Top Funds Report – March 2015

 

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Markets Cheer ECB QE Plan

Commitment to buy $68 billion a month spurs global equity gains

After a mixed January, February saw markets bounce back nicely, led higher by Europe. The MSCI Europe Index gained 6.3% as investors eagerly awaited the start of the European Central Bank’s latest quantitative easing program.

Starting March 9, the ECB will purchase $68 billion of debt securities each month. The hope is that by injecting such a massive amount of money into the economy, the struggling economies will begin to rebound, showing signs of growth.

Whether this will actually work or not remains to be seen, but it has no doubt been met with approval from investors. The rally in Europe also spread to Asia, where equities gained 5.5%. The end result was an impressive 6.0% gain in the MSCI EAFE Index.

In the U.S., the S&P 500 rebounded from its shaky January, gaining an impressive 5.8%, and finishing at a record high.

Oil showed some signs of stabilizing, closing at just under $50, up more than 3%. This helped push the S&P/TSX higher by nearly 4%. Also helping the cause were financial stocks, which rose on the stronger than expected earnings posting by the Big Five banks.

Canadian bonds were down after yields moved higher after bouncing off January’s record lows. With investor expectations for a repeat of the Corporate and high yield bonds were the bright spots, posting gains, while government issues lagged.

While another cut from the Bank of Canada is still widely expected, it has adopted a “wait and see” approach to gain a better understanding on how the economy reacts to the lower rates, and the lower dollar. Regardless, it is highly unlikely the Bank will increase rates in the near term.

In this environment, my investment outlook is neutral. I don’t see anything that will drive bond prices materially higher, but also don’t expect big declines. My preference remains on corporate bonds over governments, and am maintaining a fairly neutral duration stance.

My current investment outlook is:

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

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Funds You Asked For

This month, I take a look at offerings from Canoe, Dynamic and Capital International…

Canoe Energy Class (GOC 501 – Front End Units, GOC 502 – Low Load Units) –To be honest, I’m not sure I’m ready to be putting any money in an energy fund at the moment. I’d like to see a bit more firming around the oil price before I dive in. However, if you’re ready to make that move and are looking for a good option in the space, the Canoe Energy Fund would likely be my pick.

Manager, Ravi Tahmazian uses a macro analysis to find the subsectors in the energy space that he believes are well positioned for the expected environment. He focuses not only on oil and gas, but also pipelines, renewables, and energy service companies. He looks for companies where management has their interests aligned with the investors. He analyzes the quality of the business, its balance sheet and properties.

The manager is not afraid to move into cash when he feels there are no suitable investment opportunities, or the sector is poised for a fall.

At the end of January, it held approximately 40% in cash, and just under 30 names, with the top ten making up 36% of the fund. The process is very active, with high levels of turnover. The fund is small, which allows the manager the flexibility to take meaningful positions in some of the smaller names in the industry. If we see a big inflow into the fund, he may be forced to move to more medium and large cap names, which will more than likely effect performance.

I like the manager. He has a lot of experience in the industry, and has done a stellar job with this fund since he took it over. He has managed to outpace many of his rivals, and do so with much less volatility and stronger downside protection.

It’s pretty much all Canadian focused, which given the manager’s background is a good thing. I also like that while he doesn’t play an active role with the fund, manager Rob Taylor is at Canoe. This is a big positive for me, given Mr. Taylor’s success at BMO running their global energy mandate. Should anything happen to Mr. Tahmazian, Mr. Taylor could step in and manage the fund without missing a beat.

The only other fund that compares to this on a quantitative basis would be the BMO Global Energy Fund. But since Rob Taylor left the fund a couple of years ago, I’m not considering it until I see a solid three years with the new management team.

DynamicEdge Growth Portfolio (DYN 1970 – Front End Units, DYN 1972 – DSC Units) – This is part of a portfolio program offered by Dynamic Funds. It offers investors six strategic portfolios, covering the spectrum of investors, ranging from Conservative to Aggressive Growth. Each will invest in a well-diversified mix of mutual funds offered by Dynamic.

