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In this issue:

• What’s New
• Recommended List Review
• Model Portfolio Review

What’s New

♦Bank of Canada shocks markets – While very few were expecting the Bank of Canada to move interest rates higher anytime soon, NOBODY expected the 25 basis point cut they made back on January 21. Citing the dramatic drop in oil as a significant threat to the country’s economic well-being, the Bank of Canada governor said he made the cut as an “insurance” policy to help stimulate growth.

With oil sinking to below $50 a barrel, the bank slashed its economic growth forecast for the first half of the year to 1.4% from 2.4%. It also cited the slower growth as a key reason for the significant slack in the economy that is now not expected to improve until at least 2017.

With the lowered outlook, markets are now pricing in the possibility that the Bank will be making at least one, and as many as three more 25 basis point cuts in the coming months. This has caused a further selloff in the dollar, which is now trading around US$0.80, down from $0.86 at the end of the year.

This has created an even more challenging investment environment. Fixed income return expectations have been adjusted higher, but I still favour equities, particularly U.S. equities, over bonds, although not as strongly as I did before the rate cut.

 

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RECOMMENDED LIST REVIEW

A generally decent quarter for Recommended List finds.

By Dave Paterson, CFA

The fourth quarter was definitely an interesting one, with the big drop in oil dominating the headlines here at home. Crude sank from $91.16 at the end of September, finishing the year at $53.27 (pricing in U.S. dollars). This had big implications for the Canadian equity markets, given its importance. At the end of January, the energy sector made up more than one fifth of the S&P/TSX Composite Index. Considering this, it is somewhat surprising the index was only marginally down, losing 1.5% for the quarter.

The drop in oil has continued, touching $45 a barrel in January. In reaction to this ongoing weakness, the Bank of Canada stepped in, surprising everyone and cutting their benchmark overnight lending rate by 25 basis points to 0.75%. The market is already pricing in at least one, and possibly more cuts in the coming months, as the Bank takes steps to shore up the slowing economy.
One of the immediate effects has been an accelerating fall in the Canadian dollar. So far this year, it has fallen $0.08, or nearly 9%. With more rate cuts likely, many are expecting continued weakness for the dollar.

This has had wider implications on the markets. With the oil price expected to remain low for a while, many energy companies are shuttering rigs and cutting jobs, the Canadian equity market is likely to face increased volatility and headwinds. There is some hope that the lower dollar will help to spur demand for our exports, which will help to boost the lagging manufacturing sectors in Ontario and Quebec.

As much as things have changed, it hasn’t made an appreciable change to my investment outlook. While there is the potential for some capital gains in the fixed income market as rates fall further in Canada, I still believe that there are more risks to the downside than to the upside. This has me still favouring equities over bonds.

With the expected headwinds for Canadian equities, I continue to favour the U.S. over Canada. The big difference now is it is likely more prudent to be in an investment where the currency exposure is unhedged, as additional gains are possible as the dollar weakens. The lower oil price may also be a positive for European, Asian and Emerging Market equities. While that is possible, I’m sticking closer to home in the near term, as renewed troubles from Greece are causing concerns around the Eurozone.

Within the Recommended List, two funds were added, and three funds were removed. Of the three, two were removed because they were closed to new investors. Given that I want the list to reflect the best funds AVAILABLE to investors, I will remove any fund that is closed. The third fund removed was because of a breakdown in the risk/reward profile of the fund.

Funds Added to the List

IA Clarington Global Equity Fund (CCM 3071 – Front End Units, CCM 3072 – DSC Units) – Last July, Joe Jugovic of Calgary- based QV Investors took over the management duties of this fund. While their track record on this fund is very short, QV has been running this exact mandate as a pooled fund since January 2007 with great success. Taking that track record and adding in the additional cost of the higher MER, it would have outpaced most of its peers over the past five years on a risk adjusted basis. Based on my analysis, this would have been the number three ranked global equity fund in my coverage universe at the end of the year.

The fund is managed using the same disciplined, bottom up process that is used with other QV funds. It looks for high quality, invested management that has delivered strong growth in equity, earnings, sales and cash flows. The company must be generating a level of free cash flow that will allow it to increase dividends over time, and the balance sheet cannot be over levered. Finally, it must be trading at a level of valuation that is well below current market levels, while providing return on equity that is above average.

