Fund Analyst Notebook

By Morningstar Canada | 29/03/10

The Fund Analyst Notebook is a new feature we're launching to provide a venue for Morningstar fund analysts to share their thoughts and ideas with our readers. We often discuss issues that may not warrant an entire article but are interesting nonetheless. Members of the fund analyst team will submit entries any time they have an interesting thought to share. The entries can come in the form of an initial reaction to late breaking news, links to interesting third-party articles, or even just things that make you go "hmmm!" Analysts will add content throughout the day, so check back often.

What's in a 10-year return?
Brian O'Neill | March 29, 2010

It is widely agreed that, whenever possible, the abilities of an investment manager should be judged over long time periods. If a manager has a great three-month return, for example, then it can be tough to determine whether it was the result of luck or skill. But over a longer period --say, ten years--one can be more confident that a manager's sustained outperformance may well be the result of at least a certain measure of proficiency.

This is a sound premise. But one has to remember that even a so-called ''long-term return'' can be subject to healthy doses of short-term randomness, especially given the magnitudes of recent bull and bear markets. As such, a fund's 10-year number can at times vary wildly from year to year, as the first year being measured gets lopped off and a more recent one is included.

The next few years will be particularly interesting in this regard. It was about ten years ago now that the trend of growth funds dominating value funds reversed for several years. As such, the 10-year returns of those growth funds look far worse today than they did three years ago because their fabulous results in the late 1990's are no longer included. On the flip side, the 10-year returns of many value funds are looking increasingly good (including those for a handful of funds that didn't fare so well in the most recent downturn).

In 2013, we will see a similar momentum shift when those managers who avoided Nortel et al will no longer see their substantial relative outperformance from 2001 and 2002 reflected in their 10-year returns.

Imagine a scenario where a Canadian Equity manager made the one prescient call that mattered at the turn of the millennium: to avoid Nortel and never touch it again with a ten foot pole. Imagine also that the manager proceeded to do nothing at all special for the rest of the decade.

Guess what? That Nortel call was so colossal that that manager would have had awe-inspiring long-term returns for years to come. For instance, that imaginary manager would be sitting on a pretty sweet 10-year number right now.

But what will happen two or three years from now, when the effects of the Nortel call are muted in the 10-year returns? I can tell you that we will see a very different picture: quartile rankings will plummet and star ratings will drop, fund flows will probably be negative, and the general sense of awe will eventually fade; even though nothing has really changed.

Of course, no one said that a 10-year return was a magic box. In the above example, the managers' 13-year return three years from now may well still look good. Also, I don't mean to suggest that this fictional manager doesn't deserve some kudos for managing the Nortel debacle so aptly.

But what if that's the only good thing he's ever done?

Depending on when you looked at it, the 10-year number may have had you duped.

Tracking error is not a risk for retail investors
Al Kellett | March 29, 2010

It's an answer that always makes me cringe: when an active investment manager responds to a question about why they bought or sold a certain stock, and their answer is that they wanted to reduce risk in the portfolio by looking more like the benchmark. The problem with that rationale is that in most cases it's not their investors' risk they're reducing, it's their own.

So-called 'relative risk,' or tracking error, is often managed and monitored closely by fund companies because it represents a real risk for most people who work in the asset management industry. The majority of investment managers are evaluated relative to a benchmark, and if their funds underperform that bogey for long enough or by a wide enough margin there is a high chance they will lose business or be fired by their employer.

On the other hand, for retail investors tracking error on their equity investments is not actually a risk, in and of itself. Sure, it is an important metric in judging the efficacy of your decisions, and determining whether you've hired a good manager or advisor. And there is a certain broad keeping-up-with-the-Jones type of risk in being different from the masses in any way. But a stock portfolio's deviation from an index does not, on its own, say anything about the odds of losing money.

