Top Funds Report – December 2015

 

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Fed Moves on Rates

Zero interest rate era is over with quarter point increase in rates…

After months of speculation, the U.S. Federal Reserve Board increased interest rates by a quarter point, ending practically seven years of near zero rates. Initial market reaction was positive, with North American indices rallying sharply higher after the announcement. Unfortunately, the honeymoon was short lived, with markets selling off in the days following.

In her comments, Fed Chair Janet Yellen noted that rates remain extremely low, and this move is very small on a relative basis. She also said that she expects rates will continue to move higher in a very measured and gradual way over the next several years. This of course assumes that the pace of economic growth and the state of the economy can sustain further increases.

With rates moving higher, the U.S. dollar rallied, as many investors begin moving money back into the U.S. Another consequence of the rising dollar is it makes commodities, which are priced in U.S. dollars, more expensive for consumers in the rest of the world. As a result, we saw oil, and other commodities selloff in the aftermath.

Higher U.S. rates, and lower oil were the two key drivers that have pushed the Canadian dollar down even further in recent days. On Thursday, the dollar closed at $0.7158 U.S., down from $0.7301 on Friday, December 11. With the Fed likely moving higher and the Bank of Canada on hold, or possibly moving lower, the near term outlook for the Canadian dollar is not promising.

The outlook for stocks is less clear. The wording of the Fed’s statement indicated that while the economy is strengthening, any future moves will be gradual. This is positive for equities. Further, this move has allowed many U.S. bank to move lending rates higher, helping to boost their earnings. However, sectors that are tied to low rates, for example real estate, will struggle.

The outlook for the Canadian market is also mixed. With more than a quarter of the market tied directly to commodities, and other sectors, for example, financials and some industrials also being affected by commodities, significant headwinds remain in place. Canadian exporters, on the other hand, should do well, as the weaker loonie increases their competitiveness abroad.

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Funds of Note

This month, we look at a number of ETFs on my Focus List…

PowerShares Senior Loan CAD Hedged ETF (TSX: BKL) – It was not a good quarter for riskier parts of the fixed income market, including leveraged loans. For the three-month period ending October 31, BKL dropped 2.07%, lagging its peers, and benchmark. With markets becoming extremely volatile, investors shunned riskier assets, and instead moved into safer haven assets. If nothing else, this highlights why floating rate notes and loans should only be a portion of your fixed income allocation, and not as many wholesalers may suggest, a core part of it. Since the summer, floaters have been down, and BKL has now given back all the gains it earned in 2014 and the first few months of 2015. But as they say, past performance is not indicative of future performance, and I believe that to be the case here. The market fully expects the U.S. Federal Reserve will start moving interest rates higher in December, which will be a positive for this ETF. That said, there is no rush to get into this, as many of the loans in the portfolio have rate floors in place, which will limit gains until rates move significantly higher. I don’t expect much of a pop in this fund in the near term, but I do like the longer term outlook with it likely rates will begin moving higher soon.

PowerShares Tactical Bond ETF (TSX: PTB) – This is a tactically managed, diversified bond portfolio that provides exposure to Canadian government, investment grade corporate, and real return bonds, as well as U.S. high yield, and emerging market debt. The portfolio management team will tactically shift the exposure to a number of underlying ETFs in an effort to best position the portfolio for the market. To be blunt, so far, they’ve failed, gaining a very modest 2.55% for the year ending October 31, while the FTSE/TMX Canadian Universe Bond Index has gained 4.43%. The big reason for this underperformance is its exposure to emerging market debt, high yield, and real return bonds. Each of these asset classes has struggled, compared with more traditional, investment grade Canadian bonds.

However, as I look ahead, with rates likely to start moving higher, I expect this well-diversified, actively managed ETF to hold up better than the more traditional bond ETFs. The team is fairly active in shifting the positioning, making several tactical moves over the quarter. That should certainly help as rate volatility moves higher. A drawback to this strategy is if the management team is not reactive enough in making these changes, any outperformance may be limited.

