Top Funds Report – January 2019

 

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December’s wild ride may not be over

Higher levels of volatility are expected to prevail across all asset classes…

It’s only fitting that 2018, which saw the return of market volatility, be capped off with a very volatile December. Markets took investors on a very wild ride, with all equity markets ending the month in negative territory.

The S&P 500 Composite fell by more than 9% in U.S. dollar terms, while the S&P/TSX Composite was down by 5.4%. European and Asian markets outperformed the U.S., falling by 4.6% and 4.7% respectively.

In the U.S., the large caps outperformed the small- and mid-cap stocks. The Russell 2000 fell by nearly 12%.

As bad as the month-end numbers were, the intra-month volatility was even more pronounced. Peak to trough, the index fell nearly 16%, with many global markets falling into bear market territory.

With volatility high, fixed income did what you would expect it to do in volatile markets: It posted positive returns and muted the overall equity market gyrations. The FTSE/TMX Canada Universe Index gained 1.35% as investor demand for safe haven investments pushed yields lower. Long-term bonds outpaced short-term issues, and the safe-haven government issues outperformed corporate bonds.

The reason why markets were so volatile is anybody’s guess, but there were several factors.

Higher interest rates have triggered repricing of risk assets, a key reason why equity markets have struggled. However, other worries, such as central banks moving rates too high too fast, have also been cited as contributors to sliding investor sentiment, as was ongoing concern over trade and tariffs, slowing global growth, and tax-loss selling.

Looking ahead, we are seeing conflicting signs from the economy. Various sentiment indicators and other soft data points, such as the ISM and PMI numbers, have been extremely weak of late. However, the more tangible numbers, such as job growth, industrial production, wage growth, and housing starts, remain positive, with some slowing noted.

Where we go from here remains to be seen. If investors can continue to focus on the tangible numbers, the valuation levels of equity markets are considerably more attractive than they were a year ago. Valuations are at levels not seen since early 2015 and are now below the longer-term averages. While valuation levels have historically been terrible indicators for the short-term, they are very good long-term indicators.

Where the markets go in the short term remains anyone’s guess. However, given the more attractive valuation levels today compared with a year or so ago, the longer-term expected returns for equities are better than they were this time last year.

Still, higher levels of volatility across all asset classes are very much expected to prevail. And that could mean yet more selling pressure and movement to the downside.

However, if you have been sitting on cash waiting for a more attractive valuation, today is a better time than it has been over the past few years. But be warned: The ride from here is expected to be anything but smooth, as much uncertainty remains.

In this environment, I am slightly favouring equities over fixed income.

Within equities, I prefer high-quality, reasonably valued, well-managed investments over more richly-valued, higher-growth alternatives.

For fixed income, I continue to favour higher-quality, shorter-duration investments, but as yields move higher, I am more comfortable taking on some additional duration risk.

As the environment continues to shift, I expect to adjust my positioning accordingly.

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

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Best and Worst of 2018

A look at the highs and lows of the year, as market volatility took its toll…

Last year was a volatile one for markets, particularly when compared with the preceding two years, where volatility was noticeably absent as risk assets continued their seemingly inexorable climb. But 2018 illustrated that nothing in markets lasts forever – it was a tough year, with very few places to hide.

Fixed income was the best-performing asset class, with the FTSE/TMX Canada Universe Bond Index gaining 1.4% for the year. Government bonds outperformed corporate bonds over the year for a couple of reasons.

First, with volatility returning to the stock markets, investors sought out government debt issues on a flight-to-safety trade. Second, there were several technical factors that kept corporate bonds in check, including a very robust new issue market, which flooded the market with supply of new corporate bonds for most of the year.

In equity markets, investors were hard-pressed to find any place of refuge. In local currency terms, all the major stock market indices finished the year in negative territory.

For Canadian investors in unhedged portfolios, the strengthening U.S. dollar helped to cushion the blow. A great example is the S&P 500 Composite Index, which fell by 4.4% over the year in U.S. dollar terms. However, when we consider the move in currency, the index was actually up 4.2% in Canadian dollar terms.

The worst-performing sector of the market was energy. The price of a barrel of West Texas Intermediate crude oil fell by nearly 20%, bringing the energy sector down with it. The S&P/TSX Energy Index fell by more than 26% over the year. With energy being a key component of the broader Canadian market, the S&P/TSX Composite fell by 8.9%.

With that background sketched in, I thought it would be interesting to take a look at some of the best and worst performers through 2018.

