In this issue:

What’s New

♦ Dennis Mitchell lands at Sprott – Dennis Mitchell, the former Chief Investment Officer of Sentry Investments, has joined Sprott Asset Management as a senior portfolio manager and senior Vice President. It is not known what funds Mr. Mitchell will be managing, or when any new offerings will be launched. In an interview with BNN in September, Mr. Mitchell said he will only be managing funds that fall within his coverage area, which includes REITs, infrastructure and global equities. I see this as a positive for Sprott as they continue their transformation from a resource focused manager to a more diversified money management shop.

♦ Global ETF flows strong despite volatility – Despite the wild ride faced by many investors, assets in ETFs and ETPs around the world grew by nearly $21 billion in August, marking the 19th consecutive month of positive net inflows, according to the ETFGI, an independent research and consultancy firm focusing on the global exchange traded fund and exchange traded product universe. In Canada, there was more than $1 billion of net inflows, with BMO, Vanguard and iShares leading the way. Unfortunately, new money wasn’t enough to grow assets as market declines reduced overall industry assets by 2.0%, to just under $84 billion.

Return to the table of contents…

THIRD QUARTER LIVES UP TO VOLATILE REPUTATION

Third quarter is typically the worst, fourth quarter typically strongest

By Dave Paterson, CFA

Historically, the third quarter has been the worst for investors, and this year proved that to once again be true. Equity markets sold off hard, bringing most markets into negative territory in U.S. dollar terms. Fortunately for Canadian investors, a weakening Canadian dollar has boosted returns for those investments that have unhedged U.S. dollar currency exposure.

There were a number of factors responsible for the selloff, with worries over a slowing economy in China being the biggest. China has long been the driver of global growth and a continued slowdown is expected to drag the overall level of global growth. As a result, the Paris-based Organization for Economic Cooperation and Development (OECD) recently cut its growth estimates from 3.1% to 3.0% for this year. Next year, they expect the world economy to grow by 3.6%, down from its earlier 3.8% estimate.

Further complicating matters is the U.S. Federal Reserve, which desperately wants to start raising interest rates. Unfortunately, the U.S. economy is not cooperating, with a recent disappointing jobs report likely pushing the first hike down the road a bit further. This causes traders to speculate on when the first move will happen, meaning higher levels of uncertainty and elevated levels of volatility.

If there is a positive, it is that the final quarter of the year has statistically been the strongest. Sure, we have seen a lot of volatility in the month of October, including some of the largest drops such as the 21.8% drop in 1987, 17% in 2008, and of course the crash of 1929. Surprisingly though, it is actually August and September that have been the worst, both in terms of frequency and magnitude of declines. The table below shows the performance of the price return of the S&P 500 in U.S. dollar terms, broken out by month.

Performance of the S&P 500 from January 1950 to September 2015

 

Average Monthly Return

Worst Monthly Return

Best Monthly Return

% losing months

% of months with losses worse than -5%

 

 

 

 

 

 

January

1.02%

-8.57%

13.18%

40.00%

12.31%

February

0.05%

-10.99%

7.15%

44.62%

4.62%

March

1.17%

-10.18%

9.67%

35.38%

3.08%

April

1.47%

-9.05%

9.39%

30.77%

4.62%

May

0.21%

-8.60%

9.20%

43.08%

12.31%

June

-0.05%

-8.60%

8.23%

49.23%

9.23%

July

0.99%

-7.90%

8.84%

46.15%

7.69%

August

-0.09%

-14.58%

11.60%

49.23%

16.92%

September

-0.52%

-11.93%

8.76%

49.23%

16.92%

October

0.82%

-21.76%

16.30%

40.00%

6.15%

November

1.54%

-11.39%

10.24%

33.85%

7.69%

December

1.67%

-6.03%

11.16%

24.62%

1.54%
Source: Yahoo Finance

Even with history on our side, I remain cautious heading into the final quarter. Overall, I expect that we will see volatility start to abate but there remains the potential for periods of extreme volatility, particularly immediately before the upcoming U.S. Federal Reserve meetings. We could also see some violent swings if news out of China remains decidedly negative.

For Canadian equities, I expect to see continued pressure on commodities, particularly energy. Further, index heavyweight Valeant Pharmaceuticals is quickly losing favour with investors after probes into the firm’s pricing practices have raised concerns among lawmakers. The stock was one of the market darlings heading into the summer, and had been responsible for a good chunk of the S&P/TSX Composite’s performance. These factors keep the near term outlook for Canadian equities muted at best.

Valuations for U.S. equities are a bit more attractive now after the selloff, and the corporate earnings picture remains positive. Combined, these factors may make now a potentially advantageous entry point for those who have been sitting on the sidelines. Global equities are still a concern, given weakness in Europe and the spillover effect from a slowing China and other emerging markets.

Fixed income markets remain challenging. While it is unlikely we’ll see the Fed move at the next meeting, barring some surprisingly strong growth numbers, there is expected to be higher than normal volatility in the rates market. Add to that the relative higher valuations of fixed income over equities, and I believe the medium to long-term outlook for bonds is somewhat negative. Based on that, I am lowering my allocation to bonds from Neutral to Underweight.

My current outlook is:

 

 

Under-weight

Neutral

Over-weight

Cash

 

X

 

Bonds

 X

 

 

 

Government

 

X

 

 

Corporate

 

X

 

 

High Yield

 

X

 

 

Global Bonds

 

X

 

 

Real Return Bonds

X

 

 

Equities

 

X

 

 

Canada

 

X

 

 

U.S.

