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Hot funds, cold feet

Chasing top performers can be risky business

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What goes up must come down, and in the markets, what generally has been down should eventually rise again.

That being the case, it should come as little surprise to mutual fund investors that once-radioactive funds have become top performers.

Five years ago, health sciences sector funds were considered long-term losers.

Even one of the sector's leading funds, TD Health Sciences, lost money between 2001 and March 2009.

Today, health care equity funds have led most other categories, averaging double-digit returns over three years. The TD Health Sciences fund, for example, has one of the best track records of all mutual funds over that span, averaging more than 28 per cent a year.

But before you rush to buy into the life-sciences boom, be careful about chasing yesterday's news, says a fund expert.

"It's instructive to look at what some of the lowest-performing categories are doing, because if you would have gone back one or two years to see what was doing best, they're often what are doing worst now," says Christopher Davis, director of fund analysis for Morningstar Canada.

Precious metals, emerging markets, Canadian equity and energy funds were all the sought-after fund sectors only a couple of years ago, but today, they've largely fallen out of fashion. "All of these formerly hot categories are looking more humble," Davis says.

The Canadian precious-metals sector has lost 35 per cent year over year for the last two years, and the energy sector has suffered a similar fate.

In the last six months, Canadian investors have acted accordingly with their capital, says Alykhan Surani, manager of research and statistics at the Investment Funds Institute of Canada (IFIC).

Precious-metals funds have had a net outflow of cash of more than $220 million up to July this year, the most recent statistics available, while natural-resources funds have had outflows of more than $1 billion.

By comparison, sectors such as health sciences have performed well. IFIC statistics show monthly inflows of dollars for this year of more than $111 million for health funds.

The once downtrodden U.S. small-cap equity sector, which had its value cut in half during the 2008-09 downturn, is another top performer over the last three years.

At the top of this sector is Fidelity Small Cap America Fund, which has averaged about a 30 per cent annualized return over the last three years -- near the top of all open-ended mutual funds in Canada.

The fund's manager, Steve MacMillian, says the entire U.S. stock market -- not just small caps -- has benefited from lower commodity prices, which decreases overhead costs.

"The U.S. is more of an importer of commodities, whereas Canada is more of an exporter," he says.

The American market has also benefited from a recovering housing market and more generally, an economic recovery supported by the Federal Reserve pushing cash into the market.

Still, investors shouldn't simply chase after the funds posting the highest recent market returns, MacMillian says.

"You have to make a distinction between alpha and beta," he says. "Chasing beta is a bad idea, because that means whoever takes the most risk in a bull market makes the most money."

When the market turns to the downside, however, the losses are often amplified. In contrast, alpha refers to an investment's return in excess of the performance of its benchmark.

Generally speaking, funds with a high alpha ratio may not produce the highest return in any given year, but over longer periods they provide superior value because they're less prone to dramatic market swings.

Yet many investors often mistakenly assume the small-cap sector is inherently 'beta'-esque.

"If you say the words 'small-cap America,' I think it generally scares the heck out of people because they think of biotech companies that make no money or semi-conductor stocks that go up and down and don't add any value."

But U.S. small-cap investing generally involves the opposite. MacMillian says the sector in U.S. encompasses well-established companies with steady revenues.

The average market capitalization of companies held in the Fidelity fund, for example, is about $4 billion and includes companies like Hanesbrands, which owns apparel makers Hanes and Champion.

"I'm trying to invest in stable, recurring businesses that dominate the niche that they operate in, and they generate cash flow and have high returns on equity. These are companies I can own for many years," MacMillian says.

Hot or not, funds attracting the interest of astute investors have track records of outperforming their peers and benchmarks in good times and bad -- like the Fidelity funds, Davis says.

While investors can find value buying a well-managed fund that invests in a recently struggling sector such as precious metals and emerging markets, they can often capture these sectors' potential upside through a Canadian equity fund -- likely one of the core investments in their portfolio -- without taking on as much risk.

"You have to think about why you would need a precious-metals fund to begin with if you own a diversified Canadian equity fund, because you already have a lot of precious-metals exposure," Davis says.

"Even if you do nothing, you would probably benefit from a revival in precious metals even if you own the Canadian fund."

Republished from the Winnipeg Free Press print edition September 14, 2013 B12

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