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Markets Mixed in July
Geopolitical tensions and profit taking combine for a mixed month.
If July only had thirty days, it would have been a pretty decent month in the global equity markets. Unfortunately, there are 31 days in July, and the last day was not kind to investors. A wave of selling took hold, driving markets lower, and taking a largely positive month across the board, and turning it into a mixed bag.
The S&P/TSX Composite gained 1.4% on the month, despite a 1.25% decline on the last day of the month. It was a similar story with the S&P 500, which was down 1.4% in U.S. dollar terms, after dropping by 2% on July 31.
Europe struggled, losing nearly 4% as worries over the stability of the banking system in Portugal after a major bank bailout had investors running for the exits. Tensions between Russia and the Ukraine were again on the front page after a Malaysian passenger jet was shot down early in the month. This left investors unnerved.
The uncertainty seemed to be a catalyst for the bond market, with Canadian bonds offering up decent gains for the month. It was long bonds that were the biggest winners, with the DEX Long Term Bond Index gaining 2.6%. Government bonds outpaced corporate bonds, and investors continued to sell their high yield names.
I continue to favour equities over fixed income. Within fixed income, I am making one change. I am moving my exposure to high yield bonds from neutral to underweight. Valuations remain high and selling momentum appears to be picking up. I believe some exposure to high yield is beneficial, but would strongly encourage you to take some money off the table. I expect that as valuations normalize, I will likely move towards a neutral or even overweight position again, assuming the fundamentals remain strong.
I believe the conditions for a major correction are evident. Valuations are high, economic growth is strong, but not spectacular, and the geopolitical situation remains uncertain in both Russia and the Mid-East. Should we see conditions erode further, a selloff is likely. Still, it would be ill-advised to try to time any such correction, as the damage of being wrong will outweigh the shorter term pain of remaining fully invested.
Please send your comments to feedback@paterson-associates.ca.
Funds You Asked For
This month, I take a look at a number of the funds on my Recommended List of Funds
Chou Associates Fund (CHO 100) – I’m starting to get a bit concerned about this concentrated value fund managed by Francis Chou. After stellar years in 2012 and 2013 performance appears to be slowing. It struggled in the second quarter largely the result of its holdings in three stocks; Resolute Forest Products, Sears Holdings, and MBIA Inc. Combined, these three names make up 24% of the fund. This highlights the dangers of a concentrated portfolio in that there is nowhere to hide if the markets want to punish a few of your holdings. Short term, there may be some more pain for the fund, however, over the longer term Mr. Chou has proven to be one of the strongest value investors in the country. If you have a long term time horizon you’ll likely do very well with this fund. If you don’t, you may want to take this time to find something a little more diversified.
AGF Monthly High Income (AGF 766) – This was the strongest performing balanced fund on my recommended list in the second quarter due to its overweight position in equities. The managers are becoming increasingly concerned about the health of the equity markets, causing them to pare back their exposure over the quarter. The equity weight was cut from 63% to 58%, while the fixed income increased from 28% to 34%. While it is still one of the more aggressively positioned balanced funds, these moves are expected to help to protect capital if we see a meaningful pullback in the equity markets.
Fidelity Canadian Large Cap Fund (FID 231) – For the longest time this has been one of the strongest Canadian focused equity funds around. So far this year it has lagged considerably, gaining 6.5%, which is about half what the S&P/TSX Composite Index earned. The reason is the fund’s lack of exposure to materials, a significant under-weight in energy, and no bank holdings. Unfortunately for investors, these were the best performing sectors in the quarter. Despite a lackluster six months, I’m not ready to pull the fund from the list. The manager continues to stick with his disciplined value focused process. This will result in periods where return is much different than the broader markets, and I believe that this has been one of those periods. I will continue to monitor the fund for any erosion in the risk reward characteristics.
Franklin U.S. Rising Dividends Fund (TML 201) – What I like most about this fund is its ability to protect capital in down markets. While most other U.S. equity funds tend to fall more than the S&P 500, this gem has only fallen between 60% and 70% of the broader market. That’s because of its focus on companies that have a history of consistent and substantial dividend increases over time. Since they offer a relatively high dividend yield, they tend to hold up better when markets fall. Even in 2008 when the S&P was off by nearly 30%, this fund was only down 11%. A drawback to this strategy is these are companies that will tend to lag when markets are rising. This is a great core holding for investors who are more risk averse, but still want or need exposure to U.S. equities.
