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MONTHLY COMMENTARY
Despite modest rally in June, equity markets finish second quarter in the red. More of the same expected to follow.
After a relatively tame first-quarter, volatility returned to the global equity markets with a vengeance, whipsawing stocks with a ferocity that was reminiscent of 2008. Despite a modest rally in June, the S&P/TSX Composite Index still lost 5.67% on the quarter. Global markets seemed to hold up a little better, with the S&P 500 shedding 1.0% and the MSCI EAFE Index dropping 5.0% during the quarter. Not surprisingly, fixed income fared well, gaining 2.2% as investors flocked to bonds on their safe haven appeal.
Many of the issues that investors had ignored during the first quarter, namely the European debt crisis, the slowdown in China, and the lackluster pace of the U.S. recovery, became the focus of their attention.
China continued to show signs of a slowdown as demand at home faltered, compounding the issues brought on by Europe. The impact of the slowdown has been felt around the world, as the demand for commodities has been reduced dramatically. Canada has been hard hit given that the majority of our equity market is concentrated in the materials and energy sectors.
As we enter the second half of the year, we expect more of the same. The issues that have been responsible for the elevated levels of volatility remain firmly entrenched. Europe continues to plod along making only minor progress on its debt crisis. China’s economy continues to slow, and recent data suggests this slowdown may be greater than originally forecast. This will continue to pressure commodities, which will weigh on the Canadian equity market. In the US, the economy is showing signs of recovery, but with the headwinds resulting from a global economic slowdown, growth is expected to moderate in the second half of the year.
Our expectation is that interest rates in Canada and the U.S. will remain on hold until at least early 2013. We expect that market volatility will remain high. Given this, we continue to focus on quality, both in equities and fixed income. For equities, we continue to favor North American focused funds and prefer those that invest in well managed, attractively valued, dividend paying companies.
For fixed income, we also continue to emphasize quality. With interest rates expected to remain on hold for the near term, we are favoring actively managed funds which invest in a mix of government and high-quality corporate bonds. These types of funds will continue to provide stability in times of volatility, yet will provide some level of downside protection when rates finally do begin to move higher. We also like funds which have a duration that is lower than the benchmark.
While market volatility may tempt many investors to overweight fixed income in a portfolio, we would suggest that investors strongly avoid this. While we don’t envision rates moving higher anytime soon, the risk reward profile of fixed income is heavily weighted towards the downside. Equities, while volatile, appear to be fairly valued, and provide strong upside for investors who can stomach the near term volatility, and who have a long-term time horizon. We are not suggesting that investors abandoned fixed income. On the contrary, we are suggesting that investors exercise caution within their fixed income holdings, and are not unnecessarily exposed to the potential risks.
Please send your comments to feedback@paterson-associates.ca.
FUNDS YOU ASKED FOR
This month, we take a look at Signature Income & Growth, Sentry REIT, Scotia Global Bond, Real Return Bonds and more!
CI Signature Income & Growth Fund (CIG 6116) – Normally we are big fans of the funds managed by CI’s Signature Global Advisors. However, we are less than enamored with this fund. It’s not that it’s a bad fund; it’s just not outstanding. The long-term performance is impressive. As of May 31, the fund posted an average ten-year return of 6.1%, handily outpacing the benchmark’s 2.5% gain during the same period. Shorter term it has struggled, losing 4.5% in the past year while the benchmark gained 0.9%.
It is also more volatile than its peer group and benchmark. It has a standard deviation that is 18% higher than the category average and nearly one-third higher than the benchmark. This can be highlighted by its performance in 2008 when it dropped by 21% while the benchmark lost 3.4%. Fast forward to 2009, it posted a healthy 27.6% gain handily outpacing the benchmark by nearly 2400 basis points.
It is not all bad. It is a global balanced fund that is fairly conservatively positioned holding 8% in cash, 32% in global bonds, 25% in Canadian equity and 27% in global stocks. The underlying yield of the portfolio is higher than the benchmark while the P/E ratio is lower. This should help it not only during volatile times but also when markets move higher.
