by Oscar Belaiche and Tom Dicker using their “Quality at a Reasonable Price” approach that looks for real estate companies and REITs that have strong balance sheets, and excellent management teams with “skin in the game”. The portfolio is diversified, holding more than 50 names, with the top ten making up about a third of the fund. Performance, particularly on a risk adjusted basis, has been strong. Given the global reach of the fund, I believe it has the potential to continue to deliver decent returns into the future.
Fidelity Global Real Estate Fund (FID 1201 – Front End Units, FID 1501 – DSC Units)– Of the other real estate funds I have reviewed this month, there are two things that differentiate it. First, it is the most globally diversified, with less than 5% invested in Canada. The manager, Steve Buller, tends to keep his country allocations within a pretty tight range. Second, it is also the most large cap focused fund discussed, with a market cap well in excess of the others. Performance has been decent, but it has been more volatile than the others. This would be my pick if you were looking for non-Canadian real estate exposure.
First Asset REIT Income Fund (FAF 5803 – Front End Units, FAF 5800 – DSC Units)– While the Fidelity offering above has the biggest emphasis on large caps, this fund is the most focused on small cap names. The average market cap of the companies and REITs in this fund is significantly lower than any of the other funds on the list. The focus is predominantly Canada, but it can invest up 30% abroad. At the end of March, it held about 10% in the U.S. Launched in late 2010, performance was impressive in 2011 and 2012, but underperformed in 2013 and so far this year. Given the relatively small level of assets, and underperformance in 2013, I will be rather cautious on this offering, until I see a bit more of a track record and can do a much deeper review.
Sentry REIT Fund (NCE 705 – Front End Units, NCE 305 – DSC Units)– For the longest time, this was the go-to real estate fund in Canada. It was consistently one of the best performers in the space, handily outpacing its peer group between 2009 and 2011. However, since 2012, performance has lagged substantially, as investors piled into the fund chasing its former glory. The fund essentially became a victim of its own success. Now at $1.2 billion in assets, the managers have invested about half the fund outside of Canada as they look for suitable opportunities. I have noticed an uptick in performance in the past three months, but I’m worried that the size of the fund will continue to be a drag. Given my concerns, I would likely take a pass on this fund for now.
If there is a fund that you would like reviewed, please email it to me at feedback@paterson-associates.ca.
May’s Top Funds
CI Cambridge Canadian Equity Class
| Fund Company | CI Investments Inc. |
| Fund Type | Canadian Focused Equity |
| Rating | A |
| Style | Large Cap Growth |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Brandon Snow since June 2011Bob Swanson since Jan. 2012 |
| MER | 2.44% |
| Code | CIG 2321 – Front End UnitsCIG 3231 – DSC Units |
| Minimum Investment | $500 |
Analysis: Managed by Brandon Snow of CI’s Cambridge Advisors Team, this Canadian focused equity fund invests in large and mid-sized companies that have a defensive business model, a history of intelligent capital allocation, and a management team whose interests are aligned with the shareholders. The bottom up approach is more growth focused, but valuation is a consideration.
They can invest up to 49% of the fund outside of Canada, and at the end of April, about a third of the fund was invested abroad. The portfolio is concentrated, holding around 40 names
From a sector perspective, it was significantly underweight materials, financials and energy, with no exposure to healthcare. It was focused on consumer names, which made up roughly 30% of the fund.
They are very active in their management approach, with portfolio turnover averaging more than 225% for the past five years. Portfolio turnover is typically higher when markets are falling, as they move to pick up quality names at cheaper prices.
Performance has been strong, but more impressive is that volatility has been significantly lower than the S&P/TSX Composite Index. The fund has also shown excellent downside protection. For the three years ending March 31, it only participated in 29% of the downside of the market, and for the past five years, it has experienced about half the downside of the index.
The way this fund is positioned and managed is likely to result in performance that is much different than the index or its peer group, The absolute level of returns is likely unsustainable going forward, but I do expect it to be able to deliver above average risk adjusted returns in the near to medium term. My biggest worry is that a high level of assets in the fund may impede their ability to effectively implement their process.
Invesco International Growth
| Fund Company | Invesco Canada Ltd. |
| Fund Type | International Equity |
| Rating | B |
| Style | Large Cap Growth |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Clas Olsson since July 2000Jason Holzer since July 2000 |
| MER | 2.94% |
| Code | AIM 633 – Front End UnitsAIM 631 – DSC Units |
| Minimum Investment | $500 |
Analysis: This fund is managed using a bottom up stock selection process that is referred to as “earnings, quality and valuation”, or EQV. They look for companies that are likely to experience above average earnings growth, have high quality and sustainable earnings, and are trading at a reasonable valuation. They tend to favour companies that are able to generate solid organic revenue growth, have pricing power in their markets, strong balance sheets and offer a more defensive growth profile.