Fidelity Small Cap America (FID 261) – Manager Steve MacMillan has been at the helm of this fund for just over three years and the results have been great. For the three years ending June 30, it has gained an annualized 24.3%, handily outpacing the 18.5% return of the Russell 2000. While this is impressive, he has also done a stellar job managing the volatility, keeping it well below the category average. When it comes to protecting capital in falling markets this fund leads the category with a down capture ratio of 34% for the past three years. The portfolio is much different than its benchmark and is significantly overweight in consumer names and industrials. It holds no materials and is underweight financials and energy. While it outpaced the Russell 2000, it failed to keep pace with its peer group during the quarter. I am monitoring the fund closely.
CI Signature High Income (CIG 686) – When I think of best in class balanced funds this one is usually at the top of my list. Managed by the Signature team at CI, it has consistently been one of the strongest performers in the category, yet at the same time has tended to be one of the least volatile. For the three years ending June 30, it gained an annualized 9.3%, handily outpacing its benchmark and peer group. The portfolio is a mix of high yielding equities and high yield bonds. Historically, it could invest up to 49% outside of Canada, but that was recently changed to 70%, allowing the managers even greater flexibility. This may come in handy once we see interest rates start to trend higher, giving the managers the ability to find more opportunities abroad. It should also help to reduce the interest rate sensitivity of the equity portfolio which is now highly concentrated in REITs and energy income plays. Looking at the management team, the investment process and their track record at both growing and protecting capital, it’s not hard to see why this is one of the best balanced funds available.
CI Signature Canadian Balanced Fund (CIG 685) – It’s not that this is a bad fund. Far from it. It has a great management team at the helm. It is also managed using a disciplined, repeatable process that incorporates a top down analysis to deter-mine the overall asset mix, with fundamentally driven, bottom up security selection.
At the end of June, more than 70% was invested equities, making it one of the more aggressively positioned balanced funds. It is this positioning that is the cause of the funds above average volatility.
Performance has been more than respectable, and it has been able to outpace other funds when markets are rallying. However, it has done a relatively poor job in protecting capital when markets fall, which is a big concern for me as we move forward.
Another area of concern for this fund relates to its cost, which at 2.44% is above the category average. While that may not be an issue in a rising market, it will be a drag on performance if we enter a falling or even flat return environment.
If you hold this fund, I certainly wouldn’t suggest you run for the exits, unless you are uncomfortable with the potential for continued high volatility. I still think that over the long term investors will earn average to above average returns, however, I believe that there are better options available.
Manulife Strategic Income Fund (MMF 559) – I really hate that this is categorized as a high yield bond fund, because it really understates the quality of the fund, its management, and its risk reward profile. In reality, it is more of an opportunistic go anywhere bond fund that invests across multiple fixed income sectors such as global government bonds, investment grade bonds, high yield, and emerging market debt.
In addition, the managers will tactically manage the currency exposure and try to generate additional return from that. Their investment process starts with at top down macro analysis that is used to set the sector mix. Once set, they then use a more fundamental approach to security selection.
The average credit quality of the fund must be at least investment grade, however, the high yield exposure will typically be in the 30% to 50% range. At the end of June, 37% was invested in non-investment grade debt.
Performance has been decent, gaining an annualized 5.3% for the past three years, handily outpacing the average global bond fund. Volatility, even with the currency trading has been well below average. What is particularly attractive is that it has shown very low levels of correlation to the traditional asset classes, including Canadian fixed income. This makes it a great way to help reduce the overall volatility of your portfolio by including it as a portion of your fixed income allocation. It is a touch pricey with its 2.07% MER. It also has the potential to be more volatile than a more traditional bond fund. Still, it is my view that over the long-term, the benefits outweigh the risks.
Sentry Canadian Income Fund (NCE 717) – It’s pretty tough not to be impressed by a fund that has outpaced the broader equity markets by delivering an annualized five year return of more than 17%, and doing so with two thirds the volatility of the index.
