Top Funds Report – September 2015

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Fed Stands Pat on Rates

Global uncertainty causes Fed to keep rates on hold…

Going into the third quarter, many had expected that the U.S. Federal Reserve would begin hiking interest rates starting at their September meeting. All signs supported this view – the jobs picture is progressing nicely, consumer spending is on the rebound, and other economic indicators show that the recovery continues, albeit at a rather modest pace.

Things changed in mid-August after the People’s Bank of China surprised everyone by devaluing the yuan by nearly 2%. This move sent shockwaves through the global equity markets, taking investors on a wild ride. The brunt of it was felt on August 24, when investor panic set in, and U.S. markets opened down nearly 8% from the previous close. As the day progressed, some rationality returned, and markets finished well off session lows.

Many concerns remain over the health of China’s economy. Regardless, a slowing China will have a material impact on the pace of global growth. According to a piece written by RBC Global Asset Management’s Chief Economist Eric Lascelles, China represents more than 30% of global economic growth, and a 1% hit to Chinese growth will take 0.25% off the GDP of the U.S. and the Eurozone, and 0.50% off Canadian GDP.

Given the fragile state of the global economy, any slowdown in China will cause a ripple effect. For Canada, the biggest will be the price of oil, which is expected to stay lower for longer. This will create further pressures in the struggling energy sector. Europe may also suffer, as China has become one of the regions key trading partners. Germany, which accounts for half of all EU exports to China is likely to be hit hardest. Understandably, other emerging markets will struggle in the face of a key partner’s slowdown.

From an investment standpoint, my outlook remains consistent. For fixed income, with yields likely on hold, I am comfortable keeping duration slightly below benchmark. I will look to shorten it further once the economy starts to improve. I favour high quality corporates over governments.

In equities, I like the U.S., although valuation levels remain a concern. Still, with troubles continuing in Europe and Asia, it remains the “cleanest shirt in the laundry” for investors.

My current investment outlook is:

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Funds of Note

This month, we look at some of the ETFs on my Focus List…

PowerShares Senior Loan CAD Hedged ETF (TSX: BKL) – With many expecting the U.S. Federal Reserve to start moving rates higher at their meeting later this month, floating rate notes and loans have once again been put on investors’ radar. This is one of the better floating rate ETFs available. It provides exposure to the S&P/LSTA U.S. Leveraged Loan 100 Index, which is the largest 100 loan facilities in the S&P/LSTA Leveraged Loan Index. The interest rate paid on these loans will generally move with a benchmark rate such as LIBOR. However, even if the Fed starts moving rates higher, don’t expect the coupon rate on this ETF to move higher at the same pace. That is because the majority of the loans have an interest rate floor built into them. The interest rate floor is the lowest rate used to calculate the coupon payment. For example, if the interest rate floor is set at 1%, and the benchmark rate falls to 0.5%, the coupon payment will be determined using the 1% floor instead of the 0.50% actual rate. This feature was put in place to protect investors against falling interest rates. At the end of November 2014, 87 of the 100 loans had an interest rate floor, and 64 of those loans had a floor of 1% or higher, according to a report published by S&P Dow Jones Indices. In other words, there is unlikely to be a meaningful movement in returns until we see an increase in the benchmark rates. Ironically, this protection feature that was put in place to protect investors on the way down will hurt them on the way back up. I expect very modest levels of return in the near to medium term.

iShares 1-5 Year Laddered Corporate Bond (TSX: CBO) – Recently, FTSE/TMX Global Debt Capital Markets, the provider of the index on which this ETF is based, announced some changes to the index construction methodology. The first change allows bonds rated BBB to be included in the index. Previously, only those bonds rated A or higher could be included. This change is expected to result in a higher running yield than previously. The next change eliminates the maximum number of bonds in each maturity bucket. Previously, the number of bonds in each maturity bucket was capped at 20. This will allow for a greater level of diversification within the portfolio. The final change increases the rebalancing frequency from annually to semi-annually. On balance, these changes are positive for the ETF. A drawback however is the reconstitution of the index has caused a slight increase in the duration as the bonds with the most recent maturities were removed from the index and replaced with longer dated bonds. Over the next several months, the duration will naturally drop until the next reconstitution of the index.

iShares Canadian Universe Bond Index ETF (TSX: XBB) – Given the lackluster economic numbers posted by the Canadian economy, and news that we were officially in recession in June, many are expecting the Bank of Canada to cut rates again at their next meeting. If that does happen, this is an ETF you’ll want to own. It provides exposure to the Canadian bond universe, with two thirds in government bonds, 30% in corporates. All the bonds are investment grade, and the duration is in the 7.4 year range. This makes a great core bond holding for most investors.

