Top Funds Report – May 2015

---

 

Download a PDF Copy of this Report

---

Investment Markets Mixed in May

With bounce in energy and improving economy, Canadian yields moved higher.

April was a mixed month, with Canadian bonds lower, and equities generally higher. The bond market faced pressure as yields moved higher on two factors. The first being the expectation that the U.S. Federal Reserve may begin to raise rates soon. The other reason for a move higher in rates was the bounce in energy and the realization that the Bank of Canada is not likely to move rates lower anytime soon.

With rates creeping up, we saw the Canadian dollar rebound against the U.S. greenback. The unfortunate downside to this was that foreign equity funds that do not hedge their currency exposure faced losses in Canadian dollar terms. For example, the MSCI World Index gained 2.4% in U.S. dollar terms, but was down 2.2% in Canadian dollar terms.

As I look ahead, the investing environment remains a challenging one. The outlook for fixed income remains muted, as the likelihood of a cut by the Bank of Canada in the near term looks pretty remote. While I don’t expect rates to move sharply higher anytime soon, I don’t see any catalyst that will drive bonds higher. I continue to favour high quality corporate bonds over governments. As the economy picks up momentum, I’ll be looking to reduce duration to help protect downside.

Within equities, I’m expecting more headwinds for Canadian equities. With oil likely to remain under pressure for the near term, and the newly elected majority NDP government in Alberta looking to review the current oil royalty system, the outlook for the energy sector remains cloudy. Until the energy sector clears up, much of the Canadian market is likely to struggle.

Europe, thanks to the ECB’s quantitative easing measures, is in what appears to be a decent rally. For those with above average risk tolerances, this may be an interesting trade for the next little while. Those not comfortable taking that risk on their own may want to gain exposure to the region through a high quality global or international equity fund.

In the U.S., equities remain fully valued. While momentum may push prices higher, I’m expecting a bit of a pause as investors digest the latest round of earnings and economic numbers.

My current investment outlook is:

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

---

 

Funds You Asked For

This month, I highlight a number of funds on my Recommended List of Funds…

PH&N Short Term Bond and Mortgage Fund (RBF 6250 –Front End Units, RBF 4250 – Low Load Units) – This has long been one of my favourite short term funds available. It is run by a strong management team, and has delivered decent risk adjusted returns over the long term. At the end of March, its duration was 2.7 years, and it offered a 1.5% yield to maturity. However, with an MER of 1.16% for the advisor sold units, the cost was making the fund uncompetitive, particularly if there are no further rate cuts coming from the Bank of Canada. If you can buy the Series D or Series F units, this is still a great pick, but if you are using the advisor class units, I believe the PowerShares 1-5 Year Laddered Corporate Bond Fund is a better choice, offering a higher yield and a lower cost.

TD Short Term Bond Fund (TDB 814 – Front End Units, TDB 870 – DSC Units) – It’s not that there is necessarily anything wrong with this fund, it is just that in the current rate environment, I believe it will be tough for it to generate any level of meaningful return with its 1.34% MER.

Instead, I would suggest the PowerShares 1-5 Year Laddered Bond Fund or the PH&N Short Term Bond & Mortgage Fund, but only if you can access the low cost D or F series. If not, you’re better off with the PowerShares offering.

AGF Monthly High Income Fund (AGF 766 – Front End Units, AGF 689 – DSC Units) – I have had some concerns about this fund for the past few quarters, given its spotty performance.

I believe it has struggled against other balanced funds for a few reasons – first, it has been one of the more aggressively positioned balanced funds and has been underweight fixed income. That has hurt relative performance as Canadian yields dropped in Q1. Second, its equity exposure is concentrated in energy and financials, which have struggled of late. Third, they have about 75% of their USD exposure hedged, which has dragged the CAD performance of their foreign holdings while the dollar fell against the USD.

The bond sleeve is focused on investment grade bonds. Duration is slightly less than the FTSE/TMX Bond Universe, but the yield is significantly higher at 4.7%. As such, it should hold up better than the broader market, but will still be hit if we see upward pressure on yields.

The managers have recently pulled the equity weight back a bit, but it’s still sitting at around 62%, with a third in bonds and the rest in cash. A little less than half the equity exposure is in foreign names. They have also repositioned their energy names into higher quality companies that are expected to withstand the lower oil price.

Still, considering the above, I believe there are more attractive balanced funds available.