Managers Michael Simpson and Aubrey Hearn look for well-managed, high yielding equity names that have the ability to deliver strong and growing cash flows. The portfolio will typically hold around 60 names, and tends to look much different than its benchmark. It can invest up to 49% of the fund in the U.S., and it can also hold preferreds, corporate bonds and low risk options to help boost the internal yield.
At the end of June, it held about 6% in cash, 5% in bond, and a modest 0.3% in prefs. Unlike a lot of yield focused funds, it has a minimal exposure to financials and does not hold any banks. Even its REIT exposure is rather modest coming in at just over 7%.
There is little doubt the longer term numbers are impressive, however it has struggled to keep pace so far this year. Some of that is likely due to the U.S. holdings, which currently sit at 34%. Even still, it is pretty tough to find a fund that has done as good a job at both growing and protecting investors’ capital. While I doubt that the historic level of return can be repeated, it is expected to continue to outperform on a risk adjusted basis over the long-term.
The World Money Show
I’m excited to announce that once again, I will be presenting at the World Money Show in Toronto. This year’s show runs from October 16 to October 18. If you have never been, the World Money Show is a three day event that brings together some of the country’s best known investment experts to discuss how you can make better investing and trading decisions. The best part is that registration to the event is free.
My presentation will be on Friday, October 17 at 5:30 PM. If you are going to be in Toronto that day, I would invite you to come by and say hello. More details on my presentation topic will be available in the next few weeks.
If there is a fund that you would like reviewed, please email it to me at feedback@paterson-associates.ca.
August’s Top Funds
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BMO Monthly High Income II
| Fund Company | BMO 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 | Kevin Hall since October 2002Michelle Robitaille since June 2003 |
| MER | 2.37% |
| Code | GGF 619 – Front End UnitsGGF 260 – DSC Units |
| Minimum Investment | $500 |
Analysis: This, along with the Sentry Canadian Income Fund have been my picks for investors looking for a decent income stream, combined with the potential for capital growth. It pays investors a monthly distribution of $0.06 per unit, which works out to an annualized yield of approximately 4.5%.
Managed by the team of Kevin Hall and Michelle Robitaille, it invests mainly in high yielding common equities and real estate investment trusts (REITs).
The managers look for potential investments in the higher yielding names of the S&P/TSX Composite Index. While yield plays a key role, they are careful not to sacrifice investment quality in order to chase yield. The portfolio holds approximately 40 names, with the top ten making up about a third of the fund.
This used to be an income trust fund. In the olden days, it tended to be more focused on mid-cap names. However, since the demise of the income trusts, it has shifted more into larger cap companies. At the end of July, the top three holdings were TD, Scotiabank, and Royal Bank.
Not surprisingly, it has significant exposure to higher yielding energy names, financials and REITs. Combined, these three sectors make up nearly three quarters of the fund. This concentration highlights one potential drawback to this fund – its high level of interest rate sensitivity. Compared to a more broadly diversified Canadian equity fund, this will be expected to lag when we start to see upward pressure on yields.
Performance has been strong, gaining 16.4% for the five years ending July 31, handily outpacing its peers. More impressive, it has done a solid job in managing both volatility and downside risk. For the past five years, it has only participated in about 25% of the downside movements of the broader equity markets.
Looking ahead, I expect it to continue to deliver above average returns with below average volatility. I also expect it to continue to generate decent cash flow for investors, without significant capital erosion.
TD Monthly Income Fund
| Fund Company | TD Asset Management |
| Fund Type | Canadian Equity Balanced |
| Rating | C |
| Style | Large Cap Blend |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | Doug Warwick since June 1998Michael Lough since July 2005 |
| MER | 1.47% |
| Code | TDB 622 – No Load UnitsTDB 821 – Front End Units |
| Minimum Investment | $500 |
Analysis: There are definitely more than a few things to like about this equity focused balanced fund.
The first thing that jumps out at me is the cost. It has one of the lowest MERs for a balanced fund, coming in at 1.47%. Even at this level, there is still a 0.50% trailer that is paid to advisors. It also pays a monthly distribution of $0.0349 per unit, which works out to an annualized yield of just under 2.25%.
Where this fund really holds its own is with the risk reward profile. Yes, it was hit hard in 2008 dropping more than 23%. Much of that can be attributed to the fixed income sleeve, which at the time was invested mainly in high yield bonds. Since then, the fixed income sleeve has become more like the TD Canadian Core Plus Bond Fund, which is one of my top bond picks. Should we see another 2008, it should hold up much better than it did last time around.
