Top Funds Report – August 2015

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Lower Dollar Boosts Global Equity Gains

Dollar continues its slide on lower rates and cloudy outlook on oil…

Unless you held Chinese equities or Canadian small caps, July turned out better than many had expected. Most major indices finished in positive territory, with European shares leading the way.

The MSCI Europe Index gained 7.9% in Canadian dollar terms, more than doubling its 3.1% rise in U.S. dollars. The Canadian dollar dropped by more than 4% after the Bank of Canada Governor Stephen Poloz cut overnight lending rates by 0.25%. Struggling energy markets, and a weakening economic picture out of China also weighed heavily on the dollar.

China dragged the emerging markets, with the MSCI Emerging Markets Index losing nearly 7% in U.S. dollar terms. Economic data shows that China’s growth rate is going to be much lower than official government projections. In August, the Chinese government stepped in to devalue the Yuan against the U.S. dollar in an effort to help shore up the struggling economy. They have also taken measures to help stem losses in the stock market. Still, many investors are wary of the country and markets are being punished.

Closer to home, the S&P 500 rose by more than 6% in Canadian dollar terms. Small caps didn’t fare quite as well, as the Russell 2000 was only positive because of a weaker Canadian dollar.

Canadian bonds had a solid month, thanks to the cut in overnight rates. The FTSE/TMX Canadian Universe Bond Index gained a respectable 1.4%. However, it was the long end of the curve that benefitted most, with the FTSE/TMX Long Term Bond Index gaining nearly 3%.

My investment outlook remains stable. I continue to keep asset mix weights in line with their neutral weightings. Within fixed income, I don’t see yields, particularly short term yields, spiking anytime soon and am comfortable keeping duration slightly below benchmark. I will look to shorten it once the economy starts to improve. I favour high quality corporates over governments.

With equities, I continue to like U.S. equities, although valuation levels remain a concern. However, with troubles continuing in Europe and Asia, it remains the default, safe haven choice for equity investors. I continue to favour quality over growth.

My current investment outlook is:

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

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Funds of Note

This month, we look at some of the funds on my Recommended List of Funds…

PowerShares 1-5 Year Laddered Corporate Bond Fund (AIM 53203 – Front End Units) – Effective June 30, 2015, FTSE TMX Global Debt Capital Markets Inc., the provider of the index on which this fund is based announced some changes to the way the index is constructed. The biggest was the number of bonds will be increased from the current 25 to 50 over the next few years. To do this, each of the five equally weighted maturity buckets will see the number of bonds held in it double from five to ten. This will be done on a gradual basis, with the five year maturity bucket increasing its holdings to ten immediately. All others remain holding five. Next June, when the index is reconstituted, an additional five bonds will be added to the five year bucket, and so on. Over five years, the changes will be complete.

The rationale provided for this was to increase the diversification of the portfolio. I believe this will prove to be beneficial in the challenging fixed income environment. After the index is reconstituted, the yield to maturity of the portfolio will increase from 1.69% to 1.80%. In comparison, the yield on the FTSE TMX Canadian Short Term Bond Index is listed at 1.03%.

A drawback of the reconstitution is there has been a modest increase in the interest rate sensitivity of the portfolio. Before the reconstitution, the duration was 2.53 years. After, it increases to 3.34. In comparison, the Short Term Bond Index has a duration that is listed at 2.85 years. This happened because the shortest duration bonds were removed from the portfolio, and new, longer duration bonds were added. Over the next 11 months, the duration will gradually fall as the term to maturity shortens. This happens each time the index is reconstituted.

Normally, I wouldn’t be too concerned about this. However, with there being a strong probability the U.S. Federal Reserve will begin moving rates higher in the fall, there may be upward pressure on Canadian yields, which may affect this fund more than some of the other short term options available. Still, with a yield that is running about 30 basis points higher than my second favourite short term bond pick, the PH&N Short Term Bond and Mortgage Fund, this Powershares offering remains my top pick for those looking for short term bond exposure.

RBC Global Corporate Bond Fund (RBF 753 – Front End Units, RBF 853 – DSC Units) – The Fund had a tough quarter, losing 2.4% and underperforming its peers. A key reason for the loss was the increase in global bond yields, which were pushed higher on improving economic sentiment and expectations that the U.S. Federal Reserve will begin moving rates higher later in the year. With a duration of 6.1 years, the fund remains highly sensitive to movements in interest rates.

