Top Funds Report – July 2015

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Bank of Canada Cuts Rates

Economic data remains weak. Further cuts remain on the table…

With the Canadian economy continuing to struggle, Bank of Canada Governor Stephen Poloz cut the Bank’s key overnight lending rate by 0.25% to 0.50% on July 15. Further, the Bank cut its forecast for the Canadian economy, with GDP now expected to be a mere 1.1% for 2015, nearly half its original estimate.

It was long thought that the economic hit from the collapse in oil prices would be more than offset by increased economic activity in non-energy related sectors such as manufacturing, lumber, and services. Unfortunately this has failed to materialize, even in the face of a much weaker dollar. The dollar closed at $0.7693 on Friday, down from $0.8620 on December 31.

Clearly, the effect of the oil swoon on the Western economies was underestimated. The oil patch drives a lot of spending in spinoff industries and business investments. Further adding to this is the slowdown in China, which continues to keep other commodities under pressure.

Many now expect that barring a stunning turnaround, another cut is coming in late fall or in early 2016. Some have even begun speculating that the Bank may be forced to implement a quantitative easing program, much like the ones used the U.S. Federal Reserve or the European Central Bank in an effort to improve conditions.

While this may be a possibility, I certainly wouldn’t be holding my breath waiting for it to happen.

None of this has done much to alter my investment outlook. I continue to keep asset mix weights in line with their neutral weightings. Within fixed income, I don’t see yields, particularly short term yields, spiking anytime soon. I am comfortable keeping duration slightly below benchmark, but will look to shorten it further as the economy improves. I favour high quality corporates over governments.

With equities, I continue to favour U.S. equities, although valuation levels are a bit of a concern. However, with troubles continuing in Europe and Asia, it remains the default, safe haven choice. I continue to favour quality over growth.

My current investment outlook is:

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

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Funds You Asked For

This month, we look at some of the best and worst performers from the first half of the year…

Fidelity China Fund (FID1206 – Front End Units, FID 1506 – DSC Units) – With an impressive 29.0% gain, the Fidelity China Fund took the crown as the top performing fund for the first half of the year. It handily outpaced its peers, and kept up to the MSCI All China, Hong Kong, and Taiwan Index in Canadian dollar terms.

However, the tide seems to have turned in China, and the index is off more than 18% from its June 12th peak. Much of this year’s earlier gains were attributed to margin fueled buying, and this recent selloff will help bring prices back to normal. As this happens, expect continued volatility, as Chinese authorities have stepped in to shut down some short selling accounts and are taking other steps to bolster the falling markets.

Unless you have an extremely high appetite for risk, I would avoid China at the moment, as I believe the risks are just too high at the moment. But if you are looking to invest in China, this is not a bad fund to consider.

TD Health Sciences Fund (TDB 976 – No Load Units, TDB 320 – Front End Units, TDB 350 – DSC Units) – Apart from a couple of blips along the way, healthcare has been on a tear since August 2010. This fund is no exception, gaining an annualized 34% in the past five years.

Much of this growth has been fueled by excitement over advances such as the mapping of the human genome, great strides in cancer research, and potential merger and acquisition activity. There have also been regulatory changes that make it more difficult for the drug companies to launch new products.

This T. Rowe Price managed offering has become my top pick in the sector, after CI Global Health Sciences stumbled earlier in the year. The manager, Taylor Tamaddon, focuses on U.S. based healthcare companies that derive more than 50% of their revenues from the research, development, production, or distribution of products or services related to health care, medicine, or the life sciences.

Despite it being favourite, I am not recommending it right now, as the valuations are just too rich. The Fund has a price to earnings ratio of nearly 25 times. In comparison the S&P/TSX Composite has a P/.E of 17 times and the S&P 500 is around 19 times, both well above average levels.

While the long term picture for healthcare remains strong, particularly in light of an aging population and increasing global access, the valuations make it a bit too risky in the near term. While the momentum may keep pushing prices higher, there will need to be a correction at some point.

AGF U.S. Small-Mid Cap Fund (AGF 789 – Front End Units, AGF 680 – DSC Units) – With a gain of 24.6%, this fund captured the bronze for year to date performance from a Canadian mutual fund.