Overall

Vertex Value Fund
VRT 600 – Front-End Units
VRT 602 – Low-Load Units

This global small mid-cap equity fund was the weakest performer over the year, falling 39%. We highlighted the fund and its manager, Matt Wood, in our December issue. This is a concentrated, bottom-up value fund with a very contrarian approach that will often take it to very unloved parts of the market, such as energy, which at the end of December made up slightly less than 40% of the fund.

No doubt this is a rough patch for the fund, but if history is any guide, it may be very well positioned for a rebound. The fund has experienced many drawdowns since its 2009 launch and has often rebounded sharply after a big selloff.

While this fund is not suitable for everyone, I believe the 2018 performance is an anomaly, and I expect to see better days ahead.

Dynamic Power American Growth
DYN 004 – Front-End Units
DYN 604 – Low-Load Units

With a one-year gain of 23%, this fund posted the strongest showing overall. For a more detailed review, please see my commentary later in the report.

Fixed Income Funds

Purpose Canadian Preferred Share Fund
RAM 202 – Front-End Units

This fund is much better than its 14.4% decline in 2018 would lead you to believe. Managed by Sandy Liang of Purpose Investments, its diversified portfolio provides exposure to the Canadian preferred share market.

Unfortunately, the preferred market was subject to heavy selling pressure in the final quarter of the year, as increasing volatility led many retail investors to start dumping their preferred share holdings and ETFs, which created downward pressure in what is a very illiquid market even at the best of times.

The selling pressure then fueled tax-loss selling and a vicious cycle began, with the preferred market as a whole falling by 8%.

Looking ahead, this fund has a strong manager at the helm. Its underlying portfolio yield of 5.3% makes it an attractive source of tax-advantaged income for investors.

Furthermore, as the market stabilizes, the same illiquidity that drove prices sharply lower has the potential to push them up quickly as well.

Mawer Global Bond Fund
MAW 140

With a gain of more than 7%, this fund was at the top of the list of best-performing fixed income funds. However, before we get overly excited about this return, it appears that most of this performance was the result of the fund’s unhedged currency position.

Currency moved significantly throughout the year as the U.S. dollar gained more than 8% on the Canadian dollar.

Given the currency exposure, I would expect the fund to remain more volatile than the index and the peer group.

Instead of this offering, I’d favour a fund that has fully-hedged currency exposure or uses a more tactical currency management process.

Canadian Equity

AGF Canadian Growth Equity Fund
AGF 781 – Front-End Units
AGF 248 – Low-Load Units

With a drop of 20.6% in 2018, this was the worst performing Canadian equity fund for the year. Manager Peter Imhof has nearly 20 years’ experience managing money and has been with AGF for roughly three of those.

This bottom-up, growth-focused, all-cap Canadian equity fund looks for businesses with high growth prospects, solid management, and reasonable valuations. The portfolio is overweight energy, which has been a headwind. It is also overweight consumer names, industrials, and technology.

Unfortunately, the fund has struggled, posting below-average returns in eight of the last 10 years. In addition to the poor performance, volatility has also been well above average. I believe there are better opportunities available.

Fidelity Canadian Large Cap Fund
FID 231 – Front-End Units
FID 031 – Low-Load Units

I have been a fan of this fund for many years, largely because of the defense-first positioning used by lead manager Daniel Dupont. However, the fund’s performance through the second half of 2016, all of 2017, and the first half of 2018 really tested my conviction in the strategy.

The fund has a history of stellar performance in volatile market environments, and 2018 was no exception, with a negligible -0.15% decline for the year, it handily outpaced the index and the peer group. For a more detailed review, please see my commentary later in this report.

U.S. Equity

IA Clarington Focused U.S. Equity
CCM 9965 – Front-End Units
CCM 9967 – Low-Load Units

Manager David Taylor built a very strong reputation when he ran several funds at Dynamic. Unfortunately, he has struggled to replicate that success since striking out on his own in 2012, as seen in this fund.

The fund has an all-cap mandate that lets the Mr. Taylor search out companies he believes are trading below his estimate of their true worth.

The portfolio is fairly concentrated, holding roughly 25 stocks, with the top 10 representing a little more than half the fund. Mr. Taylor looks well off the beaten path for opportunities, and the top 10 holdings are salted with many companies that most retail investors will not have heard of.

Performance was very solid in 2016, but the fund has struggled in most other years since its 2014 launch. It has a compounded average annual 3-year loss of 3.6%.

Looking ahead, the valuation levels of the portfolio are very strong, as is the growth outlook. However, the fund’s volatility is well above average and higher than the peer group.

Still, I’d want to see a meaningful turnaround before I could start to get comfortable with this fund.