They can invest in both large and mid-cap stocks that are located in Western Europe and the Pacific basin, but the focus tends to be more on the larger cap names. It is a very well diversified, holding nearly 80 names, with the top ten making up just over 20% of the fund.
Performance, particularly the longer term numbers are very strong compared with other international funds. For the five years ending April 30, it has gained an annualized 12.6%, modestly outpacing the 12.2% gain of the MSCI EAFE Index over the same period.
In a recent commentary, the managers noted that Europe has been showing signs of modest improvement. However, the situation in the Ukraine is a wildcard that could be significantly negative to this recovery. They also note that they remain cautious and believe that valuations are way ahead of what the corporate and economic fundamentals would suggest.
Cash in the portfolio sits at more than 10% as they have recently taken some profits in some names that have shown robust gains, and they have been having trouble identifying what they believe to be strong investment candidates because of the valuation concerns highlighted above. This level of cash can be a drag on performance if we see a sharp rise in the broader markets.
On balance, I believe that this is one of the best international equity funds available. It is managed by a diverse team, using a very disciplined approach. One of the bigger concerns with it would be its cost, with an MER that is approaching 3%.
TD Canadian Small Cap Equity Fund
| Fund Company | TD Asset Management |
| Fund Type | Canadian Small / Mid Cap Equity |
| Rating | A |
| Style | Growth |
| Risk Level | Medium High |
| Load Status | No Load / Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Gord MacDougall since October 2005Gary Baker since October 2005 |
| MER | 2.54% |
| Code | TDB 628 – No Load UnitsTDB 825 – Front End UnitsTDB 835 – DSC Units |
| Minimum Investment | $500 |
Analysis: Small cap stocks have been on quite a tear of late, and this has been one of the best performing funds in the category. For the year ending April 30, it gained 40.6%, handily outpacing the index and most of its peer group. Longer term numbers are equally as impressive, with an annualized five year return of 22%, finishing in the top quartile.
It is managed using top down macro analysis combined with fundamental, bottom up security selection. When analyzing a company, they focus on a company’s growth, valuation, and financial strength. With this information, they are able to set a price target for each company that is used to better understand the risk reward profile of each company.
In addition to the bottom up security selection process, the managers also use a top down macro analysis that is used to help set the sector mix within the portfolio. Working with CC&L’s fixed income team, they consider such factors as where we are in the business cycle and the outlook for interest rates, currencies and commodities.
The result is a well-diversified portfolio that holds approximately 120 names, with the top ten making up around 20% of the fund. At the end of April, it was underweight financials and energy and was overweight technology and consumer cyclical. It also skewed more towards companies that have higher growth rates than the broader market, but are a bit more richly valued.
Historically, the fund has been more volatile than its peers. It has also been able to outperform in rising markets, and match performance when markets are falling. Costs are in line with the category average.
While not my top small cap pick (Sentry Small / Mid Cap is my pick), this is definitely a good option if you are looking for a solid, basic, no frills type of a small cap fund. It has a strong management team behind it, average costs, and favourable risk reward characteristics.
Mackenzie Cundill Canadian Security Fund
| Fund Company | Mackenzie Investments |
| Fund Type | Canadian Focused Equity |
| Rating | B |
| Style | Value |
| Risk Level | Medium High |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Lawrence Chin since April 2009 |
| MER | 2.54% |
| Code | MFC 738 – Front End UnitsMFC 838 – DSC Units |
| Minimum Investment | $500 |
Analysis: The Cundill Funds have long had a reputation as being contrarian, concentrated deep value funds, and this Canadian focused offering is no different. Using a bottom up, team driven approach, they conduct extensive fundamental analysis, looking for high quality, well managed companies that are trading at a significant discount to their estimate of its true value. Typically, this will result in companies that have experienced some negative event that has caused it to fall out of favour with investors.
This results in a portfolio that looks dramatically different than the market indices. It remains significantly overweight in materials, financials, real estate and technology, and is underweight the more defensive sectors like healthcare and utilities.
This positioning helped in 2012 and 2013 which resulted in outsized gains, but has been a drag on performance so far this year. In the first four months, it has gained 2.26%, significantly lagging the S&P/TSX Composite and much of its peer group.
A drawback to the investment process and concentrated portfolio is the fund can go through periods of extreme volatility. This happened in 2008 and 2009 when it reached levels of volatility that were out of character with the longer term norms. Looking at recent numbers, it appears that the fund has started to settle down to volatility levels that are more in line with historic averages.
Part of the decrease in volatility may be attributable to the fund’s 20% cash balance, which hasn’t been this high since 2006/07. They believe that valuations are very high and have been having difficulty finding quality names trading at a deep discount to their estimate of its true worth. If they are right, I would expect it to experience a larger than average decline
I like this fund, the investment process and the management team running it. However, I don’t believe that this is suitable as a core holding for all investors given the potential for higher than normal volatility. This fund should only be considered by those with an above average risk tolerance and a long term time horizon.