Mutual Funds and ETFs Update – April 2012

Volume18, Number 4
April 2012
Single Issue $15

 

In this issue:

• What’s New
• Stocks or Funds – The best way to play dividends
• A conversation with Larry Sarbit
• Dana Love resigns from Trimark
• Infrastructure Investing- An attractive alternative
• Your questions – Seg funds explained

PDF Version of this issue 

WHAT’S NEW

BLACKROCK DROPS THE CLAYMORE NAME – In early March, Claymore’s securityholders approved the acquisition by Blackrock Inc., the issuers of the iShares ETFs. Blackrock has wasted little time and has rebranded the newly acquired ETFs, dropping the Claymore name effective March 28. In most cases, they are simply replacing iShares in the place of Claymore in the names of the ETFs. There has been no change to any of the ticker symbols. We see this as the first step in the complete merger of the two fund families. We expect that ETFs with similar mandates may end up being merged as a way to lower or maintain costs. We may also see some of the smaller, low volume, niche focused products closed if they are not economically viable. 

DAVID FINGOLD STEPS ASIDE TEMPORARILY – In mid March, it was announced that David Fingold, manager of the Dynamic American Value Fund, Dynamic Canadian Dividend Fund, Dynamic Global Asset Allocation, Dynamic Global Discovery, and Dynamic Global Dividend Fund was stepping aside for medical reasons. It is expected that Mr. Fingold will be out of commission for the next few weeks. In his absence, the current co-manager Izet Elmazi will take over the management reigns. On a conference call it was stated that the two will remain in close contact during Mr. Fingold’s absence, and that there is not expected to be any material change to the investment process in the near term. This is expected to be a temporary situation and, as such, we are not suggesting that investors make any changes to their holdings. If this situation were to become significantly extended, or if it were to become permanent, we would need to re-evaluate. In the interim, we are wishing Mr. Fingold a speedy recovery.

DAVID TAYLOR LANDS AT IA CLARINGTON – Former Dynamic manager David Taylor recently set up his own shop and has signed an exclusive deal with IA Clarington. Under this agreement, it is expected that two new funds will be launched in the next month or two; a Canadian equity fund and a Canadian balanced fund.

The Canadian equity fund will be reminiscent of the Dynamic Value Fund of Canada, which had been on our Recommended List prior to his departure from the firm. He will use his contrarian value approach that will result in concentrated portfolios that will be actively managed, and look much different than the broader indices.

One of the bigger changes with the new portfolios is that volatility is expected to be dialed down significantly. In late 2010 and 2011 volatility within the funds had been inching higher to the point where it was beginning to erode the risk-adjusted returns. 

Mr. Taylor also expects that foreign content for the fund, at least initially, will be in the 40% to 45% range. The rationale is that the Canadian market is so narrow in terms of tradable stocks and sectors that the wider scope will help to provide more investment opportunities for the funds to help boost returns. It will also help with his goal of lowering the volatility profile. 

The second fund will be a Canadian balanced fund. Mr. Taylor will manage the equity sleeve of the fund and set the asset mix, while former Mackenzie manager Dan Bastasic will manage the fixed income portion. Within the equities, it is expected that the portfolio will be more conservative than the Canadian equity fund. 

There was no talk of costs or fees but based on other IA Clarington managed funds, we would expect them to be in the upper half of their respective categories. It is expected that the prospectus will be filed in the next several weeks.

 

---

 

STOCKS OR FUNDS – THE BEST WAY TO PLAY DIVIDENDS

By Dave Paterson, CFA

Dividends are expected to continue to play a major role in total returns. See our top picks for investors looking for dividend funds. 

With the recent levels of market volatility combined with the dismal yields currently available on fixed income investments, interest in dividend stocks, mutual funds and ETFs has reached an all time high. It’s not hard to see why. With the Bank of Canada holding overnight rates at 1.0%, a 5-Year government bond yielding 1.55% and a 10 year government yielding 2.08%, many high quality blue chip stocks are offering yields well in excess of those offered by bonds.

For example, TD Bank currently pays an annual dividend of $2.88 per share, which works out to an annualized yield of 3.4% at current prices. Many other blue chip stocks are offering even better yields including BMO which is yielding 4.7%, BCE pays 5.41% and Telus is 4.2%. Factor in the potential for modest capital gains over the long term and things start to look pretty attractive to most investors.

