Mutual Fund and ETFs Update – November 2012

Volume 18, Number 11
November 2012
Single Issue $15.00

In this issue:

• What’s New
• Mutual Fund Recommended List Review
• The Changing Role of Fixed Income
• Determining Truly Active Management
• Investing in Europe

PDF version of this issue

 

 

WHAT’S NEW

• Mutual fund sales up year over year – According to data released by the Investment Funds Institute of Canada, mutual fund sales in September were $2.1 billion, compared to just $44 million a year earlier. Balanced and bond funds continued to be the favourite with investors, seeing net inflows of more than $3.1 billion. Investors continued to shun equities, selling nearly $1.3 billion.
• ETF Fees drop – In what seems to be a race to the bottom, a number of ETF providers including Horizons, iShares and BMO cut the management fees on a number of their products. Each company cut fees on a number of ETFs including the management fee on the Horizons S&P/TSX 60 ETF is being cut from 0.07% to 0.05%. iShares is cutting the management fee from 0.24% to 0.22% on its popular iShares S&P 500 ETF. BMO is reducing its management fee on its BMO S&P 500 ETF to 0.15%.
• New managers for National Bank Mortgage Fund – National Bank has replaced Marc-Andre Gaudreau on their popular mortgage fund with the team of Richard Levesque and Nicolas Normandeau. The fund must invest a minimum of 50% of its assets in mortgages and will follow a top down approach evaluating the macro environment and then will select securities that offer the best risk return profile for their expected environment. We will continue to monitor the fund and will do a more detailed review once we get a deeper understanding on what impact these changes will have on the fund.

Mutual Fund Recommended List Review

By Dave Paterson, CFA

Central bank easing pushes global equities higher

Market Recap

Late in the quarter U.S. Federal Reserve Chairman Ben Bernanke announced a $40 billion per month plan to buy up mortgage backed securities indefinitely, and a pledge to keep interest rates extremely low until at least mid 2015. Also in September, European Central Bank President Mario Draghi announced his plan to inject liquidity into the Eurozone economy by buying up bonds indefinitely. Other countries announced similar plans including China, Japan and Brazil.

The market reaction was extremely positive, driving virtually all equity markets higher. With more stimulus set to hit the system, the main benefactors were the more economically sensitive sectors such as energy and materials. Gold was given an extra boost as some feared that these massive stimulus plans would further fuel the inflation fears. In a somewhat overdue reversal of fortune, gold companies finally outpaced the bullion.

Beyond the announced stimulus plans, there are many reasons for investors to be optimistic. Corporate profitability, one of the key drivers of stock price appreciation over the long term, has remained positive in both Canada and the U.S. The U.S. housing market, which has been a drag on the economy since 2008 appears to have finally hit bottom. Housing prices have risen four months in a row and the year over year comparisons are also positive in an overwhelming number of states. Housing starts have also been strong, which is critical to the U.S. recovery since it is estimated that housing and related expenditures can make up around 17% to 18% of the total U.S. GDP. With this on the upswing, it is likely that some level of meaningful economic recovery can continue.

The European debt crisis has been a headwind to the global equity markets for some time. Left alone, the probability of a major blow up is huge. However, with the ECB’s bond buying announcement, they have essentially provided a backstop that will help to prevent a major catastrophe. With this likelihood reduced dramatically, much of the headline risk has been taken out of European equities.

Add in the expectations that interest rates in developed nations are to be kept artificially low for the near to mid-term, and it is no wonder that both investor and consumer confidence has rebounded.

While there are many reasons for optimism, there are also reasons for concern. Signs of improvement abound in the U.S., but there is much uncertainty surrounding the outcome of the election and what actions the president will take to avoid the “fiscal cliff”, a mix of spending cuts and tax increases that are widely expected to severely affect the economic recovery.