Mackenzie Cundill Canadian Balanced Fund (MFC 740 – Front End Units, MFC 840 – DSC Units) – This is another fund that I’ve been concerned about for a while. The main reason is it’s higher than average volatility. While, I do believe that investors will see strong returns over the long term, the level of volatility has remained very high for some time. Considering the management team and the process used, I expect it to deliver returns that are in line with its peer group in up markets. However, it is likely to be hit harder in down markets. Given this, I believe there are a number of other funds that offer a more compelling risk reward profile.

IA Clarington Canadian Conservative Equity Fund (CCM 1300 – Front End Units, CCM 1400 – DSC Units) – Low volatility and excellent downside protection have been why this has been one of my favourite Canadian equity funds for the past few years. However, a recent uptick volatility has me a bit concerned. According to the managers, the reason for the higher volatility has been the fund’s significant weighting in the energy sector. Because of this, it has been un-characteristically dragged lower in lockstep with the market during the recent selloff. They believe this was an anomaly and that we should see a return to its previous risk reward profile. They also assure me that there have been no changes to their disciplined stock selection process and they continue to focus on high quality, dividend paying Canadian companies. I am inclined to believe them, particularly in light of April’s strong showing. Still I will monitor the fund closely.

Fidelity Small Cap America Fund (FID 261 – Front End Units, FID 561 – DSC Units) – Manager Steve MacMillan has done a stellar job with this small cap offering since taking it over in 2011. In the past three years, it has gained more than 33%, outpacing both the index and peer group by a wide margin. This outperformance continued in the first quarter, gaining an impressive 18.9%, thanks to a strong showing from its consumer and technology names, combined with a falling Canadian dollar.

The investment process is a fundamental, bottom up approach that looks for companies with strong management, sustainable competitive ad-vantages, a high degree of earnings visibility and the ability to grow earnings in the future. At the moment, he is finding these opportunities in the technology, consumer, and healthcare sectors.

I know I have said this a few times in the past, but this level of past performance is not likely to be sustainable going forward. If you have held this fund for a while, it may be a good idea to rebalance and take some money off the table. Still, when I look at the valuation of the underlying portfolio, it looks well positioned to outpace the index and its peer group going forward. It remains my top pick in the U.S. small cap space.

Trimark U.S. Small Companies Class (AIM 5523 – Front End Units, AIM 5521 – DSC Units) – Not surprisingly, the fund lagged both the benchmark and its peer group in the first quarter of the year. This was because of the drag caused by the nearly 30% currently in cash. This high cash balance is the byproduct of the managers’ struggle to find opportunities that are trading at valuations they believe make them strong investment candidates. In a recent commentary, they expressed continued concern over the valuations in the U.S. small cap space, where the Russell 2000 is trading at 25 times earnings. They say their holdings are trading at a nearly 40% discount to the benchmark, making this an attractively valued portfolio.

It was recently announced that co-lead manager Rob Mikalachki was recently named the Chief Investment Officer of Invesco Canada. Invesco has assured me that this new role will not detract from his ability to continue to manage the fund as he has in the past. He is supported by Virginia Au and Jason Whiting, two very capable managers, which will help as he takes on these additional responsibilities. Another concern I have is Virginia Au has taken a leave for a few months. While I don’t expect there to be a major disruption in the fund, I will continue to watch it closely.

BMO Asian Growth & Income Fund (GGF 620 – Front End Units, GGF 120 – DSC Units) – The outlook for Asia remains very challenging – with the backdrop of slowing economic growth across the region, combined with a rising U.S. dollar. Recently, many governments, from India to China have taken steps to spur growth, and speed up market reforms. Still, it will be a challenging place to invest in the near term.

In my view, this fund remains the best way to play the region. By investing in a portfolio of high quality, dividend paying stocks, as well as preferred shares and convertible bonds, it provides an excellent way to gain exposure to Asia, with less overall and downside risk.

Steadyhand Income Fund (SIF 120 – No Load Units) – Managed by Connor, Clark & Lunn, this is the closest thing Steadyhand has to a bond fund. It has a target asset mix of 75% fixed income and 25% high yielding equities, which makes it a good bond fund substitute for those with a risk tolerance that is average or higher.

Within the fixed income portion, it is heavily tilted towards corporate bonds, which make up about half the fund. The balance is invested in government bonds, with an emphasis on provincial bonds because of their higher yield relative to Canada’s. Credit quality is overwhelmingly investment grade, with only about 4.4% invested in high yield bonds.

The equity sleeve has an emphasis on yield, investing in dividend paying common stocks and REITs and other real estate securities. Given this focus, it’s not surprising to see the portfolio overweight in financials, real estate and utilities.