Dynamic Power American Growth Fund
DYN 004 – Front-End Units
DYN 604 – Low-Load Units

This is a very actively managed, concentrated U.S. equity portfolio managed by market veteran Noah Blackstein. In addition to being the best-performing U.S. equity fund in 2018, it was also the best-performing mutual fund in 2018. For a more detailed review, please see my commentary elsewhere in this report.

Global/International Equity

Mackenzie Cundill Value Fund
MFC 736 – Front-End Units

Value stocks have trailed growth names by a wide margin for most of the past few years. It really wasn’t until last fall that we saw the markets start to reward fundamentals and value stocks start to perform better. In such an environment, it’s not surprising to see a value fund as the worst performer in the year

With a loss of more than 19%, this concentrated, deep-value mandate was the worst performer in the year. The nearly 12% decline in December didn’t do the fund any favours.

Prior to the financial crisis, this was one of my favourite global equity funds. But since then, it has really struggled to regain its footing.

There has been a lot of turnover with the management team, and current managers Jonathan Norwood and Richard Wong have been running the show since 2016.

The fund has underperformed, capturing a fraction of the market’s upside while participating in significantly more of the downside.

Still, given the history of the Cundill name, I’m rooting for this fund, but until I see more evidence of stability in terms of the management team and the execution of the investment process, I’ll be looking elsewhere for global equity exposure.

Guardian Fundamental Global Equity Fund
GCG 578 – Front-End Units

This is a fund that most people will not have heard of, but it has been one of my favourites for a couple of years now. Part of the reason for its obscurity is that it is not widely available. Currently it is offered only through Worldsource Financial Management or Worldsource Securities.

In May, BMO launched a version for wider distribution, the BMO Concentrated Global Equity Fund. While the retail version has a limited track record, it has a much longer institutional history of delivering above-average risk-adjusted returns.

For a more detailed review, please see my commentary elsewhere in this report.

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

 

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January’s Top Funds

 

IA Clarington Floating Rate Income Fund

Analysis: Over the past couple of years, investor worries over rising interest rates have created significant investor interest in floating rate loans. These are instruments that pay a rate of interest that floats with a market interest rate, usually LIBOR.

A few years ago, there were only a couple of funds in the space, but number this has since grown, and today there are 15 different offerings. My favourite in the space remains this fund from IA Clarington, managed by Jeff Sujitno of IA Clarington. For 2018, the fund gained 0.4%, which was middle of the pack.

Mr. Sujitno’s approach is very simple and is best described as “clipping coupons.” He looks for loans offering an attractive coupon rate that are trading at a discount to par. The process starts with a top-down macro analysis, which helps the manager 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 manager must also do extensive bottom-up credit analysis, as some borrowers have used “add backs,” which are adjustments to earnings and cash flows that make a company look stronger than it may be.

Last year was a tough one, with spreads on loans widening in the fourth quarter of the year. Still, Mr. Sujitno sees opportunity in the space, as LIBOR is still expected to move higher, bringing the coupon rates up. While coupons are expected to move higher, so too are spreads, which are likely to widen throughout 2019. Investor demand in the space is likely to remain strong as well.

In this environment, Mr. Sujitno remains defensive and conservative to help limit price volatility and surprise risk. The focus is therefore on larger, more liquid loans, as there is a risk that liquidity may suffer if we see any turbulence in the market. He avoids those names that have cash flows that are linked to commodity prices.

Apart from 2016, the fund has posted above-average returns in every year since its launch. While other funds, namely Mackenzie’s offering, may post a more attractive absolute return stream, the defensive positioning and risk management focus of this fund keep it at the top of my list.

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Fidelity Canadian Large Cap Fund

Analysis:

This fund has been on my Recommended List of Funds for a decade. Over the past 10 years, it has generated an impressive average annual compounded rate of return of 12.5%, handily outpacing the 7.9% gain of the S&P/TSX Composite.

However, my resolve was certainly tested throughout most of 2016, all of 2017, and the first half of 2018. With its disciplined, bottom-up, value-focused approach, the fund struggled as more growth-focused names rallied, leaving value and quality stocks behind.

But last summer, volatility returned, and attention again turned to fundamentals, an environment for which this fund is designed. Manager Dan Dupont takes a defense-first type of approach that looks to find strong companies with long-term sustainable business models that have unrealized growth potential and are trading at significant discounts. He looks for high quality management teams with a strong and consistent track record that he believes can deliver a high return on capital

The portfolio tends to be somewhat concentrated, holding roughly 30 names. At the end of November, the top 10 holdings made up approximately 40% of the fund.

Given his focus on valuation, cash balances have been higher than normal, and the portfolio has been very defensively positioned. Mr. Dupont was overweight telecom, consumer staples, utilities, and technology. He was significantly underweight the more commodity-dependent sectors of energy and materials, which helped performance.