In Europe, while the risk of a blow up has been greatly reduced, the main problem of the debt crisis that cripples many countries remains. Add to that many countries in the Eurozone are in recession and others are implementing austerity measures, much risk remains. Many emerging markets, particularly China are embroiled in a slowdown, with many experts expecting it to be much worse than originally expected. This may result in a prolonged downturn in energy and materials, which will drag the Canadian market.

Investment Outlook

Considering this, we remain cautiously optimistic, particularly with respect to equities. Valuations, while increasing, are still more favourable than bonds. We believe that recent policy actions in Europe will help to at least contain the crisis and buy more time for policy makers to determine an appropriate solution.

We are also optimistic that whoever is elected in the U.S. will find a way to avoid the fiscal cliff. There is far too much at stake for even a partial solution not to be found, helping to reduce the potential damage. We are also optimistic that as we enter the final months of the year that the traditional Santa Claus rally will take hold and push markets higher.

Fixed Income Outlook

Our outlook for fixed income has not changed from last quarter. With interest rates likely to be on hold for the foreseeable future, bonds aren’t likely to produce any major gains. In this environment, we favour corporate bonds over government bonds for their higher yield potential. We still believe that some government bond exposure is needed to act as a safe haven should markets become very volatile. Going forward, we need to adjust our return expectations for fixed income investments. No longer can we expect them to be a major contributor to portfolio return, but instead, their main purpose will be to help reduce volatility in periods of uncertainty.

We favour actively managed funds that can tactically manage the portfolio and position it to take advantage of the expected environment.

Equity Outlook

We expect that equities will continue to be driven more by macro events than by the quality of the individual investments. With the economic slowdown in China, we have concerns that commodity and energy prices may be under pressure, which may hold back the broader market. Because of this, we are favouring actively managed funds that are not heavily weighted towards those sectors. We are willing to forego some of the upside should investors’ appetite for gold stocks continue, in return for much lower volatility on the downside. We also favour higher quality, large cap companies over the small cap companies.

We remain cautious on the U.S. in the immediate term while the uncertainty surrounding the election and the fiscal cliff are dealt with. We are not suggesting that exposure to the U.S. be reduced, rather we are reluctant to add any additional exposure at the moment.

Europe is still an area of concern, but with the European Central Bank stepping up to backstop Eurozone bonds, there may be some opportunity for high risk, contrarian investors to begin to dip their toes into the region. Within Asia and the emerging markets, it is our view that there is far too much uncertainty to be adding to any positions at the moment.

Recommended List Review

Funds to Sell

CIBC Canadian Short Term Bond Index (CIB 489) – This fund is designed to track the DEX Short Term Bond Index Fund and does a decent job at it. With an MER of 1.07%, it is cheaper than many other short term bond funds. However, given our outlook for a challenging fixed income environment and our current preference for active management, we felt that it was time to make the change. In its place, we are adding the TD Short Term Bond Fund (TDB 967). As you would expect, it invests in bonds issued by Canadian governments and corporations with maturities of less than five years. It is more heavily weighted towards corporate bonds, which will help to boost returns in a flat or rising interest rate environment. All of the bonds in the fund are rated BBB or higher, so there is very little credit risk. The MER is slightly higher than CIBC, coming in at 1.11%. Despite this, performance has been stronger in most time periods and we expect that with a flat to rising rate environment, this trend will continue.

Funds to Buy

Steadyhand Income Fund (SIF 120) – With interest rates expected to remain flat for the near term, this fund is a great alternative to a more traditional bond fund. With a target asset mix of 75% bonds and 25% high yielding equities, it is well positioned to provide investors with higher returns. Nearly two-thirds of the bond sleeve is invested in corporate bonds, which typically offer a higher yield than government bonds. This will no doubt add additional return in a flat or rising rate environment. A word of warning, there is the potential for higher levels of volatility, particularly if we enter into a period of unexpected volatility in the markets.

