Top Funds Report – February 2019

 

Download a PDF Copy of this report

---

 

Stocks roar back from December lows

But risks remain as volatility likely to be higher over the next month…

After what can charitably be described as a horror show in December, markets came roaring back in January. The S&P/TSX Composite Index surged higher, gaining 8.74%, with all sectors moving up led by the heavyweight financial and energy sectors. The big U.S. blue-chip S&P 500 Composite Index gained more than 8% in U.S. dollar terms, and internationally, the MSCI EAFE Index rose by 6.6%.

With conflicting economic signals, concerns over central banks, and tax-loss selling fueling losses in December, valuations were pushed well below fair value, creating a significant buying opportunity. Much of the rebound in the new year can be attributed to markets moving back from oversold levels reached in December.

Also contributing to the rally were comments from central bankers, namely U.S. Federal Reserve Chair Jerome Powell, that the next interest rate move would be data dependent. Translated, this means the Fed is likely to tone down its hawkish attitude on monetary policy that dominated its thinking in the first nine months of 2018. This pushed the U.S. dollar lower against the loonie, as the greenback dropped to C$1.3144 from C$1.3642 in the month.

Economic data released in the month showed the global economy continuing to feel the effects of the trade war. However, other data points, namely retail sales and industrial production, rebounded, suggesting that things are starting to stabilize. Strong earnings and hopes that a trade truce could be reached with China were also drivers of more positive market sentiment in the month.

Bond markets moved modestly higher as yields moved lower. Longer-dated issues outperformed shorter maturities, and corporate bonds outperformed governments. The corporate bond outperformance, like the rebound in equity markets, was mostly a result of the recovery from oversold positions.

While the overall tone of markets has improved from December’s extreme pessimism, many risks still remain. Consequently, I expect volatility to stay higher over the next month, and so I continue to emphasize quality both in fixed income and in equities.

In terms of emphasis, I continue to favour equities over bonds, although only slightly. For equities, I am favouring more defensive types of funds, including many of the low-volatility and dividend-focused funds. I have a slight tilt towards U.S. equities, but I may move to more neutral positioning if we continue to see valuations pushed higher.

Within fixed income, I continue to favour lower-duration, higher quality issues. I remain underweight high yield issues, because there may be some more room for selling in the near term.

I continue to watch the credit markets for signs of erosion, but I am very encouraged by the rebound we witnessed in January and so far in February. In this environment, I remain consistent with my investment outlook.

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

---

 

Balanced Funds Overview

A long-time reader asks some questions on balanced funds… 

A month or so ago, one of my long-time readers sent me an e-mail asking about balanced funds. With market volatility on the upswing, this reader was concerned about recent performance and wondered if balanced funds were the best way to meet his investment objectives. On the surface, this appears to be a very simple question, but digging deeper, it becomes considerably more complicated.

First, Balanced is a very broad category. The Canadian Investment Funds Standards Committee (CIFSC), the industry group that determines and defines Canadian investment fund categories, has seven different balanced categories, ranging from the more conservative to the aggressive.

The most conservative balanced funds are in the Fixed Income Balanced category. To qualify, a fund must invest at least 60% in fixed-income securities. There are also Canadian and Global Fixed Income Balanced categories.

The more “balanced” balanced funds fall into the Neutral Balanced Funds category. With these offerings, the equity allocation in the fund must range between 40% and 60%. When you think of a balanced portfolio, this is typically what most people are referring to.

The more growth-focused Equity Balanced category invests between 60% and 90% of its holdings in equity securities. There is another category that is “Tactical Balanced.” A tactical balanced fund has a flexible asset mix that gives fund managers a significant amount of leeway in managing the fund.

As with all fund categories, there are many high-quality balanced funds and many that are sub-par. There is no magic solution to a balanced fund. They are really a multi-asset fund with an equity sleeve and a fixed income sleeve. Performance is going to be largely dependent on how much is allocated to each asset class.

The first question from the reader is: Why are balanced funds down so much? Well, first, we need to see how poorly balanced funds have performed. The accompanying table shows the performance of the category averages to Dec. 31. As you can see, balanced funds have indeed struggled in the past year, and in the fourth quarter of 2018 specifically. The main reason for the poor performance is the fact that investment markets in general have struggled.

