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IA Clarington Floating Rate Income Fund (CCM 9940 – Front End Units, CCM 9942 – Low Load Units) – With the recent upward pressure on yields, investors are looking for ways to protect their portfolios. One asset class that can help do that is floating rate notes and loans, which pay a rate of interest that floats with a market interest rate, usually LIBOR. In most cases, this coupon rate is reset monthly, more or less eliminating duration risk. These loans are typically unrated, non-investment grade credits, that are often well-collateralized with seniority in the capital structure, providing protection against potential defaults. Another benefit is floating rate investments tend to have low correlation to the more traditional asset classes, making them a strong diversifier when incorporated in a well-diversified portfolio.
My favourite fund in the floating rate space is this offering managed by Jeff Sujitno since its launch in 2013. Before this Fund, he ran a similar strategy with Norrep with strong success. His approach is very simple, and is best described as “clipping coupons”. Mr. Sujitno looks for deals that offer an attractive coupon rate, and he looks to buy those at a discount to par.
The investment process starts with a top down macro analysis, which helps him and his team understand the market trends, and risks, and helps set up their outlook. Security selection is done using a fundamentally driven, bottom up credit analysis that focuses on cash flow generation, sustainability of revenues, balance sheet strength, and quality of management.
The portfolio will typically be made up of 70% to 80% in floating rate debt, with the balance in high yield bonds and other asset backed securities. The bond allocation allows for stronger diversification and provides relative value opportunities. The portfolio is diversified, typically holding between 100 and 125 securities. Individual position weights do not make up more than 2% of the Fund. It invests mainly in U.S. traded issues, and all currency exposure is fully hedged.
On an absolute basis, performance has been modest, gaining 3.3% for the three years ending June 30, putting it right around the category average. However, with the quality focused, income centric approach, portfolio volatility has been the lowest in the category for the past three years, resulting in a category leading risk adjusted return. It’s not cheap, with an MER of 1.84% for the full freight advisor series. However, in a fee based account costs are a bit more reasonable, coming in at 1.16%
Looking ahead, Mr. Sujitno is not looking for significant capital gains in the Fund. Instead, he is looking for a return more in the 3% to 4% range, which is consistent with the portfolio’s underlying yield, less fees. I like the space and particularly this Fund. But be warned, this is NOT a money market substitute, nor is it a replacement for traditional fixed income. Instead, it is best used as a piece of a well-diversified portfolio as a compliment to the more traditional asset classes to diversify risk in a portfolio.
Trimark Emerging Markets Fund (CCM 9940 – Front End Units, CCM 9942 – Low Load Units) – With valuation levels in developed markets trading well above historical averages, emerging markets look downright cheap in comparison. The S&P 500 is trading at 21 times forward earnings, while the MSCI Emerging Markets Index trades at less than 15 times. Further, growth rates in many countries in the developing world far exceed those offered by the more developed countries. Factor in positive demographics, less dependence on commodities, and increasing investor interest and the case for adding emerging markets becomes compelling.
On a risk adjusted basis, this Jeff Feng managed offering has been one of the more compelling in the space. Based in Invesco’s Hong Kong office, Mr. Feng is supported by a team of two dedicated emerging market analysts, and is also part of the broader Trimark Global Equity team. The Fund is managed much like the other Trimark branded funds, where they view investing not like they merely trading stocks of companies, but instead, taking an ownership interest in those companies.
The investment focus is on identifying well-managed, high quality companies that are located in, or very active in the emerging markets. The investment process is very much a fundamentally driven, bottom up approach, and the managers can invest of companies of any size. Once the find a potential investment opportunity, the Manager will build out a proprietary model that evaluates the historical financial statements, identifies free cash flow drivers, creates forecasts and sensitivity analysis, and determines a reasonable estimate of the true value. They look for companies that they believe can generate and grow above average levels of free cash flow, are growing organically at an above average rate, can generate unlevered, high return on invested capital through a full market cycle, and have a sustainable competitive advantage.
In addition, they are looking for strong management teams that are not only excellent operators, but have a demonstrated history of effective capital allocation. They also like to see management teams that have compensation programs that align their interests with shareholders. One factor that is particularly critical in the emerging markets is corporate governance, given the regulatory regimes, or lack thereof in certain emerging market countries.
Valuation is important to their process, but this is not a value fund in the traditional sense. They will determine a company’s valuation level using a discounted free cash flow model. Then, they will look to buy that company at a discount to what they believe it to be worth. However, they are willing to pay a higher price for an exceptional business.