There are cases when moving in line with a benchmark reduces risk, such as when a fund's high beta is brought down closer to 1. But if simply tracking an index more closely was inherently safer, then piling into Nortel in 1999, or Research In Motion and Potash in 2007, would have been conservative, risk-reducing moves, which is absurd. If a manager likes those names and believes they are the best place for the fund's capital, that's fine. But it is misleading for investment companies to claim they are shrinking risk by diminishing tracking error. It is their own career risk they are reducing; it doesn't reduce the investor's exposure.

UK regulators ban commissions to advisors
David O'Leary | March 29, 2010

News broke on Friday that the Financial Services Authority (FSA) has passed a law banning advisors from receiving commissions on products they sell to customers (to see article click here). This means that investors in the UK will negotiate a fee for advice directly with their advisor. Ostensibly, advisors won't have a monetary incentive to sell one product over another. To put it another way, it's as if the entire UK fund industry will go F-class.

I admit, I haven't had a lot of time to think through all of the implications of this, but there's something about it that is intuitively appealing. It doesn't really make all that much sense to me that the price we pay for advice and ongoing service gets lumped together with the cost of the product and that the price for that service is decided by the maker of the product, not the party giving the advice. That's kind of like buying a car and the manufacturer bundles in the cost of all future servicing and repairs over the life of the car into the purchase price. It may turn out to be a good deal for some people, but others will pay too much. And it obscures the price you're actually paying for maintenance and repairs. Why not just negotiate the price of the mechanic's service directly with the mechanic?

Admittedly there may be unanticipated consequences of a well-intentioned rule change. There's an adage called the law of unintended consequences that says, ''any intervention in a complex system may or may not have the intended result, but will inevitably create unanticipated and often undesirable outcomes.'' I can't help but think of the example cited in Steven Levitt's Freakonomics where a US daycare starts charging a fee to those parents who picked up their children late only to see the frequency of late pick ups increase after the rule was implemented. The author's explanation for this curious result was that a sense of sympathy for the daycare workers kept many parents from arriving late. After the fee implementation many parents were happy to pay the fee for the convenience of picking up their child later without having to experience any guilt.

I'm curious to see which unanticipated outcomes will result from the banning of commissions in the UK. The question is, all things considered, will investors be better off as a result of the change? I don't know the answer but whatever happens, one thing seems certain: investors will know exactly what they are paying for advice.

Low-Fee Picks for DIY Investors
Brian O'Neill | March 25, 2010

MERs for most mutual funds include a trailer fee component, which provides an income stream to investment dealers. Investment advisors receive a part of that trailer fee as compensation for selling the fund, along with part of the proceeds from any applicable sales charges. For more detail on how fund fees work and how we analyze them, click here for Analyzing fund fees, click here for Analyzing fund fees part 2, and click here for Analyzing fund fees part 3.

If you have the time, competence, and will to manage your investments without the help of an advisor, then you should normally avoid buying funds that offer such lofty payouts to distributors; that's money that should stay in your own pocket. And, needless to say, you should never, ever be willing to pay a load.

Frustratingly, when a do-it-yourself (DIY) investor wants to buy a Canadian mutual fund that is normally sold through advisors, he or she will, more often than not, be forced to pay that full trailer fee (typically 1%), even if the fund is purchased via a discount brokerage. Granted, the discounters deserve to get paid for their services, but we wholeheartedly object to the disturbingly common practice of them collecting the same trailer fees that full-service brokerages receive.

Thankfully, there are a few gems out there that are available on some discount brokerage platforms even though they charge lower trailer fees than the industry standard. Also, there are a few quality shops that sell low-fee funds directly to investors (normally with higher minimum investments). And, of course, there are always ETFs, which in many cases can be a great option.

So where can you find these gems? For the DIY investor, I've compiled a list of the lower-fee mutual funds and ETFs among our Fund Analyst Picks. For fun, I've put an asterisk next to the ones I own myself (in the case of Trimark Fund, I own a pooled version through my company's pension plan):

Isn't it ironic?
David O'Leary | March 24, 2010

Here's some food for thought. Mutual funds were created, in large part, to save investors from having to do loads of research to determine where to put their money. Even if you're planning on investing exclusively in Canadian stocks (ignoring bonds, real estate, and all other asset classes and geographic regions) to help keep things simple, you're still left with more than 3000 Canadian stocks to choose from. A good Canadian Equity mutual fund solves that problem by allowing investors to hand their money over to a professional to make those decisions. After all, few of us have the knowledge, time or energy to conduct the proper due diligence.