CI Signature High Income Fund (CIG 696) – As of September 30, this fund has gained 9.8%, outpacing most of its peers and its benchmark. Equally impressive, it has matched the performance of the MSCI World Index, but with considerably less volatility. Looking ahead, we believe that it is well positioned to continue to deliver strong relative returns. It holds about 45% high yielding equities, 42% bonds and 10% in cash. All the fixed income holdings are corporate bonds, and many of them are high yield bonds. While this will generate strong returns and downside protection in a flat or rising rate environment, it does have the potential to underperform in very volatile markets.

RBC Canadian Equity Income Fund (RBF 591) – Using a very active management approach, the team of Jennifer McClelland and Brahm Spilfogel scour the investment universe looking for stocks that have shown positive rates of change in their proprietary valuation model. When markets are volatile, they view it as an opportunity to actively trade and book profits. For example, in 2008 and 2009 portfolio turnover skyrocketed to nearly 500% for the year. Their process has worked, with the fund consistently being at or near the top of our proprietary valuation model. We expect that it will continue to deliver returns that will beat its peer group, but we don’t believe that their absolute numbers are sustainable going forward. Still, for investors looking for decent returns, modest volatility and a decent cash flow, this is one to consider.

Fidelity Canadian Large Cap Fund (FID 231) – Despite struggling in the second quarter, we still believe that this fund is well positioned for the current environment. With a significant underweight position in energy and virtually no exposure to materials it looks nothing like the heavily concentrated S&P/TSX Composite Index. Nearly half is invested outside of Canada, with the bulk of that being invested in the U.S. Further, it offers a dividend yield that is above the broader market. Given the conservative nature of this fund, we believe that it will continue to hold up well for the next few months, but could lag if cyclical stocks rally sharply.

IA Clarington Canadian Conservative Equity Fund (CCM 1300) – Despite the announcement of QE3 driving material stock prices higher, this dividend focused fund held up relatively well, gaining 2.3% in September and 4.5% for the quarter. While this lagged the index, it outpaced most of its peer group. Looking at the current environment, its focus on high yielding dividend paying stocks put this fund in a good position to continue to provide strong risk adjusted returns for investors.

RBC North American Value Fund (RBF 554) – On our last Recommended List Review, we said that we liked this fund for its large cap positioning and relatively high cash balance to take advantage of attractively valued opportunities when they arise. Those, combined with the valuation of the underlying portfolio only reinforce our view of this fund as one which we believe has the potential reward investors over the next several months with above average returns.

Beutel Goodman Small Cap Fund (BTG 799) – While our bias is generally towards large caps for the current environment, the Beutel Goodman Small Cap Fund is an exception. While the name suggest small cap, it is in fact more concentrated in the mid cap space and the management team tends to focus on companies with proven cash flows and strong business fundamentals. This, combined with an MER of 1.43% makes this our top pick for investors looking for high quality small cap exposure for their portfolios.

Mawer International Equity Fund (MAW 102) – In general, we have been avoiding Europe for several quarters in favour of North America. However, with the European Central Bank’s bond buying program essentially taking the risk of a major blow up off the table, those with an above average for risk may want to consider dipping their toes in the region. A great way to do that is with an international equity fund and in our opinion, there aren’t many better than this one. It is managed using a growth at a reasonable price approach and looks for companies that have great management teams, improving business fundamentals and a history of generating high returns on equity. It currently has 40% invested in Europe, 31% in the UK, 5% cash and the balance invested in Asia.

Sentry REIT Fund (NCE 705) – Despite lagging the index on a year to date basis, we believe that the outlook for REITs remains positive for a number of reasons including strong property fundamentals, low cost debt, increased foreign activity and an uptick in takeover activity in the sector. Combined with investors’ insatiable demand for income, we believe that this fund is well positioned to reward investors. Given that this is one of the few funds in the country to focus solely on REITs and it has a great management team behind it, we believe that investors will be rewarded.