BMO Monthly Income Fund (TSX: ZMI) – At the end of November, the ETF held nearly 60% in income equity ETFs, 37% in corporate bond, and the rest, just over 4% in emerging market debt. For the three months ending October 31, it was down by 2.2%, which while disappointing, did manage to outpace the 60/40 equity / fixed income benchmark. A big key to this recent outperformance stems from its conservative positioning, with nearly 30% in short term bonds, and most of the equity exposure focused on higher quality dividend mandates. It is scheduled to be reconstituted in January, which will see the asset mix shift back towards a 50/50 split, and will also see the short term allocation reduced to a maximum of 20%. This will result in a slight bump in the risk profile, both because of the higher equity exposure and the higher duration. This could be positive if we see a nice rally in equities, but could prove to be a negative in a market selloff. At the end of November, the distribution yield was just north of 4%, generating a nice cash flow for those looking for income. I think this could be a good one ticket solution for smaller investors looking for diversified, income focused exposure. Those with larger portfolios are likely better off building their own, more tailored asset mix.

iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (TSX: CDZ) –  With market volatility on the upswing, investors’ attention started to turn to better quality, and higher yielding issues, which this ETF invests in. To qualify for inclusion, a company must have increased dividends for at least five consecutive years. Another thing I like about this ETF is its valuation metrics look more favourable than the broader market, with valuations lower, and a yield that is higher than the S&P/TSX Composite. This should help to offer stronger downside protection if markets remain volatile. It also pays a variable monthly distribution that has ranged between $0.074 and $0.080 per unit, which works out to an annualized yield of around 3.8%. My biggest worry about this is it is an all cap mandate, with a lot of exposure to small and mid-cap names. This could result in periods of above average volatility. Still, I see this as a solid dividend focused offering.

iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC) – Canadian equities have struggled of late, with the S&P/TSX Composite Index losing 5.8% on a total return basis. There were two key factors driving this decline; continued weakness in the energy markets, and Valeant Pharmaceuticals fall from grace. The energy sector was off more than 3.3% as the outlook for oil remains weak. Until we see a stabilization in the energy markets, I expect Canadian equities to remain volatile. Valeant is another story completely. Not too long ago, it was challenging for the top spot on the TSX, with a market capitalization that rivaled RBC. However, in August, many began questioning the sustainability of the firm’s business model, sending shares tumbling precipitously. In early August, it traded at more than $346 a share. It is now trading down around $130 per share, losing nearly two thirds of its value in just a few months.

Looking ahead, barring a sharp rebound in price, Valeant isn’t likely to be a major factor that drives the market. The bigger issues will be energy, and the rate of growth in the U.S. I remain cautiously optimistic on both, and am somewhat positive on the medium term outlook for Canadian equities. Valuations appear to be quite favourable, particularly when compared with the expected earnings growth rates. Concentration within the financial and energy sector remains high, and somewhat concerning, but is less troublesome than it was before the energy selloff. Further, it is one of the most cost effective ways to access the space. Combined, these factors make this a solid pick for Canadian equity exposure.

iShares US Fundamental Index ETF (TSX: CLU) – Looking only at the fundamentals of the portfolio, this appears to be the most attractive U.S. ETFs around. Valuation metrics such as price to earnings, price to book, and price to cash flow are significantly more favourable than either the iShares Core S&P 500 Index ETF (TSX: XSP), or the Vanguard U.S. Total Market Index ETF (TSX: VUS). This is not particularly surprising, given the methodology used to select and weight the stocks. Tracking an index constructed by Research Affiliates, it holds the top 1000 U.S. listed companies as ranked by three factors; total cash dividends, free cash flow, and total sales. It also considers book value in the ratings. What this fails to consider is earnings growth, and when this is taken into account, the other two ETFs on the Focus List look to be more attractive. Further, I had hoped the fundamental methodology would result in better risk measures, but unfortunately that has not played out as expected, as its volatility and down capture measures are in line with the others. While I like the theory of the construction methodology used for this ETF, I prefer the more cost effective cap weighted options XSP or VUS at the moment.

iShares MSCI EAFE Minimum Volatility Index ETF (TSX: XMI) – Low volatility funds are designed to provide returns that are roughly in line with the broader equity markets, but also offer lower volatility, and much stronger downside protection. While there isn’t sufficient history for a lot of these funds, the early results are certainly encouraging. For example, according to Morningstar, for the past three years, XMI has shown a down capture ratio of 21%, meaning it experienced only a fraction of the downside of the broader market. This has resulted in a level of return that is much stronger than what has been experienced with the more traditionally constructed BMO MSCI EAFE Index (TSX: ZDM). One problem I have noted with other low vol funds is the level of valuation is significantly higher than comparable cap weighted ETFs. In the international equity space, that is not the case, with valuation levels of XMI, higher, but not significantly so when compared with ZDM. Things look even more attractive when forward looking growth rates are considered, making this my top international equity pick at the moment, even with the higher MER.

