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Investors Rewarded with Strong Gains
With recent run-ups, equities look ready for a pause.
The first half of the year was profitable, with most investors seeing modest gains. Canadian equities led the way with the S&P/TSX Composite Index gaining nearly 13%, handily outpacing most other developed markets, thanks to an impressive rebound in the energy and materials sectors.
The Bank of Canada is in a rather tricky position. They would like to start moving rates higher to help stem the growth in personal debt, and cool the red-hot housing market. Unfortunately the economy doesn’t appear to be strong enough to absorb the effect of higher rates. Further, any increase in rates will likely drive the dollar higher, creating further drag on our exports. I expect that they will have little choice but to keep rates on hold until the U.S. Federal Reserve starts moving higher, which is not expected to happen until early to mid-2015.
With the recent European Central Bank actions that pushed short-term interest rates into negative territory for the first time in history, it is expected to spur a liquidity driven equity rally, similar to what North America has experienced. I would suggest anyone considering this trade proceed with caution.
Despite lacklustre growth numbers, the U.S. Federal Reserve continues to wind down their quantitative easing program. In fact, growth has been so disappointing that the Fed has slashed their forecasted GDP growth rate for 2014 from 2.9% to between 2.1% and 2.3%.
Another worry I have with the equity markets is investor complacency. I have noticed that whenever volatility reaches low levels, it is quite often followed by a meaningful market correction. If I look at the recent volatility levels, they are now at levels that are at or below the levels we experienced in 2007 and 2008. I am in no way suggesting that we will see a drop as significant at what we did then, but rather I expect that we will be in for a selloff at some point in the next little while. If history is any guide, I would expect this to happen as we move into the fall.
Funds You Asked For
This month, I highlight the winners of the first half and those I think will do well for the rest of the year.
Middlefield Groppe Tactical Energy Class (MID 125) – Given the run-up we saw in energy names in the first half of the year, it’s not surprising that an energy fund was one of the best performing funds of the first half of the year. This fund is managed by Robert Lauzon of Middlefield, and Henry Groppe of Texas based oil and gas consulting firm Groppe, Long & Littell. The basic premise of the fund is that global oil production has peaked, thereby supporting strong oil prices over the next several years. They look for low cost operators with strong drilling prospects that have a proven management team in place. Recent performance has been strong, but it is significantly more volatile than its peers. If the second half is like the first, it has the potential to outperform. Still, I would prefer the Franklin Bissett Energy Fund (TML 3021) over this one, given its longer track record, strong management team, and lower volatility.
Sentry Bond Plus (NCE 742) – Launched in August 2012, this offering is managed by the highly respected James Dutkiewicz, who before joining Sentry was a key member of CI’s Signature Global Advisors team. The fund is focused on corporate bonds, and at the end of May held 70% in corporates, 13% in cash and the rest in government bonds. Credit quality is high, with 82% in investment grade bonds. The duration is lower than the DEX Bond Universe, meaning it should be less sensitive to movements in interest rates than the broader bond market. While it’s a little too early in my opinion to make a definitive call on this fund, it does appear to be a strong offering. It has a solid manager behind it, and costs, at 1.51%, while not cheap are reasonable. It appears to be fairly well positioned for the current environment, and should hold up well in the second half.
Dynamic Diversified Real Asset Fund (DYN 037) – With its focus on real assets such as infrastructure, real estate and precious metals, it is not surprising to see that this was the best performing balanced fund in the first half of the year. It is set up like a fund of funds and invests in a mix of Dynamic’s offerings. It is actively managed, and at the end of March had more than three quarters invested in equities. Until recently it has struggled, and has been one of the worst performing balanced funds over the past three years, underperforming the category average by an annualized 7.5% per year. So far this year it has experienced quite a turnaround, gaining more than 20%. Still, I don’t believe it is likely to continue. The outlook for inflation remains muted, and while there may be a short term rally, I expect that performance will soften. I would likely avoid this fund at the moment, given the outlook, and significantly higher levels of volatility.
Dynamic Aurion Canadian Equity Fund (DYN 1360) – This is a very actively managed Canadian focused equity fund, run by the team of Craig MacAdam, Robert Decker and Greg Taylor. The investment process is based on the belief that earnings drive long term gains, that markets are cyclical over the medium term, and that short term pricing anomalies exist. The team actively buy and sell companies in an effort to benefit from their core beliefs. Portfolio turnover is quite high, averaging more than 200% for the past five years. While recent performance has been stellar, the longer term numbers are less inspiring. It is significantly more volatile than the broader market, and tends to struggle during down markets. I am doubtful that it can consistently outperform, and if we do experience any sort of a market selloff, it is likely to be affected more than most other Canadian equity funds.
