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List Changes

Additions

There were no funds added to the list at this update.

Deletions

Manulife Monthly High Income Fund (MMF 583 – Front End Units, MMF 483 – DSC Units) – I added this high quality Canadian balanced fund to the Recommended List in December 2015. It is managed by the team of Alan Wicks and Jonathan Popper, with an equity approach that is rooted in a value philosophy that looks for businesses that generate high and sustainable profits that are trading at attractive valuations. The fixed income sleeve is managed using a combination top down economic review combined with a bottom up credit analysis. The process looks to generate returns by focusing on sector allocation, credit quality and individual credit selection. They also emphasize risk management by actively managing the yield curve and duration exposure. Performance, over the long term has been excellent, although recently has lagged a bit, gaining 1.08% year-to-date, which is just above the category average. Given the team and process in place, I expect that it will continue to deliver above average returns, with below average volatility.

Unfortunately, Manulife closed the fund to new purchases effective August 28. This move was made in an effort to protect current investors, as the fund was approaching a size that the managers felt may detract from their ability to continue to effectively manage it. Clearly this move was made with the best interests of investors in mind. However, because it is now closed, I am removing it from the Recommended List. I will continue to follow it closely, and should it be re-opened will consider adding it back to the list.

If you hold the fund, and it is in line with your investment objectives, risk tolerance, and time horizon, and it is still appropriate for your portfolio, there is no immediate reason to sell. I believe it will continue to be a solid Canadian balanced fund offering.

Funds of Note

PH&N Total Return Bond Fund (RBF 1340 – No Load Units, RBF 6340 – Front End Units, RBF 4340 – Low Load Units) – Starting the quarter with a duration that basically matched the FTSE/TMX Universe Bond Index was one of the factors that allowed the fund to outperform its peers in the third quarter. Over the quarter however, management became concerned over the potential for rising rates, and pared the duration back. At the end of September, the duration was 7.0 years, slightly below the 7.3 years of the index.

It was underweight in corporate bonds, but management added to the position over the quarter, after the selloff. At September 30, it held 47% in government bonds, and 44% in corporate bonds. They have also recently added a modest position in real return bonds, as they believe they are mispriced by the market.

Given the positioning, I expect it to be the best performing Canadian bond fund on the recommended list in the near term. It offers a duration that is roughly in line with the index, and a yield that is stronger. This should allow it to do well in a flat rate environment, and if we do see another cut from the Bank of Canada, which at the moment is not expected, this fund will outperform. It also has a great management team in place, using a very disciplined and repeatable process. My preference would be to use the lower cost D or F Series of units, but even paying full freight of the Advisor Series Units, the fund remains my top Canadian bond pick for the near term.

Manulife Strategic Income Fund (MMF 559 – Front End Units, MMF 459 – DSC Units) – Managed by a team headed by Dan Janis, this tactically managed global bond fund focuses on four key risks for investors; interest rate risk, credit risk, currency risk, and liquidity risk. For the quarter, it gained 1.75%, outpacing both its global bond and high yield fund peers.

In a recent commentary, Charles Tomes, a trader, and member of the management team of this fund said they expect the recent high levels of volatility to continue. One reason for this view is the uncertainty caused by the divergent policies of many central banks. There are some countries, most notably the U.S., that are poised to start normalizing their interest rate policy by raising rates. Other countries remain rather accommodative and may lower rates further, or take other stimulative actions, such as quantitative easing. Another concern is the potential global economic fallout that could result from China’s slowing growth rate. Combined, these uncertainties are likely to result in continued high levels of volatility in the near term.

In this environment, the managers do not hold any U.S. Treasuries. Instead, they have been focusing on U.S. corporate bonds. Given the uncertainty and spreads, they have also been actively reducing their high yield exposure, instead, investing in higher quality, investment grade names. At the end of September, approximately 60% of the fund was invested in the U.S. For their global exposure, they continue to like countries where they expect a favourable interest rate outlook to remain, this includes Canada, New Zealand and Australia. Combined, these three nations make up 20% of the portfolio. As the Canadian dollar has continued to drop, they have increased their currency hedge position, which will help to protect against any unexpected rise in the Canadian dollar.

For emerging market holdings, they like countries that have strong fundamentals, with most of their exposure in three countries; Singapore, the Philippines, and South Korea. Each carries an investment grade credit rating, and are running a current account surplus.