The irony is that today there are far more mutual funds than stocks. The Morningstar database contains roughly 3,500 Canadian stocks but over 7,000 Canadian mutual funds. Globally those numbers are roughly 30,000 and 130,000 respectively. In a sense, the proliferation of mutual funds has put investors right back at square one. There's an overwhelming amount of choice. I guess I shouldn't complain since it's the reason I have a job. I just can't help but note the irony.

Easy Money is the hardest to make
Al Kellett | March 24, 2010

At various points in the great rally that began in March 2009, people have argued that "the easy money has been made." The implication is that a 50% gain was so obviously going to happen, you just had to stand there and wait to be swept up in it. Now that that slam-dunk has come and gone, real decisions will have to be made, and the wheat will be separated from the chaff.

The problem is, buying equities in the spring of 2009, or staying invested through the gruelling winter that came before it, wasn't an easy route at all. It's only easy in hindsight. Things were very grim, and there was a real concern that some, or even many, companies wouldn't make it through the cycle.

Kudos may not apply to fund managers with mandates that compelled them to stay fully invested, but certainly for any individuals or institutions making asset allocation calls it was far from a no-brainer. Many in fact cashed out of equities at the bottom, as many always do. Those who didn't, and had a more enjoyable 2009 as a result, have earned their reward.

Another change we'd like to see in the fund industry
David O'Leary | March 23, 2010

Not too long ago I wrote an article listing six changes I'd like to see in the fund industry. As I think of other items for this list, I'll include them in the Fund Analyst Notebook.

One change I wish I had listed in the original article is that I'd like to see more candid commentary from fund companies. Very few firms are willing to publish an honest evaluation of their fund's performance. The best we usually get is the required discussion of a fund's performance in the Management Report on Fund Performance. In most cases this document lacks the level of detail we'd like to see. It usually includes a general market review and may discuss changes in the fund's portfolio over the period. Many firms will also include a very general discussion of the sectors that drove the fund's returns or losses.

What we'd like to see is a more detailed discussion of the decisions that were made and why. What was the manager thinking when he or she assumed deal risk by holding BCE past the announcement of its privatization? (See my colleague Al Kellett's article on The BCE decision.) Or, why did they own so much Lehman Brothers debt? What lessons did the manager learn? If they could do things over again, what would they have done differently?

While most commentaries fall short here, there are some exceptions. Firms like Steadyhand and Chou Associates Management Inc. are particularly candid in their commentary. This recent update from Steadyhand's Tom Bradley exemplifies the type of candour I'd like to see across the industry. Admittedly this is difficult for regulators to enforce, but we'd hope to see more fund companies choose to go above and beyond the required minimum to help better inform their investors. This is why we reward firms that communicate with investors frankly and frequently when evaluating their stewardship.

A pet peeve of mine
David O'Leary | March 23, 2010

I own 16 different mutual funds. I don't want to own 16 different mutual funds. I'd like to own maybe five or six funds. So why do I own so many funds you ask? I'm practically forced to. Let me explain.

Unfortunately the world is a bureaucratic place. In order to benefit from certain tax advantages or employment benefits, place particular types of trades, or enjoy cost savings, I must open specialized accounts for each. I try to keep all of my investments with one firm where I invest through an advisor who is a long time friend. But I cannot. With him I have a have a self-directed RRSP account, a locked-in RRSP account (from an old defined contribution pension plan with my former employer), a tax-free savings account (TSFA) and a margin trading account (though I don't do much stock trading and almost never trade on margin). But I also have a defined contribution pension plan through work where I have a group RRSP account and a deferred profit sharing plan account. I also hold a discount trading account with a bank (since stock trading is far more expensive through my advisor than through the discount brokerage).