Franklin U.S. Core Equity Fund (TML 3102) – With an 11.2% gain, this concentrated U.S. offering handily outpaced the S&P 500 and the U.S. equity category average in the first half of the year. Managers Brent Loder and Chris Anderson look for financially strong companies with favourable growth potential and sustainable competitive advantages. Their process is a mix of both quantitative and qualitative analysis, with a focus on larger companies. The concentrated portfolio has a growth tilt to it, with tech, financials and healthcare making up the bulk of the fund. Historically it has tended to outperform in rising markets, but dramatically underperform when markets are falling or flat. While it may very well post strong numbers in the second half of the year, I would likely avoid it because of its poor downside protection, above average volatility, and higher than average cost.
Brandes Global Opportunities (BIP 114) – Launched in June 2012, this go anywhere global equity fund is managed identically to the way that other Brandes funds are. The focus is on companies that are trading at a significant discount to what Brandes believes it is really worth. Additionally, there must be the potential to close that valuation gap and realize price gains within a reasonable period. It has a true go anywhere mandate and can invest in any company of any size, in any industry sector, in any country around the world. Country and sector allocations are the by-product of their bottom up stock selection process. I am a believer in Brandes’ deep value process, but it can lead to periods of higher volatility and periods of underperformance. Fortunately for investors in this fund, performance has been strong since its launch, gaining an annualized 28%. There are two drawbacks to this fund. First is the track record, which at just over two years is a bit short on which to conduct a thorough analysis, and second, is its cost. It carries an MER of 2.78%, which is above average in the category.
Dynamic Advantage Bond (DYN 258) –The main reason I like this fund is its defensive positioning. While I am not expecting that rates will shoot substantially higher in the second half of the year, the reality is that there will be upward pressure on rates sooner than we’d like. And when that happens this is the traditional bond fund you will want to own. It has historically held up better than its peers when the bond markets are falling and remains defensively positioned, indicating that it should do so this time around as well. Yes, you will lag when bond markets are rising, but I like the peace of mind I get from this fund knowing that it has one of the best downside capture ratios of any bond fund in Canada.
PIMCO Monthly Income Fund (PMO 005) – Since its launch in January 2011, this global bond fund has consistently been one of the top performers, both on an absolute and risk adjusted basis. For the three years ending June 30, it has gained an annualized 13.5%, which is nearly three times the category average. It has outperformed the index nearly 70% of the time, and has been up when the broader bond market is falling. It is managed using a very active process that incorporates top down elements such as duration management, yield curve positioning and sector mix, with a fundamentally driven, bottom up security selection that looks to identify undervalued bonds. The portfolio holds all types of fixed income instruments, ranging from the plain vanilla government bonds, to the spicier high yield, and emerging market debt. It will also invest in derivatives. While the fund’s low volatility return stream makes it appear that it is a relatively safe fund, make no mistake about it, this is NOT a core bond fund. It is much riskier than it appears, but if used as a portion of a well-diversified portfolio, I believe it can play a role in helping to increase returns and reduce volatility.
CI Cambridge Canadian Equity Corporate Class (CIG 14120) – 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 very active and will increase dramatically in periods of rising volatility, as they use that volatility as a way to better position the portfolio. Performance has been strong, but more impressive is that volatility has been significantly lower than the S&P/TSX Composite Index. Historically, it has captured the overwhelming majority of the gains when markets are rising, but has experienced less than half of the drawdowns in falling markets. This highly active approach should result in a respectable performance in the second half of the year. I believe that this can be a great core holding for most investors in most market environments.
Mackenzie Ivy Canadian Fund (MFC 083) – Like all Ivy branded funds, the Canadian equity offering is well regarded for its ability to withstand market selloffs better than most. It used to be the biggest knock on this fund was that you would be left way behind when equity markets were rallying. That still holds to some extent, but it is much better than it used to be. If I look at its upside capture ratio, which measures how well a fund performs when markets are rising, it has been improving dramatically over the past few years. For the past three years, it has participated in roughly 70% of the gains of the S&P/TSX Composite, compared with just 40% of the gains over the past ten years. Equally as impressive is there has been no erosion in the downside protection offered by the fund. Given the potential for a selloff in the fall, this may be a good way for conservative investors to access the Canadian equity market in the second half of the year.
