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Funds of Note
Dynamic Advantage Bond Fund (DYN 258– Front End Units, DYN 688 – DSC Units) – The fourth quarter was a challenging one for bond investors, with yields spiking sharply. In Canada, the yield on the benchmark Government of Canada five-year bond rose by 49 basis points, ending the quarter at 1.11%. It was a similar story for the Canada ten-year which rose by 72 basis points, ending the quarter at 1.72%. This had a marked effect on bond prices, as the FTSE/TMX Bond Universe Index fell by nearly 3.5% on the quarter. Understandably, with their longer duration, long bonds took the brunt, dropping by 7.6% while short term bonds were off by half a percent.
It is for periods like these that this conservatively positioned bond fund remains on my Recommended List. The managers had remained cautious throughout the year, maintaining a duration of approximately 3 years, well below the broader market, which carries a duration of around 7.3 years. Given the recent selloff, they have added some interest rate risk, bringing the portfolio’s duration up to 4 years, which is still well below the index. They are remaining conservative in anticipation of a further sell off, and improved valuation metrics.
The Fund held nearly half in corporate bonds, with a higher quality bias, but expects to use volatility to increase exposure to lower rated investment grade bonds, based on valuation. For high yield, they are keeping portfolio weights near the lower end of the range, and will add to higher quality issues when the market sells off. At the end of December, they had 7% in high yield issues.
The government exposure is modest, at roughly 25%. Of this, the overwhelming majority is in provincial bonds, which offer a higher yield than their federal brethren. There is a 15% weight in real return bonds, which may help, should Trump’s policies prove to be inflationary.
I continue to like this fund, particularly as we enter into what is expected to be an even more challenging fixed income environment. Given the lower duration and conservative positioning, I expect it to lag in flat or falling yield environments. But when things get choppy in bond-land, it is expected to hold up much better than its peers. This remains a great option for more conservative investors looking for traditional bond exposure.
CI Signature Select Canadian Fund (CIG 677 – Front End Units, CIG 777 – DSC Units) – Throughout its history, this has been one of the more consistent performing funds around. Managed by Eric Bushell and his Signature team, it is managed using an approach that blends a top down macro analysis with bottom up security selection.
The first step in the process is for the team to develop a comprehensive global outlook for the markets, which takes such factors as economic growth, interest rates, capital market conditions and geopolitical risks into account. Using this review as a framework, the geographical exposure and sector mix is determined based on the regions and industries that are expected to outperform in the anticipated environment. At the end of December, they continue to favour equities, with an overweight allocation to healthcare and consumer names. They are underweight the commodity focused materials and energy sectors, as well as industrials and real estate. Geographically, about half the fund is invested in Canadian equities, 28% in U.S. equities, and 18% in International names.
The stock selection process is completed by the team’s sector specialists who will conduct a holistic review on the company, studying its entire capital structure. This helps them to gain a better understanding of where the best risk adjusted investment opportunities are. A typical company in the portfolio will be financially strong, operate in a business where there are high barriers to entry, have strong brand recognition and be reasonably valued relative to the growth potential. The top holdings are littered with many familiar names, including the big Canadian banks, Manulife, Suncor, and Rogers Communications.
The manager is not afraid to use cash as a way to be defensive in periods of elevated valuations or above average volatility. At the end of December, it held 2.5% in cash, up from nothing at the end of September. The investment process is somewhat active, and portfolio turnover tends to increase in periods of volatility, as they can pick up attractive names at great prices.
Performance has been strong, gaining 6.2% in the quarter, making it the best performing Canadian equity fund on our list. Longer term, numbers have been good, gaining 9.6% for the five years ending December 31, compared with the S&P/TSX Composite, which gained 8.25%. Volatility has been modestly lower than the index, and it has done a better job protecting capital in down markets, experiencing approximately 70% of the market decline over the past five-year period.
I continue to like this fund for the long term. There is a very deep management team at the helm, using a disciplined, repeatable, and holistic investment process. This remains a great core equity holding for most investors.