 

 

X

 

International

 

X

 

 

Emerging Markets

X

 

 

 

Return to the table of contents…

PASSING THE TORCH

By Dave Paterson, CFA

I just wanted to give you a heads up on some changes that are coming over the next few months with Mutual Funds/ETFs Update. After a lot of thought and consideration, I have reluctantly decided to step back from this wonderful newsletter. Believe me, this was not an easy decision to make.

I am first and foremost an investment analyst, and have found that with all the other duties I have on my plate it was becoming increasingly difficult to continue to give this newsletter the time and attention it needs. As a valued reader, you deserve excellent, unbiased research, so I went out and found an organization I believe can continue to deliver that to you.

Over the next few months, I will be passing the torch to 5i Research, run by industry veteran Peter Hodson and Ryan Modesto. 5i is a wonderful organization that provides investors with “conflict free” research on a wide range of investment products including individual stocks and ETFs. They are an excellent organization and will do a great job in continuing the tradition that Gordon Pape started more than 20 years ago.

Don’t worry, I’m not completely going away. I will be contributing articles and insight to the next few editions, and hope to be a regular contributor on a go forward basis. I know they have the team in place that can keep this newsletter a great source of investment research for you well into the future.

I have enjoyed my time working for you and wish you all the best!

Respectfully,
Dave

 

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TURBULENT TIMES

An introduction to the Canadian MoneySaver model portfolio.

By Ryan Modesto, CFA

It has been nothing short of a wild last couple of months for markets and investors. Many aspects that have likely been taken for granted as ‘the norm’ have seen seismic shifts. These include the idea of $100 oil as well as a Canadian dollar that trades at parity with the US, while preferreds have been absolutely punished.

If you are an investor that is concentrated within Canadian equities, it has been a tough month or two. Fortunately, if you have been diversified across geographies and assets, you have likely been impacted far less in the downturn compared to others. This is where the Canadian MoneySaver portfolio, a model portfolio we hope to feature regularly in this newsletter, continues to shine.

So with all of these changes in the markets, is it time to make changes to the portfolio? In true passive investment fashion, we do not think so. The portfolio continues to be diversified and exposed to various markets but let’s look at the areas we could change and some potential criticisms against doing nothing.

Dump or double down on Energy

This would be the most likely move if we were to make any change. While the prospects for the energy sector do not look great in the shorter term, at a ~6% weight for an ETF, the portfolio is not overexposed to the sector while still allowing it to enjoy any potential upside if or when the energy markets turn around. So why not double down? Simply, there is too much uncertainty and no one knows where oil is going to go next. We would far prefer a prudent exposure over speculating on which way a commodity will move.

Give up on Gold

This is a similar problem to that of the energy sector. No one likes commodities right now and in the case of gold, no one has liked it for years. This type of sentiment is often reason enough to hold some exposure and at a ~3.5% weight, we are comfortable with holding for a bit of a general hedge against equities. Also, if the US dollar begins to weaken, we would expect gold to see some strength, which will help hedge against the US dollar exposure held in the portfolio.

Increase fixed income

This gets a bit more into the individual’s personal circumstances but we are looking at an ‘average’ investor – a 35 to 40 year old that is gainfully employed, a net saver (i.e. saving more than spending) with a manageable debt load. In this situation, where there is no need for a reliable cash flow from the investment portfolio, we have opted for a lower fixed income exposure in the model portfolio (nearly 20% if we include preferreds). We continue to think this is appropriate given record low interest rates that, while they may remain low for some time, cannot go much lower and are more than likely to go up at some point.

With changes in the level of interest rates determining the majority of fixed income returns, we think the situation is best posed like this: You could have a high probability chance at losing only X% in fixed income or a lower but less certain probability of earning a positive return in any given year with equities. Psychologically it can be broken down as whether you want to take a more certain and predictable loss or take a ‘gamble’ with a larger range of outcomes but less certainty as to what that outcome will be. This is why time frame is key, as this gamble may not be appropriate if you are retired, but if you have a long time frame through which you will not need to draw on funds, the ‘gamble’ starts to make a lot more sense.

Increase US or International exposure

On the US side, having some exposure in the first place has sort of taken care of this consideration for us, as the strong US markets have grown in size within the portfolio. Because of this, we feel letting this exposure continue with the momentum is appropriate. An argument could be made for adding even more to US investments but with 25% of the total portfolio in US securities, we think the CMS portfolio is fairly well covered in this respect and would also go against the idea of rebalancing where you trim the strong areas and buy the underperformers. On the international front, we will likely consider adding to this exposure at some time, as these are the most underrepresented areas but with China’s growth under the microscope and some currency issues developing, we simply do not think a position needs to be rushed.

With just over an 8% return since October 18, 2013 to September 30, 2015 compared to the TSX composite of 2.72% over the same period we are pretty happy with the portfolio’s performance so far. We are even more satisfied with the fact that very few changes were made to the portfolio, helping to limit transaction and taxation costs.

Please remember, this is a very general guide to a general audience. It in no way attempts to suggest that a reader should drop everything and follow the allocations blindly and also in no way suggests that it is a one size fits all portfolio. Every investor is different and a portfolio needs to be adjusted in a way that meets your specific needs and views. When in doubt, consult a financial advisor who understands your specific needs.

We are looking forward to assuming more of an involved role with this letter over the next few months with the help of Dave Paterson and appreciate all the effort Dave has put into the Mutual Funds/ETFs Update over the past years. Dave will continue to help us out in the background for the next few months and we will be more than happy to pass along his insights going forward in the letter. We do plan on making some small changes as we go along but we hope subscribers will find that they are all for the better. We appreciate everyone’s patience over the next few months and are happy to hear your feedback through ryanmodesto@5iresearch.ca

 

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WHY OWN AN ACTIVELY MANAGED BOND FUND?

