Fund Investing

Our favourite non-core funds
By Salman Ahmed, CFA | 08/04/14

Some investors may want to add a little oomph -- to use a very technical investing term -- to their portfolios. In order to do so, they can broaden their investment universe to include non-core funds to supplement their core holdings.

About the Author
Salman Ahmed is a former associate director of active manager research for Morningstar Canada. In this role, he sat on the Morningstar Analyst Ratings Committee for Canadian funds and helped oversee the team's research process. Ahmed’s coverage responsibilities included the Templeton, Mutual Series, PH&N, and Mawer fund families. He was the chair of the 2012 Canadian Investment Awards and represents Morningstar on the Canadian Investment Funds Standards Committee. Prior to joining Morningstar in 2011, Ahmed worked in investment consulting, where he was involved in manager searches, asset-allocation studies, and portfolio construction for several of Canada’s largest institutional investors. Ahmed holds a bachelor of commerce (honours) degree from Concordia’s John Molson School of Business and holds the CFA® and CAIA® designation.

Non-core funds can produce attractive returns over the long term, but their performance may experience wild swings over shorter periods. That's because they invest is some pretty risky securities such as stocks and bonds in developing economies, distressed assets and derivatives. Many of these are also highly illiquid, which can add an extra layer of risk. Investors may find these risks unsuitable for their portfolios, especially if they need to use the proceeds from their investments soon after investing. So it's not good enough to have the willingness to invest in riskier investments, you also need the ability to do so.

Once you've determined if non-core investing is right for you, make sure you make your investing decisions in the context of your entire portfolio. Though they have high volatility on their own, including non-core funds in a diversified portfolio may not significantly impact the overall portfolio volatility -- in some cases it may even reduce it. That's because non-core funds can have low or negative correlations with other funds, which helps mute a portfolio's standard deviation.

Investors also want to keep an eye on how including non-core funds changes the structure of their portfolio. For example, if you want to buy a Canadian small-cap equity fund, you need to make sure it doesn't overexpose you to Canadian stocks. You'll also want to check out the holdings of your core fund because many invest a small portion of their portfolio in non-core holdings. For example, Beutel Goodman Canadian Equity   , one of our favourite core Canadian equity options, invests up to 10% in Beutel Goodman Canadian Small Cap.

Below, we've presented some of our top-rated non-core mutual funds. These are fund that our analysts have rated Gold, Silver or Bronze. The Morningstar Analyst Rating is a qualitative assessment of a fund's ability to outperform either its peers or benchmark over a market cycle. While a medalist rating indicates that our analysts think highly of a fund, the difference between them corresponds to differences in the level of analyst conviction in a fund's ability to outperform.

Most of these can complement our best core mutual fund ideas or diversified ETFs. This doesn't include all of our positively rated non-core funds because we've elected to present those that are open to new investors.

Domestic Equity:

 Beutel Goodman Small Cap  : The proven management team follows a disciplined and repeatable value investment philosophy. The team's discipline limits behavioural biases from creeping into the process.

 NEI Ethical Special Equity  : This fund's sub-advisor, QV Investors, displays many characteristics of good stewardship: A strong investment team with minimal personnel turnover, policies that align employees' interests with those of unitholders and a well-defined investment process applied consistently across the firm's mandates help it distinguish itself from the pack.

Foreign equities

 Chou Associates  : Not for the faint of heart, this fund can experience wild swings in performance. But experienced value manager Francis Chou has applied his philosophy in a very disciplined manner across various asset classes and geographies, achieving an excellent track record. However, this fund is a one-man show, creating risks investors should be mindful of.

 Mawer Global Small Cap  : Mawer's team uses a fairly simple recipe for its equity funds: find wealth-creating businesses with competent management and long-term competitive advantages, buy the shares at reasonable valuations, and hold for the long term. The strength of the process lies in the multiple layers of vetting that a stock must go through.

 Brandes Emerging Market Equity  : Brandes Investment Partners' emerging markets committee applies the same deep-value philosophy used across all Brandes equity funds. The strategy focuses on buying stocks at large discounts to estimated intrinsic value to provide a margin of safety, which has helped provide downside protection compared to other emerging market funds.

Fixed Income

 PIMCO Monthly Income  : This isn't your traditional monthly income fund. The managers only set a monthly distribution target based on what the portfolio has already earned. It doesn't stop there. The fund gives Canadian investors exposure to U.S. structured credit such as asset-backed and mortgage-backed securities, which are a mainstay in the portfolio and one of PIMCO's specialties. It also has large allocations to high-yield and emerging-market debt. Its cheap price adds to its attractiveness.

 Manulife Strategic Income  : Manulife's deep team of fixed income veterans takes advantage of this fund's flexible global mandate. They invest in an array of asset classes, including high-yield and investment-grade bonds, asset-backed securities, as well as developed and emerging-market government bonds. Because of its flexibility, the fund doesn't fit neatly into a specific asset category and so its 2-star rating doesn't really do it justice (star ratings are calculated based on a fund's historical risk-adjusted returns relative to their category peers).

 Templeton Global Bond  : Lead Manager Michael Hasenstab's contrarian approach can backfire at times, but his resolve has paid off overall. His current preference for developing-market debt can cause the fund to move in sync with riskier assets, so investors shouldn't be looking to this offering for portfolio protection. He's also had a chunk of the portfolio invested in Ukrainian bonds, which haven't been faring too well with the political turmoil over there. But Hasenstab has a proven knack for building sound investment themes and finding the right bargains among sovereign bonds and currencies.

 RBC Global Bond  : This fund's managers try not to rely heavily on any single aspect of fixed income portfolio management, but over the last three years currency management has added the most value. The managers have also successfully managed to keep the fund's volatility under control relative to other global fixed income funds.

-- The author has a position in Mawer Global Small Cap.

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