The trouble is that each institution has a different product shelf. And that forces me to own more funds that I would otherwise like. For example, I own Mawer World Investment in my RSP account, but this fund isn't available through my work pension plan. My top choice from the list of funds that are available was Trimark Fund . However, neither Trimark Fund nor Mawer World Investment was available to me through my pension plan with my previous employer. So I own three different international/global equity mutual funds.

I believe that too many investors over-diversify their portfolios since they own too many funds. I believe that few investors need to own more than six or seven complementary mutual funds. But frustratingly, I own sixteen distinct mutual funds. Not because I want to, but because the bureaucracy of the world we live in forces me to.

The myth of value funds
Al Kellett | March 23, 2010

For many years it was commonly thought that value funds were inherently better at protecting capital when the markets turned sour. Certainly, many were able to do so in the tech meltdown a decade ago. But the collapse of 2008 seems to have put that myth to rest, as many value funds provided scant coverage from the storm.

There are a couple of possible explanations for this. Many deep-value investors run highly concentrated portfolios, so volatility -- on both the upside and the downside -- can be exaggerated because there's not as much of a dampening effect of diversification. As well, value managers tend to be contrarian in nature and play in names that are already unloved, so a crisis that ushers in a flight-to-quality sentiment may actually knock those stocks down even further.

This is not meant as a criticism of the value investing discipline, or an evaluation of its merit. Just that its powers of capital preservation may have been given too much credit based on many funds' performance 10 years ago.

One-stop solution? Maybe, maybe not
Philip Lee | March 23, 2010

Recently, we've received numerous inquires from our readers regarding funds of funds. These products aren't new; in fact, some have been around since the mid 1980s.

Funds of funds, which are often seen as one-stop solutions, are investment funds that own multiple funds from different asset classes. Fund companies try to cater to investors with differing risk appetites ranging from a conservative option that is fixed income heavy all the way to an all-equity portfolio for the risk-tolerant investors, with at least two options in between.

There are benefits to owning one of these funds. For starters, it takes the rebalancing exercise out of your or your advisor's hands because the fund company does all that work. As well, if you like several funds from a particular fund company, this may give you access to them with one stroke of the brush.

For the most part, funds of funds can meet many of the needs of investors. However, be careful about relying on them as a be-all and end-all investment solution. I'd like to offer up a non-exhaustive list of things to think about to balance out the argument for owning them.

  • It's rare that one fund company is an expert at everything.

  • Don't invest in one of these funds and then forget about it. Although the list of funds that make up its portfolio is probably fairly stable, it can change. As well, the portfolio managers running the underlying funds may change periodically. Most industry observers, casual or professional, would agree that manager changes occur quite frequently.

  • You may not be as diversified as you think. If all of the constituent funds are managed by the same asset manager, you might be missing out on investment style diversification.

  • Watch out for funds of funds that have a long list of constituents. While diversification is important, having more funds increases the likelihood of overlapping holdings. Having too many unique holdings isn't necessarily ideal either. Doing so may have the effect of owning the market or index, which dilutes the respective managers' best ideas.

  • Be mindful of fees. While the management-expense ratio on a fund of funds is generally in line with the asset-weighted average MER of its constituents, those underlying constituents may not be attractively priced compared to their respective peers.

  • Your risk tolerance will change as life events play out. So, the fund you picked on day one likely won't suit your investment needs several years down the road. An alternative to look at might be target-date funds, which periodically and automatically adjust the asset allocation with the passage of time.

Can money market funds withstand the HST?
Al Kellett | March 23, 2010

It's not clear at this point exactly what impact Ontario's Harmonized Sales Tax (HST) will have on the mutual fund industry, and we'll be talking a lot more about it as the story develops. Right now it looks like MERs are about to have an 8% tax added on to them starting July 1, and one of my initial questions is: what does this mean for money market funds?

The median one-year return for all money market funds in our database, as of Feb. 28, was 0.16%. That's sixteen basis points as your entire return for the year. And the median expense ratio for the same group of funds is 0.79%. An 8% increase in fees would push the median fund's cost up by six basis points a year, which, as you can see, eats significantly into what is already a miniscule net return to investors.