Performance has been excellent, gaining 7.8% for the five years ending April 30, handily outpacing both its benchmark and peer group. Shorter term numbers are equally impressive, gaining 8.8% in the past 12 months. Volatility has been slightly higher than its peers, both to the upside and downside.

As we move forward, I don’t expect that the historic performance can be repeated on an ongoing basis. This is because of the high level of interest rate sensitivity in the portfolio. While the bonds are extremely interest rate sensitive, so too are the majority of the equity holdings. In a falling or flat rate environment, these holdings have been able to post strong gains. However, once we start to see meaningful upward pressure on rates, I expect the fund to begin to face headwinds.

Even with these headwinds, I believe this fund is well positioned to outperform most traditional bond funds, with only modestly higher levels of volatility. I expect it to also hold up well against other conservative balanced funds. It has a great management team behind it, following a repeatable disciplined process, and it’s offered for a reasonable 1.04% MER.

Chou Associates Fund (CHO 100 – No Load Units) – Managed by veteran Francis Chou, this concentrated portfolio holds just 17 stocks, and nearly 30% in cash. The high cash weight is the byproduct of Mr. Chou’s disciplined, deep value approach. Philosophically, he would rather hold cash than pay what he believes to be too much for a stock.

The portfolio looks much different than its index, with a very cyclical bent to it. Approximately a third is invested in financials, 15% in consumer cyclicals, and 11% in materials, with the rest in telecom and healthcare names.

While shorter term performance has been all over the map, the longer term numbers are very impressive. For the past 15 years, it has gained nearly 10% per year, handily outpacing its global equity peers.

Recent performance has been extremely disappointing, largely because the high cash balance has dragged in a rising market. Given the process used by Mr. Chou, this is not an uncommon occurrence, highlighting why I believe it to be more of a specialty fund rather than a core holding. Still, if you can stomach the disconnect between the performance of this fund and the index, it can be a nice addition to an otherwise well diversified portfolio.

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

---

 

May’s Top Funds

–

PowerShares 1–5 Year Laddered Corporate Bond

Analysis: In a recent speech, Bank of Canada Governor Stephen Poloz highlighted that the Canadian economy is once again on the road to recovery. This essentially signals the likelihood of another cut to the Bank’s key overnight lending rate is now remote. With rates on hold for now, and eventually moving higher, shorter duration bonds will be a great way to help protect your portfolio.

The main drawback to most short term bond funds is the cost, with the average MER in the 1.3% range. With a 1.3% haircut right off the top, it is very difficult for most funds to post much in the way of returns for investors. With an MER of 0.99%, well below most of its peers, this PowerShares offering is a great fund to consider.

The fund invests in a portfolio of short term bonds that is designed to replicate the FTSE TMX Canada Investment Grade 1-5 Year Laddered Corporate Bond Index. The index is made up only of corporate bonds rated BBB or higher.

The index is built using a laddered approach, with its portfolio divided into five equally weighted segments with staggered maturity levels from one year to five years. Five bonds are chosen for each maturity bucket, based on factors like industry sector and liquidity. Controls are in pace to prevent undue levels of sector concentration.

In addition to the lower cost than its competition, the portfolio also offers a higher yield to than either the TD Short Term Bond or the PH&N Short Term Bond and Mortgage Fund. At the end of April, its yield to maturity was 1.74%, compared with 1.1% for TD and 1.5% for PH&N. Another feature is it pays a variable distribution, which has generated an annualized yield of more than 3% for investors.

Barring a major dislocation in the credit markets, I would expect this fund to hold up better than most other short term bond funds, making this a fund to consider for those looking for a high quality, low cost way to reduce the duration of your fixed income holdings.

---

 

Dynamic Advantage Bond Fund

Analysis: In an environment where interest rates are moving higher, I believe this is a bond fund you will want to own.

The management team places an extraordinary focus on preserving capital, and actively manage the portfolio’s duration, yield curve positioning, sector exposure and credit quality to help do so.

At the end of March, it held 39% in investment grade corporate bonds, 37% in government bonds, 11% in real return bonds and floating rate notes, 8% in high yield and the rest in cash. This resulted in a yield to maturity of more than 4% and a duration of 3 years, which is less than half the FTSE/TMX Bond Universe Index.

Management believes that this conservative positioning is warranted, given the uncertainty and potential for higher than normal rate volatility. This is further reinforced by recent numbers that show that the economy is on the mend. It is no longer a sure thing that the next move from the Bank of Canada will be a cut in rates.