The portfolio is fairly concentrated, holding roughly 35 names. The sector mix and geographic allocation is a byproduct of the stock selection process. At the end of December, it was overweight communication services, financials and consumer defensive, and underweight utilities and real estate. The fund also has exposure to companies of all sizes, although more than 60% is invested in larger firms.

Looking at the historic track record of the pooled fund, combined with the other QV mandates I follow, I expect this fund to deliver above average risk adjusted returns over the long term. With the focus on higher quality names, it is expected to lag in a sharply rising market, however, it will more than hold its own when markets sell off. The emphasis on yield and cash flow will also help to mitigate overall volatility. The biggest drawback is its higher MER. Still, I see this as a great core global equity fund for most investors.

Manulife Monthly High Income Fund (MMF 583 – Front End Units, MMF 483 – DSC Units) – The fund is managed by the team of Alan Wicks and Jonathan Popper. The equity approach is rooted in a value philosophy that looks for businesses that generate high and sustainable profits and are trading at attractive valuations. The fixed income sleeve is managed using a combination top down economic review combined with a bottom up credit analysis. The process looks to generate returns by focusing on sector allocation, and credit selection. They also emphasize risk management by actively managing the portfolio’s yield curve and duration exposure.

At the end of December the fund held 15% in cash, 35% in Canadian equities, 30% in U.S. equities and 20% in bonds. The equity sleeve is defensively positioned with consumer names making up 30%. It is dramatically underweight energy, materials, and financials which results in a portfolio that is significantly different than the index.

Performance, particularly since 2011, has been excellent, with the fund posting an annualized three year return of 13.2% to the end of December. Perhaps even more impressive has been the volatility profile, which has been below both the benchmark and the category average. It has also done a great job at protecting capital in down markets.

Going into 2015, if my investment thesis plays out, this fund should do an excellent job for investors. The lack of exposure to Europe and Asia is expected to help keep volatility in check, however, if a rally does take hold in Europe, this fund may lag some of its peers.

Funds Removed from the List

PH&N High Yield Bond Fund (RBF 6280 -Front End Units, RBF 4280 – Low Load Units) – When I added this fund to the Recommended List last time around, I fully expected it to be closed fairly quickly. Sure enough, it was, with RBC once again shuttering the fund to new investors effective November 26. As a result of this closing, I am removing the fund from the Recommended List. The only reason for this is because it is closed for new investment. If you hold it, consider yourself lucky. If you don’t, I wouldn’t hold your breath waiting for RBC to reopen it any time soon.

Trimark Canadian Small Companies Fund (AIM 1683 – Front End Units, AIM 1681 – DSC Units) – This is another fund that I am removing from the list because it has been closed to new investors. Effective October 8, it was “soft capped”, meaning that if you hold the fund, you can add to your holdings, but if you don’t own it, you’re out of luck. I will continue to follow the fund, and will revisit its place on the Recommended List if it is reopened.

Franklin Mutual Global Discovery Fund (TML 180 – Front End Units, TML 182 – DSC Units) – Over the past few quarters, I have noticed a material erosion in the risk/reward metrics of the fund, combined with a meaningful underperformance relative to its peers. I still believe that this is a solid fund, however, there are others that appear to be better positioned than this offering. Looking at the portfolio metrics, the valuation appears to be reasonably attractive, however, the expected growth rates are lower than the peer group, which dampens my return expectations for the near term. Considering the above, I removed it from the Recommended List. It will however remain on my watch list, and should I notice an improvement in the portfolio’s metrics, I will reconsider returning the fund to the rec list.

Funds of Note

Dynamic Advantage Bond Fund (DYN 258 – Front End Units, DYN 688 – DSC Units) – When it appeared that interest rates in Canada were likely going to rise, the defensive positioning of this fund resulted in it being my top bond fund pick. With a shorter duration and more conservative asset mix, it was well positioned to withstand the increased volatility in the bond market, and was expected to hold up better when yields started to rise. That all changed a few weeks ago when the Bank of Canada surprised everyone and cut its overnight lending rate by 25 basis points to 0.75%, with many expecting more cuts to follow. In an environment where it is more likely that yields will fall or remain flat, this fund will likely lag those funds that have a more neutral positioning. I still believe this is a great bond fund for the long term, and expect it to hold up well when yields are moving higher. Until then, my focus will shift to funds that have a higher duration exposure such as the PH&N Total Return Bond Fund, or the TD Canadian Core Plus Bond Fund.

