Top Funds Report – January 2020

 

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It was a very good year

Annual market gains for 2019 exceed expectations, uncertainties dominate early 2020…

The year 2019 turned out to be a much better year for stock markets than most had expected. While some rebound was to be expected after the stomach-churning drop we experienced in December 2018, we certainly didn’t expect total return for 2019 to be as strong as it was.

A year ago, I wrote, “…if you have been sitting on cash waiting for a more attractive valuation, today is a better time than it has been over the past few years. But be warned: The ride from here is expected to be anything but smooth, as much uncertainty remains.” I also favoured equities over fixed income.

Fast forward a year, and we see equity markets have rallied sharply, while fixed-income markets delivered returns well in excess of expectations. Growth stocks continued to lead the way, with the tech-heavy NASDAQ 100 Index rallying 39.5% in U.S. dollar terms. The S&P 500 Composite Index gained 31.5%.

Canadian equities were also strong, with the S&P/TSX Composite Index rising by 22.9% in 2019. And international stocks as measured by the MSCI EAFE Index posted a very respectable 22.7% advance in U.S. dollar terms, while the MSCI Europe Index gained 24.5%.

After such a strong showing in 2019, U.S. equity markets are now trading at very high valuation levels. According to David Kostin, the chief U.S. equity strategist at Goldman Sachs, 92% of the rise in equities came from multiple expansion, and a mere 8% driven by earnings growth. To put that in perspective, Kostin notes that since March 2009, two thirds of the market rise has come from earnings growth and roughly a third from valuation.

In addition to growing dovishness from central banks resulting in lower interest rates, there were a few other stories dominating the headlines through 2019.

The story with the greatest impact was U.S. President Donald Trump’s continuing trade war with China. Mr. Trump continued to announce new tariffs on Chinese goods, creating a level of uncertainty for investors and muting market gains somewhat. But in early December, it was announced that a Phase One deal had been reached between the two nations, helping push markets higher for the month.

We also saw political headlines dominate, including Brexit and the impeachment of President Trump. While Brexit created some headwinds in Europe throughout the year, its path became clearer in December as Boris Johnson and his Conservative party won a decisive majority victory in the U.K. general elections. In the U.S., Trump’s impeachment proceedings have had no discernable impact on markets or investor sentiment.

Fixed income also had a surprisingly strong year in 2019. Earlier in the year, the expectation was that rates were likely moving higher. That was the case until mid-year when the tone of the U.S. Federal Reserve Board’s pronouncements showed an abrupt about-face. This resulted in the Fed’s cutting rates twice, bringing its benchmark federal funds rate down to 1.75% from 2.25%.

Closer to home, the Bank of Canada kept its policy rates unchanged over the course of the year. In this environment, we saw Canadian bonds, as represented by the FTSE Russell Canadian Universe Bond Index, gain nearly 7% in the year. Corporate bonds outperformed government bonds, and the long end of the curve outpaced the short end.

With 2019 in the books, the question now is what’s in store for 2020?

Investor sentiment remains strong, and consumer spending is robust. We are also seeing some signs that the global economy is stabilizing and possibly turning higher. However, many risks remain.

Equity valuations, particularly in the U.S., are in the upper end of historic ranges. This certainly puts a damper on the long-term outlook for equities, as valuation has been shown to be a strong longer-term predictor of returns. However, in the short-term it has not been very effective, with investor sentiment and the “fear of missing out” being much stronger drivers, particularly this late in the market cycle.

Earnings growth needs to pick up to support the valuation levels, or we may see either a period of lackluster returns or a selloff to bring valuations more in line. That may be challenging, particularly in the U.S. as business investment has been weak, while the manufacturing sector contracted for five successive months (August through December).

The macro environment also remains challenging. While a Phase One trade deal between China and the U.S. has been reached, there are no assurances that further progress will be made, which can create additional uncertainty and hold back growth.

Mideast tension has risen substantially after President Trump ordered the killing of Iranian military leader Qasem Soleimani. Much saber-rattling ensued, with Iran lobbing missiles at U.S. military bases in Iraq, without much effect and with no further retaliation from the U.S.

Thus far, apart from some gains in the traditional safe havens of bonds and gold, and a temporary spike in oil prices, markets have largely shrugged this off. However, there is real potential for disruption to global growth if this escalates. Regardless, there is no quick fix in sight, and an air of uncertainty is likely to prevail for the foreseeable future.