CI Signature Global Health Sciences Fund (CIG 201) – Health care, and this fund specifically have been on a tear this year. Year to date the fund has gained 27% outpacing not only the index but every other health care fund except the TD Health Sciences Fund. Despite this impressive rise, it appears that there may be more upside in the sector in the near term. According to data provided by Morningstar, the weighted average Price to Earnings multiple for the stocks in this fund is just over 12 times, compared to 15.6 for the index. As with any sector play, caution is warranted as there is the potential for period of high volatility. Portfolio exposure should be limited to no more than 10% for the most aggressive investors and adjusted downward according to an individual’s risk tolerance.

NOTE

ABC Fundamental Value Fund – Effective immediately we are removing the ABC Fundamental Value Fund from our Recommended List. First, this is not being done in reaction to the performance or the volatility profile of the fund. It is a very deep value, high conviction portfolio that over the long term has performed quite well and of late has been performing very well. The reason we are removing the fund from the list is that it carries a minimum initial investment of $150,000 which puts it out of reach for many investors. It is also not available through any discount broker or investment advisor. Based on these factors, we have decided to remove the fund from our Recommended List. We will continue to follow the fund and will provide commentary and analysis for it on an ongoing basis.

FUND	FIRST MENTION	RESULTS           (to Sep 30)	Q3 Return	COMMENTS	ACTION
Canadian   Equity Funds
Fidelity Canadian Large Cap (B)	Oct-11	9.5% (1 Yr)	-0.9%	Lack of materials exposure hurt in Q3	Buy
IA Clarington Canadian Conservative   Equity (V)	Oct-11	8.8%   (1 Yr)	4.5%	Dividend payers continue to deliver	Buy
RBC North American Value (V)	Jun-11	13.7%   (1 Yr)	5.0%	Portfolio fundamentals look   attractive	Buy
Leith Wheeler Canadian Equity (B)	Jun-06	2.9%   (6 yr)	4.0%	Good long term pick.	Hold
Mawer Canadian Equity (B)	Jan-05	5.7%   (7 Yr)	4.3%	Less volatile than index and peers	Hold
Canadian   Small Cap Funds
BMO Guardian Enterprise Fund   (Classic)	Jan-12	10.3%   (YTD)	7.8%	Great management team at the helm	Hold
Beutel Goodman Small Cap (B)	Oct-03	10.1%   (9 Yr)	6.5%	Mid cap focus should help   outperform	Buy
ABC Fundamental Value (V)	Jul-97	6.7%   (10 Yr)	8.6%	Minimum $150,000 investment	Hold
Sector   Funds
CI Global Health Sciences	Sep-11	27.0%   (YTD)	7.3%	Healthcare continues to shine	Buy
RBC Global Precious Metals (G)	Jan-06	11.6%   (6 Yr)	19.8%	QE3 boosted gold companies higher	Hold
Balanced   Funds
Mac Cundill Cdn Balanced (V)	Apr-11	10.5%   (1 Yr)	1.7%	Best performing balanced fund YTD	Hold
AGF Monthly High Income (V)	Oct-10	10.6%   (2 Yr)	4.9%	Portfolio heavily tilted towards   equities	Hold
Steadyhand Income (V)	Oct-10	9.9%   (2 Yr)	2.7%	Positioning will help in rate   environment	Buy
Fidelity Canadian Balanced (G)	Feb-08	6.4% (4 Yr)	3.6%	Portfolio is defensively positioned	Hold
Income   Funds