PH&N Total Return Bond Fund (RBF 6340 – Front End Units, RBF 4340 – DSC Units) – With more cuts to interest rates expected from the Bank of Canada, this high quality bond fund becomes my top pick. At the end of December, it had a duration of 7.3 years, which is slightly less than the 7.6 years of the FTSE TMX Canadian Universe Bond Index. The fund itself is very much like the stalwart PH&N Bond Fund, except the managers have a little more flexibility which allows them to invest a modest portion of the fund in non-traditional strategies such as high yield, mortgages and derivatives. A little more than half is invested in government bonds, the majority of which are higher yielding provincial bonds. Approximately 40% is invested in corporate bonds. Within the corporate sleeve, they have focused on higher quality issues, and have remained underweight bonds in more cyclical sectors, namely energy. Looking ahead, I expect the management team to continue to do what it has done since the fund’s launch in 2000 – use its rigorous, highly disciplined investment process to opportunistically position the portfolio in a way they believe will best benefit the portfolio, while paying particular attention to managing risk.

AGF Monthly High Income Fund (AGF 766 – Front End Units, AGF 689 – DSC Units) – With two thirds of the fund invested in equities, combined with an overweight allocation to energy and materials, it is not hard to see why this was the worst performing balanced fund on our list in the fourth quarter. It lost 5%, while each of the other picks was in positive territory. While the equity sleeve was aggressively positioned with a cyclical bent, the fixed income sleeve was somewhat defensive, with a duration slightly lower than the index, and a yield that was higher. Approximately 50% of the U.S. dollar currency exposure was hedged against currency movements, which dampened gains in the quarter. In December, they increased the hedge from 50% to 75%, which may be a further headwind in the face of the prospect of a falling Canadian dollar. With the benefit of hindsight, we can see that they got the positioning wrong for the short term. Understandably, I will continue to monitor this fund and its positioning closely. I expect it to remain the most volatile of the balanced picks, but anticipate it will do well over the long term.

CI Signature High Income Fund (CIG 686 – Front End Units, CIG 786 – DSC Units) – Despite a modest 0.6% gain in the final quarter of the year, the fund still posted a respectable 8.6% rise for 2014. Over the year, the managers had taken profits in many of their energy names, and built up a significant cash reserve. At the end of December, it had about 20% of its assets in cash and cash-like investments. They have done this for two reasons. The first is to help boost the defensive positioning of the fund, helping it to better withstand any near term volatility. The second reason is for some “dry powder”, which will allow the managers to step in and pick up some high quality names trading at very attractive valuations. I continue to like this fund and believe it to be one of the best balanced funds out there. I expect it to continue to deliver very strong levels of risk adjusted returns, with volatility levels that are well below average.

IA Clarington Conservative Canadian Equity Fund (CCM 1300 – Front End Units, CCM 1400 – DSC Units) – For me, the big appeal of this fund is its conservative profile, which has allowed it to post decent returns over the long term, with significantly less downside than the market, and many of its peers. Historically, it has delivered about 70% of the upside of the market, yet only experienced between half to two thirds of the downside. This helps to explain why I was so disappointed with its recent performance when it dropped into lockstep with the market.

I recently had the chance to speak with Ryan Bushell, one of the managers of the fund. According to him, the main reason for this underperformance was the indiscriminate selloff of any stock that was related to energy. If you look at the fund, it has about a third invested in energy. Yet digging deeper, we see that many of these energy names are high quality, cash flow generating, conservative plays, such as pipelines and companies more focused on natural gas. This includes names such as Enbridge, TransCanada, and AltaGas. Historically, when oil sold off, these names held up much better. Unfortunately this time around, that didn’t happen, and these stocks were punished with the same veracity as their oil focused brethren.

As we move forward, Mr. Bushell believes that much of the selloff in many of the fund’s holdings was unwarranted, leaving a significant amount of upside in the portfolio. They will continue to build the portfolio on a bottom up, fundamentally driven approach that looks for companies with strong management teams and excellent balance sheets that will allow them to withstand any market cycle. They will not deviate from the same process that has worked for them since 1950. I will continue to follow the fund closely.