In this environment, I remain defensive. My asset allocation is roughly neutral. For equities, I am focused on funds and ETFs invested in higher-quality, more reasonably-valued securities. I lean to developed markets over emerging markets and would favour North America over Europe and Asia. In bonds, I am emphasizing higher-quality corporate and government issues in developed markets and am underweight high-yield and emerging market debt.

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

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Funds of Note

This month we look at some of the best and worst performers from last year… 

Here’s a review of some of the better-performing funds of 2019.

Beutel Goodman Long-Term Bond Fund (BTG 311 – Front-End Units, BTG 871 – No-Load Units) – With a gain of 11.9% for the no-load units, this was one of the best performing fixed-income funds in 2019. Focused in Canada (but with the ability to invest 49% in foreign issues), it invests in bonds that have a term to maturity of at least nine years.

Credit quality is high, with nearly 90% of the fund rated A or better. At the end of November, 70% was in government bonds with the balance in corporate issues. According to Morningstar, the average duration is listed at nearly 16 years, making it very sensitive to movements in interest rates. And it is this interest-rate sensitivity that explains the performance in 2019, with most gains made in the first half of the year.

While macro uncertainty may fuel a flight to safety trade and help push rates lower, I don’t expect the performance of 2019 to be repeated. If you’ve held this for a while, you may want to take some profits.

Manulife Strategic Balanced Yield Fund (MMF 4530 – Front-End Units, MMF 4730 – Low-Load Units) – With nearly half of this global neutral balanced fund invested in U.S. equities, it was one of the best-performing balanced funds of the year. The target asset mix is 60% equity and 40% fixed income.

Equity managers Sandy Sanders and Michael Mattioli use a seven-step process to look for highly differentiated companies that have the potential to grow earnings, high barriers to entry, and strong management teams. That’s followed by an in-depth analysis of the company’s financials, a meeting with company management, and a detailed valuation scenario analysis. They typically take a five- to ten-year outlook.

With about 50 equity positions, the fund was overweight financials, technology, and consumer defensive, at the end of December, while underweight materials, real estate, industrials, and utilities.

The fixed income sleeve is managed by Dan Janis and his team and is substantially similar to the highly regard Manulife Strategic Income Fund. The managers run a tactical global bond portfolio with an emphasis on managing and mitigating four key risks: interest rate; credit; currency; and liquidity. For the year, it delivered a rate of return roughly in line with the broad Canadian bond market.

A lot of the recent outperformance stems from the strong showing from U.S. equities. While this may continue in the short-term, I believe that an investor may be better served with a more geographically-diversified balanced fund. However, for those comfortable with the U.S. equity concentration, this may be a fund to consider.

Dynamic Power Small Cap Fund (DYN 9102 – Front-End Units, DYN 7063 – Low-Load Units) – With a one-year return of 32%, this Canadian-focused small-cap growth offering not only outpaced most of its peers, but also the Canadian equity market as a whole. Manager Vishal Patel, who took the reins last March, uses a bottom-up, growth-focused stock selection process. As Mr. Patel repositioned the fund to be more in line with his views, there has been significant turnover, and therefore historic return numbers are not helpful in assessing the fund.

While the one-year number is very strong, it is not a long enough period on which to base an analysis. I would typically require at least 24 to 36 months before getting a better understanding of the fund. So I’ll watch the fund and revisit it down the road.

Fidelity Global Innovators Fund (FID 5973 – Front-End Units, FID 5966 – Low-Load Units) – Growth stocks generally and tech stocks specifically were big winners in 2019. This fairly new growth-focused offering from Fidelity was one of the best-performing non-Canadian equity funds, gaining nearly 40% in the year.

Manager Mark Schmehl uses an interesting approach, looking for innovative companies that are undergoing some sort of fundamental change he believes will be a catalyst to unlock share price appreciation and ideally deliver above-average growth over the next 12 to 18 months. He is very active, with portfolio turnover often well above 100%.

At the end of November, the fund had 10% in Canadian equity and 88% in foreign equities. Technology was the largest sector exposure, making up just less than half the fund. Communication services is the next largest sector at 17%, followed closely by consumer cyclical and healthcare.

The fund has delivered strong albeit volatile performance since inception in November 2017, generating an average annual compounded rate of return of more than 14% to the end of November, compared with 10.7% for the Nasdaq Composite Index. Much of this outperformance can be attributed to the fund’s active, opportunistic approach combined with the market’s appetite for growth-focused investments.

At some point, when more value focused investments come back into favour, I expect this fund to lag. However, until that happens, I think this fund, and others managed by Schmehl, should continue to deliver outsized returns. But you must be comfortable with the higher volatility. If you are not, then you may want to consider an alternative fund.