TD Mortgage Fund	Apr-12	0.9%   (6 mth)	0.4%	Low volatility. 2.6% yield	Hold
CI Signature High Income (V)	Jan-12	8.6%   (YTD)	3.4%	Expect continued strong relative   returns	Buy
RBC Canadian Equity Income	Jan-10	13.8%   (2 Yr)	5.2%	Opportunistically positioned. 6.5%   yield	Buy
Fidelity Dividend	Sep-08	7.0%   (4 Yr)	2.2%	High cash position hurt performance	Hold
Signature Income & Growth	May-07	2.6%   (5 Yr)	3.8%	Conservatively positioned. Large   Cap bias	Hold
Sentry REIT	Dec-06	2.6%   (5 Yr)	2.7%	Demand for yield supports this fund	Buy
BMO Monthly Income	Nov-05	3.9%   (7 Yr)	2.2%	Current distribution yield is   nearly 10%	Hold
Mac Sentinel Income B	Feb-05	3.7%   (7 Yr)	1.9%	Conservatively positioned,   Attractive yield	Hold
BMO Guardian Monthly Dividend MF	Oct-03	5.8%   (9 Yr)	3.0%	Low volatility equity option	Hold
RBC Monthly Income	Jun-03	7.2%   (9 Yr)	3.1%	Our favourite for non reg accounts	Hold
Bond   Funds
TD Short Term Bond	Sep-12	NEW	0.6%	Lower minimum than PH&N	Hold
PH&N High Yield Bond	Feb-10	7.0%   (2 Yr)	2.6%	Continues to perform. Closed to   investors	Hold
Beutel Goodman Income	Sep-09	5.1%   (3 Yr)	0.9%	Most conservative bond fund on our   list	Hold
PH&N Total Return Bond	Aug-08	7.7%   (4 Yr)	1.5%	Higher yield makes this a buy	Hold
TD Canadian Bond	Jan-03	5.4%   (9 Yr)	1.3%	Duration slightly longer than   PH&N TRB	Hold
CIBC Cdn Short Term Bond Index	Nov-01	3.5%   (10 Yr)	0.5%	We prefer active for current   environment	Sell
PH&N Short Term Bond &   Mortgage	May-00	4.1%   (10 Yr)	0.7%	Low cost keeps this our top pick	Hold
U.S.   Equity Funds
IA Clarington Sarbit US Equity (V)	Jan-11	25.0%   (1 Yr)	2.9%	Concentrated portfolio	Hold
Dynamic Power American Growth (G)	Jan-11	13.0%   (1 Yr)	1.4%	Volatile fund has struggled   recently	Hold
TD US Small Cap Equity (G)	Jan-11	25.6%   (1 Yr)	1.2%	Diversified small cap pick	Hold
Beutel Goodman American Equity (V)	Feb-09	8.7%   (3 Yr)	3.8%	Our favourite U.S. equity fund	Hold
Dynamic American Value (G)	Aug-06	1.5%   (6 Yr)	-1.5%	Defensive positioning has hurt	Hold
International/Global/North   American Funds
Mutual Global Discovery (V)	Jul-11	18.5%   (1 Yr)	4.6%	Great long term global pick	Hold
Trimark Global Endeavour (B)	May-11	12.1%   (1 Yr)	5.8%	A great global small cap pick.	Hold
Dynamic Power Global Growth (G)	May-11	8.3%   (1 Yr)	6.6%	Bounced back nicely from last   quarter	Hold
CI Black Creek Global Leaders (G)	Mar-11	5.8%   (1 Yr)	3.2%	Renamed from Castlerock Global   Leaders	Hold
Mawer International Equity (B)	Oct-09	3.7%   (2 Yr)	5.0%	Upgraded to Buy	Buy
Chou Associates (V)	Nov-02	5.7%   (10 Yr)	6.2%	Very strong quarter for the fund	Hold

The Changing Role of Fixed Income

By Dave Paterson, CFA

Bonds can no longer be expected to be major contributors of return in your portfolio

Month after month, the Investment Funds Institute releases their monthly sales statistics, and each month, without fail, fixed income funds continue to see big inflows of new money while equity funds see net outflows. As of September 30, bond funds saw $15 billion of new money while investors pulled more than $10 billion from equity funds.