BMO MSCI Emerging Markets Index ETF (TSX: ZEM) – With the slowdown in China, and global demand for commodities weak, the emerging markets have struggled. For the year ending October 31, the MSCI Emerging Markets Index lost more than 14% in U.S. dollar terms. While the recent past is dismal, the medium to long term outlook is more positive. Valuation levels are significantly below historic averages. According to Brandes Investment Partners, the MSCI EM Index was trading at a 24% discount to the historic average, 30% to developed markets, and 35% lower than the S&P 500, based on the P/E ratio. Numbers were similar when comparing P/B and P/CF. This indicates that there is some upside to emerging markets equities. Unfortunately, with the uncertainty hovering over China and commodities, we may see more volatility and downside before things turn around, and the timing of any turnaround is unknown. I am avoiding direct exposure until we get a bit more clarity. Still, I believe this is the best option for passive emerging market exposure.

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

 

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December’s Top Funds

 

O’Leary Canadian Bond Yield Fund

Analysis: On a risk adjusted basis, one of the strongest Canadian bond funds over the past five years has been the O’Leary Canadian Bond Yield Fund. It is managed with a focus on capital preservation by a team lead by Connor O’Brien at Stanton Asset Management.

The managers use an active investment process that blends a top down macro analysis, and bottom up security selection. The macro analysis is used to set the fund’s duration, credit quality and sector allocation. Security selection is done using a rigorous, fundamentally driven credit analysis that pays particular attention to a company’s financial strength and relative valuation within its peer group.

The managers believe that it is this emphasis on valuation that has allowed the fund to deliver better risk adjusted returns over the long term. For the past three years, the fund has gained 2.2%, underperforming the FTSE/TMX Canadian Universe Bond Index, but modestly outperforming its peers. However, factoring in the funds below average volatility, the risk adjusted returns are more impressive. For the past three years, the fund has an annualized standard deviation of just under 3%, while the index is just over 4%. The result is a Sharpe Ratio that is one of the highest in the category.

At the end of November, apart from a modest 2% weight in cash, the balance was invested in corporate bonds. It can invest up to 30% outside of Canada, and holds about 13% foreign content, the overwhelming majority of which is U.S. bonds.

With this focus on corporates, the yield is 3.8%, significantly higher than the index’s 2.1%. Further, the duration is also lower, coming in at 5.1 years, compared with 7.4 years for the index.

Because of its positioning and active management, I would expect it to outperform on a risk adjusted basis in flat or falling rate environments. However, if we see a big uptick in volatility, this fund would be expected to lag as investors run for the safety of government bonds.

O’Leary was recently sold to Canoe, however, the management team for this fund will be retained.

 

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Manulife Canadian Balanced Fund

Analysis: Managed by Greg Peterson of Calgary based Mawer Investment management, this fund looks a lot like the highly regarded Mawer Balanced Fund. It is set up like a fund of funds that invests in other Manulife managed mutual funds. At the end of September it was about a third in the Manulife Canadian Bond Fund, a third in the Manulife Canadian Investment Class Fund, 20% in Manulife Global Equity Class, and just under 10% in the Manulife Global Small Cap Fund.

Each of the underlying funds are managed by Mawer. The Manulife Canadian Investment Class is the Mawer Canadian Equity Fund, but with embedded dealer compensation. Manulife Global Equity Class is the Mawer Global Equity Fund, and the Manulife Global Small Cap Fund is the Mawer Global Small Cap Fund. Each of these funds are consistently at or near the top of their respective categories.