It does provide investors with an income thanks to the $0.025 per unit monthly distribution. At current prices, that works out to a yield of approximately 6.8%.
On balance, we have a few concerns about this fund, with the biggest being the level of volatility. It is more volatile than the index and peer group, and not generated what we believe to be a sufficient level of excess return to justify the additional volatility. Further, we have some concerns surrounding the level of distribution that is being paid out. At 6.8%, this appears very high compared not only to the yield of the underlying portfolio, but also the total return profile of the fund. Another concern we have is with the cost. It has an MER of 2.42%, which is higher than the category average.
It is our opinion that this is not a bad fund, but we do believe there are better options in the global balanced category.
Sentry REIT Fund (NCE 705) – The Sentry REIT Fund is one of the few options that mutual fund investors have when looking for exposure to REITs. There are a number of funds that are focused on the real estate sector, but most of those invest more in operating companies as opposed to REITs.
It is a concentrated portfolio that holds between 40 and 50 names. It can invest in REITs of all sizes and as of March 31 held nearly two-thirds of the fund in mid caps, 16% in large caps and 14% in small caps. It pays investors a monthly distribution of $0.0833 per unit, which equals an annualized yield of 7.8% at current prices.
The fund has more than doubled since February 2009. As impressive as that is, 2008 was a year that investors in the fund would like to forget, after losing 43%. Even with that big drop, the overall level of volatility of the fund has remained in check and is lower than both the real estate category and the Dow Jones Global Real Estate Index.
Recent performance has been strong and the outlook for REITs remains positive. According to a report issued by CIBC World Markets, the demand for REITs is expected to be driven by strong property fundamentals, low cost debt, cap rate compression, increased foreign investment and increased takeover activity in the sector. These factors should bode well for this fund in the coming months.
Sentry is really the only way for investors to gain significant exposure to REITs in a mutual fund. There are two newer fund options available, First Asset REIT Income Fund and Middlefield ActiveIndex REIT Fund. While early performance indicators look positive, they both have track records of less than two years, so there is not enough data on which to conduct a more detailed analysis.
Sentry REIT is not cheap with an MER of 2.73%. If you are looking for lower cost REIT exposure, there are two ETFs available; the iShares S&P/TSX Capped REIT Index and the BMO Equal Weight REIT Index, both of which have outpaced the Sentry fund during their existence. The iShares ETF has an MER of 0.60% while the BMO is 0.62%, dramatically lower than the Sentry Fund.
Scotia Global Bond Fund (BNS 379) – With a gain of 7.2% the Scotia Global Bond Fund was one of the top performing mutual funds in May. Nicholas Van Sluytman took over the reins of this fund in January 2010 and has rewarded investors with strong returns.
As the name suggests, it invests in bonds that are issued by foreign governments and corporations as well as supranational entities like the World Bank. It can also invest in foreign currency denominated bonds issued by Canadian corporations and governments.
The portfolio mix is determined the manager’s analysis of the prevailing market conditions. He is looking to maximize returns while minimizing interest rate risk in the fund. The duration is 6.7 years, which is in line with the broader market. Currently, it is heavily weighted towards the U.S. holding 55% in U.S. Treasuries. They are carefully monitoring this position and while they don’t expect that yields in the U.S. will move higher during the year, they are ready to sell out should they see signs that this is likely to occur. In the past, they have been fairly active in their management of the fund. In late 2011 they sold out all non-government debt in the fund. It has no direct exposure to Portugal, Spain and Italy.
Despite the strong recent performance, we have a couple of big concerns with this fund. First is its volatility. It has a standard deviation that is four times greater than the DEX Bond Universe, which puts it at a level of volatility that is comparable to a Canadian dividend fund. Second, it is expensive compared to others in the category. It carries an MER of 2.19%, 24 basis points higher than the category median.
The biggest positive of this fund is that it carries a very favourable correlation profile to the major equity indices. This will allow it to help to reduce overall volatility when used in a well-diversified portfolio.