Next, we turn to a few of the funds that really struggled this year.

Vertex Funds

It was a very rough year for Vertex. The firm’s equity mandates were run with a bit of a contrarian, value-focused approach. And until the past few years, this strategy has served investors in the fund very well. But in mid-2018, things started to turn sour very quickly for the firm.

By the end of 2018, the Vertex Value Fund had dropped more than 39% as many of its value-focused energy plays continued to lag. The fund struggled on through early 2019, and in the summer, we saw founding partner Matt Wood resign.

For the year, the fund lost nearly 16%, trailing the broader Canadian equity market and peer group by a substantial margin. And that really was the beginning of the end, as the firm sought buyers for the funds.

The more equity-focused funds were taken over by Vancouver-based Penderfund, while the more income-focused mandates, including the successful Vertex Merger Arbitrage and Vertex Merger Arbitrage Plus funds, were taken over by Picton Mahoney.

Purpose Special Opportunities Fund

With a loss of 39% in the year, the Purpose Special Opportunities Fund was another one of the worst performers in 2019. It is managed by industry veteran Normand Lamarche, who co-founded Front Street Capital along with Frank Mersch.

The fund’s high-conviction, small-cap, value-focused energy approach did not resonate well with the markets. Its major weakness was the fact that the fund is very focused on energy. It holds a very concentrated portfolio of roughly 26 names, with the top 10 holdings, most of which are in the energy sector, making up nearly three quarters of the fund’s assets.

The fund is very volatile, with a 3-year annualized standard deviation of 27.1, compared with a median 15.7 for the Natural Resources Equity category, and nearly three times the broader market.

The fund has lost money in eight of the past 10 calendar years. Shorter term, however, there may be some light at the end of the tunnel. As the markets rotated back into some value names in the fourth quarter of 2019, the fund rebounded nicely, gaining 19% in December alone.

While that fourth-quarter recovery augurs well for the potential for more outsized returns if the trend towards value gains momentum in coming months, I still believe there are other funds that offer a more attractive risk-reward profile.

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

 

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January’s Top Funds

 

RBC Global Corporate Bond Fund

Analysis: With a one-year gain of 9.25%, this actively managed global bond fund had a solid year. Managed by the team of Frank Gambino, Marty Balch, and Soo Boo Cheah, the fund invests in a diversified portfolio of bonds from corporate issuers around the world. While the focus is on investment-grade bonds, it can invest a portion in non-investment grade issues. And in fact, at the end of November, about 18% of assets were allocated to non-investment grade bonds.

Average credit quality is modest, with a weighted average of BBB, which is the lowest rung of the “investment-grade” rating.

Geographically, the focus is on developed markets. Roughly half is invested in the U.S., 20% in Canada, followed by the U.K., Germany, and France. The remainder is allocated to emerging market bonds. Given this mix, the weighted average term to maturity is listed at 8.4 years, resulting in a duration of 6.3 years. This makes the fund somewhat sensitive to the movements in interest rates.

It offers a yield to maturity of 3.2%. In comparison, the yield to maturity for the Canadian bond market is listed at 2.2%. With global interest rates expected to remain flat or move lower, this fund would be expected to help increase return in a well-diversified fixed-income portfolio.

The fund has been defensively positioned, which has muted absolute returns. For the three years ending Dec. 31, it generated an average annual compounded rate of return of 3.3%, which was in line with the peer group.

However, volatility has been much lower than the peer group, resulting in above-average returns on a risk-adjusted basis. In addition, it has done a very good job protecting capital in down markets.

This is a fund that has been on my focus list for several years. I like the well-resourced management team, the disciplined process, and the focus on risk management. I see this as a solid pick for those looking for high-quality, global bond exposure.

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Mackenzie Canadian Balanced Growth Fund

Analysis: This growth-focused balanced offering had a very solid 2019, gaining more than 16.5%, outpacing the majority of its category. It has posted top-quartile performance for the past three calendar years.

The fund is run like a fund of funds, with the top asset mix being determined by Mackenzie’s Multi-Asset Strategies Team, headed by Nelson Arruda, who took over from Alain Bergeron, who has since moved to iA Financial Group. There’s a bit of flexibility, with equity exposure expected to range between 60% and 90%.

The equity sleeve looks very much like the Mackenzie Canadian Growth Fund. Veteran bond manager Steve Locke leads the fixed-income team. His a “core plus” approach uses not only Canadian investment-grade issuers but also high-yield bonds, floating-rate loans, and other fixed-income instruments, using a blend of top-down macro analysis and bottom-up credit analysis.