RBC O’Shaughnessy U.S. Value Fund (RBF 776 – Front End Units, RBF 134 – Low Load Units) – If you follow the ETF space at all, you’re very well aware that most of the new products coming to market these days are the so called “smart beta” strategies, that use some sort of a rules based approach to select and weight stocks. Examples include fundamental factors, volatility, dividends, and more recently, more traditional factors such as growth and value.
This U.S. equity fund, managed by Jim O’Shaughnessy was well ahead of the curve in 1997 when he launched this fund, using a strategy he outlines in great detail in his book, “What Works on Wall Street”. Basically, this fund was smart beta before it became hip and cool.
In managing the fund, Mr. O’Shaughnessy and his team start with the entire U.S. equity universe of more than 3,300 names, and looks for those with above average market capitalizations. They exclude REITs, MLPs, and utility stocks from this screen, which brings the investible universe down to approximately 700 securities. Next, screens are run that measure a company’s financial strength, earnings quality, and earnings growth. Those names that don’t meet the requirements are eliminated. Next, they rank the stocks based on shareholder yield, which is a measure of a company’s dividend yield, share buybacks, and debt reduction. The names with the best yield will typically make up the portfolio.
The fund’s currency exposure is fully hedged, which is in part why it tends to be a bit more volatile than that most other U.S. equity funds that don’t hedge their currency. Typically, unhedged currency exposure is a little less volatile than fully hedged, because the U.S. dollar tends to strengthen in periods of uncertainty, which can help to lessen some of the losses for Canadian investors.
The sector mix is the byproduct of the stock selection process, and at the end of December, was overweight more cyclical sectors such as consumer cyclical, materials, financials, and industrials. It was underweight healthcare, consumer defensive and tech names. With its focus on value, the portfolio valuation numbers look considerably more attractive than the S&P 500 on every metric. For example, according to Morningstar, the Fund trades at a price to earnings ratio of 12.7 times earnings, compared with the index, which trades at 18.5 times. Further, the dividend yield of the portfolio is higher with the Fund, providing a source of return to investors.
Performance against the peer group has been somewhat disappointing over the long term, but a good portion of that can be attributed to the currency hedge that is in place. For example, for the five years ending January 31, the Fund was up by nearly 13%, on a fully hedged basis. Given the movement in the U.S. dollar relative to the Canadian dollar, there may have been an additional 600 basis points in performance resulting from the currency movement.
The Fund has done well recently as value names have begun to outperform after several years of lagging. They recently rebalanced the portfolio, which added to their financial names and pulled back some of their industrial holdings. In a recent manager commentary, they noted fund offers higher levels of return on capital, lower reliance on external financing, and more attractive valuations than the benchmark and peers. Also helping to make this a more attractive option is the MER, which at 1.49%, is well below average. Given this, I expect it to do well over the longer term, but would expect volatility levels to remain higher than both the index and the peer group.
Fidelity Small Cap America Fund (FID 261 – Front End Units, FID 561 – DSC Units) – In early December, I had the opportunity to sit down with manager Steve MacMillan to discuss this fund, its recent performance, and the market environment. The fund has struggled in the past year, losing 1.4% while the Russell 2000 Index, gained 17.7% in Canadian dollar terms.
In our conversation, Mr. MacMillan noted that if he were to have done better in 2016, it would have meant he would have had to change his investment process and invest in a portfolio that had a much lower quality bias, and much more cyclical exposure. Given his focus on risk management, this was not something he could do. He reiterated he remains true to his investment process and while the recent performance has stung, he has not made any changes to his investment philosophy or process.
One question I asked was if the recent influx of new money had any effect on how he managed the fund. Mr. MacMillan said that new money had very little impact on his management approach. When he took over the fund in 2011, he made a couple of key changes to the fund. First, he reduced the number of fund holdings, taking a more concentrated approach. He now holds around 40 names in the portfolio, down from around 200 when he took over. He also increased the average market cap of the Fund, bringing it much closer to a mid-cap fund. The result was a much higher quality, more liquid portfolio, which has helped him more effectively deal with running a larger asset base.