It seems unlikely that many money market funds would actually be seen to have a negative return -- it's essentially a cash alternative, and why would you hold your cash in an account that loses money? -- so who will bear the extra tax cost? Will fund companies be forced to absorb the extra costs to keep returns in the black; will investors accept an even lower rate or return; or will the entire product structure be threatened, at least until rates go up?

Recent Fund Analyst Notebook Entries

Brandes funds placed under review
Adam Fisch | 07/11/12

Brandes Investment Partners announced recently that long-time CEO Glenn Carlson was stepping down from his post, effective Feb. 1, 2013. Current managing director of investments Brent Woods is slated to take over the position, having been with the firm for 17 years and a partner since 1998. In addition to this change, the firm announced a change to the structure of the Large Cap Investment Committee, creating two committees to each manage half of the firm's large cap products.

This change in structure represents a fundamental change to the firm's investment process, and as such, we have placed the three Brandes large cap funds that we cover -- Brandes Sionna Canadian Equity , Brandes Global Equity and Brandes International Equity -- under review until we have had a chance to meet with the firm and gain some familiarity with the new structure and those team members assigned to each.

Changes at Jarislowsky Fraser
Adam Fisch | 06/11/12

On Nov. 5, Jarislowsky Fraser Ltd. announced the resignations of Len Racioppo and Marc Trottier from the firm, effective Nov. 30. Racioppo acts as chair of the Investment Strategy Committee, and is the longest tenured member of the team. The committee will now be co-chaired by Margot Ritchie and Chris Kresic, himself a transplant from Mackenzie Investments and co-head of fixed income at the firm. In addition, firm co-founder Stephen Jarislowsky will begin transitioning into retirement and out of his responsibilities as CEO of the firm.

Both Ritchie and Kresic will join JF's Executive Committee, a new committee established in place of the CEO role that will also include Pierre Lapointe and CFO Erin O'Brien. The additional workload on Kresic's plate is likely to be minor since he has been a member of the Investment Strategy Committee since he joined the firm, and his new executive responsibilities are shared with the other members of the committee.

We have placed the firm's three retail offerings -- JF Select Canadian equity , JF Select Income , and JF Select Balanced -- under review until we have had an opportunity to speak to relevant members of the team to get a sense of how these changes will affect fund management.

Lead manager of largest health-care fund to retire
Nick Dedes | 05/09/12

Vanguard announced today that Ed Owens of Wellington Management will retire at the end of the year. Owens is the long-time lead manager of the largest health-care funds offered in both Canada ( Renaissance Global Health Care with $306.6 million in assets) and the U.S. (Vanguard Health Care with US$22.4 billion in assets).

Owens has run Renaissance Global Health Care since its 1996 inception with remarkable success, especially considering the fund's hefty fee hurdle (its current MER is 3.28%). From December 1996 to August 2012, the fund posted an annualized return of 10.8% versus 5% for its benchmark MSCI World Health Care (CAD).

Owens charted a different course than his competitors. In marked contrast to most health-care investors -- generally a fast-trading, growth-leaning bunch -- he employed a slow-moving, value-oriented approach. He was among the first managers to appreciate the health-care sector's global nature. Even today, the fund's non-U.S. stake remains above the norm in the Health Care Equity fund category. Ballooning assets in the late 1990s and early 2000s made it increasingly difficult for Owens to invest in smaller names, but he continued to deliver strong results with moderate volatility.

Owens's successor, Jean Hynes, no doubt has big shoes to fill. But she appears well-equipped for the task. Hynes has co-managed the fund with Owens since 2008 but has worked with him for far longer. She has been on sub-advisor Wellington Management's health-care team since 1992. Investors should expect Hynes's approach to mirror that of her predecessor, and she'll be able to draw upon the insights of an experienced team.

--With files from Christopher Davis

Canadian fund managers fail to impress
Adam Fisch | 15/08/12

My fellow fund analysts and I are currently conducting our annual stewardship review, where one of the elements of our grading system is the fees charged by funds. Fees can weigh heavily on fund performance, as we were reminded earlier this year when Standard & Poor's released its annual S&P Indices Versus Active (SPIVA) scorecard for the Canadian market for 2011. The results were not encouraging for proponents of active management.