RBC O’Shaughnessy U.S. Value Fund (RBF 776 Front End Units, RBF 134 – Low Load Units) – If you look at the quarterly performance of this fund compared to the other U.S. equity funds on the list, you might be wondering what happened. It posted a very modest 2.1% rise, while the others were all significantly higher than that. Well since you asked, I’ll tell you what happened – currency happened. Over the quarter, the Canadian dollar dropped by nearly 4%. The RBC O’Shaughnessy U.S. Value Fund hedges its currency exposure, while the other U.S. equity funds on the list are largely unhedged. When a fund is unhedged and the Canadian dollar drops, the U.S. dollar assets will see a rise in value because of the falling currency. For example, the TD U.S. Blue Chip Fund rose by 3.7% in U.S. dollar terms. When the returns were converted into Canadian dollars, the gain was nearly double, coming in at 7.3%. With the U.S. Federal Reserve likely to start moving rates higher in the U.S. and the Bank of Canada expected to cut rates at home, it is highly likely we will see a further drop in the value of the Canadian dollar. At the very least, I would expect that currency volatility will be on the upswing in the near term. For this fund, or any other that hedges a significant portion of its U.S. dollar exposure, it may result in underperformance when compared with funds that do not hedge their currency. That said, I still believe this to be an excellent U.S. equity fund for those who can stomach a bit higher level of volatility in their portfolio.

Trimark Global Endeavour Fund (AIM 1593 – Front End Units, AIM 1591 – DSC Units) – While I have this fund in the Global Small and Mid-Cap Equity category on the Recommended List, it is really much more of an all-cap mandate. Managers Jeff Hyrich and Erin Greenfield have built a concentrated portfolio of high quality names, with sustainable competitive advantages that trade at a discount to their estimate of intrinsic value. Their fundamentally driven, bottom up approach has resulted in a portfolio that looks nothing like its benchmark. They are very disciplined when it comes to valuation, and as a result, cash balances can run quite high. For example, at the end of September, cash was sitting at 14%. Over the course of the quarter, they used market weakness as an opportunity to chip away at a few opportunities, adding a couple of new names to the portfolio, and adding to existing ones. This brought the cash down to around 11% at the end of the year. They continue to be patient, waiting for high quality names to trade at values they like. They are also starting to find some ideas in the emerging markets. This remains a great global mid-cap pick for those investors who can be comfortable with a performance stream that is much different than the index.

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Energy weighs on RRIF portfolio

Despite the market volatility experienced in the second half of the year, four of our five model portfolios finished in positive territory. The one laggard, was our RRIF Portfolio which was down 0.55%, dragged lower by two funds, Bissett Canadian High Dividend, and AGF Monthly High Income. Both of these funds were lower because of their higher allocation to the energy sectors.

I remain cautious for 2015. With the Bank of Canada more likely to ease rates than to raise them, I am expecting Canadian bonds to have a modest year. In the equity space, Canadian stocks are likely to face headwinds with the likelihood of lower oil prices. Despite higher valuations, the U.S. remains the place to be in the next few months. Economic numbers continue to improve and lower oil prices are expected to spur consumer and business spending.

With that as my thesis, I have made some modest changes to our portfolios to position them for the current environment.

As a refresher, let?s do a quick review of the portfolios. They were originally created by Gordon Pape on January 1, 2009 with an initial value of $25,000 each. I took them over in January 2012. The goal is to provide you with a guide to help you in setting up your own portfolio.

When looking for potential investments, I consider all mutual funds and ETFs available in Canada for inclusion except those which are only available to “sophisticated investors” through offering memorandum. The investment objectives of each portfolio are as follows:

The Ultra-Safe Portfolio: As the name suggests, this portfolio is designed for people who are looking to earn returns that are better than what you could earn in a GIC or money market fund, without taking on much in the way of risk.

The Non-Registered Defensive Portfolio: There’s a little more risk and extra cash flow in this portfolio. It is best suited to non-registered accounts where safety and income are the main priorities. The fund targets an average annual compound rate of return of between 4% and 6%. Since inception, it has outpaced that target, gaining an annualized 6.5%.

The RRSP Portfolio: This portfolio is structured in much the same way as a conservatively managed pension plan. Risk is kept to a reasonable level consistent with a long-term annualized growth target in the 6% to 7% range. To date, we have met out target, delivering an annualized gain since inception of 7.6%.

The RRIF Portfolio: Cash flow and capital preservation are the goals. The portfolio is designed to provide enough income to avoid dipping into capital for as long as possible, while shielding investors from heavy losses in market downturns. The target return is approximately 6% a year. It has outpaced that target, delivering investors an annualized 6.7% gain since inception, with a current distribution yield of more than 3.8%.