This is the growth offering, with a target asset mix of 80% equities and 20% fixed income. The equity sleeve has about a third in Canada with the balance abroad. The focus is on large cap, but does have some exposure to small and mid-cap names. Sector exposure and country mix is the result of the positioning of the underlying funds.

The fixed income portion is heavily weighted to investment grade, with some modest exposure to high yield and global bonds. A drawback to this is interest rate sensitivity will run fairly high, meaning it may struggle in a rising rate environment.

It is well diversified, investing in 15 funds including Dynamic Canadian Bond Fund, Dynamic Dividend Fund, and the Dynamic Value Fund of Canada.

Performance has been middle of the pack, with a five year annualized gain of 9.4% to the end of February. Volatility has been slightly lower than the index, resulting in decent risk adjusted returns.

A fund like this is only going to be as good as the underlying funds in it. While there are some high quality offerings, there are also some that don’t add much to the overall portfolio. It is limited to Dynamic funds only.

To be honest, most investors are better off creating a portfolio using funds from a mix of companies to get a mix that is more in line with their investment objectives and risk tolerances rather than using a prepackaged portfolio solution. This fund is no exception to that.

Capital International Global Equity Fund (CIF 843 – Front End, CIF 863 – Low Load – This global equity fund is managed using a unique, multi-manager approach with different managers responsible for portions of the fund, independent of each other. Running the show are Carl Kawaja, Dina Perry, and Galen Hoskin. Also contributing is a team of 30 analysts who are responsible for about a quarter of the 200 or so names in the fund.

Each manager has a unique, yet complimentary investment approach, including contrarian value, growth and a more tactical, opportunistic style. Regardless of the style, the research process is strictly bottom up, fundamentally driven. It is patient and long term focused. A significant portion of the manager’s pay cheque is based on their performance over an eight year period, allowing the managers to focus on the big picture drivers of equity returns, rather than short term noise.

The sector mix and geographic allocation is the byproduct of stock selection process.

Performance has been strong. For the five years ending February 28, it gained an annualized 15.1%, outpacing much of its competition, but lagging the MSCI World Index. Volatility has been in line with the broader market.

On balance, this is a great core global equity fund for most investors. It has a very strong team behind it, a proven process, and a reasonable cost. I would expect that it will continue to be one of the better performing global equity funds over time.

TD Retirement Portfolios – With market volatility on the upswing, many are looking at new ways to help reduce the risk they take in their portfolios. One such product that has gained a lot of attention has been the TD Retirement Portfolios, which are the TD Retirement Conservative Portfolio, and the TD Retirement Balanced Portfolio. Combined, these funds have attracted nearly $2.5 billion in assets, and have consistently been at or near the top of the list of TD’s top selling funds since their launch.

At the core, they are conservatively managed balanced funds, with a focus on risk management. They invest in a mix of cash, bonds and equities, allowing the manager some flexibility to shift the asset mix around based on market expectations.

Where these portfolios set themselves apart is through the use of an options based strategy that is designed to provide downside protection while still allowing for capital growth. The funds invest in the TD Risk Reduction Pool. In very simple terms, this pool is using a “collar” options strategy that consists of three parts; exposure to the S&P 500 through individual equities and ETFs, covered call options, and protective put options.

The pool will invest nearly all of its assets in the S&P 500, providing the equity exposure. Next, they will sell covered call options. A covered call option allows the buyer the right to buy a stock or ETF at a predetermined price at a time in the future. The set price is referred to as the “strike price”. When the fund sells these call options, it generates premium income, which is used to purchase put options, which provides the pool with its downside protection.

While a call option allows the purchaser to buy a stock or ETF at a set price at a future time, a put option allows the purchaser to sell a stock or ETF at a predetermined price in the future. So, when the price of the stock or ETF falls below the strike price, the value of the put increases, offsetting the drop in the underlying stock or ETF, and protecting the value of the portfolio.

For every dollar of S&P 500 exposure, TD will purchase a dollar of put option protection. The covered call strategy is more tactical in its approach, and the amount of call options sold will be dependent on their outlook. When they see more upside in the markets, fewer options will be written, allowing for higher growth potential. When they see flat or a falling environment, they may write more calls to generate the extra premium income.