On average, the fund’s duration is expected to range between 3.25 and 3.75 years. The duration policy is the result of their duration calls on each of their underlying country investments.

I continue to like this as an excellent diversifier within the fixed income sleeve of a portfolio. It is classified as a high yield fund, however, I tend to look at it more as an actively managed global bond fund. I expect that it will continue to deliver above average returns with average volatility.

IA Clarington Canadian Conservative Equity Fund (CCM 1300 – Front End Units, CCM 1400 – DSC Units) – It is taking an increasing amount of patience to keep recommending this fund. Year to date, it is down more than 15%, and is off nearly 20% in the past year. In comparison, the S&P/TSX Composite is down 7% year to date, and 8.4% over the past year.

The biggest reason for this dramatic underperformance stems from its significant overweight in high yielding energy names. At the end of September, it held nearly 30% in energy compared with an 18% weight in the index. Most of the energy names held tend to be pipeline or infrastructure plays, such as TransCanada Corp., Pembina, and Enbridge. These types of names make up about half the energy exposure, and unlike previous energy corrections, have been punished just as severely as a number of the lower quality companies. The managers believe that a rebound to a more sustainable oil price is forthcoming over the near to medium term, which will bode well for the fund.

Another positive note is dividends paid by the underlying companies has continued to grow, and has grown by more than 15% in the past five years. The current underlying yield of the portfolio is nearly 5%, which is an all-time high, and they believe put an underpinning of support under the fund, helping to restore its downside protection.

While I don’t disagree with their position, I have been extremely disappointed in the volatility profile. Historically, downside capture had been around 50%, meaning the fund experienced about half the drop of the market. But over the past year, it has tripled to nearly 150%. I am monitoring the fund closely and am looking for a significant improvement to the downside protection. If I do not see any such improvement, I will be removing the fund from the Recommended List. The strong downside protection was the key differentiator for this fund. Without that, there are many other Canadian Equity and Canadian Focused Equity Funds that offer potentially better risk reward profiles.

Franklin U.S. Rising Dividends Fund (TML 201 – Front End Units, TML 301 – DSC Units) – I have long viewed this fund as somewhat similar to the IA Clarington Canadian Conservative Equity Fund. With its focus on fundamentally sound companies that have generated growing and sustainable dividend streams, the fund’s returns have been much less volatile than the broader market. It has lagged in rising markets, but that is a tradeoff I’m willing to make for the fund’s downside protection. However, of late, I have noticed a jump in volatility and an erosion in the fund’s downside protection. Much of this has been the result of a sharp selloff in many of the fund’s consumer names, such as GAP, which is down 25% for the past three months (to October 31), Wal-Mart is down 20%, and Walgreens is down 10%. Another drag on the fund is its significant allocation to materials, which make up more than 10% of the fund, compared to a 2.7% weight in the S&P 500. I am placing the fund UNDER REVIEW effective immediately, and will be monitoring it closely for any further erosion in the risk reward metrics of the fund.

Fidelity Small Cap America Fund (FID 261 – Front End Units, FID 561 – DSC Units) – Despite dropping 1.4% in the third quarter, the fund’s trend of outperformance to its peers and benchmark continued. The Russell 2000 was down 6.9% in Canadian dollar terms, while the average U.S. Small / Mid Cap equity fund lost nearly 5%. The recent outperformance was the result of strong relative returns from a number of technology and consumer discretionary names, with both Ingram Micro and Jardine Group helping the cause.

In building the portfolio, manager Steve MacMillan, uses a bottom up approach. This means the fund’s sector exposure is the result of available investment opportunities. He continues to look for well-managed, high quality companies that have strong recurring revenue and a high return on equity. Of late, he has been finding these types of attractive opportunities in the technology, consumer, and healthcare sectors.

During the recent market volatility, the manager used the selloff to put some cash to work by adding to some existing names, and adding a couple new ones at attractive prices. At the end of September, he held just shy of 4% in cash.

Looking ahead, the manager believes the U.S. will hold up well in the face of global economic uncertainty. He sees the stronger dollar keeping inflation in check, which will allow the U.S. Federal Reserve to hold interest rates low for the foreseeable future. Lower commodity, and specifically energy prices will also be a boost to consumer spending, which is a significant contributor to the U.S. economy.