Active management can help protect capital and generate returns in challenging environment

By Dave Paterson, CFA

I have always maintained that one area of your portfolio where costs really matter is with the fixed income sleeve. With bond returns expected to be flat or even negative for the near to medium term, I have been asked a few times why I still recommend bond funds that carry higher MERs than low cost index ETFs.

For example, my top pick at the moment, PH&N Total Return Bond Fund, carries an MER of 1.16% for the advisor sold units, while my other favourites, TD Canadian Core Plus Bond and Dynamic Advantage Bond, both carry MERs that are just north of 1.5%. In comparison, the iShares Canadian Universe Bond Index (TSX: XBB) has an MER of 0.33%. With such a difference in costs, how could I still recommend one of the mutual funds over the ETF?

There are actually a few reasons. They include:

  • Cost – Hear me out on this one. If you are a do-it-yourself investor, then the cost posted for the ETF is the cost you pay, plus any trading costs. In that case, a lower cost ETF is likely going to be the best solution. However, if you are working with an advisor, there will likely be a management fee added, which can close the cost gap pretty quickly. For example, a lot of advisors are charging 1%, which will bring the cost of XBB up to at least 1.33%. Add in HST, and you could be at 1.46% in Ontario, which is only a smidge cheaper than my expensive mutual fund picks. Back that cost off the return of XBB, and the returns of the mutual funds don’t look so bad.
  • Duration Management – Active bond managers have a number of tools available to them to try to add value and preserve capital. One such strategy is to actively manage the duration profile of the fund, lengthening it when they believe rates will fall or remain flat and shorten it when they are expected to rise. This will allow the fund to benefit from the rate outlook. In comparison, the passive ETF has the duration of the underlying index, which in the case of the FTSE/TMX Bond Universe is north of 7 years, meaning that for every 1% move in rates, there is a move of approximately 7% in the opposite direction.
  • Security Selection – The ETF that tracks the index must look like the index, which means that it will invest only in investment grade bonds and will be about two-thirds in government bonds, with the rest in corporate bonds. In comparison, an actively managed bond fund can invest across the quality spectrum. For my bond picks, each can invest a portion in non-investment grade bonds. Further, actively managed bond funds are often able to dramatically alter the mix between government and corporate bonds. The TD Canadian Core Plus Bond Fund has nearly 60% invested in corporate bonds, PH&N Total Return Bond has about a third, while the Dynamic Advantage Bond holds about 45% in corporates. The higher corporate and non-investment grade exposure allows the funds to generate higher yields, and offer higher return potential in most market conditions.
  • Trading Strategies – An active bond manager can use a number of trading strategies that may generate higher returns. One example is a relative value strategy where the manager exploits mispricing in the bond market, selling overvalued bonds and buying bonds that appear to be undervalued. Another example would be to try to take advantage of the mispricing between bonds of different maturities. In the manager’s credit review process, they may find that one maturity may offer a more attractive risk adjusted return than another. In that case, they would sell the overpriced bond and buy the underpriced bond. Another strategy, known as “curve roll down” was recently discussed by Bill Kim of Dynamic’s fixed income team. In very simple terms, this strategy involves holding a bond for one year, and selling it at a profit, after collecting the year’s coupon payment. The proceeds are then reinvested in another bond and the process is repeated. In current market conditions, Dynamic estimates they can generate approximately 5% on each one of these trades over the course of a year. Any of these strategies, if executed correctly, is expected to generate a return that is in excess of the yield.

Bottom Line

When an active bond manager is able to effectively implement these strategies, it is likely that they will be able to generate returns that are comparable to the index, with lower levels of volatility. This result is stronger risk adjusted returns.

In my analysis, I have found that a high quality actively managed bond fund is more likely to earn its management fee in an environment where yields are expected to rise, or even stay flat. This is where the additional return from the active strategies can add return or reduce the downside. However, when yields are falling, and bond prices rising, most active managers have not been able to keep pace.

Looking ahead, with the fixed income environment likely to remain extremely challenging, I am favouring the high quality, well managed actively managed bond funds mentioned above over low cost passive options.

Return to the table of contents…

LOW VOLATILITY FUNDS

Low volatility funds hold up relative well in recent volatility.

By Dave Paterson, CFA

The third quarter saw volatility return with a vengeance, causing some investors to get a little nervous. And rightly so; the CBOE VIX Index, also known as the “fear index”, spiked from around 13 to more than 40, levels not seen since 2012. The VIX measures the market expectations of near term volatility on S&P 500 index options. When the VIX is high, market participants are expecting things to get rocky. The longer term historic average has been around 20, and it closed slightly higher at 24.50 on September 30.

This fear sent global equity markets on a wild ride during the quarter, with the S&P 500 losing 6.4% in U.S. dollar terms. But, thanks to continued weakness in the Canadian dollar, it gained 0.5%. The S&P/TSX Composite also struggled, losing 7.9% on weakness in energy and materials. Also dragging on the market was healthcare, which saw index heavyweight Valeant Pharmaceuticals fall by 22% in September, resulting in a drop of 14% for the quarter.

With these wild swings, I thought it might be helpful to take a look at the performance of some of the low volatility funds during the third quarter.

Canadian Low Volatility Equity Funds

First up are the Canadian low volatility offerings; PowerShares Canadian Low Volatility Index Fund, RBC QUBE Low Volatility Canadian Equity Fund, and TD Canadian Low Volatility Fund. The chart below shows the return of the three funds compared with the S&P/TSX Composite Index.

Source: GlobeInvestor

Clearly, over the full quarter, the low vol funds outperformed the index. One thing that I do find rather troubling is the drops these funds experienced between August 18 and August 24. In that period, the index dropped by slightly more than 8%. The low vol funds also dropped significantly, with the PowerShares fund holding up the best, with a 6.5% drop while the TD offering was down 7%. This represents a down capture ratio in the 80% to 90% range, which is not substantially different than a high quality actively managed fund. It is also substantially higher than the historic down capture ratios experienced by the funds over a three-year period. However, the overall volatility levels were significantly lower than the broader index.

