Top Funds Report – November 2015

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Equities Rebound in October

Expecting volatility in bonds as December Fed meeting approaches…

After five consecutive months of negative returns, Canadian stocks bounced back, posting a modest 2.0% gain in October. Other global equity markets followed suit, with the S&P 500 gaining 6.3% in Canadian dollar terms, while the MSCI EAFE Index rose by more than 5.3%.

Gains would have been higher, had it not been for a rise in the Canadian dollar, which was up on stronger oil prices. In U.S. dollar terms, the S&P 500 rose by 8.4%, while EAFE jumped by 7.8%.

While October left investors with a positive outlook on the world, that all came crashing down on Friday the 13^th, when radical ISIS terrorists unleashed a wave of bombings in Paris, killing more than 130 and injuring hundreds more.

This human cost is immeasurable, while the economic cost remains to be seen. The general worry is a fearful public will be reluctant to venture out to malls and shops, putting a significant dent in consumer spending. With the global economy already in a fragile state, any slowdown will further drag economic growth.

Even if we do see a slowdown in the near term, it is likely to be permanent. According to analyst Prableen Bajpai, the March 2004 train bombing in Madrid saw a 0.6% drop in GDP in the quarter following the attack. Longer term however, the effects were short lived. Perhaps the biggest economic impact was after the 9/11 attacks. The New York Times estimates the total costs were more than $3.3 trillion, with $123 billion in direct economic impact. Of this amount, the majority was directly attributed to reduced travel. Barring further attacks, the long-term economic impact from Paris would be expected to be minimal.

Investors have once again ramped up the Fed watch, as recent minutes from the latest meeting of the U.S. Federal Reserve seems to indicate that a rate hike is to be expected in December. As of November 18, bond traders have pegged the probability of a hike at approximately 72%. The Bank of Canada is widely expected to remain on hold for the foreseeable future.

Regardless, expect higher levels of rate volatility as we approach the December 15/16 meeting. This could translate into a rough ride for bonds.

 

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Funds of Note

This month, we look at a number of funds on my Recommended List…

Manulife Monthly High Income Fund (MMF 583 – Front End Units, MMF 483 – DSC Units) – I added this high quality Canadian balanced fund to the Recommended List in December 2015. It is managed by the team of Alan Wicks and Jonathan Popper, with an equity approach that is rooted in a value philosophy that looks for businesses that generate high and sustainable profits that are trading at attractive valuations. The fixed income sleeve is managed using a combination top down economic review combined with a bottom up credit analysis. The process looks to generate returns by focusing on sector allocation, credit quality and individual credit selection. They also emphasize risk management by actively managing the yield curve and duration exposure. Performance, over the long term has been excellent, although recently has lagged a bit, gaining 1.08% year-to-date, which is just above the category average. Given the team and process in place, I expect that it will continue to deliver above average returns, with below average volatility.

Unfortunately, Manulife closed the fund to new purchases effective August 28. This move was made in an effort to protect current investors, as the fund was approaching a size that the managers felt may detract from their ability to continue to effectively manage it. Clearly this move was made with the best interests of investors in mind. However, because it is now closed, I am removing it from the Recommended List. I will continue to follow it closely, and should it be re-opened will consider adding it back to the list.

If you hold the fund, and it is in line with your investment objectives, risk tolerance, and time horizon, and it is still appropriate for your port-folio, there is no immediate reason to sell. I believe it will continue to be a solid Canadian balanced fund offering.

IA Clarington Canadian Conservative Equity Fund (CCM 1300 – Front End Units, CCM 1400 – DSC Units) – It is taking an increasing amount of patience to keep recommending this fund. Year to date, it is down more than 15%, and is off nearly 20% in the past year. In comparison, the S&P/TSX Composite is down 7% year to date, and 8.4% over the past year.

The biggest reason for this dramatic underperformance stems from its significant overweight in high yielding energy names. At the end of September, it held nearly 30% in energy compared with an 18% weight in the index. Most of the energy names are pipeline or infrastructure plays, such as TransCanada Corp., Pembina, and Enbridge. These types of names make up about half the energy exposure, and unlike previous energy corrections, have been punished just as severely as a number of the lower quality companies. The managers believe that a rebound to a more sustainable oil price is forthcoming over the near to medium term, which will bode well for the fund.