Another factor that weighed on it was its high yield and emerging market debt exposure. Both struggled in the face of continued weakness and uncertainty in the energy sector. Recent troubles in China also weighed on the broader emerging market region. With continued uncertainty expected, more volatility is likely in the near term.

Despite the short-term outlook, this remains an excellent global bond fund, given the management team and process behind it. While not a core holding, it can play an important role in your fixed income allocation.

PH&N Monthly Income Fund (RBF 6660 – Front End Units, RBF 4660 – Low Load Units) – I have been disappointed with this fund for the past few quarters, and the nearly 2% drop posted in Q2 did little to help. Since peaking in mid-2014, it has failed to keep pace with its peers.

The fund’s neutral asset mix is 50% Canadian equities, 35% Canadian bonds, 10% high yield, and 5% preferred shares. Part of the reason for the underperformance would be its 5.1% weight in preferreds, which have been hit very hard in the face of the Bank of Canada rate cuts. Performance was also hurt by its holdings in Canadian Utilities, which fell by 8.8% in the quarter, and TransAlta, which was down by more than 16%.

The managers have reduced their exposure to corporate bonds, and have kept the interest rate positioning close to the benchmark. Within the equity sleeve, they are looking for higher yielding names, which explains the overweight to financials, energy, and utilities. Unfortunately, the near term outlook for those sectors, particularly energy, points to further volatility and headwinds.

The fund pays a monthly distribution of $0.042 per unit, which works out to an annualized yield of nearly 5.2%. It is this yield that makes it an attractive candidate for those looking for cash flow. However, until I see a more sustained recovery in performance I would suggest caution. I am continuing to monitor this fund closely.

TD U.S. Blue Chip Equity Fund (TDB 977 – No Load Units, TDB 310 – Front End Units, TDB 340 – Low Load Units) – U.S. equity has been one of the most difficult categories to outperform the index, but this fund that has done a respectable job in doing just that. For the five years ending June 30, it’s 21.7% annualized gain (after all fees) has bested the S&P 500’s 21.2% rise. Year to date, performance has been even stronger, gaining 13.8% while the index rose by 8.9%.

While this is great, I certainly don’t expect it to continue to outperform at this pace. The fund tends to be more volatile than the broader market. For the past five years, the S&P 500 has had a standard deviation of 8.3%, while the fund was 11.0%. It tends to outperform when the index is positive, but underperforms by a greater margin when it falls. The reason for this is it has a growth tilt to it, with healthcare, consumer cyclical and tech being the largest sector weights. Those sectors have had a tremendous run of late. As a result, the fund’s valuation metrics are on the high side, with price to earnings, price to cash flow, and price to book ratios that far exceed the index and peer group. It is also the most highly valued U.S. equity fund on the Recommended List. But, it also shows the strongest rate of earnings growth, both on a historical and forward looking basis. Factoring in the growth projections, it is not as overvalued as it may appear in isolation.

In a recent commentary, manager Larry Puglia noted that after the six year market rally, U.S. equities’ “…somewhat high absolute valuations make them vulnerable to the Fed’s timetable for returning interest rates to more historically normal levels.” He also noted that this far into the market cycle, it will be difficult for many companies to expand margins by cost cutting, and only those that can effectively execute their strategy are likely to see profit growth.

Considering the above, I would suggest that if you have held this fund for a while, you may want to consider taking some profits. I expect higher levels of volatility as we enter the fall, but over the long term, I expect this fund to deliver index like returns, with higher levels of volatility.

Trimark Global Endeavour Fund (AIM 1593 – Front End Units, AIM 1591 – DSC Units) – In a quarter that saw the overwhelming majority of funds on the Recommended List finish in negative territory, this concentrated, value focused all-cap offering posted a very respectable 2.4% gain; the best of the bunch. The MSCI World Index lost 1.2% during the same period.

This divergence in performance highlights just how different this portfolio is from the broader markets. It has approximately 30 names, with the top ten making up just under half the fund. In a concentrated portfolio, a good quarter by a couple of stocks can really boost returns. In the second quarter, it was DCC PLC and Lewis Group that were the key contributors to the outperformance. DCC was higher on news of an acquisition that is expected to be accretive to earnings, while Lewis rose on better than expected results.

