Hey there, time traveller! This article was published 13/9/2013 (1471 days ago), so information in it may no longer be current.
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."
A look at the ups and downs of funds by sector: Each mutual fund category has its own performance story, though some share more in common with one another than others. Below is a little more insight about why some sector-specific mutual funds have been on the upswing over the last few years while others have struggled.
Looking healthy: Fund analyst Christopher Davis says the health care sector comprises mainly large pharmaceutical firms from the U.S. and Europe that faced a couple of major headwinds just a few years ago. "Up to around 2012, investors stayed away because there was a lot of negative news that they weren't coming out with new blockbuster drugs, and they were losing a lot of the patents on their most profitable drugs." But big pharma has experienced better growth over the last couple of years. "Life-sciences companies tend to be less economically sensitive because people need drugs regardless of the economy." Furthermore, biotech has become a buzzword. Many investors are drawn to the sector as news about promising technologies and therapies come to light. "These upstart biotech firms generally tend to be headed up by science experts and are not necessarily sales and distribution experts," Davis says. "So the big firms buy these small biotechs and then push the new drugs through their sales network."
Small-cap funds, a tale of two nations: U.S, small-cap funds invest in companies that are large by Canadian standards, says small-cap fund manager Steve MacMillian. U.S. small caps on the S&P 500 are worth billions of dollars. "Your average small cap in Canada is about $500 million to $600 million," he says. "By Canadian standards, these (U.S. firms) could even be considered large-caps." Like much of the rest of the U.S. market, the small-cap sector has performed well in the last few years because the U.S. economy is improving. But some of the performance, at least for Canadian mutual funds investing in this sector, can be attributed to the rising U.S. dollar versus the Canadian dollar, Davis says. The small-cap sector in Canada has also performed well over the last three years, with many funds that invest in this sector posting double-digit returns. The top funds have even exceeded 20 per cent average annual returns over the last three years. But the Canadian sector overall hasn't performed as well as the U.S. sector, with a group-average three-year return of about seven per cent versus the U.S. average of more than 17 per cent.
Emerging opportunities: Emerging-market equity funds have suffered because the economies of China, India and others have not grown at the same pace as in the last decade, Davis says. "They are still growing quickly by developed-world standards, but not as quickly as they have been in the past." Even many of the best funds in this category, such as Mackenzie Emerging Markets and Brandes Emerging Markets Equity, have struggled posting three-year average annual returns that have barely kept ahead of inflation. Overall, the group average for this category over the last three years is about -0.7 per cent per year. Still, Davis says long-term investors shouldn't ignore this sector's potential. "I wouldn't really have a hard time recommending emerging markets as part of a long-term plan as long as investors know that it's going to be volatile." But they also need to be careful when choosing a fund, because many share much in common with Canadian equity funds. "What I mean by that is if you look at the emerging-market indices, you'll see that the biggest sectors are materials, financials and energy, so they might not be getting as much diversification as they think."
Digging resources: After the crash in 2008-09, commodity-focused funds fared well because commodity prices rebounded, but that shine has worn off over the last few years as demand for commodities has waned because the economies of the emerging markets and Europe have struggled. Although investors may want to invest in these funds today because they may appear attractively priced, Davis says investing in commodities can be tricky and may have very long down cycles. "Gold, for instance, was down for 20 years before its revival over the past 10 years or so." Still, picking long-term top performers compared to their peers -- such as the RBC Global Precious Metals fund -- as a complementary portion of a portfolio can add value, he adds.
Go global: While investing in a Canadian equity fund can offer exposure to upswings for energy, precious metals and even emerging markets, well-diversified global funds can provide an even greater opportunity to take advantage of growth in many sectors, Davis says. Many fund managers in this sector have the latitude to increase their holdings in companies operating in emerging markets, energy and precious metals when these sectors show an upside, he says. Furthermore, a top-performing global fund usually makes a good foundation for your portfolio "because it gives you diversification in one fell swoop." Mawer Global Equity and Franklin Mutual Global Discovery are two broadly diversified funds in the global category that are also top performers, averaging about 16 per cent and 12 per cent, respectively, over the last three years.