Another positive note is dividends paid by the underlying companies has continued to grow, and has grown by more than 15% in the past five years. The current underlying yield of the portfolio is nearly 5%, which is an all-time high, and they believe put an underpinning of support under the fund, helping to restore its downside protection.

While I don’t disagree with their position, I have been extremely disappointed in the volatility profile. Historically, downside capture had been around 50%, meaning the fund experienced about half the drop of the market. But over the past year, it has tripled to nearly 150%. I am monitoring the fund closely and am looking for a significant improvement to the downside protection. If I do not see any such improvement, I will be removing the fund from the Recommended List. The strong downside protection was the key differentiator for this fund. Without that, there are many other Canadian Equity and Canadian Focused Equity Funds that offer potentially better risk reward profiles.

Franklin U.S. Rising Dividends Fund (TML 201 – Front End Units, TML 301 – DSC Units) – I have long viewed this fund as some-what similar to the IA Clarington Canadian Conservative Equity Fund. With its focus on fundamentally sound companies that have generated growing and sustainable dividend streams, the fund’s returns have been much less volatile than the broader market. It has lagged in rising markets, but that is a tradeoff I’m willing to make for the fund’s downside protection. However, of late, I have noticed a jump in volatility and an erosion in the fund’s downside protection. Much of this has been the result of a sharp selloff in many of the fund’s consumer names, such as GAP, which is down 25% for the past three months (to October 31), Wal-Mart is down 20%, and Walgreens is down 10%. Another drag on the fund is its significant allocation to materials, which make up more than 10% of the fund, compared to a 2.7% weight in the S&P 500. I am placing the fund UNDER REVIEW effective immediately, and will be monitoring it closely for any further erosion in the risk reward metrics of the fund.

Mackenzie Ivy Foreign Equity Fund (MFC 081 – Front End Units, MFC 611 – DSC Units) – I have said it before, and I will say it again – when global equity markets get rocky, this is the fund you want to own. With markets on a rollercoaster, the MSCI World Index lost 1.6% in the third quarter. According to Morningstar, the average global equity fund was down 3.4%. Yet this high conviction, quality focused offering managed to gain 2.6%. Part of this outperformance can be attributed to its cash position, which at the end of September sat just shy of 30%. The rest of it is the result of stock selection, with consumer staples and financial names outperforming. The portfolio is concentrated, holding 30 names at the end of August. The sector mix and country allocation is the result of the manager’s disciplined stock selection process.

In a recent commentary, the managers noted the recent selloff has improved the outlook for a number of their holdings. However, they voiced concerns the market valuation remains high, particularly in light of the slow and potentially slowing growth. They continue to focus on well-managed, high quality companies.

I continue to like this fund. It offers one of the most attractive risk reward profiles of any equity mutual fund. It offers decent upside when markets are rising, but to me the selling feature is how it behaves in down markets. The downside protection of this fund is excellent, participating in only 60% of the markets drops over the past five years. Given there has been no material changes to the way the managers execute their strategy, I don’t envision a substantial change to this on a go forward basis. I expect it will continue to do what it does, offering strong risk adjusted returns. It is likely to lag in a rising market, but that’s a tradeoff I’m comfortable with for the downside protection.

PH&N Monthly Income Fund (RBF 1660 – No Load Units, RBF 6660 – Front End Units, RBF 4660 – Low Load Units) – I continue to be disappointed by the performance of this fund. After a solid 2011 and 2012, it has lagged dramatically. I am a fan of PH&N on the fixed income side, and had hoped that was enough to offset middle of the road equity management. To date, I have been wrong. Right now, the only positive I can find in the fund is the cash flow it generates, which is currently about 5.4%. Unfortunately, with a mutual fund, cash flow does not equal quality. I am placing the fund UNDER REVIEW immediately, and will be looking for signs of a turnaround. If that doesn’t happen, it will be replaced.