Canadian equities fell by more than 10% in the fourth quarter and were down nearly 9% for the year. U.S. equities and international equities both struggled, falling sharply in the fourth quarter. U.S. equities ended the year in positive territory helped only by the drop in the value of the Canadian dollar, while international equities were down nearly 6% in the year.

Fixed-income markets were mildly positive both in the quarter and the year. The FTSE/TMX Canada Universe Bond Index gained 1.8% in the quarter and ended the year up 1.4%.

When we put the broader context around what actually makes up a balanced fund, it becomes clearer why they have performed so poorly in the recent past.

The second question from the reader is: “Like many others, my goals are capital appreciation PLUS protection of capital. For this purpose, I am currently invested in balanced funds. Are balanced funds the best way to go to achieve these goals?”

I’ll be honest, I have historically not been a fan of balanced funds. I have found them to be largely sub-par investments. A key reason for this comes down to the fact that no one fund company does everything well. Some fund companies are great at managing equities while others are great at fixed income. It is rare to find a company that can do it all. The result is a portfolio that is well diversified but that may have a portion that is consistently underperforming.

Another concern is that while many managers are great at selecting securities and building their own portfolios, be they equities or bonds, they may not have the expertise to determine the most appropriate asset mix for the conditions.

This has changed over the past few years as many of the bigger fund companies (Fidelity and Mackenzie are two that immediately spring to mind) have created teams that are responsible for setting the asset mix of the various balanced portfolios, while letting the underlying fund managers do what they do best. This structure has the potential to lead to better risk-adjusted performance over the long term. Still, it doesn’t make up for the fact that all fund managers are not great in all asset classes.

While I appreciate the simplicity of a balanced fund, I believe that in most cases investors can do a better job by creating their own portfolio using the best-in-breed funds. This allows the investor to tailor the portfolio to meet their specific needs. It also allows the investor to become more aggressive or more defensive depending on their outlook on the markets.

In the end, a build-your-own solution has the potential to result portfolios that better match the investor’s objectives. I look at some of the better balanced funds below and in my Top Funds reviews.

 

---

Balanced Fund Highlights

This month, I take a look at some of the wide range of balanced funds available… 

BMO Monthly Income Fund (GGF 70148 – No Load Units, BMO 95148 – Low Load Units) – For investors seeking regular income, this one may be a decent option. It aims to deliver stable income while protecting capital and providing the potential for capital gains. It pays a stable $0.02 per unit monthly and will pay out any capital and other income in December. Not factoring in other distributions, the distribution yield was about 3.7% at the end of January.

The fund invests in a balanced portfolio of income-generating equity securities and predominantly investment-grade bonds.

For the equity sleeve, the manager applies a bottom-up fundamental investment process to identify attractively priced securities. On the fixed-income side, the approach is based on the manager’s interest rate outlook.

Performance has been decent, with 5-year average annualized compounded rate of return of 5.7%, outperforming the peer group. Volatility has been roughly in line with the benchmark and peer group.

It has done a solid job protecting capital, participating in nearly all the upside, and less than two thirds of the downside. All things considered, this is a decent, conservative balanced offering, that is probably better suited to do-it-yourself investors.

PH&N Balanced Fund (RBF 6350 – Front End Units, RBF 4350 – Low Load Units) – The fund is structured very much like a fund of funds with investments in mutual funds managed by RBC Global Asset Management. The asset mix is managed by Sarah Riopelle, who uses a top-down macro analysis to understand the broader economic environment and positions the fund accordingly. The neutral asset mix is 38% Canadian bonds, 30% Canadian equities, 26% foreign equities, 4% emerging market equities, and 2% in cash. At the end of December, the asset mix was roughly in line with the benchmark.

The manager has positioned the fund for slowing global growth but expects that equities, while likely more volatile, will deliver better risk adjusted-returns compared with bonds.

Performance has been above average. The 5-year average annual compounded rate of return was 5.5%, putting it well into the top quartile. In 2018, the fund was down 4%, faring only slightly better than average. Volatility has been higher than average, resulting in slightly better risk-adjusted performance.

In addition to the higher overall volatility, the fund tends to experience much of the downside of the market. While the overall numbers have been decent, the fund’s volatility is a negative. I’d lean towards other balanced funds that have a smoother ride.

Mackenze Ivy Canadian Balanced Fund (MFC 082 – Front End Units, MFC 3160 – Low Load Units) – Over the years, I have come to equate Mackenzie’s Ivy brand with capital preservation and downside protection, and this fund is no exception.