The Growth Portfolio: This is suitable for investors seeking higher returns over the long term and who are willing to accept more risk. We aim for a compound annual growth rate of 8% or more. To date, the return has averaged more than 12% per year. This target allows us to maintain risk at reasonable levels. We avoid highly speculative funds.

Here are the latest results to December 31:

ULTRA SAFE PORTFOLIO

PERFORMANCE TO DATE

COMMENTS

The portfolio has certainly lived up to its objectives and delivered a stable, rate of return that has outpaced what you could earn with a GIC. For the second half of the year, it rose by 1.4%, and is up by 3.9% for the year. It is very conservative, with 65% focused on short term investments. Despite this, it was largely the iShares Canadian Corporate Bond Index ETF and Fidelity Monthly Income Fund that were the key drivers of return.

CHANGES

With it very likely that the Bank of Canada will make at least one more cut to its overnight rate, I believe we can safely move out the yield curve in search of return without taking on too much additional risk. To do this, I am reducing the money market exposure and adding to the TD Mortgage Fund and the Fidelity Monthly Income Fund. This is expected to add increased return potential without increasing the risk profile significantly.

REVISED ULTRA SAFE PORTFOLIO

DEFENSIVE PORTFOLIO

PERFORMANCE TO DATE

COMMENTS

The Defensive Portfolio has the objective of delivering 4% to 6% without taking on a lot of risk. It has been pretty successful at doing this, gaining 6.5% since inception, and earning 5.8% last year. It is defensively positioned, with the conservative Mackenzie Ivy Foreign Equity Fund being its only pure equity exposure. There is also some equity exposure through the balanced funds. Not surprisingly, it was the equities that were the main driver of returns in the most recent period.

CHANGES

With the short term interest rates likely moving lower in Canada, I am adding a little more duration and equity exposure to the portfolio. To do this, I am removing the TD Mortgage Fund, and allocating the proceeds equally between the PH&N Total Return Bond Fund and the Mackenzie Ivy Foreign Equity Fund. This is expected to increase the return potential without significantly increasing risk.

REVISED DEFENSIVE PORTFOLIO

RRSP PORTFOLIO

PERFORMANCE TO DATE

COMMENTS

The portfolio had an excellent first half, gaining nearly 5%, with the Beutel Goodman American Equity Fund and the Mackenzie Ivy Foreign Equity being the main drivers of return. The portfolio is fairly balanced, with approximately 50% in fixed income, and 50% in equities.

CHANGES

With a 50/50 split between equity and fixed income, the portfolio is fairly conservatively positioned. Given my investment outlook that favours equity over bonds, I am going to add a bit more equity exposure. To do this, I am reducing the Steadyhand Income Fund by 10% and splitting the proceeds between the Beutel Goodman American Equity and the Mackenzie Ivy Foreign Equity Fund. I believe this will increase the potential for capital growth without substantially increasing the risk.

REVISED RRSP PORTFOLIO

RRIF PORTFOLIO

PERFORMANCE TO DATE

COMMENTS

It was a pretty ugly period for the RRIF Portfolio, which lost 0.55% in the second half of the year. This was mainly because of two funds; the Bissett Canadian High Dividend Fund and the AGF Monthly High Income Fund. Both suffered material losses, with Bissett dropping nearly 20% in the second half, while AGF lost 7%. In both cases, the funds had significant exposure to energy and materials, two sectors that were sold off heavily.

CHANGES

Despite the selloff of those two funds, I am maintaining their exposure in the portfolio for a couple of reasons. First, I believe in the managers and their investment processes. I expect that we will see a return to positive returns in the coming months and am monitoring the funds and portfolios closely. The second reason I am keeping the portfolio steady is it offers a higher yield, currently at 3.8%, which is up more than 40 basis points from our last update. This is helpful, given the portfolio?s emphasis on cash flow generation.

REVISED RRIF PORTFOLIO

GROWTH PORTFOLIO

PERFORMANCE TO DATE

COMMENTS

It was a very strong year for the Growth Portfolio which gained 13.6% for the year. All funds, except the Beutel Goodman Small Cap Fund contributed to the performance in the second half, with the Beutel Goodman American Equity Fund leading the way. The portfolio is very equity focused, with only a 10% exposure to fixed income.

CHANGES

The portfolio remains very well positioned for growth, with 90% equity exposure. Given the outlook, I am not making any changes to the portfolio at this time.

REVISED GROWTH PORTFOLIO