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Capital Group U.S. Equity Fund (CIF 847 – Front End Units, CIF 867 – Low Load Units) – Historically, the U.S. equity market has been one of the most difficult to outperform, making picking an actively managed fund in the category rather difficult. More often than not, you’re better off just going with a low-cost index product for your U.S. equity exposure.
One fund that has grabbed my interest of late is the Capital Group U.S. Equity Fund, offered through the U.S. based Capital Group’s Canadian division. While the fund is only publishing a track record of just under three years in Canada, it is now modelled after the firm’s oldest portfolio, the Investment Company of America, a fund that was launched in 1933, and boasts a strong track record of performance.
Like all Capital Group funds, it is managed using a multi-manager approach. The portfolio is divided into different sleeves that are managed independently by managers of different backgrounds and styles. There is also a portion of the fund that is made up of the top picks from the firm’s analyst teams.
There is much diversity between the styles and philosophies used by the different managers. Each uses their own unique, research driven approach to stock selection. The result is a portfolio that tends to be somewhat style agnostic.
Overseeing the portfolio is the firm’s Portfolio Coordinating Group, which is responsible for monitoring the portfolio in real time. They are also responsible for setting the weight between the managers and analysts within the fund, based on their outlook of the investing environment.
The portfolio is often quite different than its benchmark. For example, at the end of June, it was significantly overweight materials and energy, with underweights in financials, consumer discretionary, and technology.
It holds 70 names, with the top ten making up just over a third of the fund. Digging deeper, the portfolio valuation metrics, while not cheap, do look slightly more attractive than the S&P 500.
The managers take a longer-term outlook to investing, which is reflected by their very modest 23% average annual portfolio turnover. Another interesting item about the fund and the firm is the compensation structure. Incentive bonuses are paid to the managers based on their rolling one, three, five, and eight-year performance numbers, with more emphasis being placed on the longer-term numbers. Further, Capital Group is well known for its high level of manager co-investment in the funds. At the end of September, 97% of the firm’s managers had more than $1 million invested in their mandates. This goes a long way to help align the interests of the managers with those of the investors.
Costs are very reasonable, with an MER of 2.05%, which is well below the category average. The lower fee hurdle will help in this category where outperformance is very difficult.
Given the emphasis on risk management, I wouldn’t expect this to shoot the lights out, but I would expect it to deliver index like or better returns with volatility levels that are slightly better than the broader market. All these factors align to make this a very compelling reason to consider this fund for your U.S. equity exposure. I am adding it to the Recommended List.
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Funds of Note
TD Canadian Core Plus Bond Fund (TBD 695– Front End Units, TDB 696 – DSC Units) – This continues to be an excellent choice for investors looking for an actively managed Canadian bond fund. It is managed in a similar fashion to the highly regarded TD Canadian Bond Fund, except it can invest up to 30% in “non-core” fixed income strategies such as high yield, global bonds, and emerging market debt. At the end of August, it held just under 9% in non-investment grade bonds.
During the quarter, it modestly outpaced its rival, the PH&N Total Return Bond Fund. Both funds are of exceptional quality, and both have very comparable duration positioning, with TD offering a slightly higher yield to maturity. The key reason for this modest outperformance was TD had a higher weighting in corporate bonds, which made up more than 60% of the fund. In comparison, PH&N has been very active with their corporate exposure, and at the end of September held roughly 37% in corporate credit. PH&N also held only a modest position in high yield, which outpaced government issues over the quarter.
Looking ahead, both bond funds are excellent picks, particularly in an environment where the Bank of Canada is expected to keep rates on hold. If I had to choose between the two, I would likely give a slight edge to the PH&N offering. My main reason for this is the PH&N offering has a higher weight in government bonds, which would be expected to hold up better in periods of volatility. Many are expecting higher than normal volatility in both the bond and equity markets in the coming weeks. Another reason would be the modestly lower cost, with the advisor series of PH&N carrying an MER of 1.16% compared to 1.50% for TD for the advisor sold units of each fund.
PIMCO Monthly Income Fund (PMO 005 – Front End Units, PMO 105 – DSC Units) – Managed by the team of Alfred Murata and Dan Ivascyn, this actively managed, global bond fund has a decided focus on income generation, paying attention to protecting invested capital. The managers have a lot of tools at their disposal and can invest in a wide range of fixed income securities including mortgage backed securities, investment grade bonds, high yield debt, and emerging market bonds. At the end of September, mortgage backed investments made up 28% of the portfolio, followed by government issues, which were a quarter of the fund, and 24% weight in emerging market debt. The duration is very defensive, coming in at 2.68 years, which is significantly shorter than the broader Canadian bond market.