At the end of the quarter, cash sat at approximately 16%, up from 13% in March. A high cash balance can be a buffer in a market selloff, but can act as a drag in a market rally. However, given the concentrated nature of this portfolio, it is less of a concern.

Managers are still concerned about valuation levels, noting in a recent commentary they continue to find it rather challenging to find undervalued investments. They continue to find interesting opportunities in the emerging markets. Still, given the discipline of their process, I would not be surprised to see the cash weighting increase in the coming quarters as names reach full valuation and they are sold out of the portfolio. The managers are likely to use any period of market weakness as an opportunity to pick up new quality names at attractive prices, or add to existing positions.

This remains a great all cap fund and can be a great diversifier in an otherwise balanced portfolio. Given the concentration in the portfolio, I would be reluctant to use it as a core holding. If you have held it for some time, I would suggest you take some profits.

Chou Associates Fund (CHO 100 – No Load Units) – I have a great deal of respect for manager Francis Chou and all that he has done, and continues to do in the investment industry. He is a disciplined manager who sticks to his process, rarely straying from his deep value convictions. Long term returns have been excellent, with a 15 year return of nearly 10%. Shorter term numbers however are less impressive. For the past year, it has gained 7.42%, significantly lagging both its peer group, and the MSCI World Index.

In reviewing the fund, I have some concerns. The first is the level of key person risk involved with the fund. Chou Associates is essentially a one man show, with Francis Chou having sole responsibility for the management of all five Chou Funds. This is a lot for one person to handle. But perhaps more concerning is what would happen if Mr. Chou were unable to continue managing the fund. In a conversation a year or so ago, Mr. Chou said a succession plan was in place, but couldn’t elaborate on it. While I believe this to be true, the skill Mr. Chou has demonstrated will be tough to replace. My other concern with the fund is the recent erosion of the risk reward profile. I have noticed a marked increase in volatility at a time when volatility of the index and peer group has remained low.

Considering the above, I am removing the fund from the Recommended List. That does not mean you should run for the exits. If you hold it and are comfortable with the higher volatility, then keep it in your portfolio. I believe the fund has the potential to continue to deliver excellent long term numbers. However, I am not comfortable investing new money into it at the moment given my views of the risks.

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

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August’s Top Funds

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PIMCO Monthly Income Fund

ANALYSIS: This global bond fund came out of the gate at full speed, gaining 18% in 2011 and 24% in 2012. Obviously these returns weren’t sustainable, and have since settled down to more reasonable levels, gaining 6.4% in 2013, and 6.6% in 2014.

Managed by the team of Alfred Murata and Dan Ivascyn with the objective of income generation, it invests in a wide range of fixed income securities including mortgage backed securities, investment grade bonds, high yield debt, and emerging market bonds. The portfolio tends to be U.S. focused.

The process used is a combination top down macro analysis and bottom up security selection. The top down macro analysis looks at both the long term outlook and the near term cyclical view. This analysis helps the managers set the fund’s sector mix, duration and yield curve positioning. Securities are chosen using a fundamentally driven, bottom up process.

The managers look at the portfolio in two distinct parts; high quality core, and non-core. Within the high quality core portion, they tend to focus on investment grade issues in developed countries and agency mortgage backed securities. This portion is designed to provide downside protections and modest returns in periods when economic growth is weak. The non-core portion holds lesser quality issues such as high yield bonds, emerging market debt, and non-agency mortgage backed securities and is for growth.

They are very active in their approach with levels of portfolio turnover that have averaged more than 200% since the launch of the fund.

Unlike a lot of other monthly income funds, this one is managed with a focus on income generation. The monthly distribution amount is variable and is based on what the managers believe they can generate from the portfolio. For the past 12 months, income distributions have totaled approximately $0.70, resulting in an annualized yield of 4.8%.

Costs are very reasonable, with an MER of 1.38%.

While I like this fund, I do not consider it to be a core fixed income offering. It is more risky than what historic volatility has indicated. Instead, I see this as a piece of a well-diversified portfolio..