Managed by Tony Genua using a bottom up, earnings growth momentum driven approach, this concentrated portfolio’s performance seemed to turn a corner in May 2014, when began outpacing not only its peers, but also the Russell 2000.

Much of this outperformance can be attributed to the overweight technology exposure, which made up 43% of the fund at the end of May.

Given the momentum approach used, it is possible that the fund may continue to outperform, but be warned, valuations are quite rich, and some pullback is likely. If you have held this fund for a while, you may want to take some money off the table sooner than later.

Marquest Explorer Fund (MIN 100 – Front End Units) – Generally I don’t like to write anything bad about a fund. I will try to keep to that, but it may be difficult to do.

So far this year, it has lost nearly 27%. But digging deeper, it is not that difficult to see why. This fund is a bit of a special situation in that it invests in small and mid-cap mining stocks that are rolled into upon expiry of Marquest flow through funds.

Flow through shares are a uniquely Canadian investment. They are a special type of common share that is issued by Canadian oil and gas or mineral exploration companies. These shares allow you to claim various federal and provincial tax credits and deductions for the exploration costs the companies incur. This will often allow you to write off the entire amount of your investment in the shares against your taxable. It is for this reason that these investments are popular, making them a tax product first, and an investment second.

Another reason that performance has lagged is many of the companies are very small exploration companies. They have limited market caps, and are of little interest to most investors, putting a lot of selling pressure on them once they are transferred out of the flow through fund and into the rollover fund. The result is often very dismal performance.

While the first half loss of 27% is bad, it is not out of character for this fund. If you had invested $10,000 in it five years ago, today, it would be worth a little more than $1,000. Granted, most people will be in this fund because their flow through shares have been rolled into it. Once the tax benefit is taken into account, the net loss may not be as dramatic.

Regardless, I believe there are better investment options available, and anyone who is not being rolled into it from a flow through investment should avoid it.

Aston Hill Energy Growth Class (AHF 915 – Front End Units) – In hindsight, it would have been pretty tough to find a worse time to launch an energy fund.

Launched back in March 2014, oil was trading north of $100 per barrel. Investor demand was strong, and all looked good. The fund was doing okay, keeping pace with its peers. Then in June, the oil market started its free fall, taking this fund down with it.

In the past year, it has lost 61%, losing 21.3% in the last six months, with nearly half of that loss coming in June. It has underperformed the benchmark and has lagged its peers and is the worst performing energy fund in the country over the past one, three, and six month period, and also over the past year.

Management had tried to stop the bleeding by raising cash, but it was too little too late. At the end of May, two thirds of the fund had been in cash. Over the course of June, the managers started putting some of that cash to work, adding to current holdings including Whitecap Resources, Peyto Exploration, and Gibson Energy. They also took on some new positions including Anadarko Petroleum, Calfrac Well Services, and Tusla based energy explorer, Helmerich & Payne Inc. The June 30 cash balance was reported at 47% of the fund.

In addition to the dismal performance, high costs are another knock on this fund. With a pretty standard management fee of 2%, the MER for the fund is listed at 8.29%, meaning there are significant operating expenses in the fund, largely the result of its small size. The assets in the fund are listed at $860,000. Add to that trading costs of more than 1%, and it’s not hard to see why this fund is struggling.

With that backdrop, I would likely look elsewhere for my energy exposure, with Canoe Energy Income, Canoe Energy Class, or Franklin Bissett Energy being stronger candidates than this offering.

PowerShares Canadian Preferred Share Fund (AIM 56203 – Front End Units) – I’m a little surprised to see a preferred share fund on the worst of the year list. Typically, prefs are thought of as fairly conservative investments, and they tend to hold their value fairly well.

Unfortunately, this year has been an exception to that, with preferred shares, particularly fixed rate reset preferreds being hit especially hard after the Bank of Canada’s rate cut. With a dividend rate that is fixed based on the prevailing rate of interest, fixed resets were sold off as investors worried that future dividends would be pushed lower.

All preferred funds were negative, but this was hit the hardest, losing 10.5% in the first half of the year.

The reason this was hit harder than the other funds is it is passively managed, fully invested, and tracks an index. The preferred indices were all hit hard, with the S&P/TSX Canadian Preferred Index losing 8.6%.