The fixed-income sleeve is managed seasoned manager Steve Locke and his team. The equity sleeve has a strong large-cap and value style orientation. The process is benchmark agnostic and results in a portfolio that is much different than the index. The equity sleeve of between 35 and 40 names is currently defensive and holds industry leaders in both Canadian and global companies.

The fixed-income sleeve uses a “core-plus” approach that invests in both Canadian investment-grade issuers and higher-yield instruments. At the end of December, the bond sleeve was overweight corporate bonds, with about 80% of holdings rated investment grade.

Asset mix for the overall portfolio is somewhat defensive right now, running approximately 68% in equity, 7% in cash, and 25% in bonds. The fund has also done an excellent job protecting capital, participating in only 50% to 60% of the market downside. Over the past five years, it has delivered roughly 70% of the market upside.

This is not a fund I would ever expect to “shoot the lights out.” But if you’re a bit more conservative and are looking for a relatively steady ride in a Canadian-focused balanced fund, I believe this is one to consider.

Mackenze Canadian Growth Balanced Fund (MFC 724 – Front End Units, MFC 3197 – Low Load Units) – Another superior fund from the Mackenzie stable, this fund has produced excellent long-term performance, and I don’t see that changing. In the near term, though, it may be susceptible to higher volatility and may see modest underperformance. More conservative investors may want to look elsewhere given the potential for higher volatility.

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

 

---

 

February’s Top Funds

 

Mawer Balanced Fund

Analysis: Top-rated Mawer Investment Management uses a very disciplined, repeatable, and apparently very simple investment process. On the equity side, managers look for high-quality wealth-creating companies that have a sustainable competitive advantage, excellent aligned management teams, and shares trading below what mangers believe to be their true value.

This process has resulted in steady, consistent above- average risk-adjusted performance across all asset classes. Each of the company’s equity offerings has delivered top-quartile performance over the longer-term. Not so for their two fixed-income offerings, one Canadian bond and one global. The fixed-income managers use a relative-value type process that looks for both government and corporate bonds that offer a very attractive risk-reward framework. Performance has been more mixed, relative to the equity strategies.

The Mawer Balanced Fund is an excellent one-ticket solution that invests in a mix of the underlying Mawer funds. The asset mix is determined by manager Greg Peterson based on his view of the risk-reward outlook. At the end of December, the fund held 6% in cash, 34% in bonds, 15% Canadian equity, 20% U.S., and the rest in international stocks.

Performance across all time periods has been excellent. Looking back over the past 10 years, the fund has posted above-average returns each year, except 2016, when it posted third-quartile performance. As of Jan. 31, the fund posted a 5-year average annual compounded rate of return of 7.41%, handily outpacing the category average of 4.9%.

Volatility has been in line with the category, but the above-average returns have resulted in risk-adjusted performance that is well above average. The fund has also done an excellent job in protecting capital in down markets. For the five years ending Jan. 31, it participated in only 80% of the downside of the benchmark.

When it comes to balanced funds, this remains an excellent choice, mainly driven by the extremely high quality of the underlying investment funds, particularly on the equity side. Factor in a very low MER of 0.92% and it becomes an excellent core holding for do-it-yourself investors and those using fee-based accounts.

.

---

 

Manulife Monthly High Income Fund

Analysis: Co-managed by Alan Wicks and Jonathan Popper, this fund has long been a favourite of mine. The fund’s equity approach is rooted in a value philosophy that looks for businesses that generate high and sustainable profits and that are trading at attractive valuations. Each investment candidate is scored on a number of fundamental factors. A deeper due diligence review then includes meetings with management and generating an estimate of fair value.

The managers then determine appropriate buy and sell prices. And position sizes are actively managed based on real-time valuation levels. While this seems to imply a lot of trading, turnover levels have averaged a modest 62% over the past five years.

The fixed-income sleeve is managed using a combination top-down economic review and bottom-up credit analysis, focusing on sector allocation, credit quality, and individual credit selection. The managers also actively manage the yield curve and duration exposure.

Longer-term performance numbers have been excellent, with a 5-year average annual compounded rate of return of 6.2% and a 10-year return of 8.8%, both of which handily outpace the category average. However, like most, the fund struggled in 2018, falling 5.7% for the year. The fourth quarter was rough with a 7.5% loss.