While the downside protection is a nice feature, it comes with a cost, which is the upside participation you give up. In the event there is a sharp rally, the pool will be forced to sell their S&P 500 holdings to the call option holders at the strike price, thereby capping the growth until more equities can be purchased. Through covered calls, they generate additional income for the pool, which is used to buy the downside put protection.

Performance is tough to measure with these funds for a few reasons. The first, obviously, is that with about a year and a half of returns, there really isn’t sufficient data on which to do a meaningful analysis. Second, given the option strategy used, the focus of the funds is really more on delivering modest returns with less risk. Judging by absolute and relative returns may not be the most appropriate. Finally, because of the way mutual funds are categorized in Canada, these funds get lumped in with Global Equity Balanced Funds, which is a bit misleading when looking at the peer group.

Performance to the end of January has been disappointing on an absolute basis. However, if I look at their volatility profile, they have been less volatile and offered stronger downside protection than what a more typical balanced fund has experienced in the same period. They have behaved as advertised in volatile times.

To their credit, TD has done a great job at positioning these funds as potentially suitable for investors who have just entered, or are just about to enter retirement. They may also be appropriate for very conservative investors looking for the potential for some growth, but are more worried about significant losses. Beyond that, I struggle to find an investor for whom these funds may be appropriate. In almost all cases where an investor has a medium to long term time horizon and average risk tolerance, a more traditional balanced fund or well diversified portfolio may be more appropriate.

These are indeed very interesting products. They use a unique approach and could potentially serve a need for more conservative investors.

My fear is that many don’t fully understand the tradeoffs the funds have made for the benefit of the strong downside protection, namely lower gains in rising markets. This could result in many disappointed investors down the road, when they see that their returns may lag a more traditional balanced fund over the long term. Considering all factors, I remain cautious on these funds.

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

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March’s Top Funds

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Jarislowsky Fraser Select Income Fund

Analysis: With bond yields in Canada expected to remain lower for longer than many had expected, investors need to take a more diversified approach to find reasonable levels of income. This conservatively managed balanced fund is certainly one investors may want to consider.

The fixed income sleeve is managed using a top down macro analysis combined with a bottom up security selection process. The macro view helps the managers determine the most appropriate maturity profile and credit mix for the fund. Once this is set, they look for securities that fit the macro view and can help maximize yield.

The equity portion of the fund invests in large, industry leading companies that have strong management teams and a track record of earnings and limited financial leverage. The managers rely heavily on the firm’s in-house equity team, and use a top-down and bottom up economic analysis with a focus on long-term investment themes to help identify the most attractive areas of the market. They believe this allows them to find companies that have long-term, stable earnings prospects.

The fund pays a set monthly distribution. For 2015, it has been set at $0.0362 per month. This works out to an annualized yield of 3.9%.

Performance has been strong, boasting a three year annualized gain of 7.8%, outpacing much of its peer group. Performance has lagged in the past few months, largely because of its exposure to energy and financials.

The other headwind I see this fund facing is its high level of interest rate sensitivity. While the corporate bond exposure will help a bit, it is still very sensitive to rates, which will drag performance when yields finally do start moving higher in Canada.

Still, for very conservative investors, this may be a good choice for those looking for a high quality balanced fund. For those with higher risk tolerances I would suggest that something with a more diversified bond sleeve may be more appropriate.

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Dynamic Equity Income Fund

Analysis: Managed by Oscar Belaiche and Jason Gibbs, this former income trust fund invests in a diversified portfolio of high yielding equity investments like dividend paying common equity and REITs. Using a process dubbed “Quality at a Reasonable Price”, they look for companies that offer sustainable cash flow, hold a dominant position in their industry, and are managed by a high quality management team that holds a significant equity stake in the business.

With a focus on income, energy and financials make up the biggest weights in the fund. As oil started falling, they began positioning the portfolio out of energy producers, moving more into energy infrastructure plays.

Overall portfolio turnover is modest, averaging between 35% and 45% per year. Typically, turnover increases in more volatile markets, as they are able to pick up some higher quality names are more reasonable valuations.

Performance has been decent, but where this fund really earns its stripes is with its significantly lower volatility. It has consistently been less volatile than its peers and the broader equity market. The fund’s volatility has been more in line with a balanced fund than with a pure equity play. Further, it has experienced less than a third of the downside of the broader market, while still delivering two thirds of the upside.