While yield is one appealing aspect to dividend stocks, another is the proportion of the total return that is made up from the dividends. A study completed by Ned David Research shows that between 1972 and 2011, dividends made up more than 60% of the total return of the S&P 500 Index. In lower growth environments, dividends make up a substantial portion of total return. Given that many economists are forecasting a lower growth environment in the near to medium term, the importance of dividends remains high.

There are really two ways for an investor to play the dividend space – either through purchasing a basket of dividend stocks directly, or through investing in a dividend focused mutual fund or ETF. Let’s take a look at some pros and cons of each option:

Investing in Dividend Stocks Directly

Pros 

• There are no management fees to pay because there is no investment manager.
• You maintain full control and decide what is in your portfolio at all times.
• Dividends received in a non-registered account will be eligible for the dividend tax credit, which will result in a more favourable tax treatment when compared to interest and other forms of regular income.

Cons 

• You will need a reasonably large portfolio as you will want to build a basket of several dividend paying stocks in order to reduce the overall risk.
• You will need to do your own research to select the stocks in your portfolio. This can be a complicated and time consuming process.

Investing in Dividend Focused Funds or ETFs

Pros

• You can usually start with as little as $500.
• There is less work involved in picking a dividend mutual fund or ETF when compared to building a portfolio of dividend paying stocks.
• A high quality dividend fund will provide you with instant diversification as the fund will hold several dividend paying stocks.
• Distributions paid can be higher than the dividends paid by individual stocks. Unlike stocks, mutual funds can choose to pay out more than the dividends received to investors as a “return of capital”.

Cons

• Some dividend funds do not pay out regular distributions to investors.
• Because there is an investment manager involved, the costs will be higher. For example, the median MER for Canadian dividend fund is 2.17%. For dividend focused ETFs, the average MER is approximately 0.65%.

Within the past couple of years, the Canadian Dividend & Income Equity fund category has become more cluttered as many of the former income trust funds have now converted into high yielding dividend focused funds. For this review, we will not be considering these former income trust funds as they tend to be focused more on small and mid cap companies, rather than the larger, more established blue chip companies. While their distribution payouts are typically higher, they also tend to be much more volatile than a pure dividend fund.

For investors looking for high quality dividend funds and ETFs, our favourites include:

BMO Canadian Dividend ETF (TSX: ZDV) – This is a relatively new addition to the ETF world, launched in October 2011. Unlike more traditional ETFs, this one employs a quantitative screening process that looks for not only high yielding dividend stocks, but also for those companies that are most likely able to continue to pay their dividends. The end result is a portfolio of the top 50 names that have passed both the dividend growth rate screen and the sustainability screen. There are various limits in place to protect against significant concentration within the fund. The portfolio is rebalanced semi-annually and the screens are re-run on an annual basis. The ETF is currently yielding 4.2% on an annualized basis. The management fee is 0.35%, which is currently the cheapest in the category.

S&P/TSX Canadian Dividend Aristocrats Index (TSX: CDZ) – This ETF is designed to replicate the performance of the S&P/TSX Canadian Dividend Aristocrats Index. The index is designed to capture sustainable dividend income and capital appreciation potential, screening for companies that have followed a policy of consistently increasing dividends for a number of years. The focus is on large cap, blue chip companies from a broad spectrum of industries and is well diversified across all sectors. There are currently 40 stocks in the index and the yield is approximately 2.6%. The management fee is 0.60%, which results in an MER of 0.67%

Fidelity Dividend Fund (FID 221) – Managed by the team of Geoffrey Stein and Derek Young, this fund looks to provide investors with a mix of growth and income over the long term by investing in a portfolio of dividend paying equities. The fund is very focused on large cap stocks and is currently defensively positioned. Not surprising, it is significantly overweight in financial and utility stocks and is underrepresented in the volatile energy category. It is very well diversified, holding more than 100 stocks in the portfolio, with the top 10 making up about a third. The managers are fairly active in their strategy, as portfolio turnover has averaged approximately 70% for the past five years. It pays a variable monthly distribution which has ranged between $0.005 and $0.022 per unit. Because of this variability in the distribution, we would not consider it a great fund for those seeking regular income. Rather, it is better suited for those looking for long term growth. The long term performance numbers have been good, posting a five year return of 4.4%, doubling the return of the S&P/TSX Composite Index. Volatility has also been well below that of the index, making it a good core fund for investors with a lower risk tolerance. Costs are reasonable, with an MER on the Series B units of 2.12%, slightly below the category average. 