First Asset Morningstar Canadian Momentum ETF (TSX: WXM) – Even with a concentrated portfolio, following a “riskier” momentum strategy, this rules based ETF continued to outperform. For the three months ending July 31, it lost 0.80%, which is pretty uninspiring, until you consider the S&P/TSX Composite lost 4.3% in the same period. The underweight in energy, and financials was a key reason for this outperformance. While I don’t expect the absolute level of outperformance to be sustainable over the long term, I do expect this to modestly outpace the broader market, with a slightly higher level of volatility. I likely wouldn’t use it as a core holding, but it could definitely be a nice return enhancing addition to an otherwise well diversified portfolio.

BMO Low Volatility Canadian Equity ETF (TSX: ZLB) – One of the worries that I have about many of the low volatility funds out there is that they won’t hold up when the going gets rough. If the most recent three month period is any indication, I think these products will be just fine. Of the seven Canadian equity ETFs on the focus list, this was the only one to finishing in positive territory, gaining 1.7%. Even in August, when the S&P/TSX Composite lost more than 4%, this was down by just under 3%, again, holding up better in volatile times. As we head into the fall, with September historically being the most volatile period for equity markets, I expect this ETF to continue to do what it is designed to do – provide better downside protection than the broader markets. Longer term, I have some concerns with the valuation levels of the portfolio as a whole, but if you’re comfortable with it, this could be a good pick for your portfolio.

PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) – I’ll be honest, I love the concept of a fundamentally constructed ETF. I like that it takes a look at a number of the same factors a good active manager would consider; things like earnings, sales, and dividends. Theoretically, it should result in a better built, and more diversified index than an index that is simply made up of the largest publicly traded companies in Canada. Unfortunately in practice, this hasn’t been the case. Looking at the sector mix, it is significantly more concentrated than the S&P/TSX Composite, which is itself fairly concentrated. For example, it has more than 40% invested in financials, not including real estate, compared with just over 30% for the index. It also has more than 23% in energy, compared with just under 20% for the index. The reason for this level of concentration is based solely on the relative ranking of the stocks, based on the fundamental criteria. While I can appreciate that, I believe that it has become just too concentrated a portfolio to be used as a core holding, with nearly two-thirds invested in two sectors. If you’re comfortable with that kind of concentration risk, this isn’t a bad option. However, if you are looking for marginally better diversification, you’re better off sticking with XIC for your Canadian equity exposure.

BMO MSCI EAFE Hedged to CAD Index ETF (TSX: ZDM) – After a pretty impressive run-up, this ETF has hit a rough patch, losing 7.8% in August, on fears of a global slowdown. With China playing an ever increasing role in the economy of many Asian and European nations, any significant pause will hurt the outlook for many EAFE based companies. This rough patch is what we are experiencing now. The other thing that has hurt this ETF is its currency hedging policy. With the Canadian dollar losing more than 12% on a year-to-date basis, ZEA, the unhedged version of this ETF has dramatically outperformed, solely on the weaker currency. Looking ahead, I believe that the worst of the drop is behind us, but still see the potential for more downside and heightened volatility. I still see this as the best option for EAFE exposure over the long term, but have some concerns in the near term. In the near term, I’m favouring the iShares MSCI EAFE Minimum Volatility Index ETF (TSX: XMI) for the potential for lower volatility. However, if you hold ZDM and are comfortable with the near term outlook, I’d suggest holding on to it. If you’re looking to step in and buy more, you’re likely better off waiting for a pullback.

iShares Core S&P 500 Index ETF (CAD- Hedged) (TSX: XSP) – If I had to rate the markets I feel will hold up best over the next few quarters, the U.S. is definitely at the top of that list. While the economy is far from firing on all cylinders, it is still growing at a modest clip, and is much stronger than Canada, Europe or Asia. That being the case, I continue to favour the U.S. for my core equity exposure. Sure, more volatility is expected into the fall, but the U.S. is expected to hold up better. While I don’t have it on my list, I am actually favouring XUS over this ETF in the near term. This is particularly true if the Fed does indeed start raising rates in the fall, as it will push the value of the U.S. dollar even higher, amplifying gains or muting losses solely because of the currency effect. However, over the long term, the fully hedged XSP remains my top pick.