All things considered, we would suggest that investors approach this fund with caution. Given the risk reward profile, we do not consider it to be appropriate as a core holding in a portfolio. It is our opinion that this is a fund that should only be considered by investors who are comfortable taking on equity like volatility within their fixed income investments.
Mackenzie Sentinel Real Return Bond Fund (MFC 1579) – This fund is designed to provide a steady flow of income and to provide a hedge against inflation. To do this, it invests in real return bonds issued by the Government of Canada and the province of Québec. It also can invest in real return bonds issued by foreign governments.
The issue not the fund itself, but rather real return bonds in general. It is a fairly competitive offering within the real return bond space. It is run by a good management team, is reasonably priced and has posted decent relative performance.
The issue is the valuation of real return bonds. With real yields at historic lows, currently at 0.39%, there is only one direction for them to go – up. Further, real return bonds tend to be very long duration bonds, which results in an extremely high level of interest rate risk for the fund. As rates move higher, real return bonds will be hit harder than traditional bonds.
With inflation expected to remain low over the next several quarters, there is certainly a very strong case to be made that real return bonds are overvalued. Considering that, it seems inappropriate to add any additional real return bond exposure to your portfolio at the moment. In recent conversations with a number of bond managers, they suggested that now is a good time for investors who have real return bond exposure to consider taking some money off the table.
Investors looking for inflation protection may wish to consider switching into high yield corporate bonds. However, those considering such a move must be aware that they will be trading the interest rate of the real return bonds for the default risk of the high yield bonds.
Those worried about rising interest rates may want to consider looking at floating rate note funds, which invest in notes which will pay a coupon that will fluctuate with the prevailing rate of interest in the economy.
TD Entertainment & Communications Fund (TDB 652) – The TD Entertainment and Communications Fund is an interesting fund that invests in companies that are involved in the entertainment, media, and communications industries. Typical holdings include such companies as Apple, Walt Disney, Comcast, and AT&T.
It is a fairly concentrated portfolio where the top 10 names make up slightly more than half of the fund. Not surprisingly, it is heavily weighted towards technology, which makes up 55%. Consumer services is the next largest sector, making up nearly 40% of the fund.
Stunningly, it has been classified as a global equity fund. While the industry may have done away with the science and technology category, we continue to classify it as such and do not in any way consider this fund to be an appropriate core holding, as the industry’s fund classification would suggest.
It has been a very strong performer, finishing in the first quarter file every year except for 2008 and 2002 when it finished near the bottom. It is slightly more volatile than the category average, which is not surprising given the narrowness of its mandate. If you are considering investing in this fund, you’d better be ready for a potentially bumpy ride.
Is our opinion, this fund is only suitable for investors who have a high-risk tolerance and are looking to add some exposure to the entertainment and media sectors. For those seeking a more broad technology mandate, we would suggest they look at the TD Science and Technology Fund, CI Global Science and Technology Fund, or the BMO Guardian Global Technology Fund. Each of these is a high quality, well-managed fund providing broad based exposure to the sector.
Is there a fund you would like us to review?? Please send any requests for fund reviews to feedback@paterson-associates.ca.
July’s Top Funds
Omega Consensus International Equity
| Fund Company | National Bank Securities |
| Fund Type | International Equity |
| Rating | $$$ |
| Style | Blend |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | John Reese since November 2007 |
| MER | 2.05% |
| Code | NBC 491 – Front End Units NBC 591 – DSC Units NBC 691 – Low Load Units |
| Minimum Investment | $500 |
Analysis: The Omega Consensus International Equity Fund is an interesting fund that looks to identify the top 50 stocks that are ranked on a number of factors that are used by some of the most successful investors of all time including Warren Buffett, Peter Lynch, Ben Graham, and Martin Zweig. Each of the managers uses a different style and approach and bases their investment decisions on different criteria.