The geographic and sector allocation is a byproduct of the stock selection process. They are benchmark agnostic, and can invest in company of any size. At the end of June, it held roughly 65 names, with the top ten making up around 22% of the Fund. Approximately 70% was invested in large cap names, with the balance in mid-cap names. Looking at the sector mix, there is a decided consumer focus to the portfolio, with more than 50% invested in consumer-focused names. It also had more than 18% in technology, and 17% in financials. They like the consumer areas because as the emerging markets continue to evolve, there will be a growing middle class that will be able to purchase not only things they need, but soon, things they want. This bodes very well for the consumer and technology sectors over the long-term.
Geographically, China is its biggest weight, coming in at more than 30%. South Korea is the next largest, followed by Brazil and Russia. Combined, these three sectors don’t have as much weight as China. The Manager likes China because, as noted in a recent commentary, they believe Chinese economic growth is now more important for global growth than any other country. They see some early signs of a bottom, and does not expect a hard landing.
Performance has been excellent, and it has outpaced both its benchmark and peers on both an absolute and risk adjusted basis. Over the past three and five years, the Fund has experienced nearly all the upside of the market, and has done an okay job protecting capital on the downside. Volatility has been in line with the index and category average, but given the quality focus of the portfolio, this has the potential to be lower in time.
My biggest concern for this Fund is its cost, with an MER of 2.79% for the full freight advisor sold units. This is above the category average. If you are buying the Fund in a fee based account or buying the do-it-yourself units, the cost is lower, coming in a 1.68%, and 1.67% respectively.
For those looking for emerging market exposure, but don’t want the potential volatility of the Brandes Emerging Markets, this is an excellent fund to consider. It has a great management team in place, using a proven, disciplined investment process, in an asset class with a very strong long-term outlook. Be warned, this is a sector specific fund, as a result has the potential to be highly volatile in certain market environments. As long as you are aware of, and comfortable with the risks, this is a solid pick.
Deletions
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Funds of Note
Dynamic Advantage Bond Fund (DYN 258– Front End Units, DYN 538 – Low Load Units) – The Fund again lagged its peers over the quarter, but managed to outperform in June as bond yields shot higher after an abrupt about face from Bank of Canada Governor Steven Poloz. For the quarter, the Fund eked out a modest 0.1% rise, while the FTSE/TMX Canadian Universe Bond Index rose by 1.1%. However, in June, while the index dropped by nearly 1.2%, this Fund lost 0.75%, or 64% of the downside. In July, it was a similar scenario, with the index losing 1.9%, while the Fund lost 0.76%, or only 40% of the downside.
This recent performance highlights why I have liked this Fund. Unfortunately, it appears I was much too early in my call, as the conservative positioning has certainly cost it return in the falling yield environment. As we head into the fall, it appears as if the Canadian bond market is expecting another two or three rate hikes from the Bank of Canada, and these are already priced in to bond prices. In this environment, higher volatility is likely, and these are the market conditions where this Fund should really shine. I will be watching it very closely to make sure it performs as expected. If I see a significant deviation from expectations, it will be removed from the Recommended List.
CI Signature High Income Fund (CIG 686– Front End Units, CIG 1786 – Low Load Units) – This tactical balanced offering which is managed by Eric Bushell and the Signature Global Asset Management team has long been one of my favourite balanced funds. However, in recent quarters, I have noticed some modest erosion in the risk adjusted returns, which I believe can be explained by the focus on quality and yield, which have been out of favour of late.
The Fund invests in a mix of income focused equities and fixed income, with a decided focus on corporate bonds. It has a tactical mandate, and can invest anywhere in the world. At the end of June, it has 60% invested in the U.S., 23% invested in Canada, with the rest globally. The investment approach is somewhat style agnostic, and involves an analysis of an investment candidate’s entire capital structure. This provides a very holistic view of the company, and allows the managers to be opportunistic, and invest in the most attractive part of the company. In addition to the fundamental review, the team focuses on many qualitative aspects of the company, such as management, disclosure, and governance. The team also develops a comprehensive outlook for economic growth, interest rates, capital market conditions, and geopolitical tensions, which helps identify the asset classes and sectors that are most likely to benefit.
In the equity sleeve, the focus is on higher yielding instruments including REITs, and infrastructure, as well as more traditional dividend paying stocks. According to Morningstar, the underlying yield of the Fund’s equity holdings was approximately 4.75%, which is well above the index and peer group. While the stock selection process is bottom up focused, the sector mix is consistent with a yield focused portfolio, with overweights in Real Estate, utilities, and energy infrastructure plays. They like the infrastructure as an asset class, because they quite often will have revenue streams that move up with inflation.
On the fixed income side, the focus is on corporate bonds. They can invest in government bonds, but will typically only do so when they are being very defensive. Given the outlook for rising interest rates, they expect credit spreads to tighten, particularly in high yield bonds, which is why they have taken a significant weight in the non-investment grade space. They also hold some floating rate preferred shares, and some floating rate loans. This will help lessen the duration exposure of the portfolio, protecting against any further yield hikes.