 

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Manulife Monthly High Income Fund

ANALYSIS: Since I recommended this fund in January, it has struggled to keep pace with its peers, with a modest 0.70% gain so far this year. At the end of June, equity exposure was 55%, with Canadian equity making up more than half. The equity sleeve is fairly concentrated, holding less than 50 names. A few of the big holdings struggled in the quarter, including Enbridge, which was down in the face of continued weakness in the energy sector, and Oracle, which sold off heavily after missing its earnings targets. The fixed income exposure is mainly in investment grade corporate bonds, which finished the quarter in the red.

Despite this recent underperformance, I believe it is an excellent balanced fund for those with a longer term time horizon. The managers use a very disciplined, bottom up process that has rewarded investors with excellent long term results, both on an absolute and risk adjusted basis. It also carries an MER of 2.04%, which is below its peers. I expect it to continue to deliver above average returns over the long term.

Unfortunately accessing this fund will become increasingly difficult. On August 17, Manulife announced they will be closing the fund to both new and existing investors effective August 28.

The main reason they are closing the fund is it has grown to be too large. At the end of June, it had nearly $10 billion in assets under management (AUM). Factoring in all related mandates, AUM exceeds $11 billion. If the fund continues to grow, it will become more challenging for the managers to continue to execute the disciplined process that has resulted in the tremendous long term track record.

While the closing is unfortunate for potential investors, it is the right thing to do.

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Beutel Goodman Canadian Equity Fund

ANALYSIS: Beutel Goodman is one of those shops you don’t hear a lot about. They quietly go about their business of managing money and offer one of the strongest fund lineups in the industry.

A great example is this concentrated, Canadian equity fund. It is managed using a bottom up, fundamentally driven, value tilted investment approach. They tend to favour large cap companies that are leaders in their industry, but will consider small and mid-cap names that show the potential to become industry leaders. This exposure is obtained by buying units of the highly regarded Beutel Goodman Small Cap Fund.

In addition to being significantly undervalued, any investment must have recurring, dependable earnings, free cash flow, and competitive advantages in their industry or sector. They must also have the ability to close the valuation gap within a three year period.

The result is a portfolio that holds just over 30 names, with the top ten making up slightly more than half of the fund. It is overweight financial and consumer names, and underweight energy and materials. Portfolio turnover has been quite low, averaging well below 20% for the past five years.

They use an interesting sell discipline. Once a holding hits their internally generated price target, they automatically sell one third of the holding, and undertake an updated detailed review. If the review shows an increased price target is justified, they will hold the remaining shares. If it is not, they will immediately exit the position.

Performance, particularly the long term numbers have been excellent, handily outpacing the index over a three, five and ten year period. Volatility has been roughly in line with the broader market, and it has tended to modestly outperform in falling markets.

Costs are reasonable, with an MER of 1.37% for the “Do it yourself” units, and 2.11% for the advisor units.

On balance, this is an excellent core equity holding for most investors. Over the long term, I would expect it to continue to do what it has done in the past – above average returns with less volatility.

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Fidelity Special Situations Fund

ANALYSIS: This fund has a unique and opportunistic mandate that looks for companies of any size that are, or are expected to undergo some positive changes in their underlying fundamentals.

These opportunities may come in a wide range of investments including high growth companies with underappreciated potential, or significantly undervalued companies that may be in a position to benefit from improvements in company or industry fundamentals. They may also look at restructuring and merger opportunities, where the outcome has the potential to unlock significant value for shareholders.

The investment process is very much a bottom up approach where each opportunity is evaluated, considering the economic and market conditions, the industry, and financial position. They also review total growth potential, earnings and quality of management.

At the end of June, it held 52% in Canadian equities, 43% in U.S. equities. Given the opportunistic mandate, it’s not surprising to see it concentrated in the technology and healthcare sectors, which combined, make up approximately 45% of the fund. It is also overweight consumer names. The portfolio is well diversified, holding around 100 names. The top ten make up just over a quarter of the fund.

The investment process is very active, with turnover averaging nearly 300% for the past five years. This has worked well for them, posting excellent performance since inception. It has finished in the upper half of the category every year since its launch.

Volatility has been above average, but it has held up relatively well in down markets. According to Morningstar, the fund has a negative down capture ratio, meaning on average, it has been in positive territory when the index is negative.

Despite this excellent track record, this is not a fund that is for everybody. It is a high risk fund, and in my opinion should only be used as part of a well-diversified portfolio, with portfolio exposure determined by an investors risk tolerance.

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