Putting this into practice, manager John Reese has built a quantitative model that scores and ranks the universe of non north American companies according to the different criteria from each of the gurus. It invests in non north American stocks and ADRs. Once a year, the universe of companies is re-ranked and the top 50 are the fund’s holdings. Each will start with an equal weighting in the fund, and will be replaced or rebalanced if it exceeds various risk criteria set by the manager. The manager will not make any tactical calls on cash and will remain fully invested always.
It is heavily exposed to Europe, with 61% of the fund exposed to the region. Its biggest sector exposure is technology, with a 23% weighting, followed by communications and energy. Some of the names in the fund include drink maker Diageo, Forest Labs and Prudential. Despite being rebalanced only once per year, portfolio turnover has been high, averaging 100% a year.
Performance has been strong, outpacing the benchmark in every year except for 2011. In 2010, the fund was up 13.4% while the index was up 3.2%. For the three-year period ending May 31, it had an annualized compound return of 6.3%, outpacing the index’s 1.9% gain. It has been a touch more volatile than both its peer group and the index, but thus far has rewarded investors with stronger performance. According to information provided by National Bank, the fund has done well in rising markets, capturing more than 106% of the upside, while in down markets has held up better than the index.
The costs of the fund are very reasonable with a Management Expense Ratio of 2.05%, well below the category average of 2.50%.
Considering the above, we are initiating coverage of this fund with a rating of $$$. It can be a good core international equity fund for investors who have a medium to high-risk tolerance and a longer-term time horizon. Given the higher exposure to Europe, we expect that volatility will remain above average for the near term.
Mackenzie Ivy Foreign Equity Fund
| Fund Company | Mackenzie Financial Corporation |
| Fund Type | Global Equity |
| Rating | $$$$ |
| Style | Blend |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | Paul Musson since January 2001 David Arpin since January 2009 |
| MER | 2.52% |
| Code | MFC 081 – Front End Units MFC 611 – DSC Units |
| Minimum Investment | $500 |
Analysis: With market volatility expected to remain high for the next few quarters, risk adverse investors may want to consider adding some of the Ivy Foreign Equity Fund into their portfolios as a core global equity holding. Capital preservation is hallmark with this fund as it looks to provide long-term growth through investing in a concentrated portfolio of high quality companies.
Management has done a very good job at preserving capital. For example, last year the fund managed to gain 3.2% while the index was down 5.7%. This is consistent with the manager’s approach. In 2008 when the index was down nearly 30%, the fund was down by 6.7%. During the tech collapse in 2002, the market was down 19.4% while the fund was down 2.2%. The fund also does a good job at keeping volatility in check. Its volatility is significantly lower than both the index and its peer group.
Returns, particularly the longer-term numbers have been strong. For the five years ending May 31, the fund has gained an average of 1.3% per year while the Dow Jones Global Index has lost 4.0% per year.
To achieve this, the managers run the portfolio using a very simple and basic philosophy. The have a concentrated portfolio of 20 to 30 profitable large cap companies with strong balance sheets and excellent management teams that are trading at reasonable valuations. The managers take a long term and very patient view. As a result, portfolio turnover tends to be relatively low.
The fund is very defensively positioned. As of May 31, the fund was very heavily overweight in consumer staples and consumer discretionary, which combined make up more than half of the fund. Currency is not hedged, which will hurt the fund when the Canadian dollar is appreciating, but will boost performance when the Canadian dollar is declining.
The biggest knock on this fund is that it will very likely underperform during a significant market run up. Given our expectation for continued volatility, this is a fund that will serve most investors well until things settle down. Within the context of a portfolio, it is our opinion that this fund is a great core global equity holding for most investors. Those with a higher risk tolerance may want to look at a more aggressive global fund for the better upside participation when markets do rally higher.
Manulife Strategic Income Fund
| Fund Company | Manulife Mutual Funds |
| Fund Type | Global Fixed Income |
| Rating | $$$$ |
| Style | Yield Management |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Dan Janis since February 2006 |
| MER | 2.15% |
| Code | MMF 559 – Front End Units MMF 459 – DSC Units |
| Minimum Investment | $500 |
Analysis: Interest rates are hovering near historic lows and will eventually begin moving higher. Before this happens, investors should take steps to protect themselves against this inevitability by shortening duration, increasing yield and investing in actively managed funds where the manager can be tactical in navigating the fixed income markets. The Manulife Strategic Income is one fund that can help investors do just that.