Given the current fixed income environment, this trend causes us great concern. We’re not the only ones either. A few months ago we sat down with Tom Bradley of Steadyhand Funds and he said that, “bonds used to be thought of a risk free return. But now, they are really return free risk.” He is not wrong. There is no conceivable way that the returns that bond investors have experienced for the past 30 years can be repeated and at some point in the future, bond investors may experience something most have yet to experience – a bear market in fixed income.

Let’s take a look at why we believe this to be the case. As you know, the price of a bond moves in the opposite direction to interest rates. Interest rates have been on the decline since 1982 when the ten-year Government of Canada Bond yielded nearly 16%. Today it is yielding around 1.8%. According to TD Asset Management, an investor in the Canada 10-year bond would have realized an annualized return of 10.4% between 1982 and 2012.

With yields, they can only go to 0%, since it is very unlikely that any rational investor would pay to invest in a bond under normal conditions. Considering that premise, the upside in bonds is very limited from where we sit today. For example, if interest rates were to move down to 0%, the best an investor can expect to earn in capital gains would be approximately 12%.

On the flip side, if rates move higher, bond investors can expect to realize a loss. For example, if yields move up to a more realistic 3%, then the loss an investor would experience is likely to be in the neighborhood of 8% or so. Should they move to 4%, the loss will be expected to be in the 15% range.

Looking at the near term outlook, central banks around the globe have committed to keeping interest rates low for the foreseeable future. Bank of Canada governor Mark Carney wants to move rates higher, but with many economic headwinds and the potential impact such a move would have on the Canadian dollar, his hands are effectively tied. This means that for at least the next few quarters, we don’t expect any significant movement in interest rates. Considering this, the best return one can expect from your fixed income investments is the underlying yield, less any fees. Looking at the DEX Universe Bond Index, which is a well known bond benchmark, the current yield is 3.6%.

Despite these low return expectations, we still believe that bonds should be a cornerstone of your portfolio. Our rationale is that when used in part of a well diversified portfolio, bonds can help make it more stable over the long term. Historically bonds move in the opposite direction to equities. In a portfolio this is important because when equity markets drop, bonds tend to be positive and reducing the losses for investors.

When looking at bond funds for your portfolio, there are a few characteristics which you we believe you should look for. They include:

1. Low Fees – With bond yields expected to remain low for some time and relatively low expected returns, you will want to reduce the impact of costs, keeping more money in your portfolio.
2. Active Management – With an active fund, the manager can do things such as increase the yield, shorten the duration and take advantage of other opportunities as they arise. They may also be able to invest in other strategies such as high yield, derivatives and currency, which can not only provide additional return, but also help protect you against major drops in value.
3. Higher Yields – With yields expected to be the main driver of return for the near term, you will want to maximize them. As well, a higher yield can provide a better buffer against rising interest rates than lower yields.
4. Lower Duration – The shorter the duration of a bond, the less it is affected by movements in interest rates. Given that rates will eventually be moving higher, you will want to shorten duration to help preserve capital.
5. Global Bonds – Global bonds trade off of a different set of economic factors than Canadian bonds. By bringing some exposure into your portfolio, you can provide an extra layer of diversification than what you can get with only investing in Canadian bonds.

Bottom Line – Bonds have been and should continue to be an integral part of your portfolio. They can provide a tremendous safe haven in periods of uncertainty, and can help preserve the value of your portfolio when equity markets drop. Going forward, we cannot assume that bonds will continue to be a significant contributor to your overall return. They will NOT! Instead, look at them as a great shock absorber, making your investment ride smoother.

Determining Truly Active Management

By Dave Paterson, CFA

If you want to beat the index, you can’t look like the index

For many do if yourself investors actively managed mutual funds are considered to be a sucker’s bet. They believe that active funds offer nothing more than poor investment returns and high fees. Their rationale is that you can simply go out and buy a low cost ETF that will provide the same investment exposure at a much lower cost. Sure, you won’t ever beat the index, but you also aren’t expected to underperform by much more than the MER.