Bissett Canadian Dividend Class A (TML 107) – While the Fidelity Dividend Fund takes a somewhat diversified approach, the Bissett Canadian Dividend Fund is considerably more concentrated. Holding 34 stocks, the team of Juliette John and Ryan Crowther look for high quality businesses which have a history of low earnings volatility and solid dividend records. More than 60% of the fund is currently invested in financials and energy. It pays investors a steady monthly distribution, currently set at $0.025 per unit, which works out to be an annualized yield of approximately 2.2%. An added bonus is that the distribution is a mix of dividends and return of capital which will be treated more favourably from an income tax perspective. Returns have been strong with a five year return of 4.5%. The volatility has also been significantly lower than both the broader market and the category average. That said, it is a touch more volatile than the more broadly diversified Fidelity Dividend Fund. Still, this is a good choice for those looking for a good mix of capital gain potential with some level of monthly income.

BMO Guardian Monthly Dividend Fund Ltd. (GGF 411) – This fund is a bit of a different animal when compared with the others that have been mentioned. While the other funds focus on the common shares of high quality, blue chip Canadian companies, this fund is mandated to invest at least 50% in preferred shares. It currently holds 60% in preferreds and 30% in common shares. Because of this focus on the more conservative preferreds, the expected return will be lower, but so too will the expected volatility when compared to the funds that are focused more on traditional dividend stocks. However, on a risk adjusted basis, returns are expected to be comparable. This is a good fund to hold over the long term, but we would exercise caution in a rising rate environment, as preferred shares will likely experience losses. The fund is reasonably well positioned for a rising rate environment because its exposure to common shares has been increasing and the exposure to preferreds, particularly the long duration perpetual ones, has been gradually on the decline. This should help protect capital when rates begin to move higher, but it will be hit more than a more common equity focused fund. It pays a monthly distribution of $0.035 per unit. For investors with a long term time horizon and a medium risk tolerance, this fund is a good way to gain some equity exposure without taking on too much risk.

Bottom Line: Dividend funds and ETFs are a great way for investors to gain exposure to a high quality portfolio of Canadian blue chip companies. ETFs offer a much lower cost way to access dividends, while mutual funds provide the benefit of active management. The funds and ETFs listed above would be good options for most investors.

 

By Dave Paterson, CFA

Eclectic manager’s search for terrific companies has rewarded with investors with strong gains.

Maligned by most academics, personal finance columnists, and do it yourself investors, active fund management gets a bad rap these days. They argue that most active funds underperform their benchmarks on a consistent basis, so why even try? Instead, investors are told to buy low cost index funds or ETFs.

To be fair, there is some merit to the argument. It is true that most actively managed funds, and all ETFs for that matter, underperform their benchmarks over time. There are many reasons for this including manager skill, investment style, and of course, high fees. In my opinion, the biggest reason that many actively managed funds underperform their benchmark is that they too closely resemble their benchmark.

If you look at the majority of funds and compare their holdings to those of their benchmark you will find that, in many cases, there is an eerie similarity between the two. Much of this is mandated by the mutual fund companies themselves. Under the guise of risk management they will often have prescribed limits on the minimum and maximum sector exposure a manager is allowed to have within a fund.

While this helps to keep the risk in check, it also may have the undesired effect of handcuffing the talented investment management teams that they employ. It may prevent them from making the portfolio decisions that will allow them to potentially generate higher returns for investors, while at the same time providing better downside protection in periods of higher market volatility. Factor in a management fee of 2% or higher and even the most skilled portfolio managers will have trouble outpacing the benchmark in this sort of environment.

But there are managers out there who are free to invest outside of these types of constraints. While they won’t always outperform their benchmarks, they are at least able to put their funds in a position where they have a higher chance of doing so. One such manager we had the opportunity to meet with recently is Larry Sarbit, manager of the IA Clarington Sarbit U.S. Equity Fund.

Mr. Sarbit has been in the investment business since 1979 and has been actively managing money since 1987. He has run money for Investors Group and AIC, and most recently for IA Clarington through his firm Sarbit Asset Management. Many people first became aware of him back in the early 2000s, when his AIC American Focused Fund was holding only three stocks and 92% cash. Love it or hate it, that tactical call is indicative of his bottom up, high conviction management style.