PH&N U.S. Multi Style All Cap Equity Fund (RBF 1380) – This provides exposure to a well-diversified portfolio of U.S. based companies of all sizes. It is managed much like a fund of funds, where there are five distinct components that cover the full range of investment styles. They include large cap growth, large cap value, mid cap growth, mid cap value, and small cap core. Each segment is actively managed by its manager, with the allocations to each being determined by RBC’s Investment Solutions group.

The portfolio currently favours large cap names, which make up nearly two thirds. Mid-cap names comprise about a quarter of the fund, with the balance, approximately 10% in small cap names.

Given the multi-manager approach, portfolio turnover is high, averaging well above 100% for the past five years.

Costs are reasonable, with the Series D units carrying an MER of 1.17% while the advisor sold units are 2.02%, which is below its peers.

Performance has been middle of the road, gaining 18.2% for the five years ending August 31. This was just above the category average, but trailed the S&P 500 which rose by 20.9. Volatility has also been roughly in line with the index and peer group. It also exhibits a very high correlation to the index, making it very index like.

Given this, I would likely go with either a more actively managed U.S. equity fund, or a lower cost index product over this offering, even with the wide range of market cap exposure.

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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Jarislowsky Select Balanced Fund

ANALYSIS: While this actively managed balanced fund may have only been launched in 2010, Jarislowsky Fraser have long been one of the most respected investment management companies in Canada since 1955.

The management team has a great deal of flexibility, and can take the equity exposure as low as 50% and as high as 70%. The asset mix will be based on where they see the best risk reward opportunities. At the end of July, it stood at the higher end of the equity spectrum, running at 64%, and 34% bonds.

The equities tend to be invested in large, industry leading companies that have strong management and a track record of earnings, with limited financial leverage. They rely heavily on the firm’s in-house equity team, and use a top-down and bottom up process with a focus on long-term investment themes to help identify the most attractive areas of the market. They believe this allows them to find companies that have long-term, stable earnings prospects. The biggest overweight is in tech, industrials, and consumer staples, while there is less exposure to materials, telecom and real estate.

The fixed income sleeve is managed using a top down macro analysis combined with a bottom up security selection process. The macro view helps the managers determine the most appropriate maturity profile and credit mix for the fund. Once this is set, they look for securities that fit the macro view and can help maximize yield. Currently, they are titled towards corporates, which make up more than two thirds of the bond allocation. The duration is in line with the benchmark, and credit quality is all investment grade. This positioning sets the bonds up mainly as a shock absorber in volatile markets.

Performance has been excellent, finishing in the upper half of the category in all time periods since launch. Even more impressive is this has been done with a lower level of volatility, and much stronger downside protection than many of its peers.

If I had to pick a flaw with the fund it is the fixed income exposure looks to be highly sensitive to interest rates. That should bode well near term, however once rates start moving up, it may drag returns. Still, I see this as a great core balanced fund for most investors.

 

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Dynamic Dividend Fund

ANALYSIS: Managed by the team of Oscar Belaiche and Jason Gibbs, this Canadian focused dividend fund looks to provide investors with a stable stream of income. It pays a monthly distribution of $0.018, which works out to an annualized yield of just over 1.8%.

To fund this distribution stream, the managers have built a concentrated portfolio of what they believe to be best in class companies that pay a sustainable dividend and have the potential for growth. They call their process “quality at a reasonable price” which is a fundamentally driven, bottom up approach that focuses on identifying low volatility firms with strong balance sheets, dominant industry positions, invested management, and a history of steadily growing free cash flow and increasing shareholder yield.

Holding approximately 45 names, the managers have the flexibility to invest not only in common shares, but also preferred equity and trusts. It can also invest outside of Canada, and at the end of July held 22% in the U.S., 71% in Canada, and the balance in cash. The top ten makes up over a third of the fund.