The valuation metrics of the portfolio look attractive compared with its benchmark, offering a lower P/E ratio, higher returns on equity, and higher growth rates. In addition to the strong performance, its volatility has remained in line with the index, but has offered much better downside protection.

Still, with a one year gain of 28%, an annualized three year gain of 28%, and an annualized five year gain of 25%, it may be time to take some money off the table and take some profits in the fund. If it is appropriate for you, I wouldn’t suggest selling your entire positing, but instead, rebalancing your portfolio, bringing its weight to a more neutral level, based on your objectives and risk tolerance.

Mackenzie Ivy Foreign Equity Fund (MFC 081 – Front End Units, MFC 611 – DSC Units) – I have said it before, and I will say it again – when global equity markets get rocky, this is the fund you want to own. With markets on a rollercoaster, the MSCI World Index lost 1.6% in the third quarter. According to Morningstar, the average global equity fund was down 3.4%. Yet this high conviction, quality focused offering managed to gain 2.6%. Part of this outperformance can be attributed to its cash position, which at the end of September sat just shy of 30%. The rest of it is the result of stock selection, with consumer staples and financial names outperforming. The portfolio is concentrated, holding 30 names at the end of August. The sector mix and country allocation is the result of the manager’s disciplined stock selection process.

In a recent commentary, the managers noted the recent selloff has improved the outlook for a number of their holdings. However, they voiced concerns the market valuation remains high, particularly in light of the potential for slow and potentially slowing growth. They continue to focus on well managed, high quality companies.

I continue to like this fund. It offers one of the most attractive risk reward profiles of any equity mutual fund. It offers decent upside when markets are rising, but to me the selling feature is how it behaves in down markets. The downside protection of this fund is excellent, participating in only 60% of the markets drops over the past five years. Given there has been no material changes to the way the managers execute their strategy, I don’t envision a substantial change to this on a go forward basis. I expect it will continue to do what it does, offering strong risk adjusted returns. It is likely to lag in a rising market, but that’s a tradeoff I’m comfortable with for the downside protection.

PH&N Monthly Income Fund (RBF 1660 – No Load Units, RBF 6660 – Front End Units, RBF 4660 – Low Load Units) – I continue to be disappointed by the performance of this fund. After a solid 2011 and 2012, it has lagged dramatically. I am a fan of PH&N on the fixed income side, and had hoped that was enough to offset middle of the road equity management. To date, I’ve been wrong. Right now, the only positive I can find in the fund is the cash flow it generates, which is currently about 5.4%. Unfortunately with a mutual fund, cash flow does not equal quality. I am placing the fund UNDER REVIEW immediately, and will be looking for signs of a turnaround. If that doesn’t happen, it will be replaced.

Brandes Emerging Markets Value Fund (BIP 171 – Front End Units, BIP 271 – DSC Units) – To say this fund has struggled of late would be a bit of an understatement. Over the past year (to September 30), it has lost more than 20%, significantly underperforming its peers. In the past quarter alone, it was down 14%, again lagging both its peers and its benchmark. Does that mean the fund has lost its mojo? No. The problem the fund is experiencing at the moment has more to do with its deep value style, than the manager’s skill. Brandes has a well-deserved reputation as being a very strong, deep value manager. They also have a reputation of sticking to their style, regardless of what the markets are doing. Unfortunately at the moment, the value style is significantly underperforming growth and more core styles in the emerging markets. This has no doubt affected the fund. Another factor that has hurt performance is it is more of an all cap fund compared to many of its peers, holding many more small and mid-cap names. While this is a positive over the long term, there are periods when small and mid-caps will lag. We are in one of those periods. However, I don’t expect we will be forever.

If I look at the valuation metrics of this fund compared to its peers and benchmark, it offers a significantly more attractive portfolio. For example, according to Morningstar, the P/E ratio of the MSCI Emerging Markets Index is 10.6 times. For this fund, it is 6.6 times. For the price to cash flow, the index is 5.2 times, while the fund is 2.5 times. It is even more attractive compared to its peers, with Morningstar reporting the category average P/E is 12.5 times, and the price to cash flow is 8.0 times.

That doesn’t mean the near term will be any easier. With continued worry over China, combined with lower demand for commodities, emerging markets are likely in for more trouble. If you are uncomfortable with this outlook, you may want to avoid this and other emerging market funds. However, if you are comfortable with it, and you have a medium to long time horizon, I believe this is a solid pick.