In the past three years, it has only experienced about a quarter of the drops experienced by its benchmark. On the equity side, Doug Warwick and his team use a fundamentally driven, bottom up approach that looks to find well managed companies with strong financials, solid fundamentals, and the ability to pay and grow their dividends.
The result is a fairly concentrated portfolio that is overweight in financials and energy. The top five largest holdings are the big five banks, followed by Canadian Oil Sands, Enbridge and Suncor.
The overall asset mix is set by the manager, with input from TD’s asset allocation committee. Historically, it has been relatively stable, as they are more focused on security selection, rather than making tactical bets.
If I had to list a concern with the fund it is that there is a fairly high level of interest rate sensitivity in it. If we see a big spike in rates, this fund is likely to lag. However, with rates expected to remain relatively low in the near term, I don’t expect it to be a problem for now.
Manulife World Investment Class
| Fund Company | Manulife Mutual Funds |
| Fund Type | International Equity |
| Rating | B |
| Style | Large Cap Blend |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | David Ragan since November 2007 |
Jim Hall since March 2010MER2.61%CodeMMF 8521 – Front End Units
MMF 8421 – DSC UnitsMinimum Investment$500
Analysis: The Mawer International Equity Fund has been one of the best international equity funds for as long as I’ve been in the investment business, and this fund is virtually identical to it. The main difference is it has a higher level of cost, which includes embedded dealer compensation.
Like the Mawer offering, 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.
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. Analysts put their assumptions on each company through a scenario analysis, testing a wide range of outcomes to get a stronger understanding of what the company’s true worth will be under a range of situations.
The 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.
Performance has been stellar, consistently outpacing most of its peers at a level of volatility that is below average. For the past five years, the fund has gained an annualized 11.6%, slightly lagging the MSCI EAFE Index, which gained 11.9%. Except for 2013, it has posted above average returns in every year since its launch in 2006.
It offers decent downside protection, and will outperform the index more often than not. It is managed by a great team, using a rock solid process.
The biggest drawback to it is its cost, with an MER of 2.71%, it is substantially higher than the 1.49% MER of the Mawer International Equity. If you are using a fee based account, I would use the Mawer offering, otherwise, this is a great substitute. Even with the higher cost, I believe this will continue to be one of the best international equity funds available to Canadian investors.
Brandes Global Small Cap Fund
| Fund Company | Bridgehouse Asset Managers |
| Fund Type | Global Small / Mid Cap Equity |
| Rating | B |
| Style | Small Cap Value |
| Risk Level | High |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Brandes Management Team |
| MER | 2.71% |
| Code | BIP 152 – Front End Units |
BIP 252 – DSC UnitsMinimum Investment$500
Analysis: This deep value small cap offering from Brandes continues to be one of my favourites in the space. While its performance has been stellar of late, it is really more the process and risk controls that attract me to the fund.
It is managed by Brandes’ Investment Committee using a very collaborative approach. 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. Each of the team members will do their own review of potential investment candidates, with discussions on each name taking place. It is through these discussions that an investment will be bought or sold within the fund. They also serve to help the team set position sizes, with those names where there is a higher degree of confidence earning a higher weight in the fund.
The portfolio is fairly diversified, holding just under 80 names, with the top ten making up about a quarter of the fund. Sector weights and country allocations are the result of the bottom up stock selection process.
In following this disciplined process, the fund’s performance is often quite different than its benchmark. It can certainly be a test of one’s patience when the fund is lagging its peers and benchmark. However over the long term, it has shown it can be one of the best performers in the category. For the five years ending July 31, it has gained 18.7%, handily outpacing the index and the peer group.
Along with the potential of periods of outperformance, it can exhibit higher volatility than other similar funds. For example, in 2007 and 2008 it was one of the worst performing global small cap funds, only to bounce back sharply in the years following. Despite this, it has shown relatively strong downside protection on average.
Another concern I have is with the cost of the fund. Its MER is higher than average, coming in at 2.71%
Considering the above, I believe this is a great global small cap fund for those who can tolerate the higher level of risk. The potential volatility make this a non-starter for those investors who cannot.