So while 10.5% may be bad compared with its peers, it’s not out of line given the performance of the broader share market. If we take the 8.6% loss of the index, factor in the 1.75% MER, and we get an expected loss of 10.4%, right in line with the actual performance. If nothing else, this highlights how in some sectors and asset classes, active management can add value in volatile times.

Given that, if I were looking for pure preferred share exposure, I’d lean towards a high quality actively managed fund. However, until the rate picture is a little clearer, I’m avoiding the preferred market entirely.

Sentry REIT Fund (NCE 705 – Front End Units, NCE 305 – DSC Units) – On July 7, Sentry Investments shocked the investment community, announcing that it had terminated the contract of Dennis Mitchell, the firm’s Chief Investment Officer, and one of their most respected, and likable managers. No reason was given for the departure, other than it was not for the mismanagement of funds. This has led to speculation that a clash of personalities or disagreement with upper management was the cause.

Mr. Mitchell also managed a number of other Sentry funds including Sentry Global Growth & Income, Sentry Global Balanced Income Fund, Sentry Global Infrastructure, and the recently launched Sentry Global Mid-Cap Income Fund.

Taking over management duties of the REIT fund is Michael Missaghie. Mr. Missaghie joined Sentry in 2008, and has been co-manager of the fund since 2010, so he is well versed in Sentry, the fund, and its investment process.

Sandy McIntyre, a respected industry veteran with more than 40 years industry experience will step back into the CIO chair. Mr. McIntyre held the role between 2008 and 2012, when he handed the reins to Mr. Mitchell. He will be an excellent replacement for Mr. Mitchell, given his extensive experience, and the fact that he was instrumental in shaping Sentry into what it is today, both from a process and personnel standpoint.

Still, this move causes some concern. I will continue to monitor the firm and its funds closely over the next little while. I will be looking for further troubles within the company and its investment management team. Stay tuned…

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

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July’s Top Funds

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PH&N Total Return Bond Fund

ANALYSIS: After Bank of Canada Governor Stephen Poloz cut rates in January, and economic signals showed another rate cut was likely, this fund was again promoted to my top pick. It has consistently been one of the best bond funds in the country, and with the depth of the team behind it, combined with their disciplined repeatable process, it highly likely it will continue to be a great fund.

It is managed much like the highly regarded PH&N Bond Fund, except for this fund’s ability to take a more active approach and invest up to 10% in high yield bonds. In a potentially volatile environment, that is what I believe gives this fund the edge.

At the end of June, it held approximately 16% in Federal bonds, 37% in provincial bonds, and 38% in corporates. It also had very little exposure to any high yield bonds. Its duration was listed at 7.2 years, which is just shy of the 7.4 years of the FTSE TMX Canada Universe Bond Index, and the yield to maturity was 2.2%, slightly above the benchmark.

This positioning has resulted in a fairly high level of interest rate sensitivity. While it will help when rates are falling, it will most certainly hurt when they move higher. After the Bank of Canada’s rate cut last week, I would expect the managers to trim their duration exposure slightly, but expect it to remain fairly high.

The outlook for the fund now depends on the direction of interest rates. Economic data has continued to remain weak, leading some to believe another rate cut is likely, either late this year or early in 2016. Some are even speculating that the Bank of Canada may be forced to step in and launch a quantitative easing program, much like the U.S. Federal Reserve and the European Central Bank. Regardless, barring a major improvement, an increase is likely off the table.

That being the case, this remains my top bond pick for the near term. However, if you have held this for a while and have seen some strong gains, you may want to consider taking some money off the table by realizing some profits.

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GBC Growth & Income Fund

ANALYSIS: This fund shows that good things come in small packages. With just a little over $61 million in assets under management, this offering from Pembroke Private Wealth Management has delivered a solid five year annualized return of 12.6%, handily outperforming not only the benchmark’s 7.6% gain, but also its peers in the Canadian Equity Balanced category.

Unlike many traditional balanced funds that usually invest in big blue-chip names, this one focuses more on small- and mid-cap companies for its equity exposure. The managers combine a top-down, macro analysis that is used to set the asset mix with a fundamentally driven, bottom-up security selection process.