In a recent commentary, management stated they intend to keep their duration lower until there is a sustained move in ten year bond yields, at which point they will look at increasing duration. They are also using interest rate swaps to better manage risk.

This strategy is likely to outperform when rates are volatile or moving higher. However, it is also expected to result in underperformance in a flat or falling rate environment, compared with the PH&N Total Return Bond and the TD Canadian Core Plus Bond Fund. At the end of March, both of these funds had a duration that more than double this fund.

Given that rates in Canada are extremely unlikely to rise significantly in the near term, I am favouring the longer duration funds. However, as we start to see the economy gain further momentum, the possibility of a rate increase will become more likely. As that happens, The Dynamic Advantage Bond Fund will once again become my top bond fund pick. If you hold it, I would likely hang tight as it is still a quality fund, just likely to underperform in a flat or falling rate environment.

---

 

Sentry Conservative Balanced Income Fund

Analysis: This conservatively managed balanced fund is managed by the team of Michael Simpson, who runs the equity sleeve, James Dutckiewicz, who is responsible for the fixed income and broader asset mix.

The equity portion is managed in a similar way to the highly regarded Sentry Canadian Income Fund, although this fund’s smaller size allows it to take more of an all cap approach. Like other Sentry managed funds, it has been increasing its exposure to the U.S. in recent quarters. At the end of March, more than 25% of the fund was invested in the U.S.

The fixed income sleeve is very heavily weighted towards corporate bonds, which make up more than three quarters of the bond exposure. While the focus is on investment grade bonds, about one quarter is invested in high yield bonds. On a whole, the bond sleeve offers investors a higher yield than the FTSE/TMX Bond Universe, with a lower duration. This positioning will lessen the overall sensitivity to rising interest rates, while providing better returns in a flat or falling yield environment.

They have a fair amount of flexibility with the asset mix, which can range between 40% and 60% in stocks or bonds. At the end of March, it held approximately 44% in equity, 44% in bonds, and the balance in cash.

The fund’s performance has been very strong, particularly on a risk adjusted basis. For the five years ending March 31, it generated an annualized return of 9.7%, finishing well ahead of the pack. Most of this outperformance can be attributed to the fund’s ability to hold its value in falling markets. I certainly don’t expect that it will continue to outperform as strongly as it has going forward, but I do expect it to be well above average on a risk adjusted basis.

It is also a decent option for those looking for cash flow. It pays a monthly distribution of $0.0375 per unit, which works out to an annualized yield of 3.6 %.

Still, when all things are considered, this looks to be a decent balanced fund for those with a modest appetite for risk.

---

 

Sentry Small / Mid Cap Income Fund

Analysis:  This fund just keeps delivering, posting an impressive 7% gain in the first quarter, handily outpacing both the benchmark and its peer group. Much of this outperformance is attributed to the investment process used by the managers.

This fund is very similar to the highly regarded Sentry Canadian Income Fund, with the key difference being its focus on small and mad-cap names. An ideal investment candidate will have a high return on capital, low leverage, rising free cash flow, low earnings volatility, strong management teams, high barriers to entry, sustainable competitive advantages, and the ability to consistently grow their dividends over time.

It is diversified, holding approximately 60 names, with the top ten making up less than 30%. With its emphasis on income, it is significantly underweight in energy, materials, and somewhat surprisingly, financials. The portfolio is positioned for an economic recovery, with a heavy emphasis on consumer and industrial names.

The fund can invest up to 49% of its holdings outside of Canada, and they have been taking advantage of that. In the first quarter, their U.S. holdings were strong contributors to the outperformance.

I would expect the U.S. holdings will remain high for a couple reasons. First, management believes that growth in the U.S. will continue to outpace Canada for the next few months. Second is the fund, now with more than $1.5 billion in assets, must look beyond Canada to find suitable investment opportunities that meet the manager’s valuation criteria.

The size of the fund is definitely something I am monitoring to make sure it does not have a negative effect on the risk re-ward profile on the fund. So far, I have not noticed any meaningful erosion, but will continue to watch the fund closely.

This is also a good option for those looking for cash flow. It pays a monthly distribution of $0.05 per unit, which at current prices is a yield of 2.7%.

While I don’t believe that the historic level of returns are sustainable going forward, I still expect that it will continue to deliver above average returns with below average risk.

---

All Rights Reserved. Reproduction in whole or in part without written permission is prohibited. Financial Information provided by Fundata Canada Inc. © Fundata Canada Inc. All Rights Reserved. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.