It is a tactically managed global bond fund that provides investors exposure to a wide range of fixed income investments with the added bonus of a dynamic currency overlay process which will help protect investors against adverse currency movements.
Dan Janis and his team invest in a number of different types of fixed income investments including high yield bonds, investment grade corporate bonds, global and emerging market debt, U.S. treasuries, and Government of Canada bonds. The team determines the appropriate sector weights based on a top down business cycle analysis which considers such things as yield spreads, and economic growth. Once the sectors are selected, they invest in the securities that they feel best positioned to benefit from their macro view, with an emphasis on yield generation.
The managers believe that high yield and emerging market debt will outperform sovereign debt over the long term. It holds about 17% in emerging market debt and more than 57% of the portfolio is invested in corporate bonds. Quality is relatively high, with an average credit rating of BBB. The portfolio has a yield of 5.17%, which is more than double the yield of the Citigroup Global Government Bond Index. The duration is also lower than the broader bond market coming in a 5.4 years versus 6.9 years for the index.
The managers are fairly tactical with this fund, having made some significant shifts within the sector allocation of the fund over the past few years to take advantage of some of the major trends. For example, in 2009 they dramatically increased their exposure to high yield bonds, moving it from more than 10% to nearly 40% of the fund by the end of the year.
While the shorter term performance numbers have been less than impressive, the long term numbers are solid. We believe that the managers have the fund well positioned for the current fixed income environment. We see this fund as a good diversifier within the fixed income portion of a well diversified portfolio. We are increasing the rating of the fund from $$$ to $$$$.
Mawer Canadian Equity Fund
| Fund Company | Mawer Investment Management Ltd. |
| Fund Type | Canadian Equity |
| Rating | $$$$ |
| Style | GARP |
| Risk Level | Medium |
| Load Status | No Load |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | Jim Hall since December 1999 Vijay Viswanathan since September 2011 |
| MER | 1.25% |
| Code | MAW 106 – No load units |
| Minimum Investment | $500 |
Analysis: Below average volatility, strong returns and a low MER make the Mawer Canadian Equity Fund one of our favourites in the category. Managed by the team of Jim Hall and Vijay Viswanathan, it looks for well known businesses that are trading below their true worth. The fund’s modest asset level of $975 million allows it some flexibility to go off the beaten path and look for companies which can compound their capital at a high rate for a number of years.
The portfolio tends to be fairly well diversified holding between 40 and 50 names, with the top ten making up about 40% of the fund. It is a pure Canadian equity fund and currently has no exposure to the U.S. or other foreign markets. Not surprisingly, the top ten is filled with many of the usual suspects such as TD Bank, Bank of Nova Scotia, Brookfield Asset Management and TELUS. It is also heavily weighted towards financial services, energy and industrials. Combined, these three sectors make up 65% of the fund.
Historic performance has been strong, outpacing not only the S&P/TSX Composite Index, but also the majority of its peer group. For the ten years ending May 31, it gained an average of 7.6% per year compared with the index, which posted a gain of 6.7%. Shorter term numbers have also been impressive with a three year gain of 10.9% compared to the 6.4% gain in the index.
The managers have done a great job at keeping volatility in check. For example, last year the index lost nearly 9% yet the fund gained 2%. It has a standard deviation that is lower than both the index and the category average.
The cost of the fund is very reasonable, boasting a rock bottom MER of 1.25%, well below the category average. Perhaps the biggest drawback to this fund is that it carries a minimum initial purchase of $5,000 which might put it out of reach of some smaller investors just starting out.
In our opinion, this is a great core equity fund for investors with a medium risk tolerance and a longer term time horizon. We are maintaining the fund’s rating of $$$$.