“I’m very difficult to categorize as a manager because my process is a mix of both growth and value,” says Mr. Sarbit. “Instead of considering myself an investment manager, I consider myself to be a manager of a concentrated portfolio of terrific businesses.” His “common sense” stock selection process is modelled after the investing behaviour he has seen practiced by many successful business people, including his hero, Warren Buffett. Like Mr. Buffett, there is one very simple rule that guides his process: “Don’t lose money.” He goes on to say: “After all, if you don’t lose money, you make money.”

To achieve this lofty goal, Mr. Sarbit sets out to find what he calls “terrific businesses.” In his view, a terrific business is one that has “a strong franchise, very high barriers to entry, operates in an expanding market, and is generating high levels of free cash flow for investors.”

Another feature of the companies he likes is that they are very simple businesses with easily understood business models. He likes companies that can be explained in about thirty seconds. “I look for businesses that any idiot can run, because sooner or later, some idiot will.”

He needs to fully understand all aspects of the company in order to gain a true understanding of all of the potential risks of the business. If he is unable to do this, he won’t invest. That is why he has no exposure to any of the banks or insurance companies. In looking at their balance sheets, there are off balance sheet items and derivative exposures which complicate the structure and “have the potential for too many ticking time bombs.” By not knowing, he believes that you are putting investors’ money at risk.

Another key component he looks for is free cash flow. Mr. Sarbit prefers to invest in “companies that you can essentially put a coupon rate on the stock certificate – basically, an equity bond.” These are companies that have a demonstrated history of delivering steady, dependable and growing free cash flow to investors. Earnings and other metrics are important, but cash flow is critical because it is real. “At the end of the day it is the cash flow that the owner walks away with.”

Valuation is also a key factor in Mr. Sarbit’s process, however, it is only considered once all of the other factors have been reviewed. A lot of companies that appear to be attractively valued on paper may not actually be terrific companies – the classic value trap. On the topic of valuation Mr. Sarbit says: “I would rather be approximately right than absolutely wrong. I am not afraid to pay a premium for quality.” That said, any premium for quality must be reasonable. In other words, “You can’t afford to over pay.”

To help demonstrate his investment philosophy, Mr. Sarbit put his Blackberry and his can of Diet Coke beside each other on the table and asked: “Which one of these would you rather own? Sure, Research in Motion (makers of the Blackberry) looks cheap these days, but I would take Coke over RIM any day. Will people still be drinking Coke in five years or ten years? Of course they will – in pretty much every country in the world. Will people still be using smartphones in five to ten years? I don’t know. Sure, we will be using something, but we don’t know what it will look like or who will be making it. It could be a tablet, a small ear piece, or it could be a chip embedded in our heads. The point is, we just don’t know. And regardless of how cheap the stock is, there is just too much uncertainty.”

He sees similar risks in technology darling Apple. “Apple is a great company with wildly innovative products. But is Apple without Steve Jobs going to be the same company that it was with Steve Jobs? Sure, he probably has a road map laid out with his ideas for the next several years, but without him there to oversee its development it you can’t have the same level of comfort in the company. There are just too many unknowns.”

It is this holistic process and focus on risk management that helps differentiate Mr. Sarbit from many of his peers. Looking at the IA Clarington Sarbit U.S. Equity Fund, you will see a fund that looks nothing like its benchmark. The fund is heavily concentrated, holding 16 stocks and nearly 20% in cash. It has no exposure to energy and a miniscule weighting in materials. Instead, it is focused on consumer discretionary stocks which make up more than 30% of the fund, followed by financials and consumer staples which comprise 17% and 12% respectively.

Performance for the fund has been strong. Since taking over in June 2009, the fund has returned 15.8% as of February 29. During the same time period, the return of the S&P 500 in Canadian dollar terms was 13.8%. While this has been impressive, we should note that there will be periods where this particular style will underperform. The fund also has the potential to experience periods of very high levels of volatility. Given the concentrated nature of the fund and its focus on small and mid cap names, this is to be expected.

When I asked Mr. Sarbit about the higher volatility he seemed unfazed. “I don’t focus on standard deviation as a measure of risk. Instead, I focus on the quality of the underlying businesses. Look, if CVS, or Six Flags (two of his favourite companies at the moment) were private companies, how would you value them? You would focus on the quality of the underlying businesses and the cash flow to investors.” In fact, Mr. Sarbit likes volatility in the share prices as it allows him to pick up these terrific companies “on sale.” Given this potential volatility, investors considering this fund should have at least a three to five or even seven year time horizon. Anything shorter and the risks are too high.