While this may look impressive, it is less so if we compare it to my favourite Canadian focused equity pick, the Fidelity Canadian Large Cap Fund. According to GlobeInvestor, it was down 3.4%, which is significantly lower than its benchmark even accounting for the higher foreign content, and is much stronger than the low vol peer groups. While year to date performance is significantly higher than the low vol offerings, it lagged in the third quarter, despite holding up better in the volatile period.

U.S. Low Volatility Equity Funds

In the U.S. low vol space, the comparison is a bit more complicated because there are a couple of funds in the space, PowerShares U.S. Low Volatility Index Fund and the Mackenzie U.S. Low Volatility Fund, that use currency hedging, while the TD U.S. Low Volatility Fund and the RBC QUBE Low Volatility U.S. Equity Fund do not.

Looking first at the funds that use currency hedging, we see a somewhat similar pattern to what we saw with the Canadian low vol funds. Both funds held up better than the U.S. dollar returns of the S&P 500.

Source: GlobeInvestor

Surprisingly, in addition to outperforming over the quarter, the Mackenzie offering held up much better than the index during the highly volatile August 18-24 period. During that time, the S&P 500 lost 9.7% in U.S. dollar terms, while the fund was down 4.3%. This represents a down capture ratio of 45%, which is about what I would expect from a low vol fund. The PowerShares fund also held up better than the index falling 7.4%, but fared much worse than the Mackenzie fund, experiencing more than three quarters of the downside of the index.

From an overall volatility standpoint, Mackenzie lived up to its name with a level of volatility that was roughly half that of the index, while the PowerShares fund was lower, but not nearly as much as Mackenzie.

The reason I say this is surprising is that in my analysis, I have found that the U.S. market, with its high level of efficiency is one of, if not the toughest to beat, yet the low vol strategy did just that.

Turning to the unhedged funds, both the RBC QUBE Low Volatility U.S. Equity Fund and the TD U.S. Low Volatility Fund outperformed the S&P 500 in Canadian dollar terms.

Source: GlobeInvestor

While the RBC fund may have outperformed over the quarter, it was the TD offering that held up better during the massive selloff. The S&P 500 lost 8.7% in Canadian dollar terms. TD lost 6.2% and RBC lost 6.5%. Still, this performance is a little disappointing, representing 71% and 75% of the markets drawdown.

Even the overall volatility exhibited by both of these funds was a little disappointing and while lower than the index, it wasn’t what I would call significantly so.

Global Low Volatility Equity Funds

In the global low vol space, TD and RBC are the main players, although Lazard, Desjardins, and Investors Group have all launched funds in the recent months.

Looking at the past quarter, the RBC QUBE Low Volatility Global Equity Fund was far and away the best performer, outpacing both the TD Global Low Volatility Fund and the MSCI World Index. Somewhat disappointingly, TD barely beat the index, losing 1.2%, compared with the benchmarks 1.6% drop.

Source: GlobeInvestor

RBC also held up the best during the selloff between August 18 and the 24th, dropping 4.3% compared with the 6.5% decline in the TD Global Low Vol fund, and the 7.9% fall in the index. From an overall volatility standpoint, RBC exhibited the lowest volatility, with a standard deviation of slightly more than half the index.

As with the Canadian low vol funds, this looks respectable, but a further examination comparing to a high quality, defensively positioned global equity fund the results aren’t quite as impressive as they first appear. Looking at my top defensive global equity pick, Mackenzie Ivy Foreign Equity, we see the fund dropped by 3.1% between August 18 and 24, which is lower than the low vol offerings. Further the overall volatility was in line with the RBC low vol offering. For the full quarter, the Ivy fund gained 2.6% while the RBC low vol offering was up 3.85%. Longer-term numbers show a similar story with the defensively positioned global equity fund posting comparable returns to the RBC low vol fund.

Bottom Line

Low vol funds are a very interesting concept and have generally lived up to their promise during the most recent bout of volatility. However, as with traditional mutual funds, not all low volatility funds are created equally and you will need to fully understand the workings of each.

For example, TD funds use a quantitative approach that screens the universe looking for stocks that have demonstrated lower long-term volatility. The focus of their approach is on forecasting future volatility, rather than returns. They will also apply value and quality metrics in an effort to enhance returns. The portfolio is built using volatility and correlation to help set the security weights.

In comparison, RBC uses a slightly different approach. They use a quantitative screening process that has a strong fundamental overlay, looking at growth, stability and quality factors of each potential portfolio constituent. With the model output, they forecast return, transaction costs, and expected risk. They then do an optimization to find the lowest risk portfolio. Next, they bring in the fundamental factors in an effort to maximize the risk adjusted return of the portfolios, arriving at the final mix.

Mackenzie follows yet another approach that focuses on Beta and looks to minimize downside risk.

It is far too early to tell which of these approaches is the best. Recent performance favours the RBC offerings, but I have my doubts that this level of outperformance is sustainable.

Another factor to consider is you can still get excellent downside protection from more traditional, high quality, actively managed funds. Two of my favourites are the Fidelity Canadian Large Cap Fund, a concentrated, value focused, Canadian focused equity fund run by Daniel Dupont, and the Mackenzie Ivy Foreign Equity Fund, a concentrated, quality focused global equity fund that offers some of the best downside protection in the business. Both offer excellent management, a disciplined repeatable process, and excellent long-term performance, on both an absolute and risk adjusted basis. In other words, you don’t necessarily need to run out and buy a low volatility fund to get low volatility returns.