Mackenzie Ivy Foreign Equity Fund (MFC 081) – This is another one of my favourite global equity funds, particularly for periods of higher than normal volatility. When volatility returns, and mark my words, it will, this is the global equity fund you will want to be holding. In a down market, it holds up significantly better than other global equity offerings. For example, in 2008 when the average fund was down 30%, it was down only 6.7%, and in 2011, the average fund was down 6.7%, yet this fund was higher by 3.2%. The trade-off, of course, is that you will lag behind in a sharply rising market. But if you’re comfortable with not making as much on the upside to protect capital when things get rough, this is the fund to do that.
Mawer Balanced Fund (MAW 104) – In January, I had named this the one fund to own for 2014, and I’m adding it to the list of those funds I believe will be strong performers in the second half of the year. So far this year, it’s done well, gaining 6.5%. But where this fund really shines is over the long term with performance numbers that leave its peers in the dust. To achieve this, the fund invests in other funds that are offered by Mawer. Each of the underlying Mawer funds are top notch, except for maybe the U.S. equity fund, which has struggled to differentiate itself from the pack. Another potential drawback is that Mawer Canadian Bond Fund looks pretty similar to its index. While not necessarily a deal breaker, it only has about 40% in corporate bonds, which may cause some underperformance in a flat or rising yield environment, compared with a fund that has higher corporate bond exposure. Still, I think that this fund will continue to chug along nicely, rewarding investors with above average returns over the long term.
If there is a fund that you would like reviewed, please email it to me at feedback@paterson-associates.ca.
July’s Top Funds
Mawer International Equity Fund
| Fund Company | Mawer Investment Management |
| Fund Type | International Equity |
| Rating | B |
| Style | Large Cap Blend |
| Risk Level | Medium |
| Load Status | No Load |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | David Ragan since November 2007Jim Hall since March 2010 |
| MER | 1.49% |
| Code | TDB 645 – No Load Units |
| Minimum Investment | $5,000 |
Analysis: This has been one of the “go to” international equity funds for as long as I been in the investment business and then some.
It is managed using a “growth at a reasonable price” approach that looks for wealth creating companies that are trading at discounts to their estimate of intrinsic value. A typical company will also generate high returns on equity. Their research process is one of the strongest in the business, with analysts conducting thorough, in-depth analysis on the company’s business model, financial position, and quality of management. Another interesting exercise that analysts put a company through is scenario analysis. They test a wide range of their assumptions to get a stronger understanding of what the company’s true worth will be under a range of situations.
The result is a portfolio that is made up of between 50 and 60 names, with the top ten making up about a quarter of the fund. Sector and country weights are largely the result of their rigorous stock selection process. At the end of June, the portfolio had nearly 80% invested in Europe. This could result in a nice rally thanks to the European Central Bank’s recent stimulus actions. It is also heavily invested in industrials, which should benefit from an economic rebound.
Performance has been stellar, consistently outplacing most of its peers at a level of volatility that is below average. For the past five years, the fund has gained an annualized 12.5%, while the MSCI EAFE Index has gained 11.9%. Except for 2013, it has posted above average returns in every year since 2004. Volatility levels are slightly below the index, and lower than most of its peers. It offers decent downside protection, and will outperform the index more often than not.
With a great team, rock solid process, and fair pricing, it’s not hard to see why this has been and will continue to be one of the best international equity funds available to Canadian investors.
Sentry Canadian Income Fund
| Fund Company | Sentry Investments |
| Fund Type | Canadian Dividend & Income Equity |
| Rating | A |
| Style | Large Cap Blend |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | Michael Simpson since February 2002Aubrey Hearn since January 2012 |
| MER | 2.67% |
| Code | NCE 717 – Front End UnitsNCE 317 – DSC Units |
| Minimum Investment | $500 |
Analysis: Managed by the team of Michael Simpson and Aubrey Hearn, this fund invests in a mix of large and mid-cap income producing securities like common equity, fixed income and REITs. Historically, the focus had been in Canada, but given the funds growth in assets, currently sitting at just under $5 billion, they can now invest up to 49% in the U.S. At the end of June, 34% was invested in the U.S.
It is first and foremost an income fund. It pays a monthly distribution of $0.0775, which at current prices works out to an annualized yield of 4.75%. In 2013, more than two-thirds of the distribution was treated as capital gains for tax purposes, with the balance being return of capital.
Given the emphasis on income, they tend to focus on companies that are generating positive and growing levels of free cash flow. They also like to see a management team that have their interests aligned with the shareholders. In addition to high yielding equities, and REITs they may also have limited exposure to preferred shares, corporate bonds, or option strategies.
The process is very much bottom up, with sector mix and country exposure being driven by their stock selection process. As a result, the portfolio looks nothing like the index or its peers.