Another concern about this fund is key person risk. This has started to change recently as Sarbit has been bulking up its investment management team, hiring a couple of new analysts and another investigator. It is expected that it will take about five years before the succession plan is fully operational. Until then, it is our opinion that key person risk will remain high.

The fund has a $164 million tax loss carry forward which will help to offset any potential capital gains distributions in the medium term. This is significant given the fund’s asset base of $430 million and makes it an attractive option for investors in non registered accounts.

Bottom Line: The U.S. equity space is one where I believe that an ETF is usually a better solution than an actively managed mutual fund. There are exceptions, and I believe that the IA Clarington Sarbit U.S. Fund is one of them. It is managed by a very experienced, high conviction manager who uses a distinctive style that emphasizes preservation of capital. Over the long term, we would expect that this fund will provide investors with strong risk adjusted returns. However, we expect that the monthly volatility will be higher than average, making it suitable only to those investors who have a time frame of five years or more. We would be reluctant to recommend this fund as a core fund for conservative investors however for those with medium or higher risk tolerances it may be suitable.

---

DANA LOVE RESIGNS FROM TRIMARK

By Dave Paterson, CFA

Yet another respected manager leaves the firm.

Just as it had appeared that the revolving door of managers had slowed at Invesco Trimark, Dana Love, long time manager of the Trimark Fund resigned from the company on March 8. Stepping in to the lead manager chair is Michael Hatcher, who has been co-manager on the fund for the past year or so. He will be supported by the current co-managers Darren McKiernan and Jeff Feng.

From an optics standpoint, this is yet another blow to the venerable Trimark franchise, which over the past few years has seen a near complete changing of the guard within the portfolio manager ranks. Most of those who were around for the glory years of the company have now left.

It is also very disappointing because the fund had begun to show a marked improvement in performance on both an absolute and risk adjusted basis. For the year ending February 29, the fund rose by nearly 11%, handily outpacing the 0.6% gain in the MSCI World Index and finishing well into the first quartile. Mr. Love had gone on record on a number of occasions saying that this was the highest quality portfolio that he had owned in his time with the fund and was excited for the coming months as the market focus returned to high quality companies.

But digging deeper, this may not be as big a blow as it would first appear. Mr. Love is being replaced by a very capable portfolio management team which has worked together for a number of years, the last two of which were at Trimark. Before that, they were at Burgundy Asset Management. This is important to note becauseBurgundyuses a fundamentally driven bottom up investment management approach that is very much like that which is employed within the Trimark discipline. Both firms have a reputation of seeking out strong, well-managed, financially sound companies that are trading at a significant discount to their intrinsic value.

The other factor which causes us to not pull the panic switch at the moment is that the team has been working on this fund since April of last year. They are very familiar with the fund, the process, and, most importantly, the names in it. Thus far it is expected that there will not be a significant amount of portfolio turnover, nor is there expected to be any fundamental change in the way in which the fund is managed.

While our preference would have been for Dana Love to remain with the fund, we feel that there is a strong team replacing him. Under the new regime, we do not expect a significant change. We will be meeting with the new management team on April 17 to discuss their approach and any further changes which are expected to the fund. We will continue to monitor the fund to ensure that there is not any significant erosion in the risk reward profile.

Bottom Line: Manager changes are never easy and this one is no exception. Mr. Love is being replaced by a very capable team and we don’t expect that there will be significant changes to the fund or the management process. We would suggest that investors hold tight for now, until we are able to meet with the managers later in the month. A more detailed report will follow in our next edition. 

INFRASTRUCTURE INVESTING – AN ATTRACTIVE ALTERNATIVE

By Dave Paterson, CFA

How investing in infrastructure can help you build better portfolios.

Over the past decade, many large pension funds have been making significant investments in infrastructure projects. Through these investments, the pension funds have been able to better diversify their portfolios, reduce the risk of capital losses and, in many cases, hedge against potential inflation. This enthusiasm has started to gain some traction with retail investors with a number of infrastructure mutual funds and ETFs available.

Infrastructure investments can include such things as toll roads, airports, cell phone towers, bridges, and water utilities. The funds will typically invest in a company that is involved in infrastructure and in some cases they may invest directly in the project.