 

Return to the table of contents..

In this issue:

What’s New

♦ Dennis Mitchell lands at Sprott – Dennis Mitchell, the former Chief Investment Officer of Sentry Investments, has joined Sprott Asset Management as a senior portfolio manager and senior Vice President. It is not known what funds Mr. Mitchell will be managing, or when any new offerings will be launched. In an interview with BNN in September, Mr. Mitchell said he will only be managing funds that fall within his coverage area, which includes REITs, infrastructure and global equities. I see this as a positive for Sprott as they continue their transformation from a resource focused manager to a more diversified money management shop.

♦ Global ETF flows strong despite volatility – Despite the wild ride faced by many investors, assets in ETFs and ETPs around the world grew by nearly $21 billion in August, marking the 19th consecutive month of positive net inflows, according to the ETFGI, an independent research and consultancy firm focusing on the global exchange traded fund and exchange traded product universe. In Canada, there was more than $1 billion of net inflows, with BMO, Vanguard and iShares leading the way. Unfortunately, new money wasn’t enough to grow assets as market declines reduced overall industry assets by 2.0%, to just under $84 billion.

Return to the table of contents…

THIRD QUARTER LIVES UP TO VOLATILE REPUTATION

Third quarter is typically the worst, fourth quarter typically strongest

By Dave Paterson, CFA

Historically, the third quarter has been the worst for investors, and this year proved that to once again be true. Equity markets sold off hard, bringing most markets into negative territory in U.S. dollar terms. Fortunately for Canadian investors, a weakening Canadian dollar has boosted returns for those investments that have unhedged U.S. dollar currency exposure.

There were a number of factors responsible for the selloff, with worries over a slowing economy in China being the biggest. China has long been the driver of global growth and a continued slowdown is expected to drag the overall level of global growth. As a result, the Paris-based Organization for Economic Cooperation and Development (OECD) recently cut its growth estimates from 3.1% to 3.0% for this year. Next year, they expect the world economy to grow by 3.6%, down from its earlier 3.8% estimate.

Further complicating matters is the U.S. Federal Reserve, which desperately wants to start raising interest rates. Unfortunately, the U.S. economy is not cooperating, with a recent disappointing jobs report likely pushing the first hike down the road a bit further. This causes traders to speculate on when the first move will happen, meaning higher levels of uncertainty and elevated levels of volatility.

If there is a positive, it is that the final quarter of the year has statistically been the strongest. Sure, we have seen a lot of volatility in the month of October, including some of the largest drops such as the 21.8% drop in 1987, 17% in 2008, and of course the crash of 1929. Surprisingly though, it is actually August and September that have been the worst, both in terms of frequency and magnitude of declines. The table below shows the performance of the price return of the S&P 500 in U.S. dollar terms, broken out by month.

Performance of the S&P 500 from January 1950 to September 2015

 

Average Monthly Return

Worst Monthly Return

Best Monthly Return

% losing months

% of months with losses worse than -5%

 

 

 

 

 

 

January

1.02%

-8.57%

13.18%

40.00%

12.31%

February

0.05%

-10.99%

7.15%

44.62%

4.62%

March

1.17%

-10.18%

9.67%

35.38%

3.08%

April

1.47%

-9.05%

9.39%

30.77%

4.62%

May

0.21%

-8.60%

9.20%

43.08%

12.31%

June

-0.05%

-8.60%

8.23%

49.23%

9.23%

July

0.99%

-7.90%

8.84%

46.15%

7.69%

August

-0.09%

-14.58%

11.60%

49.23%

16.92%

September

-0.52%

-11.93%

8.76%

49.23%

16.92%

October

0.82%

-21.76%

16.30%

40.00%

6.15%

November

1.54%

-11.39%

10.24%

33.85%

7.69%

December

1.67%

-6.03%

11.16%

24.62%

1.54%
Source: Yahoo Finance

Even with history on our side, I remain cautious heading into the final quarter. Overall, I expect that we will see volatility start to abate but there remains the potential for periods of extreme volatility, particularly immediately before the upcoming U.S. Federal Reserve meetings. We could also see some violent swings if news out of China remains decidedly negative.

For Canadian equities, I expect to see continued pressure on commodities, particularly energy. Further, index heavyweight Valeant Pharmaceuticals is quickly losing favour with investors after probes into the firm’s pricing practices have raised concerns among lawmakers. The stock was one of the market darlings heading into the summer, and had been responsible for a good chunk of the S&P/TSX Composite’s performance. These factors keep the near term outlook for Canadian equities muted at best.

Valuations for U.S. equities are a bit more attractive now after the selloff, and the corporate earnings picture remains positive. Combined, these factors may make now a potentially advantageous entry point for those who have been sitting on the sidelines. Global equities are still a concern, given weakness in Europe and the spillover effect from a slowing China and other emerging markets.

Fixed income markets remain challenging. While it is unlikely we’ll see the Fed move at the next meeting, barring some surprisingly strong growth numbers, there is expected to be higher than normal volatility in the rates market. Add to that the relative higher valuations of fixed income over equities, and I believe the medium to long-term outlook for bonds is somewhat negative. Based on that, I am lowering my allocation to bonds from Neutral to Underweight.

My current outlook is:

 

 

Under-weight

Neutral

Over-weight

Cash

 

X

 

Bonds

 X

 

 

 

Government

 

X

 

 

Corporate

 

X

 

 

High Yield

 

X

 

 

Global Bonds

 

X

 

 

Real Return Bonds

X

 

 

Equities

 

X

 

 

Canada

 

X

 

 

U.S.