The process used is a combination top down macro analysis and bottom up security selection. The top down macro analysis looks at both the long-term outlook and the near term cyclical view. This analysis helps the managers set the fund’s sector mix, duration and yield curve positioning. Securities are chosen using a fundamentally driven, bottom up process.
The managers look at the portfolio in two distinct parts; high quality core, and non-core. Within the high-quality core portion, they tend to focus on investment grade issues in developed countries and agency mortgage backed securities. This portion is designed to provide downside protections and modest returns in periods when economic growth is weak. The non-core portion holds lesser quality issues such as high yield bonds, emerging market debt, and non-agency mortgage backed securities and is for growth.
They are very active in their approach with levels of portfolio turnover that have averaged more than 200% since the launch of the fund.
This fund is managed so that its monthly distributions are covered mostly by the income generated by the portfolio, as the managers do not want to encroach on capital. That explains why the monthly distribution amount is variable. For the past 12 months, income distributions have totaled just over $0.67, resulting in an annualized yield of 4.6%.
Costs are very reasonable, with an MER of 1.39%.
For the quarter, it gained 3.2%, handily outpacing its peers. Year to date, it’s up nearly 6.5%, making up for a somewhat disappointing 2015. Volatility is well below its competition, and its downside capture is negative, meaning it is likely to be positive when global bonds are down. This has resulted in an excellent risk reward profile.
Looking ahead, I expect this fund has the potential to continue to deliver excellent risk adjusted returns, particularly when compared to its competition. I certainly don’t think it will deliver the types of gains it did in 2011 and 2012, but what we’ve seen in the past couple years appears to be more reasonable. While not a core holding, it can be a great addition to an otherwise diversified fixed income sleeve.
Fidelity Canadian Large Cap Fund (FID 231 – Front End Units, FID 531 – DSC Units) – Since taking over the reins of this fund in 2011, manager Daniel Dupont has posted stellar numbers, gaining nearly 14% annualized to the end of September. In comparison, the S&P/TSX Composite has returned just over 8%. While a lot of this outperformance can be attributed to his U.S. holdings, which at the end of August made up 23% of the portfolio, his focus on capital preservation, quality, and valuation have also played a significant part.
Despite this enviable long-term track record, the fund has struggled recently. For the third quarter, it gained 2.9%, lagging both the index and the peer group. Year-to-date, the fund is up by 7.6%, but it has trailed the broader Canadian market by more than 800 basis points. In some cases, this sort of underperformance would be cause for concern. While we never like to see any our recommended funds underperform, it’s important to understand why the underperformance has happened.
In this case, the recent underperformance is largely the result of the fund’s defensive positioning. It is significantly underweight materials and energy; two sectors that have accounted for most of the gains in the index this year. At the end of August, the fund had no exposure to materials, which have risen by more than 50% on a year-to-date basis. Turning to energy, the fund held about a third of the exposure of the index, which has risen by more than 25% so far this year.
Another factor contributing to the underperformance is the high cash position. At the end of August, the fund held 17% in cash, up from 6% at the end of June. The higher the cash balance, the more drag the fund experiences when markets rise. The cash will also act as a buffer when there is a market selloff. It is for this reason that the cash has been increased. In a recent commentary, Mr. Dupont noted there are several risks on the horizon, including deteriorating balance sheet strength in several companies, worries that the earnings cycle has peaked, and valuation levels. Combined, these risks lead him to carry more cash than he would like, but given his emphasis on capital preservation, he believes this is a prudent move in the short-term.
The higher cash can also be a source of “dry powder”. He has shown in the past that he is rather adept at using periods of market volatility to put his cash to work, and improve the quality of the portfolio by picking up quality companies at more attractive valuations.
As much as I am a fan of the performance numbers, I am even more impressed by the risk metrics of the fund. Volatility has remained well below the index and peer group, and the upside and downside capture ratios are excellent. Even in the past year when it has struggled by historic standards, it still managed to deliver more than half the upside of the market, and had a negative downside capture ratio, indicating the fund was likely to be higher on days when the market fell.
While some may be frustrated by the recent underperformance, I remain extremely comfortable with this fund on my Recommended List of Funds. I believe in the manager and I am comfortable with the investment process used. I continue to monitor this fund closely for any significant erosion it the risk reward outlook.
IA Clarington Canadian Small Cap Fund (CCM 520 – Front End Units, CCM 521 – DSC Units) – With a respectable 4.7% rise in the third quarter, this mid-cap focused fund lagged both the benchmark and its peers. There are a couple of reasons for this. First, the portfolio is very quality focused, holding a concentrated mix of excellent franchises, with strong balance sheets and reasonable valuations. In the past few months, market leadership has come from higher beta names with weaker balance sheets, meaning the market has not been rewarding quality. Second, the fund is carrying a relatively high cash balance, which acts as a headwind in a rising market environment. It is estimated that the 9% cash balance cost the fund approximately 49 basis points in performance in the quarter.