Brandes Emerging Markets Value Fund (BIP 171 – Front End Units, BIP 271 – DSC Units) – To say this fund has struggled of late would be a bit of an understatement. Over the past year (to September 30), it has lost more than 20%, significantly underperforming its peers. In the past quarter alone, it was down 14%, again lagging both its peers and its benchmark. Does that mean the fund has lost its mojo? No. The problem the fund is experiencing at the moment has more to do with its deep value style, than the manager’s skill. Brandes has a well-deserved reputation as being a very strong, deep value manager. They also have a reputation of sticking to their style, regardless of what the markets are doing. Unfortunately, at the moment, the value style is significantly underperforming growth and more core styles in the emerging markets. This has no doubt affected the fund. Another factor that has hurt performance is it is more of an all cap fund compared to many of its peers, holding many more small and mid-cap names. While this is a positive over the long term, there are periods when small and mid-caps will lag. We are in one of those periods. However, I don’t expect we will be forever.

If I look at the valuation metrics of this fund compared to its peers and benchmark, it offers a significantly more attractive portfolio. For ex-ample, according to Morningstar, the P/E ratio of the MSCI Emerging Markets Index is 10.6 times. For this fund, it is 6.6 times. For the price to cash flow, the index is 5.2 times, while the fund is 2.5 times. It is even more attractive compared to its peers, with Morningstar reporting the category average P/E is 12.5 times, and the price to cash flow is 8.0 times.

That doesn’t mean the near term will be any easier. With continued worry over China, combined with lower demand for commodities, emerging markets are likely in for more trouble. If you are uncomfortable with this outlook, you may want to avoid this and other emerging market funds. However, if you are comfortable with it, and you have a medium to long time horizon, I believe this is a solid pick.

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

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PH&N Total Return Bond Fund

Analysis: Starting the quarter with a duration that basically matched the FTSE/TMX Universe Bond Index was one of the factors that allowed the fund to outperform its peers in the third quarter. This longer duration allowed it to see a nice gain after the Bank of Canada cut its benchmark overnight lending rate in July.

As the quarter progressed, the focus shifted to the market’s expectation over a potential move for the U.S. Federal Reserve to begin moving rates higher. Because of this, management became concerned over the increasing pressure on yields, and pared the duration back. At the end of September, the duration was 7.0 years, slightly below the 7.3 years of the index.

They also started the quarter underweight in corporate bonds, which proved to be a good call, with corporate and high yield issues experiencing a big selloff over the summer. After the drop, management stepped in and picked up some attractively priced issues.

At September 30, it held 47% in government bonds, and 44% in corporate bonds. They have also recently added a modest position in real return bonds, as they believe they are mispriced by the market.

Given the positioning, and active management approach, I expect it to be the best performing Canadian bond fund on the recommended list in the near term. It offers a duration that is roughly in line with the index, and a yield that is stronger. This should allow it to do well in a flat rate environment, and if we do see another cut from the Bank of Canada, which at the moment is not expected, this fund will outperform. It also has a great management team in place, using a very disciplined and repeatable process.

My preference would be to use the lower cost D or F Series of units, but even paying full freight of the Advisor Series Units, the fund remains my top Canadian bond pick for the near term.

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Manulife Strategic Income Fund

Analysis: Managed by a team headed by Dan Janis, this tactically managed global bond fund focuses on four key risks for investors; interest rate risk, credit risk, currency risk, and liquidity risk. For the quarter, it gained 1.75%, outpacing its peers.

In a recent commentary, Charles Tomes, a trader, and member of the management team of this fund said they expect the recent high levels of volatility to continue. One reason for this view is the uncertainty caused by the divergent policies of many central banks, with some countries, like the U.S., looking to raise rates, and others looking to cut, or take other stimulative actions, such as quantitative easing. Another concern is the potential economic fallout that could result from China’s slowing growth rate.

In this environment, they do not hold any U.S. Treasuries. Instead, they have been focusing on U.S. corporate bonds. They have also been reducing their high yield exposure, instead, investing in higher quality, investment grade names. At the end of September, approximately 60% of the fund was invested in the U.S. For their global exposure, they continue to like countries where they expect a favourable interest rate outlook to remain in place. This includes Canada, New Zealand and Australia, which make up 20% of the portfolio. As the Canadian dollar has continued to drop, they have increased their currency hedge position to protect against adverse currency moves.