 

 

X

 

International

 

X

 

 

Emerging Markets

X

 

 

 

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PASSING THE TORCH

By Dave Paterson, CFA

I just wanted to give you a heads up on some changes that are coming over the next few months with Mutual Funds/ETFs Update. After a lot of thought and consideration, I have reluctantly decided to step back from this wonderful newsletter. Believe me, this was not an easy decision to make.

I am first and foremost an investment analyst, and have found that with all the other duties I have on my plate it was becoming increasingly difficult to continue to give this newsletter the time and attention it needs. As a valued reader, you deserve excellent, unbiased research, so I went out and found an organization I believe can continue to deliver that to you.

Over the next few months, I will be passing the torch to 5i Research, run by industry veteran Peter Hodson and Ryan Modesto. 5i is a wonderful organization that provides investors with “conflict free” research on a wide range of investment products including individual stocks and ETFs. They are an excellent organization and will do a great job in continuing the tradition that Gordon Pape started more than 20 years ago.

Don’t worry, I’m not completely going away. I will be contributing articles and insight to the next few editions, and hope to be a regular contributor on a go forward basis. I know they have the team in place that can keep this newsletter a great source of investment research for you well into the future.

I have enjoyed my time working for you and wish you all the best!

Respectfully,
Dave

 

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TURBULENT TIMES

An introduction to the Canadian MoneySaver model portfolio.

By Ryan Modesto, CFA

It has been nothing short of a wild last couple of months for markets and investors. Many aspects that have likely been taken for granted as ‘the norm’ have seen seismic shifts. These include the idea of $100 oil as well as a Canadian dollar that trades at parity with the US, while preferreds have been absolutely punished.

If you are an investor that is concentrated within Canadian equities, it has been a tough month or two. Fortunately, if you have been diversified across geographies and assets, you have likely been impacted far less in the downturn compared to others. This is where the Canadian MoneySaver portfolio, a model portfolio we hope to feature regularly in this newsletter, continues to shine.

So with all of these changes in the markets, is it time to make changes to the portfolio? In true passive investment fashion, we do not think so. The portfolio continues to be diversified and exposed to various markets but let’s look at the areas we could change and some potential criticisms against doing nothing.

Dump or double down on Energy

This would be the most likely move if we were to make any change. While the prospects for the energy sector do not look great in the shorter term, at a ~6% weight for an ETF, the portfolio is not overexposed to the sector while still allowing it to enjoy any potential upside if or when the energy markets turn around. So why not double down? Simply, there is too much uncertainty and no one knows where oil is going to go next. We would far prefer a prudent exposure over speculating on which way a commodity will move.

Give up on Gold

This is a similar problem to that of the energy sector. No one likes commodities right now and in the case of gold, no one has liked it for years. This type of sentiment is often reason enough to hold some exposure and at a ~3.5% weight, we are comfortable with holding for a bit of a general hedge against equities. Also, if the US dollar begins to weaken, we would expect gold to see some strength, which will help hedge against the US dollar exposure held in the portfolio.

Increase fixed income

This gets a bit more into the individual’s personal circumstances but we are looking at an ‘average’ investor – a 35 to 40 year old that is gainfully employed, a net saver (i.e. saving more than spending) with a manageable debt load. In this situation, where there is no need for a reliable cash flow from the investment portfolio, we have opted for a lower fixed income exposure in the model portfolio (nearly 20% if we include preferreds). We continue to think this is appropriate given record low interest rates that, while they may remain low for some time, cannot go much lower and are more than likely to go up at some point.

With changes in the level of interest rates determining the majority of fixed income returns, we think the situation is best posed like this: You could have a high probability chance at losing only X% in fixed income or a lower but less certain probability of earning a positive return in any given year with equities. Psychologically it can be broken down as whether you want to take a more certain and predictable loss or take a ‘gamble’ with a larger range of outcomes but less certainty as to what that outcome will be. This is why time frame is key, as this gamble may not be appropriate if you are retired, but if you have a long time frame through which you will not need to draw on funds, the ‘gamble’ starts to make a lot more sense.

Increase US or International exposure

On the US side, having some exposure in the first place has sort of taken care of this consideration for us, as the strong US markets have grown in size within the portfolio. Because of this, we feel letting this exposure continue with the momentum is appropriate. An argument could be made for adding even more to US investments but with 25% of the total portfolio in US securities, we think the CMS portfolio is fairly well covered in this respect and would also go against the idea of rebalancing where you trim the strong areas and buy the underperformers. On the international front, we will likely consider adding to this exposure at some time, as these are the most underrepresented areas but with China’s growth under the microscope and some currency issues developing, we simply do not think a position needs to be rushed.

With just over an 8% return since October 18, 2013 to September 30, 2015 compared to the TSX composite of 2.72% over the same period we are pretty happy with the portfolio’s performance so far. We are even more satisfied with the fact that very few changes were made to the portfolio, helping to limit transaction and taxation costs.

Please remember, this is a very general guide to a general audience. It in no way attempts to suggest that a reader should drop everything and follow the allocations blindly and also in no way suggests that it is a one size fits all portfolio. Every investor is different and a portfolio needs to be adjusted in a way that meets your specific needs and views. When in doubt, consult a financial advisor who understands your specific needs.

We are looking forward to assuming more of an involved role with this letter over the next few months with the help of Dave Paterson and appreciate all the effort Dave has put into the Mutual Funds/ETFs Update over the past years. Dave will continue to help us out in the background for the next few months and we will be more than happy to pass along his insights going forward in the letter. We do plan on making some small changes as we go along but we hope subscribers will find that they are all for the better. We appreciate everyone’s patience over the next few months and are happy to hear your feedback through ryanmodesto@5iresearch.ca

 

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WHY OWN AN ACTIVELY MANAGED BOND FUND?