When looking ahead, it is these very factors that lead me to believe it is well positioned for the future. First, the valuation levels of the portfolio look rather attractive next to the index and peer group. It becomes even more so when the dividend yield is factored in. At the end of September, Morningstar estimates the yield of the portfolio at more than 3.4%, well above its peers. Second, the operational and management quality of the companies in the portfolio is very strong, which will help the portfolio to withstand an extended economic slowdown or period of market volatility better than companies with weaker fundamentals. Finally, the high cash balance which can be a headwind in a rising market, provides the managers with the ammunition to improve the portfolio in periods of market volatility by picking up quality names at more attractive valuations. The longer-term performance numbers back this up, with better than average returns, lower than average volatility, and excellent downside protection.
This remains one of my top small cap picks.
Fidelity Small Cap America Fund (FID 261 – Front End Units, FID 561 – DSC Units) – Since Steve MacMillan took over this fund back in 2011, it has been one of the best performing U.S. small cap funds around. However, in recent months, performance has begun to slide. In the third quarter, the fund gained a very modest 2.2%, while the Russell 2000 Index gained nearly 10% in Canadian dollar terms. Year-to-date, the fund is down 2.7% while the benchmark was up more than 18%.
This recent underperformance is the result of the investment process used by the manager. Mr. MacMillan uses a fundamentally driven, bottom up stock selection process that places an emphasis on stocks that have a history of high return on equity, and high earnings visibility. He also likes companies that have low economic sensitivity, and are trading at reasonably valuations. Because of this focus on quality, the portfolio tends to have less exposure to more cyclical sectors such as energy, materials, and financials. It also tends to eschew those names trading at high valuation levels. Looking at the sectors that have driven the U.S. market higher, it has been materials, energy, and real estate – the very sectors this fund is likely to avoid. True to the process, the fund had no exposure to materials and real estate, and was significantly underweight energy.
One of the worst performing sectors has been healthcare, which has lost 6.6% on a year-to-date basis. The fund is significantly overweight healthcare, which makes up 21% of the portfolio. It also has significant exposure to consumer discretionary names, which have dropped 1% so far this year. Also creating a headwind in a rising market, has been the fund’s 10% cash weighting.
Putting it all together, and you get the “perfect storm” for underperformance – a significant overweight in sectors that are underperforming, little or no exposure to sectors that are outperforming, and a higher than normal cash balance.
Looking ahead, I remain cautious on small and mid-cap names in general, based mostly on valuation levels. I expect that we could see a period of underperformance from small and mid-cap stocks that will allow valuation levels to return to more normalized levels.
With this fund specifically, I expect to see some further short term underperformance, however, over the long-term, with its focus on quality and valuation, I would expect it to produce solid returns, with better than average levels of volatility. I remain comfortable with this fund on my Recommended List of Funds, and will continue to monitor it on an ongoing basis.
BMO Asian Growth & Income Fund (GGF 620 – Front End Units, GGF 120 – DSC Units) – Asian markets had a very strong quarter, with the MSCI Pacific Index gaining nearly 9.5% in Canadian dollar terms. In a recent commentary, the managers of the fund noted that this rebound was likely the result of a few factors including a reduced likelihood of major capital outflows in the wake of slower than anticipated rate hikes in the U.S., and the success of China’s accommodative monetary policies, that appear to have stabilized the country. This backdrop helped to fuel strong capital inflows into emerging markets, with all Asian markets benefitting, and large cap companies being the largest benefactor.
Despite this positive market backdrop, the fund lagged the index, rising 4.2%. Much of this underperformance was the result of the fund’s lack of exposure to the high-flying tech names, which rallied nicely in the quarter. It’s exposure to convertible bonds, preferred shares, and cash also acted as a headwind in a rising market. Combined, these investments account for nearly 20% of the portfolio.
Looking ahead, the managers remain cautious. They note that much of the market rally is a function of an influx in capital, rather than an improvement in market fundamentals. They expect 2016 to be another year with no growth in corporate earnings. Further, market valuations remain on the high side. There are also several risks that could impact Asia including a more protectionist trade environment following the upcoming U.S. election, further threats to the stability of the E.U., and troubles in the European and Chinese banking sector.
Given the riskier outlook, I believe this remains one of the best ways to access Asian equities. The mix of equities and convertible bonds provide a more balanced exposure. Obviously, the drawback to this is the probability of underperforming in a rising market. However, I believe this is more than offset by the lower volatility and stronger downside protection offered.