As we head into the fall, the managers expect continued global growth, but given Central Banks newfound enthusiasm for tightening, combined with high valuations, and low market volatility, there is a very high probability we may see a return of market volatility. If that higher volatility scenario plays out, I would expect to see the fixed income sleeve hit harder, given its larger exposure to high yield bonds. However, the quality and yield focus of the equity sleeve should hold up better than many of the highly levered, richly valued names that have been responsible for much of the recent market moves. Over the long term, I expect the Fund to continue to deliver average or better returns with lower levels of volatility.
Guardian Global Dividend Growth Fund (GCG 570– Front End Units) – The Fund has struggled in the past few quarters, significantly underperforming the MSCI World Index. For the year ending June 30, the Fund gained 7.3%, while the index gained nearly 18.5%. Much of this underperformance happened in the second half of 2016, although it continues to lag in the first half of 2017.
Recently, I had the opportunity to speak with Fiona Wilson, one of the portfolio managers on the Fund’s investment team. According to Ms. Wilson, a key reason for this underperformance has been that the sectors driving most of the gains, namely technology, contain a significant number of stocks the Fund cannot invest in, because they pay no dividend, or offer a yield that is well below the minimum threshold for inclusion in this dividend focused fund. The fund was unable to invest in nearly 40% of the top gaining tech names because of this yield constraint. One prominent driver they cannot invest in would be Amazon, which gained 35% in the past year, but paid no dividend. Facebook is another strong driver of index returns, with a one-year gain of more than 32%, but again, pays no dividend, preventing the Fund from holding it.
Another factor that it has been lesser quality, higher beta, lower yielding names that have been responsible for the lion’s share of the market gains, and dividends, and specifically dividend growth strategies have been out of favour for the past several quarters. A feature of this strategy is it tends to be rather defensive, and holds up better in more volatile markets. Markets have been very calm of late, with measure of market volatility touching on historic lows.
Combined, there is an almost perfect storm which is causing the underperformance for this Fund. Looking at the underlying portfolio metrics of the Fund, it trades at more attractive valuation levels, with higher levels of expected earnings growth than the index or peer group.
It is expected that as we start to see a more normalized interest rate environment, and the equity markets return to having fundamentals, rather than liquidity drive share prices, the Fund will be expected to see improving performance. Further, if we see an uptick in volatility in the fall, this Fund would be expected to hold up better than the index and peer group. This bodes well for future expected returns, unfortunately the timing remains uncertain.
I understand the investment process and see the underlying portfolio metrics as a positive. While the Fund has underperformed, I will continue to exercise patience for the next quarter or two and keep the Fund UNDER REVIEW. I will monitor it closely, looking for any meaningful change in its expected risk reward metrics, or its valuation or growth outlook.
Fidelity NorthStar Fund (FID 253– Front End Units, FID 053 – Low Load Units) – In the past few quarters, the cash position in the Fidelity NorthStar Fund has risen substantially. At the end of June, it held nearly 40% in cash, with the overwhelming majority of this coming from the portion of the portfolio that is managed by Dan Dupont. Mr. Dupont is a disciplined value manager who focuses on mitigating downside risk. In the current environment, he is having difficulty finding high quality, well managed companies, that are trading at a price that he is comfortable paying.
In a recent commentary piece, Mr. Dupont noted that he is finding that debt levels of many companies are high compared with their level of profitability. At these debt levels, higher interest rates will create higher costs for companies, which will negatively affect their profitability and cash flow levels. Another worry was profit levels remain elevated by historic levels, and they tend to mean revert in time. But perhaps his biggest concern was valuation, which is significantly higher than historic averages. While there are individual securities that are reasonably priced, they are more difficult to find.
To help manage this high cash balance, Mr. Dupont has been investing in select merger arbitrage opportunities. How this works is when two companies announce a merger, the target company will often be trading at a discount to the deal price. By purchasing the stock of the target company at a discount on those deals with a very high probability of closing, he is able to lock in a modest profit for the fund in a reasonably short period of time. This is not expected to be a significant alpha driver for the Fund, but more of a way to earn a rate of return that is in excess of the current rate paid on cash.
Also note, the cash levels are very high in the Fidelity Canadian Large Cap Fund, also managed by Mr. Dupont. At the end of June, it held around 20% in cash, which is the maximum it is allowed based on its investment policy statement. I’m certain that if he could go above this limit, he would.
While I agree with Mr. Dupont that valuations are elevated, the significant high cash balance is starting to become a concern in the NorthStar Fund. I will watch things closely. In the event that we do see any meaningful market correction, both NorthStar and Fidelity Canadian Large Cap Fund would be expected to hold up better than the index and peer group.