Active management can help protect capital and generate returns in challenging environment

By Dave Paterson, CFA

I have always maintained that one area of your portfolio where costs really matter is with the fixed income sleeve. With bond returns expected to be flat or even negative for the near to medium term, I have been asked a few times why I still recommend bond funds that carry higher MERs than low cost index ETFs.

For example, my top pick at the moment, PH&N Total Return Bond Fund, carries an MER of 1.16% for the advisor sold units, while my other favourites, TD Canadian Core Plus Bond and Dynamic Advantage Bond, both carry MERs that are just north of 1.5%. In comparison, the iShares Canadian Universe Bond Index (TSX: XBB) has an MER of 0.33%. With such a difference in costs, how could I still recommend one of the mutual funds over the ETF?

There are actually a few reasons. They include:

  • Cost – Hear me out on this one. If you are a do-it-yourself investor, then the cost posted for the ETF is the cost you pay, plus any trading costs. In that case, a lower cost ETF is likely going to be the best solution. However, if you are working with an advisor, there will likely be a management fee added, which can close the cost gap pretty quickly. For example, a lot of advisors are charging 1%, which will bring the cost of XBB up to at least 1.33%. Add in HST, and you could be at 1.46% in Ontario, which is only a smidge cheaper than my expensive mutual fund picks. Back that cost off the return of XBB, and the returns of the mutual funds don’t look so bad.
  • Duration Management – Active bond managers have a number of tools available to them to try to add value and preserve capital. One such strategy is to actively manage the duration profile of the fund, lengthening it when they believe rates will fall or remain flat and shorten it when they are expected to rise. This will allow the fund to benefit from the rate outlook. In comparison, the passive ETF has the duration of the underlying index, which in the case of the FTSE/TMX Bond Universe is north of 7 years, meaning that for every 1% move in rates, there is a move of approximately 7% in the opposite direction.
  • Security Selection – The ETF that tracks the index must look like the index, which means that it will invest only in investment grade bonds and will be about two-thirds in government bonds, with the rest in corporate bonds. In comparison, an actively managed bond fund can invest across the quality spectrum. For my bond picks, each can invest a portion in non-investment grade bonds. Further, actively managed bond funds are often able to dramatically alter the mix between government and corporate bonds. The TD Canadian Core Plus Bond Fund has nearly 60% invested in corporate bonds, PH&N Total Return Bond has about a third, while the Dynamic Advantage Bond holds about 45% in corporates. The higher corporate and non-investment grade exposure allows the funds to generate higher yields, and offer higher return potential in most market conditions.
  • Trading Strategies – An active bond manager can use a number of trading strategies that may generate higher returns. One example is a relative value strategy where the manager exploits mispricing in the bond market, selling overvalued bonds and buying bonds that appear to be undervalued. Another example would be to try to take advantage of the mispricing between bonds of different maturities. In the manager’s credit review process, they may find that one maturity may offer a more attractive risk adjusted return than another. In that case, they would sell the overpriced bond and buy the underpriced bond. Another strategy, known as “curve roll down” was recently discussed by Bill Kim of Dynamic’s fixed income team. In very simple terms, this strategy involves holding a bond for one year, and selling it at a profit, after collecting the year’s coupon payment. The proceeds are then reinvested in another bond and the process is repeated. In current market conditions, Dynamic estimates they can generate approximately 5% on each one of these trades over the course of a year. Any of these strategies, if executed correctly, is expected to generate a return that is in excess of the yield.

Bottom Line

When an active bond manager is able to effectively implement these strategies, it is likely that they will be able to generate returns that are comparable to the index, with lower levels of volatility. This result is stronger risk adjusted returns.

In my analysis, I have found that a high quality actively managed bond fund is more likely to earn its management fee in an environment where yields are expected to rise, or even stay flat. This is where the additional return from the active strategies can add return or reduce the downside. However, when yields are falling, and bond prices rising, most active managers have not been able to keep pace.

Looking ahead, with the fixed income environment likely to remain extremely challenging, I am favouring the high quality, well managed actively managed bond funds mentioned above over low cost passive options.

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LOW VOLATILITY FUNDS

Low volatility funds hold up relative well in recent volatility.

By Dave Paterson, CFA

The third quarter saw volatility return with a vengeance, causing some investors to get a little nervous. And rightly so; the CBOE VIX Index, also known as the “fear index”, spiked from around 13 to more than 40, levels not seen since 2012. The VIX measures the market expectations of near term volatility on S&P 500 index options. When the VIX is high, market participants are expecting things to get rocky. The longer term historic average has been around 20, and it closed slightly higher at 24.50 on September 30.

This fear sent global equity markets on a wild ride during the quarter, with the S&P 500 losing 6.4% in U.S. dollar terms. But, thanks to continued weakness in the Canadian dollar, it gained 0.5%. The S&P/TSX Composite also struggled, losing 7.9% on weakness in energy and materials. Also dragging on the market was healthcare, which saw index heavyweight Valeant Pharmaceuticals fall by 22% in September, resulting in a drop of 14% for the quarter.

With these wild swings, I thought it might be helpful to take a look at the performance of some of the low volatility funds during the third quarter.

Canadian Low Volatility Equity Funds

First up are the Canadian low volatility offerings; PowerShares Canadian Low Volatility Index Fund, RBC QUBE Low Volatility Canadian Equity Fund, and TD Canadian Low Volatility Fund. The chart below shows the return of the three funds compared with the S&P/TSX Composite Index.

Source: GlobeInvestor

Clearly, over the full quarter, the low vol funds outperformed the index. One thing that I do find rather troubling is the drops these funds experienced between August 18 and August 24. In that period, the index dropped by slightly more than 8%. The low vol funds also dropped significantly, with the PowerShares fund holding up the best, with a 6.5% drop while the TD offering was down 7%. This represents a down capture ratio in the 80% to 90% range, which is not substantially different than a high quality actively managed fund. It is also substantially higher than the historic down capture ratios experienced by the funds over a three-year period. However, the overall volatility levels were significantly lower than the broader index.