Infrastructure makes a fairly compelling investment because it offers long term stable cash flows, low risk of loss of capital, and potentially attractive risk adjusted returns. Many of the projects operate in highly regulated industries which will allow for revenues that may increase with the rate of inflation. Infrastructure also serves as a great diversifier in a portfolio because it has the potential to offer very low levels of correlation to traditional asset classes. This lower correlation can help reduce overall portfolio volatility.

But there are risks. For example, many of the underlying investments are very illiquid, which can make it difficult if the manager wishes to make a change in the portfolio. There is also a very high level of leverage that is typically employed with many infrastructure investments. While the leverage has the potential to amplify returns, it also could result in larger losses for investors. Since many of these projects operate in highly regulated industries, there is a very high level of regulatory risk, which could significantly impact the return potential for the investment should government policies change.

For those investors looking for some infrastructure exposure in their portfolios, there are a number of interesting options available. Some of our favourites in the sector include:

BMO Global Infrastructure ETF (TSX: ZGI) – By far the cheapest infrastructure option available, this ETF is designed to replicate the performance of the Dow Jones Brookfield Global Infrastructure Index, net of expenses. The index focuses on companies that derive at least 70% of their cash flows from infrastructure assets. The index is global in nature, but is currently more than half invested in theU.S. with 22% inCanada. Performance has been impressive with a two year return of 18.6%, outpacing much of the category and the broader equity markets. The MER is a 0.62%, cheaper by 200 basis points than any of the mutual funds, making this a very compelling option.

Dynamic Global Infrastructure Fund (DYN 2210) – Managed by Jason Gibbs, this fund invests in publicly traded companies that hold infrastructure assets directly or are involved in the building or maintenance of these assets. The fund has a go anywhere mandate and can invest in companies of any size. Despite the fund’s recent underperformance, the medium term numbers are impressive. As of February 29, the three year return was 18.7%, handily outpacing the peer group and the broader equity markets. The cost of this fund is reasonable, with an MER of 2.60%, which is about average for the category. This is our top choice for investors who prefer an actively managed fund over an ETF. It is also available in a T-Series which pays a distribution of $0.044 per month.

Manulife Global Infrastructure Fund (MMF 4569) – Craig Noble of Brookfield Investment Management runs this fund using a disciplined, bottom up stock selection process that looks to identify infrastructure related companies that are trading below their intrinsic values. InEurope, the fund holds a number of toll roads, while the North American focus is on energy infrastructure including pipelines and power generation. Performance has outpaced much of the global equity category, returning 14.9% for the most recent three year period. The biggest drawback of this fund is its cost, with an MER of 3.06%.

Mackenzie Universal Global Infrastructure Fund (MFC 2710) – With the exception of 2008, this fund, managed by the team of Mark Grammer and Hovig Moushian, has posted positive returns since its launch. It is available in a couple of different T-Series options which provide monthly distributions to investors. Returns have been decent, posting a three year return of 14.2%. The cost is in line with other global equity funds with an MER of 2.57%.

Bottom Line: Infrastructure funds are not for everybody. While they have the potential to bring some level of diversification and potentially higher returns to a well diversified portfolio, they can also bring higher risks. Investors who are looking at infrastructure funds should approach them in the same way that they would approach any other sector specific fund and ensure that they are used as a component of an otherwise well diversified portfolio. In our opinion, maximum portfolio exposure should be capped at approximately 10% for the higher risk investors and adjusted downwards for more conservative investors. 

Seg funds offer some interesting features, but at a fairly high price.

Question – What are your thoughts on segregated funds? I am 75, my husband is 78. Our insurance agent suggested buying segregated funds from him so there would be no income tax to be paid on our estate.

Dave Paterson – On the surface, segregated funds, or seg funds for short, look a lot like traditional mutual funds. They provide exposure to a wide range of asset classes including fixed income, equity funds and specialty funds. But unlike a mutual fund, seg funds are actually insurance contracts that are issued by a life insurance company. Some of the big players in the space include Manulife, Sun Life, Great West Life and Clarica, all of whom offer a wide range of some of the more popular funds available from the largest mutual fund companies in Canada.