There is much support for this position too. Many of the personal finance columnists are firm believers in low cost ETFs, and the regular SPIVA Report which compares active managers to their benchmarks more often than not shows indexing the winner over the long term. Even putting the investment universe we follow through our valuation model, only 50% show a higher absolute or risk adjusted return than their benchmark.

With all of this compelling evidence, why would anybody even consider investing in active management? Quite simply, active management can produce better risk adjusted returns. However, identifying those managers who are truly active can be a challenge.

The reality is that there are a number of managers that engage in a practice known as closet indexing. With closet indexing, the manager is looking to keep their performance in line with that of their benchmark. There are a number of reasons that this happens such as looking to control risk, or hoping to keep performance close to the index to keep investors happy, or in some cases, managers may do this to keep their jobs.

Regardless of the reason, it severely limits the ability of the manager to manage the fund in such a way as to give them an opportunity to outperform their benchmark and add any value for investors. If you knew before hand that you were essentially destined to get a return that is roughly that of the index, then why would you pay a higher management fee to earn roughly the same return?

According to a study that was done by Martijn Cremers of the Yale School of Management, closet indexing is quite prevalent in Canada. He estimates that approximately 40% of the funds in Canada would be considered closet indexers, with most of it occurring with Canadian equity funds where it is estimated that 70% of the funds engage in the practice. Global and international equity funds typically do not engage heavily in the practice, while about 13% of the regional and sector funds are closet indexers.

Using this information, we set out to see if we could uncover a number that we suspect are closet index funds. To qualify, a fund had to have at least a 5-year track record and could not be a real index fund. In our study, we ranked funds based on their “R-Squared” and Correlation. R-Square is a statistical measure which shows how much of the fund’s movement can be explained by the movement of its benchmark. It ranges between 0 and 100, and the higher the number, the more of its movement is based on the index, rather than the manager. In other words, the higher the number, the more likely that the fund was engaging in closet indexing.

Correlation is a measure which shows how two funds move in relation to each other. Correlations will range between -1 and +1 where -1 indicates that the two funds move in the exact opposite direction, while +1 means that the two funds will move in the same direction. Again, the higher the correlation, the more likely that closet indexing is involved.

Funds Most Likely to be Closet Indexers	R-Squared	Correlation to Benchmark	MER
RBC Canadian Equity Fund	0.9946	+0.9973	2.05%
RBC Jantzi Canadian Equity Fund	0.9858	+0.9929	2.10%
Fidelity Canadian Disciplined Equity Fund	0.9849	+0.9924	2.28%
IA Clarington Canadian Growth Fund	0.9787	+0.9893	2.94%
Fidelity True North Fund	0.9773	+0.9886	2.28%

 

Funds least Likely to be Closet Indexers	R-Squared	Correlation to Benchmark	MER
Dynamic American Value	0.3467	+0.5888	2.45%
Dynamic Global Discovery	0.4125	+0.6423	2.76%
Mackenzie Ivy Canadian Fund	0.4178	+0.6464	2.51%
Mackenzie Ivy All Canadian Fund	0.4469	+0.6685	2.54%
Mackenzie Ivy Foreign Equity Fund	0.4990	+0.6378	2.57%

 

Bottom Line: If you are able to separate the true active managers from the closet indexers, you will have a much better chance at identifying funds that have the potential to deliver returns that are much different than the index. Looking at a fund’s R-Squared and correlation can be helpful in identifying these funds. For truly active management, you will want to avoid funds that have a high R-squared as those funds are the ones that are most likely to be the closet indexers. R-squared cannot be viewed in isolation as it is not an indication of quality. Instead, you will first want to identify high quality funds, managed by experienced, disciplined management teams who use a very sound, repeatable investment process. Then, you can look at the likelihood that they are engaging in closet indexing. Combined, this should help you find the funds that have the greatest chance of outperforming over the long term.