At the end of October, the fund had 30% in fixed income, 33% Canadian equity, 18% in U.S. equity, 11% in international equity, and the balance in cash. The bond portfolio was split roughly between corporate and government bonds. Credit quality was high, with only a small exposure to high-yield debt.

With its slight growth tilt, the equity portfolio overweights industrials, healthcare, and communication services. It was underweight energy and materials, as well as financials.

Longer-term performance has been excellent, with a 5-year average annual compounded rate of return of 7.9% to Dec. 31, handily outpacing the benchmark and peer group. Volatility was only slightly above the peer group, and the fund has a good record of protecting capital. Over the past three years, it has participated in about 100% of the benchmark’s upside, and only 80% of the downside.

Over the long-term, the fund has the potential to deliver above-average returns, but also with above-average levels of volatility, given the growth tilt of the equity sleeve. So only those with an above-average risk tolerance will want to consider this fund. More conservative investors may want to look elsewhere.

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Mawer New Canada Fund

Analysis: In the Canadian small- and mid-cap space, Mawer has consistently been one of the top managers, delivering above average long-term results to investors, below-average volatility, and strong downside protection.

I haven’t written about this fund in a long time for the simple reason that it has been closed to new investors for about as long as I can remember. While this can be frustrating, it highlights the commitment Mawer has to its investors, closing the fund when the managers realized they could no longer implement their investment strategy with the same level of effectiveness.

For those who own the fund, that’s been a big win. Its 5-year average annual compounded rate of return to Dec. 31 is 7.9%, more than doubling the Canadian Small and Mid Cap Income category average. More impressive, it has posted only two years of below-average returns since 2009, in 2010 and 2017. In 2019 the fund gained 28.8%.

These numbers are achieved through consistency and discipline. Manager Jeff Mo took over the reins in 2016, but has been on the team since 2012. He uses a highly disciplined, research-focused, bottom-up investment process, looking for companies with strong business models that earn a high return on capital arising from a sustainable competitive advantage. Mr. Mo does not specifically target any industries or sectors.

The team also spends a great deal of time focusing on a company’s management. Once they have identified a potential investment candidate, the managers build out and stress-test financial models under a number of different scenarios and invest only at a level that is well below their estimate of a company’s true worth.

Their patient, long-term, research-intensive approach allows them to give holdings a bit of runway and companies time to execute their strategy. Changes to the portfolio are made only when a better opportunity arises, there’s an erosion in a company’s fundamentals, or there’s a change in valuation.

Volatility has been slightly lower than the category average. And in down markets, the fund has held up very well, participating in less than 20% of the downside of the small-cap market over the past three and five years.

This is an excellent fund. I believe those who are fortunate enough to own units should continue holding.

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Leith Wheeler U.S. Small/Mid Cap Equity Fund

Analysis: Launched in October 2016, this U.S. small- and mid-cap fund from under-the-radar, Vancouver-based Leith Wheeler (with $21.8 billion assets under management) has come out of the gate swinging, delivering an 3-year average annual compounded rate of return of 10.7% at Dec. 31. This has significantly outpaced its peer group and bested the 7.4% return in the Russell 2000 Index.

Managers Raymond Lai and David Slater work closely with the other members of the small-cap equities team, using a fundamentally-driven, bottom-up process to look for companies with proven track records and sound valuations. They approach their investment as if they were buying the whole company and favour businesses with sustainable competitive advantages. Given the value focus, the managers are also somewhat contrarian and are not afraid to invest in companies that may be out of favour with the market.

As important as it is to find good investments, the managers believe it is equally important to ensure they are sized correctly in the portfolio. The goal in setting position size is to generate returns from the winners, while mitigating losses from the losers. When determining position size, managers consider the effect to the real risk of adding the company, the target price, confidence level, intrinsic value estimate and margin of safety, and their probability of success.

The managers do not set out to find those “home run” stocks. Instead, they hold a diversified portfolio of companies that hit a lot of “singles.” In a recent interview, the managers noted that the fund’s outperformance has not been the result of huge wins but rather wins from most of their holdings. They note that as of Sept. 30, out of the 36 names that have been in the portfolio since inception, 26 were considered winners, five roughly broke even, and five were losers. This translates into a “hit rate” of more than 70%.

This discipline has shown up not only in the returns, but also in volatility, which for the three years to Dec. 31, has been significantly lower than the category average. The fund is also strong at capital protection, participating in less than three quarters of the market drop over the past three years

The fund is available only as either a do-it-yourself version or through advisors in fee-based accounts.

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