While this may look impressive, it is less so if we compare it to my favourite Canadian focused equity pick, the Fidelity Canadian Large Cap Fund. According to GlobeInvestor, it was down 3.4%, which is significantly lower than its benchmark even accounting for the higher foreign content, and is much stronger than the low vol peer groups. While year to date performance is significantly higher than the low vol offerings, it lagged in the third quarter, despite holding up better in the volatile period.

U.S. Low Volatility Equity Funds

In the U.S. low vol space, the comparison is a bit more complicated because there are a couple of funds in the space, PowerShares U.S. Low Volatility Index Fund and the Mackenzie U.S. Low Volatility Fund, that use currency hedging, while the TD U.S. Low Volatility Fund and the RBC QUBE Low Volatility U.S. Equity Fund do not.

Looking first at the funds that use currency hedging, we see a somewhat similar pattern to what we saw with the Canadian low vol funds. Both funds held up better than the U.S. dollar returns of the S&P 500.

Source: GlobeInvestor

Surprisingly, in addition to outperforming over the quarter, the Mackenzie offering held up much better than the index during the highly volatile August 18-24 period. During that time, the S&P 500 lost 9.7% in U.S. dollar terms, while the fund was down 4.3%. This represents a down capture ratio of 45%, which is about what I would expect from a low vol fund. The PowerShares fund also held up better than the index falling 7.4%, but fared much worse than the Mackenzie fund, experiencing more than three quarters of the downside of the index.

From an overall volatility standpoint, Mackenzie lived up to its name with a level of volatility that was roughly half that of the index, while the PowerShares fund was lower, but not nearly as much as Mackenzie.

The reason I say this is surprising is that in my analysis, I have found that the U.S. market, with its high level of efficiency is one of, if not the toughest to beat, yet the low vol strategy did just that.

Turning to the unhedged funds, both the RBC QUBE Low Volatility U.S. Equity Fund and the TD U.S. Low Volatility Fund outperformed the S&P 500 in Canadian dollar terms.

Source: GlobeInvestor

While the RBC fund may have outperformed over the quarter, it was the TD offering that held up better during the massive selloff. The S&P 500 lost 8.7% in Canadian dollar terms. TD lost 6.2% and RBC lost 6.5%. Still, this performance is a little disappointing, representing 71% and 75% of the markets drawdown.

Even the overall volatility exhibited by both of these funds was a little disappointing and while lower than the index, it wasn’t what I would call significantly so.

Global Low Volatility Equity Funds

In the global low vol space, TD and RBC are the main players, although Lazard, Desjardins, and Investors Group have all launched funds in the recent months.

Looking at the past quarter, the RBC QUBE Low Volatility Global Equity Fund was far and away the best performer, outpacing both the TD Global Low Volatility Fund and the MSCI World Index. Somewhat disappointingly, TD barely beat the index, losing 1.2%, compared with the benchmarks 1.6% drop.

Source: GlobeInvestor

RBC also held up the best during the selloff between August 18 and the 24th, dropping 4.3% compared with the 6.5% decline in the TD Global Low Vol fund, and the 7.9% fall in the index. From an overall volatility standpoint, RBC exhibited the lowest volatility, with a standard deviation of slightly more than half the index.

As with the Canadian low vol funds, this looks respectable, but a further examination comparing to a high quality, defensively positioned global equity fund the results aren’t quite as impressive as they first appear. Looking at my top defensive global equity pick, Mackenzie Ivy Foreign Equity, we see the fund dropped by 3.1% between August 18 and 24, which is lower than the low vol offerings. Further the overall volatility was in line with the RBC low vol offering. For the full quarter, the Ivy fund gained 2.6% while the RBC low vol offering was up 3.85%. Longer-term numbers show a similar story with the defensively positioned global equity fund posting comparable returns to the RBC low vol fund.

Bottom Line

Low vol funds are a very interesting concept and have generally lived up to their promise during the most recent bout of volatility. However, as with traditional mutual funds, not all low volatility funds are created equally and you will need to fully understand the workings of each.

For example, TD funds use a quantitative approach that screens the universe looking for stocks that have demonstrated lower long-term volatility. The focus of their approach is on forecasting future volatility, rather than returns. They will also apply value and quality metrics in an effort to enhance returns. The portfolio is built using volatility and correlation to help set the security weights.

In comparison, RBC uses a slightly different approach. They use a quantitative screening process that has a strong fundamental overlay, looking at growth, stability and quality factors of each potential portfolio constituent. With the model output, they forecast return, transaction costs, and expected risk. They then do an optimization to find the lowest risk portfolio. Next, they bring in the fundamental factors in an effort to maximize the risk adjusted return of the portfolios, arriving at the final mix.

Mackenzie follows yet another approach that focuses on Beta and looks to minimize downside risk.

It is far too early to tell which of these approaches is the best. Recent performance favours the RBC offerings, but I have my doubts that this level of outperformance is sustainable.

Another factor to consider is you can still get excellent downside protection from more traditional, high quality, actively managed funds. Two of my favourites are the Fidelity Canadian Large Cap Fund, a concentrated, value focused, Canadian focused equity fund run by Daniel Dupont, and the Mackenzie Ivy Foreign Equity Fund, a concentrated, quality focused global equity fund that offers some of the best downside protection in the business. Both offer excellent management, a disciplined repeatable process, and excellent long-term performance, on both an absolute and risk adjusted basis. In other words, you don’t necessarily need to run out and buy a low volatility fund to get low volatility returns.

 

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