For emerging market holdings, they like countries that have strong fundamentals, with most of their exposure in three countries; Singapore, the Philippines, and South Korea. Each carries an investment grade credit rating, and are running a current account surplus.

On average, the fund’s duration is expected to range between 3.25 and 3.75 years. The duration policy is the result of their duration calls on each of their underlying country investments.

I continue to like this fund as an excellent diversifier within the fixed income sleeve of a portfolio. It is classified as a high yield fund, however, I tend to look at it more as an actively managed global bond fund. I expect that it will continue to deliver above average returns with average volatility.

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Fidelity Small Cap America Fund

Analysis: Despite dropping 1.4% in the third quarter, the fund’s outperformance continued. The Russell 2000 was down 6.9% in Canadian dollar terms, while the average U.S. Small / Mid Cap equity fund lost nearly 5%. The recent outperformance was the result of strong relative returns from a number of technology and consumer discretionary names, with Ingram Micro and Jardine Group helping the cause.

Manager Steve MacMillan, uses a bottom up approach, with sector exposure being the result of available opportunities. He continues to look for well-managed, high quality companies that have strong recurring revenue and a high return on equity. Of late, he has been finding these opportunities in the technology, consumer, and healthcare sectors.

During the recent market volatility, the manager used the selloff to put some cash to work by adding to some existing names, and adding a couple new ones at attractive prices. At the end of September, he held just shy of 4% in cash.

Looking ahead, the manager believes the U.S. will hold up well in the face of global economic uncertainty. He sees the stronger dollar keeping inflation in check, which will allow the U.S. Federal Reserve to hold interest rates low for the foreseeable future. Lower commodity, and specifically energy prices will also be a boost to consumer spending, which is a significant contributor to the U.S. economy.

The valuation metrics of the portfolio look attractive compared with its benchmark, offering a lower P/E ratio, higher returns on equity, and higher growth rates. In addition to the strong performance, its volatility has remained in line with the index, but has offered much better downside protection.

Still, with a one year gain of 28%, an annualized three year gain of 28%, and an annualized five year gain of 25%, it may be time to take some profits in the fund, rebalancing your portfolio, bringing its weight to a more neutral level, based on your objectives and risk tolerance.

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Dynamic Dividend Income Fund

Analysis: One of the things that has caught my attention with this fund has been its consistency. Managed by the team of Oscar Belaiche and Michael McHugh, it has been one of the least volatile Canadian Neutral Balanced Funds around.

The target asset mix is set at 50/50, but the managers have some discretion around that. At the end of October, the fund held 20% in cash, 25.5% in bonds, 49% in equities, and 5% in the Dynamic Premium Yield Fund. The Premium Yield Fund is a neat little offering that uses what is best described as a hedged derivative strategy to generate its return.

Oscar Belaiche runs the equity sleeve using his “Quality at a Reasonable Price” approach. This approach looks to find high quality, well managed companies that have strong fundamentals and free cash flow yields. It is a bottom up process, with the sector mix being the result of the stock selection process. Currently, it is overweight higher yielding, more conservative sectors including utilities, telecom and real estate. Not surprisingly, it has no exposure to materials, and is underweight energy, with most of the energy exposure being in higher yielding infrastructure names.

The fixed income sleeve is conservatively positioned, with an overweight exposure to corporate bonds. It also carries a duration that is lower than the benchmark.

Performance, particularly over the long term has been excellent, gaining 6.2% for the five years ending October 31, while the category benchmark was up by 5.6%. Still, I have been more impressed with the fund’s volatility profile, with a level of volatility that has been well below the benchmark and the category average. The downside protection has also been strong, with a five year downside capture of just over 40%.

It pays a monthly distribution of $0.042 per unit, which works out to an annualized yield of 3.5%.

Looking forward, I expect this fund to continue to deliver above average risk adjusted returns.

 

 

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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.