Fund Analyst Notebook

By Morningstar Canada | 08/04/10

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.

Hedge funds' drug problem
Al Kellett | April 8, 2010

Depending on the particular strategy they're pursuing, many hedge fund managers are paid rather large sums of money on the assumption that they are the very best stock pickers out there. It's an ultra-competitive landscape, with mountains of capital up for grabs to those who put up the numbers that back up their claims.

But with allegations of nefarious trading practices now being hurled at individuals associated with some of the biggest firms in the world, names like Moore Capital and Galleon Group, it raises the question: is insider trading the performance enhancing drug that's been propelling the impressive results of these global giants? Like with the ascent of steroids in professional sports, there is beginning to be a sense that this is simply what it takes to compete at the top level, and if you're not doing it you will not be able to keep up.

In hedge funds, just like in baseball, the rewards for outperformance are huge, and policing the problem has traditionally been ineffective, so it's been easy to get away with cheating. Only when enough political will is mustered do the authorities try to expose the culpable. When they do, the culpable are often -- and perhaps unsurprisingly -- the game's biggest heroes.

With steroid use in sports, it may not be immediately clear who the victims are. Fans like to see home runs, so there are many that would prefer there weren't a crackdown on steroids, or would suggest the only way to level the playing field is to legalize them. But the drugs are destroying the players and encouraging a host of youngsters to get in the habit. In financial markets, although the client getting double-digit returns may not be the first to complain about the problem of insider trading, it damages the credibility of the system to the long-term detriment of everyone.

Right now all we have are questions, not answers. It's entirely unclear to what extent, if at all, high-profile fund managers have bent the rules to advantage themselves. But what does seem likely is that the behemoth hedge funds have long been afforded exalted status by Wall Street as a result of the commissions generated by their large notional exposures and frequent trading. Perhaps we will soon come closer to learning what privileges have come from membership in that club.

New hires strengthen CIBC's Canadian equity team
Nick Dedes | April 8, 2010

CIBC Global Asset Management (CGAM) recently announced two new additions to its Canadian equity group: Marilyn Brophy will be joining CGAM in the new role of head of Canadian equity research, and Colum McKinley will be joining as vice president, Canadian equities.

These experienced hires will bolster a team that has lost a considerable amount of bench strength over the past year and a half. Stephen Gerring, who was responsible for well over $8 billion in assets across several mandates including CIBC Monthly Income , left the firm in December 2008. More recently, veteran manager Gaelen Morphet departed to assume the chief investment officer role at Empire Life Insurance. Managers Lieh Wang and Nessim Mansoor also left the firm to join Morphet at the insurer. As a result, managers David Graham and Domenic Monteferrante have been stretched a bit thin, picking up the additional duties from their departing colleagues.

While there are no details yet regarding the specific mandates that McKinley will be overseeing, it's worth noting that he is particularly well-suited to pick up some of the offerings previously managed by Morphet. McKinley spent the last four and a half years at Sionna Investment Managers, adhering to the same relative value approach employed by both Morphet and Sionna's founder Kim Shannon (the two had worked together at Merrill Lynch Investment Managers Canada Inc.)

Performance fees: Heads I win, tails we flip again
Brian O'Neill | April 6, 2010

Performance fees are normally associated with the hedge fund world, yet they exist to a smaller degree in the Canadian retail space. A common structure is the "2 and 20," where the fund charges a 2% base management fee plus 20% of the outperformance relative to a benchmark, provided certain requirements are met. Normally, these requirements include surpassing a high-water mark after periods of underperformance.

Some managers will tell you this structure aligns their interests with those of unitholders. I disagree, and not merely because performance fees typically make MERs higher. My qualm is that, in Canada, these incentives tend to be applied asymmetrically: if the fund outperforms, it charges a performance fee; if it underperforms, it doesn't really suffer because it still collects its base management fee until it eventually surpasses its hurdle (if ever). This is in contrast to the more desirable "fulcrum fee" structures in certain U.S. mutual funds, where fees increase and decrease proportionately with performance.

The prevalent asymmetrical structure can encourage short-term thinking and inappropriate risk-taking behaviour. For example, imagine you are running a fund and are slightly below your targets. You may be tempted to ratchet up the risk with the hope that you surpass your hurdle and trigger a fat bonus. Conversely, if you're ahead of the game, you may be tempted to decline attractive opportunities because you are unwilling to risk any bonus you already stand to earn. Not to mention that you have the incentive to take on a lot of risk much of the time because that gives you the best chance of striking it rich. After all, if it doesn't work out and the fund performs very poorly, you can always close it and start up another one with a clean slate.

On top of it all, some of these funds use inappropriate benchmarks (such as gold bugs and peak-oil buffs measuring themselves against the S&P/TSX Composite Index), potentially allowing them to collect performance fees even if their numbers aren't all that great relative to more suitable indices or peer groups.

I do like that the managers have the incentive to cap their funds while they are still nimble to maximize performance potential. I also like that these firms tend to attract talented investment professionals. But I'd say the cons outweigh the pros.

Dire state of affairs?
Philip Lee | April 5, 2010

Over that past couple of quarters, much noise has been made about European countries such as Greece, Portugal and Spain struggling to make ends meet, which may lead to possible defaults on their debt obligations. While it's difficult to figure out what the actual ramifications are, it's safe to say that it would set off a chain of undesirable events in the financial and currency markets.