This paid off very well as we headed into the final months of the year. For example, in October, the TSX was down 6.3%, while the fund was down 1.1%. In December, the index was down 5.4%, and the average Canadian-focused equity fund fell nearly 6%. But this fund was down a mere 5 basis points. While three- and five-year returns have been in the middle of the pack risk-adjusted returns are above average.

Even more impressive, the downside participation over 1-, 3-, 5-, and 10-year periods has been less than half, meaning this is an excellent fund to hold in a volatile market environment to protect your capital.

Given the expectation of higher volatility from here, this remains a great choice for investors looking to have some exposure to the equity markets, but with capital well protected in periods of volatility.

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Guardian Fundamental Global Equity Fund

Analysis: The retail version of this fund went live in July 2014 in Canada, but it has roots dating back to 2006. The managers use a somewhat unique, but very disciplined investment process, which has delivered excellent results. In 2018, it gained 8.9%, handily outperforming the 0.1% gain in the MSCI World Index and leaving most of its peer group in the dust.

This is no fluke. Looking at the institutional version of the fund going back much further, and adjusting for fees, it has gain an annualized 14.4%, compared with the 12% rise in the index.

While the investment process has a growth tilt, what makes it unique is that instead of looking out a quarter or two, or even a year, the managers take much longer-term view. Instead, they are looking for companies that have the ability to sustain their growth rates for five to 10 years and be able to withstand economic shocks.

The managers look at a variety of growth, quality, and valuation criteria, seeking companies with the ability to generate returns on invested capital in excess of 12%. The valuation of companies that emerge from these screens are carefully assessed to ensure the managers are not overpaying.

The portfolio is concentrated, with fewer than 25 names in the portfolio at the end of November, with the top 10 making up 54% of the net asset value. The managers have a long-term outlook and are patient, evidenced by their portfolio turnover of less than 40% per year.

The process is bottom up, with the sector weights and country mix being the result of the stock selection. At the end of November, the fund was overweight financial services, consumer names, and healthcare. It had no exposure to energy, materials, telecos, or utilities. Risk controls set industry maximums at 20%. Geographically, it had roughly 70% in the U.S., 22% in Europe and the U.K., with the balance in Asia.

Given the growth tilt, valuation levels were well above the index and peer group, but so too were the earnings growth expectations. Volatility has likewise been above the index and peer group.

The fund is currently available exclusively through Worldsource. Recently, BMO launched a version of the fund, the BMO Concentrated Equity Fund.

Looking ahead, the fund may see its relative return moderate as the market leadership shifts toward value. However, the emphasis on quality gives the fund the potential to hold up better than some of its more growth focused peers. All in all, this remains a great core global equity option for most investors.

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Dynamic Power American Growth Fund

Analysis: Even after falling 19% in the final quarter of the year, this fund managed to outperform all the other mutual funds in Canada, with its one-year gain of 23.2%, well above the index and the peer group.

There is no real secret to what veteran fund manager Noah Blackstein does. While his management style is no secret, there are very few managers who do it better. He runs a very concentrated, growth-focused portfolio.

He looks for companies that have the best growth prospects, strong earnings momentum, and a history of upside earnings surprises. At the end of October, the fund held only 26 stocks spread across five sectors.

Mr. Blackstein’s mandate allows him to invest of companies of any size, but he tends to favour mid-cap and large-cap names. His approach is very active, with portfolio turnover approaching 200% per year.

Not surprisingly, technology is the largest exposure, making up more than half of the fund. The individual names in the portfolio change frequently but will often include many “off-the-beaten-path” type of stocks. For example, at the end of September, tech holdings included payment processor Square Inc., food delivery service Grubhub, and cloud computing company ServiceNow.

Next up is healthcare, which constitutes a quarter of the fund’s allocation. Again, most of the holdings are not exactly household names, including, for example, genetics firm Illumina and biotech firm Vertex Pharmaceuticals. The rest of the portfolio is invested in consumer-focused stocks.

Performance, particularly over the long-term, has been excellent, with the fund outperforming the index and the peer group by a substantial margin. But the ride has been anything but smooth. The fund’s volatility is substantially higher than the index and the peer group.

Furthermore, the fund can experience some pretty dramatic drawdowns. For example, in 2008, it fell by more than 44%, and peak to trough during the financial crisis, it was down 50%.

While this has been an excellent performer over the long-term, I don’t believe it is well suited as a core holding. It is much too volatile for that. Still, if you have a very high risk tolerance and are looking to add some torque to your portfolio, this should be one of the funds at the top of your list for consideration.

 

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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.