Given the dividend focus of the fund, it’s not surprising to see financials are the biggest sector weight, followed by other high yielding industries like telecom, energy infrastructure and utilities.

Performance has been strong, with a five year annualized gain of 9.6% to the end of August, compared with 6.1% for the broader S&P/TSX Composite Index. Even with a loss of 4% year to date, it has managed to outperform its peer group. More impressive is volatility has been significantly lower than the broader market, and it has provided significantly better downside protection. According to Morningstar, the three year downside capture ratio was 31% and the five year was 23%, meaning this fund has experienced significantly lower markets than the index.

This fund may not always keep up with the competition, but with lower than average volatility, I would expect it to deliver above average risk adjusted returns over the long-term. I see this as a great core holding for risk averse investors looking for high quality equity exposure.

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Steadyhand Equity Fund

ANALYSIS: After struggling in 2009 and 2010, the Steadyhand Equity Fund has blossomed into one of the better Canadian focused equity funds available today. It is managed by CGOV Asset Management using a fundamentally driven, benchmark agnostic, approach that strives to deliver investors absolute returns in all market conditions.

The concentrated portfolio looks nothing like its benchmark. It has a significant overweight position in consumer defensive, industrial and healthcare names. It has virtually no exposure to real estate and is about half the index weight in financials. This results in a portfolio that will give you returns that are much differently than the benchmark.

For the past five years returns have been stellar, gaining an annualized 14.8%, leaving the index and its competition in the dust. A lot of that outperformance can be attributed to its 45% allocation in foreign holdings, which have significantly outperformed Canadian equities in the recent energy swoon. The portfolio’s concentration also helped, as the focus on strong, cash flow generating businesses paid off with outsized returns.

The fund’s volatility has been significantly below average, and it has outperformed in both rising and falling markets. The focus on quality has certainly helped in falling markets, as the fund has experienced less than 40% of the drop of the S&P/TSX Composite Index over the past five years, and less than a quarter over the past three years.

With just under $70 million in the fund, the managers have the ability to be very flexible in managing the fund, and can continue to take meaningful positions in mid cap names, if the investment opportunity is there. An option not available to many of its larger peers.

While I don’t expect that the historic returns will be repeated, I do believe that the fund can continue to deliver above average returns with below average risk, making it a solid core holding for most investors. The emphasis on downside protection and margin of safety will go a long way in helping the cause, especially in volatile markets. Investors in this fund must be in it for the long term, because it is very likely to experience periods where performance lags significantly. I would expect this to happen more in a sharply rising market.

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Manulife Global Real Estate Fund

ANALYSIS: Managed by New York based Third Avenue Management, this global real estate fund has posted decent long term numbers. For the five years ending August 31, it gained an annualized 13%, outpacing the peer group, but lagging the index.

The fund has a very flexible mandate. In addition to investing in REITs and real estate operating companies (REOCs) as most real estate funds do, it can also invest in companies associated with the real estate sector. This includes companies such as forestry company Weyerhaeuser, and hardware giant Lowe’s. The managers also have the ability to raise cash based on their macro view, and use option strategies to hedge risk where they deem it appropriate. Currency exposure is tactically managed.

The investment process used is very much a bottom up, deep value approach. The team looks for what they believe are high quality, well managed companies that are out of favour with the market. They pick these companies up at a big discount and patiently wait for the market to acknowledge the value.

They have been reasonably patient, with portfolio turnover averaging less than 25% over the past five years.

The fund is focused on providing investors with total return with an emphasis on capital appreciation. As a result, it does not pay a regular dividend, like more REIT focused funds.

Because of this total return focus, the managers prefer REOCs over REITs. The reason for this is REOCs do not have to pay out a significant portion of their net income the way REITs do. By reinvesting earnings, REOCs may be in a better position to finance growth without needing to issue additional equity. It also has the potential of reducing the interest rate sensitivity of the portfolio, compared with a pure REIT fund.

It does have a couple of drawbacks. The first is cost, with an MER of nearly 3%. The second is it is one of the more volatile real estate funds out there.

Still, for those looking for diversified global real estate, this is not a bad place to start.

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