Investing in Europe

By Dave Paterson, CFA

Risk of a catastrophe in the region reduced considerably

When the European Central Bank announced that they would be buying an unlimited number of bonds to help inject liquidity into the Eurozone’s fragile economy, the likelihood of a big blow-up in the region was lessened considerably. While the risks may be lessened, the debt crisis is still far from being solved and until it is, there is still considerable uncertainty that needs to be addressed.

The region remains mired in the grips of a severe economic recession and many governments are introducing potentially stifling austerity measures as they grapple with their crippling debt loads. Add to that the recent equity rally may have pushed valuations ahead of the fundamentals and there are many reasons to remain cautious about the region.

Out of this crisis, there are also potentially some attractive opportunities. While the timing may not be perfect, some contrarian investors with a very high appetite for risk may want to look at dipping their toes into the region. If you are one of those investors, we have identified three funds which we believe will give you the best chance of making good returns in Europe. Our picks are:

Mackenzie Ivy European Fund Class (MFC 1565) – This is by far our most conservative pick of the group and like all funds that carry the Ivy banner, it avoids highly levered companies and banks with complicated structures. Instead, they look for stable companies with clean balance sheets, good management, healthy profitability and sustainable competitive strengths. The portfolio itself is fairly concentrated holding approximately 20 names. While the characteristics may indicate that this is a value fund, valuation is considered only after the quality of a business has been determined.

It is defensively positioned with very little exposure to cyclical businesses and holds around 9% in cash. Because of this, it is expected to lag when markets move sharply higher. For example, as of October 31, the MSCI Europe Index gained 11.6% in Canadian dollar terms, while this fund gained 5.9%, lagging its peer group.

This is our top pick for one reason – quality. It invests only in quality companies and as a result is much less volatile and will hold its value much better in periods of extreme market volatility. Case in point, the index is down 4.7% over the past five years, yet this fund has generated a positive return of 2% in the same period. Given that much headline risk remains in Europe, this fund should hold up well for investors looking to make baby steps into the region.

CIBC European Equity Fund (CIB 494) – While this fund can invest in both medium and large companies in Europe, it is current focused on the bigger names. They look for companies that are global and market leaders that have strong management teams, attractive growth prospects and reasonable valuations. This is a more aggressive offering than the Ivy offering. It has more pop to it on the upside, but it will also be hit harder when markets drop. It is growth oriented in its approach which results in higher levels of volatility. We believe that this is a good pick for higher risk investors looking for a momentum play.

Fidelity Europe Fund (FID 228) – Similar to the CIBC European Equity Fund, this offering can invest in companies of any size and looks for those that offer strong growth potential and high quality management teams. It tends to be fairly well diversified and will hold around 50 companies. The managers continue to avoid
investing in companies located in the current trouble spots of Greece, Spain and Portugal, with biggest holdings in the UK, Germany and France.

Unlike the first two funds we mentioned, this one employs a very active management style with high levels of portfolio turnover. Perhaps as a result, it is also the most volatile fund on our list. It is likely to provide the most upside in a market rally, but will also be hit the hardest when markets fall. Year to date, the fund has had a great run, gaining 16.9%, outpacing the MSCI Europe Index by 9.3%. This is a good pick for those with a higher risk tolerance

Bottom Line – While some aggressive and contrarian minded investors may want to consider investing in the region, caution is warranted. Yes, central bank activity has removed the biggest risks from the region, but markets have rallied higher, pushing up valuation levels. The economic picture still remains murky, but opportunities are there for those willing to take the risk. The picks discussed above, in our opinion, have the potential to provide better than average gains for investors looking for exposure to Europe. For more conservative investors looking for exposure to the region, you are most likely better off investing in a high quality global or international equity fund and let the portfolio manager make the call as to how much exposure to Europe is appropriate.