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Mutual fund ELEPHANT under fire

Many haven't performed well since the last century, but first-rate funds deserve a look

By: Gordon Pape

Posted: 02/8/2012 1:00 AM | Comments: 0 (including replies)

POSTMEDIA (DARREN CALABRESE/NATI Enlarge Image

Darren Calabrese / Postmedia News Author Gordon Pape shows his latest book. Many mutual funds have performed relatively poorly since the opening of the 21st century. Two stock market crashes will do that.

On the face of it, the mutual fund industry hardly looks like one that needs defending.

According to the latest figures from the Investment Funds Institute of Canada (IFIC), member companies had assets under management of $772.6 billion as of the end of November. Since many fund companies -- including some biggies such as CI Fund Management -- are not IFIC members, it's safe to say that collectively, Canadians have more than $1 trillion stashed away in these funds. And we continue to invest more -- the assets of IFIC members increased by about two per cent over the 12 months to Nov. 30. Considering the weakness of world stock markets during that time, it was a respectable performance.

But although mutual funds are still the elephant of the industry, the upstart exchange-traded funds (ETFs) are steadily eating away at market share. It will take many years to close the gap -- as of Nov. 30, Canadian ETFs had $41.8 billion in assets under management. But if present trends continue, it will happen, especially with major U.S. players such as Vanguard now in the field.

ETFs are popular because they are low-cost, low-maintenance and easy to understand (at least in theory). I suspect a lot of the disenchantment with mutual funds stems from the fact that many of them have performed relatively poorly since the opening of the 21st century. Two stock market crashes will do that.

Most ETFs have not been around long enough to establish a 10-year record.

There's no doubt the mutual fund industry has some serious systemic problems that it seems reluctant to address. These include a flawed compensation system that creates a built-in conflict of interest for financial advisers and a marketing philosophy that all but ignores the end user (the investor) and focuses on the middleman (the adviser). That's like Procter & Gamble blowing its entire marketing budget on grocery-chain buyers and snubbing consumers.

Plus, the industry offers a lot of products that are at best mediocre and at worst lousy. Investors, quite rightly, are increasingly reluctant to pay top dollar for inferior results. But there are very few businesses of any size that don't have some rotten apples in their barrel -- including the ETF industry. Some of the leveraged ETFs are nightmarish. Look at the HBP NYMEX Natural Gas Bull+ ETF (TSX: HNU). It has lost an average of 79 per cent annually for the past three years (to Nov. 30). That means $1,000 invested three years ago is worth less than $10 today!

An ETF doesn't have to be leveraged to be a potentially bad investment. Some of the mainstream iShares funds are in negative territory over the past 10 years, including the iShares S&P 500 Index Fund (hedged) (TSX: XSP). It lost 1.46 per cent on average every year over the decade to Nov. 30. Proponents of index investing stress the importance of patience, but this is ridiculous.

This is not meant to be an attack on ETFs. I think some of them are excellent, especially on the fixed-income side. But there are also some first-rate mutual funds out there. So don't throw out the baby with the bath water.

Instead, zero in on the mutual funds that meet these criteria: low cost, strong management and consistent above-average performance. There are plenty from which to choose, but you can narrow your search by focusing on a few companies. They include Beutel Goodman, Mawer Investment Management, Steadyhand Funds, Phillips, Hager & North, and Leith Wheeler Investment Counsel. Interestingly, all but Beutel Goodman are based in Western Canada. The only bad news is that all these companies have higher-than-normal initial investment requirements.

Here are a few examples of funds from these companies that are especially suitable for RRSPs.

-- Beutel Goodman Corp./Provincial Active Bond Fund: This little-known fixed-income fund has an unusual approach. The portfolio is a mix of short-term corporate and federal bonds and long-term investment-grade securities (rated BBB or better) issued by governments and corporations. Unorthodox as this may be (I don't know of any other fund quite like it), you can't argue with the results. It's been a first-quartile performer every year except one since 2004, with a 10-year average annual compound rate of return of 6.66 per cent (D units). As for safety, the worst 12-month period it ever experienced was the year to June 30, 2006, when it lost 0.19 per cent. Distributions are paid quarterly. The management expense ratio (MER) is 0.79 per cent.

-- Mawer Canadian Diversified Investment Fund: This global balanced fund can invest around the world, but right now the main emphasis is on Canada and the United States. Exposure to Europe, which appears poised on the brink of recession, is minimal. About 61 per cent of the assets are in stocks, with the rest in bonds and cash. With the exception of 2009, the fund has been a consistent first- or second-quartile performer and was showing a 10-year average annual compound rate of return of 5.57 per cent at the end of November, compared to only 1.89 per cent for the category as a whole. The MER is 0.96 per cent, which is very low for an actively managed balanced fund.

-- Steadyhand Income Fund: This is a balanced fund that is heavily skewed toward bonds (target allocation is 75 per cent, although the current weighting is 76.2 per cent). The rest of the fund is in dividend-paying stocks, real estate investment trusts (REITs) and income trusts (of which only a few remain). The portfolio is in the hands of Warren Stoddart, of Connor, Clark & Lunn, which has a solid reputation as a disciplined, conservative house. Returns have been excellent, exceeding the average for the Canadian Fixed Income Balanced category over all time periods. The average annual compound rate of return since inception in January 2007 is 6.21 per cent. The fund makes quarterly distributions of $0.10 a unit plus a year-end capital gains payment that was $0.19 a unit in 2011. In a few short years, this has evolved into one of the better funds of its type. The MER is one per cent.

-- Leith Wheeler Canadian Equity Fund: Most Canadian equity funds had a rough time in the past year as the TSX fell 11 per cent in 2011. This conservatively run fund kept losses to a minimum, dropping 2.55 per cent over the 12 months to Nov. 30, compared to an average loss of 5.85 per cent for the category. But most of the time, investors enjoy decent returns. The fund's 10-year average annual compound rate of return is a very respectable 8.25 per cent, and this was achieved despite a big hit of 41 per cent in the 2008-09 market crash. The portfolio consists mainly of blue-chip stocks, but this is not a closet index fund. Some positions are quite large (five per cent or more) and there are several mid-cap companies in the mix such as Astral Media and Finning International. The MER of 1.52 per cent is low for an actively managed equity fund.

-- Phillips, Hager & North Short Term Bond and Mortgage Fund: If I had to pick one team to look after my fixed-income investments, it would be the one from PH&N. And in fact, most of my personal bond holdings are with the company. This is one of the funds I especially like right now. The fund has been a first-quartile performer in every year but four since it was launched. The returns exceed the peer-group average for all time periods. Over the 12 months to Nov. 30, the fund gained 3.32 per cent compared to a category average of 2.71 per cent. One of the reasons for this is a very low management expense ratio of 0.61 per cent for the no-load D units, which can be purchased directly from the company. Quarterly distributions have recently been running at $0.07 per unit. If that continues through 2012, the yield will be 2.7 per cent based on a net asset value of $10.50.

As long as there are good choices like these available, mutual funds will continue to be a viable option for your portfolio. But the industry as a whole would be a lot stronger if it moved to emulate the business model of these companies. Should that ever happen, the ETF wave might be reduced to a ripple.

-- Postmedia News

Gordon Pape's new book is Retirement's Harsh New Realities, published by Penguin Canada (www.buildingwealth.ca).

Republished from the Winnipeg Free Press print edition February 8, 2012 E1

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