Performance, particularly the long-term numbers have been very strong. For the five years ending June 30, the fund has gained 17.1%, handily outpacing the broader equity market and most of its competition. More recently however, it has lagged behind. The main reason for that would be it is underweight in materials, financials and energy, whichhavedriven gains.
While this positioning may have hurt shorter term performance, it is also responsible for the stellar downside protection it offers. Historically, it has participated in between 70% and 80% of the markets upside movement, but has only experienced less than 15% of the downside in the past five years.
The biggest drawback to this fund is its cost.
Still, I believe this is one of the best dividend and income fund options available at the moment.
Dynamic Power American Growth Fund
| Fund Company | Dynamic Funds |
| Fund Type | U.S. Equity |
| Rating | B |
| Style | Large Cap Growth |
| Risk Level | High |
| Load Status | Optional |
| RRSP/RRIF Suitability | Fair |
| TFSA Suitability | Fair |
| Manager | Noah Blackstein since July 1998 |
| MER | 2.46% |
| Code | DYN 004 – Front End UnitsDYN 704 – DSC Units |
| Minimum Investment | $500 |
Analysis: Like most of the other funds under the Power banner, this is not for the faint of heart. Manager Noah Blackstein uses a very concentrated, growth approach in managing this fund. Because of this, it tends to be considerably more volatile than other U.S. equity funds, with a standard deviation that is nearly two times the S&P 500 Index.
His investment ideas come from screening the U.S. market looking for companies that are showing strong earnings momentum and a history of upside earnings surprises. Once identified, he does a detailed fundamental review focusing on cash flows, management, and competitive environment.
The portfolio is very concentrated, typically holding 20 to 30 names, with the top ten making up about half the fund. It is also quite concentrated from a sector perspective, with the overwhelming majority of the fund invested in three sectors; technology, healthcare and consumer cyclical. This concentration can be a double-edged sword, amplifying gains in up markets, but offering little refuge when stocks fall.
It also has the potential to be a rather pricey fund to own. In addition to the typical 2% management fee, operating expenses and HST, it also carries a performance fee for outperforming its benchmark. This can add significantly to the cost of the fund, pushing the MER up considerably.
It has struggled so far this year, after being on quite the tear last year. Looking at the underlying fundamentals of the portfolio, there is even more room to fall. However, when it does bounce back, it will likely take off sharply. Historically, it tends to significantly outperform in rising markets, and underperform dramatically when they fall.
I like this fund, but not as a core holding. It should only be used as a small portion of your portfolio as a way to give it some pep. If you want to invest in this, you have to be able to stomach the jaw dropping declines like we saw in 2008. If you’re looking to add some of this to your portfolio, I would likely hold off for a bit, waiting for a further drop before buying in.
Renaissance Global Markets Fund
| Fund Company | CIBC Asset Management |
| Fund Type | Global Equity |
| Rating | D |
| Style | Blend |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | David Winters since October 2006 |
| MER | 2.62% |
| Code | ATL 1029 – Front End UnitsATL 1873 – DSC Units |
| Minimum Investment | $500 |
Analysis: Despite dramatically underperforming the MSCI World Index in 2012 and 2013, I still believe this go anywhere global equity fund can be a great core holding for most investors.
Manager David Winters uses a value tilted approach, looking for strong businesses which offer an identified competitive advantage and strong management teams that are trading at a discount to its intrinsic value. The process is very much bottom up and he generally takes a long term, patient view when evaluating a stock. This is reflected in the fund’s low level of portfolio turnover, which is approximately 30% per year.
The portfolio tends to be fairly concentrated, holding less than 40 names with the top ten making up more than 60% the fund. It is benchmark agnostic, allowing it the ability to take significant sector bets when the risk reward tradeoff warrants it. Cash, which stood at 8% at the end of April is a byproduct of the stock selection process.
So too are the fund’s sector weight and country allocation. About a third is invested in the U.S, and 50% is in non-North American equities. Nearly 60% is invested in consumer focused names.
It is the concentrated, non-benchmark like portfolio that is the main reason the fund has lagged of late. Over the long term however, the fund has shown that it can deliver above average returns with a level of risk that is well below the category average. It has also done a pretty decent job of protecting investors’ capital, participating in only half the drop of the broader market over the past five years.
The cost of the fund has been dropping, withthe most recent MER comingin at 2.62%. This is still above average, but is well below where it was a couple of years ago.
If you are an investor with an ethical bent, you may want to avoid this fund. It has a meaningful weight in both tobacco and gaming companies, because of their ability to generate cash flow.
Overall, this is one of the better global funds available, and one that remains on my recommended list.