The equity sleeve of the portfolio has a slight growth tilt, and growth stocks were certainly hit harder in the final quarter of the year. The fixed-income sleeve is focused on corporate bond holdings, which trailed government bonds during the market volatility. Combined, these factors led to the fund trailing its peers in both the quarter and for the year.

The fund has also done an excellent job at protecting capital in down markets, participating in about 70% of downside over the past five years, while delivering more than 100% of the upside.

Fourth-quarter underperformance was an anomaly, and all things considered, this remains an excellent balanced fund for most investors.

.

---

 

EdgePoint Global Growth & Income Portfolio

Analysis: This global balanced offering from the highly-respected Edgepoint shop invests in equity and fixed-income securities of companies located anywhere in the world, and managers have a high degree of flexibility in setting asset mix. Fixed-income weighting can range from as high as 60% to as low as 25%. At the end of December, the fund held about 31% in bonds.

The managers take a very long-term and patient approach, buying in at a price that is well below what they believe it to be worth, based on the company’s prospects. The management team undertakes extensive due diligence, using a fundamentally-driven, bottom-up process.

They are not traditional value investors, so their view of a business is likely to differ from the market consensus, and they are not afraid to pay up for what they believe is a quality company with excellent long-term prospects. This helps explain why their valuation metrics appear to be higher than the index.

This approach results in a portfolio that tends to look much different than its benchmark or peer group. They are meaningfully overweight industrials and underweight materials, energy, and utilities.

The fixed-income sleeve is focused on corporate bonds across the quality spectrum. On the fixed-income side, they can invest in both investment-grade and high-yield issues. At Dec. 31, the average credit quality was listed as BBB by Morningstar.

Performance has been excellent, with above-average returns in every year except 2010. As of Dec. 31, its 10-year average annual compounded rate of return was 12.7%, and 9.2% over five years, handily outpacing the peer group. The fund even ended 2018 in the top quartile with a very modest 1.2% loss. The fund’s volatility is higher than average, but the above-average returns more than offset this higher risk.

Despite its volatility, this is an excellent balanced fund for those who have an above-average risk appetite. If you’re comfortable with that and have a medium- to long-term time horizon, this is a great balanced fund to consider.

.

---

Fidelity Canadian Balanced Fund

Analysis: The fund is structured like a fund of funds, with managers Geoff Stein and David Wolf responsible for the asset mix. Underlying asset class pools are managed by dedicated managers. Asset mix is targeted at 50% Canadian equities and 50% fixed income.

While the goal is to maintain the asset mix near the target, managers have some flexibility: Equities can range between 40% and 60%, investment grade bonds between 30% and 50%, and high-yield between 0% and 20%. At Dec. 31, the portfolio was allocated 47% equity, 44% bond, 6% high yield, and the remainder in cash.

The equity sleeve is managed by Darren Lekkerkerker who looks for high-quality, well managed companies with strong balance sheets that are trading below his estimate of fair value. The result is a portfolio of 40 to 50 mid- and large-cap Canadian companies.

The fixed-income sleeve takes a more core-focused approach that uses a blend of top-down macro analysis and fundamentally-driven, bottom-up security selection. Duration is expected to be roughly in line with the benchmark. High-yield exposure is used as a way to generate extra return while reducing interest-rate sensitivity.

Performance has been strong, with a 5-year average annual compounded rate of return of 4.8%, outpacing the peer group. Despite ending in negative territory in 2018, it was a decent year for the fund, with above-average returns. Volatility has been in line with the category, resulting in slightly better risk-adjusted returns than the peer group.

It has done a good job at protecting capital in down markets over the long term, delivering 100% of the upside of the benchmark and participating in only 86% of the downside. With interest rates likely on hold, the fund is well positioned to deliver strong risk-adjusted returns for investors.

If rates are expected to move sharply higher, I would likely look to an alternative balanced fund that employs a more dynamic asset allocation strategy or a more tactical fixed-income sleeve to help mitigate the potential headwinds. For now, though, this remains a very solid balanced fund offering.

---

All Rights Reserved. © D.A. Paterson & Associates Inc. All Rights Reserved. Reproduction in whole or in part without written permission is prohibited. Financial Information provided by Fundata Canada Inc. © Fundata Canada Inc. 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.