Potential sovereign debt defaults are grabbing news headlines, but bloated debt levels at individual states in the U.S. aren't getting nearly the same attention. I recently came across this interesting article penned by Mary Williams Walsh of The New York Times that sheds some light on the situation that some American states are facing. According to the article, when pension obligations are included, California's debt level is about four times higher than its stated borrowings, or 37% of total gross domestic product (GDP).

To put California on the map, so to speak, the U.S. Department of Commerce estimated that California's GDP was slightly more than $1.8 trillion, which made it the world's eighth-largest economy in 2008, ranking ahead of Brazil, Russia and Canada.

After reading the article, several questions came to my mind:

  • While California's debt load may seem manageable, if the state runs out of options, how difficult and costly will a bailout or restructuring be? Remember, at the end of 2009, the U.S. national debt was more than 80% of its total GDP.

  • How badly would market confidence be shaken and what would that do to equity and credit markets?

  • Who are the lenders to state borrowers? Is it mutual funds, institutional investors, endowments? What kind of a financial hit could these investors sustain?

  • How bad are the debt and total obligations of states and provinces in other countries?

  • With the recent health care reform take shape, are there additional costs coming down the pipeline that would further strain the situation.

  • What might set off a potentially ugly chain of events?

I don't have the answers to these questions, but it gets me thinking about potential risks. So, despite stock and bond markets rallying significantly off the March 2009 lows as investors feel a bit better about the economic environment, perhaps we're not out of the woods just yet.

Chinese Warren Buffett? Hardly
Al Kellett | March 31, 2010

The trials (literally) and tribulations of Weizhen Tang -- self-anointed "Chinese Warren Buffett" -- have been making the news lately. The Canadian-based investor was arrested and ordered back from China by the RCMP to address allegations that he was running a Ponzi scheme that had defrauded clients out of $30 million.

I'm in no position to judge whether Mr. Tang is guilty or not, but a quick perusal of his firm's website is revealing, to say the least.

Among other claims, Tang was promising his investors returns of 1% per week. Yes, you read that correctly. Just to be clear: 1% a week compounds to 68% per year. There are certainly managers who have achieved such lofty results in a given year; many did so in 2009. But for Tang it was a targeted average, not an anomaly. And, spectacularly, he intended to achieve such performance while keeping 99% of the total investment pool outside the market, as a risk control, according to the same website. The mind reels at what he would have had to consistently earn on his 1% exposure in order to get a 68% return on the entire pool. If he really was that good, his moniker would flatter Mr. Buffett.

Whether Tang is guilty or not of running a Ponzi scheme, his claims are so outlandish as to give him zero credibility as an investment professional. Investors should always be skeptical of claims that seem too good to be true; or in this case, downright ridiculous.

What is the Canadian Investment Funds Standards Committee (CIFSC)?
David O'Leary | March 31, 2010

The CIFSC is a committee responsible for establishing the standards for categorizing mutual funds in Canada. In essence it determines the rules for including funds in various categories, and then assigns every fund to the appropriate category. The committee's membership consists largely of fund data providers and research firms, including Morningstar. For more information on the CIFSC, click here.

Each month it must handle the category reclassification requests it receives (usually requested by a fund company that either disagrees with the categorization of its fund or simply dislikes it) and categorizing new funds that are launched. Furthermore, on a quarterly basis it re-examines every fund's holdings to determine whether the fund needs to be reclassified. It isn't uncommon to come across funds that have had a change in mandate or fund manager which warrants a category change. With thousands of funds out there, the committee has its hands full.

Adding to its workload is the fact that the investment fund landscape changes quickly. I've been a member of the committee since 2005. And in that relatively short time I've seen important developments such as the elimination of the foreign content rule for RRSP investments, the explosion of target-date funds and wraps, the emergence of China funds, and the gradual blurring of the lines between mutual funds and hedge funds. As the industry changes, so too must the rules that govern their categorization.

Given these developments and the committee's limited resources, the to-do list has been growing over time, not shrinking. The following are some of the bigger issues I believe the CIFSC should focus on resolving:

  • Create new categories to deal with the increasing divergence in target-date fund objectives;

  • Review the definition of what constitutes an Alternative Strategies (aka Hedge) fund, given that an increasing number of traditional mutual funds can engage in short-selling;

  • Create a set of categories to help organize the messy world of fund share classes (for a discussion of this issue, see the last point in my article entitled Six changes we would like to see in the Canadian mutual fund industry.

  • Figure out how to deal with the emergence of synthetic bond funds (funds that own equities but use derivatives to create a tax-efficient, bond-like, return)

  • Figure out how to deal with the growing heterogeneity of the types of businesses listing on the Nasdaq exchange, which has resulted in a much more diversified Nasdaq 100 Index. As a result, funds that track this index no longer have enough exposure to traditional technology sectors to qualify for the Science & Technology category.

Last month I was elected chair of the CIFSC for a one-year term. Over the next year, I'd like to see the committee put a significant dent in the list of outstanding issues. It has already begun to discuss how to treat synthetic bond funds, and my most ambitious wish is that the committee tackles the business of creating categories based on fund share classes. I have no doubt that new issues will arise throughout the year that will add to this list, but if I can end my term as chair with fewer issues on the to-do list than when I started, I'll consider it a modest success.

Previous articles

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

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

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

Low-fee picks for DIY investors
Brian O'Neill | March 25, 2010

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

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

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

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

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

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

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

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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