Equities are managed using the same fundamental, bottom up, GARP approach that looks for wealth creating companies that trade at a discount to intrinsic value. They take a very patient approach. Their culture is research focused, and all assumptions in the investment process are subject to rigorous stress test and scenario analysis before any decision is made.

If I had to pick a weak spot in the fund, it is the fixed income fund, which is a higher fee version of the Mawer Canadian Bond Fund. Further, it looks a little too index like for my tastes, especially once we hit a patch of rising rates. The portfolio holds more than half in governments, and just over a third in corporates. It only invests in investment grade bonds, effectively limiting options.

The asset mix is based on their macro call on which asset classes are likely to offer the best risk adjusted return. They don’t move the mix much, and any changes are done very gradually.

Unfortunately, two of the underlying funds; Canadian Investment Class and Global Small Cap have been capped to new investors. As a result, this fund has also been closed to new investors since March of 2013. Still, this is an excellent fund and I expect above average risk adjusted returns. If you hold it, consider yourself fortunate.

 

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Fidelity NorthStar Fund

Analysis: Daniel Dupont joined longtime manager Joel Tillinghast on this go anywhere, all cap equity fund in late 2011. They have continued to build on the excellent long term track record, outpacing both the index and peers. More impressive, this was done with lower volatility and stellar downside protection. According to Morningstar, it has experienced about half of the market declines over the past five years.

The managers meet both formally and informally to discuss the relative attractiveness of investment opportunities in various regions around the world. Apart from that, they work largely independent of each other, with each using their unique, bottom up, value focused approaches to security selection.

Daniel Dupont uses a concentrated approach that focuses on 20 to 50 companies with sustainable business models that can deliver high return on capital over the long term. To be considered, it must be trading at a significant discount to its true value. In comparison, Fidelity veteran Tillinghast uses a value focused approach that looks for companies that are growing faster than their peers, have little or no debt, a strong, aligned management team, and the ability to deliver consistent earnings and stable revenue. He also looks for low valuations, high barriers to entry, and robust returns on equity and assets.

The portfolio is well diversified, holding more than 500 names, with a sector mix that is much different from the benchmark. Neither manager is afraid to hold cash when no opportunities are available. At the end of October, 38% of the fund was in cash,

This is not a fund that will shoot the lights out when markets are rallying. But it should hold its own when markets get rocky. The result is that over the long term, you can be expected to earn an above average rate of return, with a below average level of volatility. If you have an above average risk tolerance, you could use this as a core global equity holding, but if not, it can be a good complement to an otherwise well diversified portfolio.

 

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First Asset MSCI Europe Low Risk Weighted ETF

Analysis: While it might be a bit early to step into direct European equity exposure for many people, those with a higher appetite for risk may want to consider it. One interesting way to get some exposure to the region without taking on the full risk of the market would be to use this ETF. It provides exposure to the 100 least volatile stocks in the MSCI Europe Index. Stocks that have a lower level of variance are given a higher weight within the index, while those with higher volatility carry a lower weight. Currency exposure is hedged, which will help protect against any adverse movements in the value of the Canadian dollar. The index is rebalanced on a quarterly basis.

Given the selection methodology, the portfolio looks somewhat different than the MSCI Europe Index. Company size tends to skew a little smaller, with an average market cap that is about two-thirds that of the index. Sector weights are also different, with this ETF holding over-weight positions in more defensive sectors such as real estate, consumer staples, industrials, and utilities.

While the ETF is relatively new, launched in early 2014, back tested data going back to 1999 shows this risk weighted index would have significantly outperformed the broader MSCI Europe Index over the past three, five, and ten year periods. Over the past year, the ETF out-paced other hedged ETFs, gaining an impressive 14.5%. While this is impressive, what really catches my attention are the risk metrics. Ac-cording to the back tested data provided, the level of volatility was about two thirds that of the broader European market. Further, it had a down capture ratio of 47%, meaning on average, it only experienced about half the downside of the market, yet was still able to participate in more than 70% of the upside.

Going forward, I would expect that with the potential for higher volatility not only in Europe, but with markets in general, I see this as a rea-sonably attractive way to access European equities, without taking on a lot of extra risk. I would expect that it will continue to strongly out-perform in falling markets, but lag in rising markets. This is a tradeoff I am comfortable making!

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