I see a couple of headwinds in the near term. The first is its exposure to energy, which could result in above average volatility while oil finds its footing. Second, the fund by its makeup is fairly interest rate sensitive. While that may not be an issue in the near term, once rates in Canada do start moving higher, the fund may struggle to generate the same level of absolute returns as it has in the past.

On balance, this is a good fund for investors seeking regular income with the potential for capital gains over the long term. The team has done a good job in providing strong total returns, while keeping volatility in check. This is a good fund for investors seeking some level of income with the potential for modest capital gains over the long term.

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Bissett U.S. Focus Corporate Class

Analysis:  One of the most difficult things for any investor to do with any level of consistency is to outperform the S&P 500. Many try, and many fail. There are however a few funds that can come pretty close at times, and this is one such fund.

It is managed by the team of Gary Aitken and Jason Hornett using a quantitative process that scores the U.S. equity universe on a number of valuation and quality factors. In addition to the typical valuation ratios, they screen for profitability, earnings growth and consistency, and price and earnings momentum.

The stocks are scored on the above metrics and then ranked best to worst, with the top 40 names making up the portfolio in equal weights. Because it is based on the quantitative ranking of stocks, and there are no limits on sector exposure, the end portfolio has the potential to look dramatically different than the index.

That is certainly the case at the end of February when it was significantly overweight in healthcare and consumer defensive names, while being underweight in consumer cyclical and energy. As with most Bissett funds, they favour dividend paying stocks. As a result, most of companies in the fund pay dividends and the yield is well in excess of what is offered by the index.

The model is rerun monthly and any stock that has a weight of more than 3.5% will be rebalanced back to the 2.5% target weight. Any name that has fallen dramatically in the rankings will be replaced by the next best ranked security.

Performance has been solid, on both an absolute and risk adjusted basis. For the five years ending February 28, it has gained 18.4%, outpacing most of its competition. Volatility has also been significantly lower, resulting in excellent risk adjusted returns. Unfortunately this has lagged the S&P 500 on both an absolute and risk adjusted basis. Even still, this is much better than the average U.S. equity fund.

I still believe that most investors would be better off with an index product when looking for pure U.S. equity exposure. However, for those who prefer an actively managed mutual fund, this is definitely one to consider.

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Manulife Global Infrastructure Fund

Analysis:  Over the past decade, many large pension funds have been making significant investments in infrastructure projects to help better diversify their portfolios, reduce the risk of capital losses and in many cases, hedge against potential inflation. This enthusiasm has started to gain some traction with retail investors with a number of infrastructure mutual funds and ETFs available.

Infrastructure investments make a fairly compelling investment because it offers long term stable cash flows that are often adjusted to inflation, low risk of loss of capital, and potentially attractive risk adjusted returns.

One of the more interesting options in the space is the Manulife Global Infrastructure Fund, managed by a team headed up by Craig Noble at Brookfield Investment Management. Brookfield is one of the recognized leaders in the infrastructure investing space.

The investment process is a mix of top down macro analysis and bottom up company selection. The top down process is used to identify potential investment themes and starts with a detailed economic outlook that is used to provide an understanding of which industries, countries and themes are expected to do well. This helps the team narrow down the companies on which they will do a more detailed fundamental analysis that evaluates the quality of the balance sheet, free cash flow generation, and valuation.

The portfolio tends to be well diversified, holding about 50 names from around the world. Given the nature of infrastructure holdings, the portfolio is concentrated in utilities, energy, and industrials, which combined make up nearly 85% of the fund.

Performance has been decent. For the three years ending February 28, the fund gained an annualized 18.1%. In comparison, the more broadly focused MSCI World Index gained more than 23%. Volatility has been lower than both the index and many other global equity funds.  But what really makes this an attractive piece of a well-diversified portfolio is the downside protection it offers. For the past three and five years, it has participated in approximately two-thirds of the upside of the global equity markets. However, it has been flat to positive when markets are falling.

Given the management team behind it, this is a great option for investors looking for infrastructure exposure in their portfolios.

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