For the fixed-income exposure, the fund invests directly in the GBC Canadian Bond Fund, a well-diversified fixed-income fund, with exposure not only to Canadian, but also global bonds. It is overweight corporate bonds, with approximately half invested in Canadian corporate bonds and 17% in foreign corporate bonds. Still, investment quality is high, with all rated A or better. Its duration is 4.5 years, which is below the benchmark.

Within the equity portion of the fund, the focus is on small- and mid-cap companies with a focus on yield. At the end of June, technology, and consumer names were the biggest equity weights. The fund has a concentrated portfolio, holding 41 equity names, with the top 10 making up about 30% of the fund.

While the longer term performance has been stellar, it has struggled of late. In 2014, it was up by 3.3%, but finished well in the bottom quartile, while on a year to date basis it is basically flat. Much of this underperformance is the result of poor returns in its top holdings including big losses from Cervus Equipment, Alaris Royalty, and Sylogist Ltd.

I really like this fund. However, I am a little leery of recommending it as a core holding. With the focus on small- and mid-cap names, I’m worried that we may see periods of higher volatility, at least higher than you would see in a more traditional large-cap focused fund. Still, if you’re comfortable with this risk, it’s a good option to consider, particularly if you have a longer-term time horizon.

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Mawer U.S. Equity Fund

ANALYSIS: Mawer is one of those companies that seems to do most things right. They offer a decent family of funds run by quality managers, following a disciplined repeatable process, all at a reasonable cost.

Like their other funds, this one is managed using a research driven, bottom up approach that looks for well managed companies with a history of earning attractive return on capital, strong balance sheets, and a record of delivering strong operational and financial results.

Valuation is a consideration, and manager Graydon Witcher will try to buy names when they are trading below their estimate of its true worth. They stress test their models and assumptions through an intensive scenario analysis that gives them a stronger understanding of the company’s fundamentals and valuation. The entire research team is involved with the vetting of new investment ideas, which portfolio managers and analysts challenging each other’s research, inspiring each other to dig deeper to find stronger investment candidates.

The process is very patient, with portfolio turnover averaging well below 10% for the past five years.

The result is a well-diversified portfolio that holds just under 60 names with the top ten making up a third of the fund. Sector positions are capped at 20% of the fund based on book value, but recent market growth has brought the weighting of the financials and tech sectors over this limit, representing 21% and 22% respectively.

The biggest problem with this fund is it is a U.S. equity fund, a category in which it is notoriously difficult to outperform the index. This fund is no exception. With a five year annualized gain of 19.8%, it was one of the top performers in the category, yet trailed the S&P 500’s 21.2% rise in the same period.

If you are looking for pure U.S. equity exposure and are unable or unwilling to use an ETF (XSP or XUS), then this is a great pick. It offers a strong management team, disciplined process and the potential for above average returns.

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TD Global Low Volatility Fund

ANALYSIS:  They say that if something sounds too good to be true, it probably is. That’s how I first felt about the concept of low volatility investing. Not only are you expected to earn as good, or even better return, but you can do it with a lower level of risk.

Upon further review of the data, the low vol anomaly appears to hold. TD Asset Management did a study of the constituents of the MSCI World Index between 1997 and 2014 and found equities with lower volatility characteristics outperformed higher volatility equities 76% of the time. The only time the low vol equities consistently lagged was when markets rose by more than 4%.

Looking to take advantage of this, TD were the first movers into the low vol investing space, launching this fund in November 2011. Since then, RBC and Mackenzie have also launched low volatility funds.

The portfolio has the objective of outperforming the MSCI All Country World Index (ACWI) over the long term with less volatility. To do this, the manager uses a quantitative model that forecasts expected volatility and expected return for the MSCI ACWI. Once the low vol investment candidates have been identified, manager Jean Masson will optimize the portfolio weights to reduce overall portfolio volatility.

The portfolio is well diversified, holding just shy of 300 names. Perhaps not surprisingly, it is overweight more stable sectors such as communications, consumer staples, and real estate, while underweight the high flying tech and healthcare sectors. It also has a bit of a value bent to it, offering more attractive valuations, and a higher underlying dividend yield.

Performance, on an absolute basis has been somewhat disappointing, although given the strong rise in global markets, not unexpected. On a risk adjusted basis, things look a little better, and it held up well during the selloff in the fall. While I really like the concept, I will reserve my opinion until we get more track record.

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