Over a five-year period, the proportion of domestic actively managed funds that outperformed the S&P/TSX Composite Index comes in at just under 3% on an asset-weighted basis. Fees for active management no doubt weigh on results compared to the benchmark (which includes no fees or transaction costs) and are an understandable element of the investment universe.

However, comparisons to funds sold in the United States are more concerning. Domestic equity funds in Canada underperform the S&P/TSX Composite by 2.7% on a five-year annualized, equal-weighted basis, while large-cap domestic equity funds in the U.S. underperformed the S&P 500 by only 0.1%. While some might argue that the Canadian market is more challenging, with a smaller opportunity set, U.S. Equity managers in Canada underperformed the S&P 500 (in Canadian dollars) on a five-year basis by 2.2%. International and global equity funds in the U.S. show five-year annualized returns of -1.3% and -4%, respectively, underperforming their benchmarks by 0.3% and 1.2%. By contrast, international and global equity funds in Canada show five-year annualized returns of -8.3% and -5%, respectively, underperforming their Canadian-currency benchmarks by 3.7% and 2.3%.

There could be many reasons for this underperformance, though manager ability should not be among them. Anecdotal evidence does suggest that fees in the U.S. are lower than those in Canada. Domestic equity funds in our southern neighbor have MERs that regularly fall below 1.5%, while in Canada, fees over 2% are the norm. This fee difference, while seemingly minor, feels the effect of compounding over a period of years.

Though these numbers are disheartening, investors continue to show interest in active management. Our fund analyst team strives to separate the wheat from the chaff, and to provide positive ratings of those funds that we think will beat their peer group on a risk-adjusted basis over time.

Standard Chartered in hot water
Adam Fisch | 07/08/12

On August 7, 2012, shares of the British bank Standard Chartered PLC dropped nearly 20% on news that the New York State Department of Financial Services (DFS) issued an order accusing the bank of hiding a quarter trillion dollars in transactions tied to Iran. Allegedly, the UK institution, previously considered a safe and reputable alternative to its more aggressive peers, defied US sanctions and hid as many as 60,000 transactions over a decade that generated hundreds of millions in fees for the bank. The bank has denied any wrongdoing, and is slated to appear before the DFS on August 15.

As of our most recent data, the Canadian retail funds with largest exposure to Standard Chartered by portfolio weight are:



As of
Altamira Asia Pacific 5.0 7/31/2012
Altamira European Equity 4.6 7/31/2012
IA Clarington Global Opportunities 4.0 3/31/2012
Desjardins Global All Cap Equity 3.0 7/31/2012
Desjardins Overseas Equity Value 2.7 7/31/2012
Desjardins Overseas Equity Growth 2.7 7/31/2012
Excel Blue Chip Emerging Markets 2.6 3/31/2012
TD International Growth 2.5 7/31/2012
Desjardins Emerging Markets 2.4 7/31/2012
MD International Growth 2.4 5/31/2012

Apple’s second miss in a decade
Joanne Xiao | 07-26-12

The Tempest and the Teapot
Serkan Altay | 07-26-12

Nexen acquisition benefits these funds' investors
Adam Fisch | 07-23-12

Digging for the right data
Adam Fisch | 07-19-12

Reinstating Silver rating for Fiera Sceptre Equity Growth
Nick Dedes | 07-12-12

Portfolio manager David Arpin no longer with Mackenzie Ivy Team
Nick Dedes | 07-10-12

Dana Love joins Sentry
Salman Ahmed, CFA | 07-05-12

Experienced bond manager leaving Signature
Adam Fisch | 05-11-12

Watching Zynga's Bubble OMGPOP!
Adam Fisch | 05-03-12

Lead manager change prompts "Under Review" rating for Trimark Income Growth
Nick Dedes | 04-26-12

For more Fund Analyst Notebook entries…

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