From a process perspective, he takes a longer term outlook than many managers, typically looking three to five years out. The result is a level of portfolio turnover that is rather low. In a given year, he will typically only add four to six names. When evaluating a company, he starts by focusing on the risk, specifically the downside risk. He looks for high quality companies that have a history of delivering significant levels of free cash flow, and high return on invested capital. He also looks for low earnings variability and reasonable valuations. According to Mr. MacMillan, at the end of November, the average return on equity in the portfolio was approximately 18%, and was trading at a multiple of 15 times earnings, compared with more than 20 for the benchmark.
This quality focused investment process leads to a portfolio that does not have a lot of cyclical exposure in it. He generally avoids energy, materials, and cyclical industrials. He also tends to shy away from biotechs and semiconductors. His criteria tends to favour stable industrials, consumer discretionary, and healthcare.
In building the portfolio, position sizes are dependent on risks. He will look at a number of factors, including volatility of earnings, valuation, risk and return, and liquidity. The higher the conviction based on those factors, typically the higher the weight the stock will have in the portfolio. While he prefers to buy undervalued names, he is not a deep value managers, and his process is really more a balance between risk and expected return. In other words, he won’t buy a stock just because it is cheap. Rather, there must be the ability to compound earnings into the future, and the valuation must still be attractive. Based on this approach, he has found that his losing stocks have historically been smaller weights in the portfolio, helping to further minimize the downside risk of the fund.
Cash has been running higher than normal in recent quarters, finishing the year at 17%, up from 10% at the end of September. Ideally, he would like to run around 5% in cash, but is not afraid to carry more when valuations are elevated. He’d much rather sit on cash than make an investment that doesn’t meet his criteria.
The recent underperformance has largely been driven by the market, which has been experiencing a cyclical rebound. Given the lack of cyclical exposure in the Fund, this underperformance is understandable. He continues to focus only on those opportunities that meet his criteria.
Even with the recent underperformance, I continue to like the fund, and believe it to be a great holding for the long term. I have concerns about the valuation in general of U.S. small caps, and expect to see more volatility and underperformance from both the fund, and the asset class. If you have held the fund for a while, you may want to take some profits, reducing your exposure to the fund, and generally rebalance your portfolio to bring it back into alignment with your long term target asset mix.
Manulife World Investment Fund (MMF 4536 – Front End Units, MMF 4436 – DSC Units) – This international equity fund is more or less the highly regarded Mawer International Equity Fund, just in a different wrapper. The key difference between the two funds is this offering is targeted at investment advisors, carrying a higher management fee, and embedded dealer compensation. This Fund carries an MER of 2.55%, which is significantly higher than the 1.52% of the Mawer version. The difference is the 1% trailer fee paid to advisors.
Even with this higher fee, the Manulife offering is consistently one of the stronger international equity funds around. However, even strong funds run into a rough patch, and 2016, and specifically the last half was a rough one for this fund (and Mawer as well…). In the fourth quarter, it was off by 6.4%, compared with the MSCI EAFE Index, which was up by 1.7%, in Canadian dollar terms.
The key reason for this underperformance is the market’s rotation out of higher quality sectors that this fund is partial to, such as consumer staples, and into more cyclical sectors like energy, materials, and financials. Further, within the financial sector, it has been largely the lower quality names that have rallied higher. For example, Deutsche Bank, which Mawer doesn’t own, gained 43% in the quarter. In comparison, their largest financial holding, insurance giant Aon was higher by a mere 1.5%. In a recent commentary, Mawer noted they are avoiding European banks because they don’t meet their investment criteria. The competitive and regulatory environment in Europe make it very difficult for them to earn a sustainable return on equity. Even with the more attractive valuation levels, the uncertainty makes them unattractive.
Looking ahead, we may see some further underperformance from this fund, but I believe the disciplined investment process will help to deliver above average returns over the long term. As with any fund that follows a disciplined approach, there will be periods where the performance diverges significantly from the benchmark and the peer group. I believe we are in one of those for the near term.