Seg funds do have a number of interesting features that are not available with a traditional mutual fund. Some of these features include:

Probate Protection – This is obviously the feature that your agent is promoting. Like other life insurance products, if there is a named beneficiary the seg fund will be exempt from probate and executor fees and the proceeds will pass directly to the beneficiary upon death. This can definitely help simplify the process. In comparison, a traditional mutual fund will become part of the overall estate and the assets paid out only after the will has been probated. This will take time and be subject to probate fees. An exception to this is that with an RRSP or RRIF, if there is a beneficiary, the proceeds may transfer on a tax deferred basis to the beneficiary.

Death Guarantee – Because seg funds are technically a life insurance product, they will guarantee the value of the invested principal for investors. The amount that is insured will vary based on the particular seg fund, but it will typically be either 75% of the value or 100% of the value. Upon death the guaranteed value or the market value, whichever is greater, is paid to the beneficiary.

Maturity Guarantee – As mentioned above, seg funds are technically life insurance contracts and will have a maturity date. That is typically 10 years from the date of the investment. As a result, they are able to offer a maturity guarantee. Seg funds will guarantee the value of the insured amount at the maturity of the contract. The actual amount that is insured will be either 75% or 100% of the insured amount.

Periodic Resets – Over time, the value of the seg fund may increase as a result of the fluctuations in the investment markets. Many seg funds allow investors to lock in the higher amount through a reset. Once the reset is complete, the insured value is the higher value that the investor had locked in. Typically, once a reset has been completed, the maturity date is extended to 10 years from the date on which the reset was completed. Resets are typically allowed one or two times per year, but it will depend on the insurance company and the seg fund being purchased.

Creditor Protection – While it’s true that the federal government has recently implemented creditor protection for RRSPs, such protection is not available in non-registered accounts. Seg funds, regardless of the type of account in which they are held are protected from creditors, assuming certain conditions are met.

These features, particularly the guarantees and reset feature, would definitely be appealing to a lot of investors, particularly in today’s volatile market environment. However, seg funds are not without their drawbacks. Perhaps the biggest drawback is cost. In almost all cases, the cost of a seg fund is significantly higher than the cost of a traditional mutual fund.

 Let’s take a look at a quick example. There are a number of seg funds that are based on the CI Harbour Growth and Income Fund. The MER for the mutual fund version is 2.43%. In reviewing the various seg fund versions, we find that the MERs range from a low 2.79% to a high of 3.90%. Given that the underlying investment exposure is identical, the increased cost of the seg fund versions is the cost of the various insurance features. Obviously, the higher the cost, the bigger the drag will be on performance over time.

Bottom line:

Clearly seg funds offer some very interesting and compelling features. However, the additional costs make them considerably less attractive. It is my opinion that seg funds are an insurance product first and an investment product second. Therefore, you should only consider them if you are looking to take advantage of one of the insurance focused features such as creditor proofing or probate protection in non registered accounts. From an investment perspective, I believe that investors will be better served by a well diversified portfolio made up of mutual funds and ETFs. In your case, I would verify with your tax professional to see which course of action is most appropriate for your particular circumstance.

---

Mutual Funds Update
Editor and Publisher: Dave Paterson
Circulation Director: Kim Pape-Green
Customer Service: Katya Schmied, Terri Hooper

Gordon Pape’s Mutual Funds Update is published monthly.

Copyright 2012 by Gordon Pape Enterprises Ltd. and Paterson & Associates

All rights reserved. Reproduction in whole or in part without written permission is prohibited. All recommendations are based on information that is believed to be reliable. However, results are not guaranteed and the publishers and distributors of Mutual Funds Update assume no liability whatsoever for any material losses that may occur. Readers are advised to consult a professional financial advisor before making any investment decisions. Contributors to the MFU and/or their companies or members of their families may hold and trade positions in securities mentioned in this newsletter. No compensation for recommending particular securities or financial advisors is solicited or accepted.

Mail edition: $139.95 a year plus applicable taxes. Add $30.00 for delivery outside Canada.

Electronic edition: $69.95 a year plus applicable taxes.

Single copies: $15.00 plus applicable taxes.

Reprint permissions: Contact customer service (416) 693-8526 or 1-888-287-8229

Change of address: Please advise us at least four weeks in advance, enclosing the address label from a recent issue.
Send change of address notice to:
Gordon Pape’s Mutual Funds Update
16715-12 Yonge St. Suite 181, Newmarket, ON L3X 1X4

Customer service:
By mail to the address above.
By phone to Katya or Terri @ (416) 693-8526 or 1-888-287-8229
By email to customer.service@buildingwealth.ca