Mutual fund dogs
Funds that deserve to be ignored
I've devoted a lot of space to 'buy this fund' and 'overweight this sector' but I've yet to address the funds that should repel you at first glance. Many pay attention to the ratings of firms like Globefund, Fundata, and Morningstar; and book authors like Gordon Pape. However, nobody ever talks about the skeletons in the mutual fund industry's closet. For various reasons, there are some investment funds that don't deserve a place in your portfolio. This week, we take a look at a few dubious standouts.
If you've read my columns for any length of time, you know that the more conservative the fund, the more important that fees are in relation to future performance. Bond and balanced funds bare that rule out beautifully over time. There are always exceptions in the short term, but if you look at longer-term trends, fees are a very significant factor.
Trans-Canada Bond grabs top honours for bond funds to ignore. Its stated management expense ratio (MER) of 5.19 per cent per year stopped me in my tracks, but that's as far as I needed to go to know this fund should be avoided. Interestingly, Sagit Investment Management, the lead manager of the fund, actually lists its expense ratio as one of the risk factors of the fund. Of all bond funds that have existed throughout the ten years ending January 31, 2002 this fund's performance ranks dead last, sporting an annualized return of 3.3 per cent over that period. This is not a coincidence.
A large category of bond funds that investors should think twice about investing in is segregated bond funds. Recall that segregated funds are investment funds offered by life insurers and offer some guarantees and the potential for creditor protection. These extra features, however, come at a price. Using Morningstar Canada's database of fund information, the median MER for seg bond funds is 2.15 per cent per year.
With yields at historic lows and rates likely to stay flat at best, bond fund MERs are critical in the selection process.
Investors Asset Allocation is the largest fund to make this dubious list. Six straight years of sub-par performance and high fees go hand in hand for this fund. Its 3.23 per cent MER is extremely high for a fund that holds nearly half of its assets in bonds and cash. To add insult to injury, the fund's assets are more than four times what they were six years ago, but the MER hasn't budged.
Royal Select Growth Portfolio is a fine example of why I don't usually take to fund-of-fund products. One of many reasons is that it's tough to know what the asset mix really is. Royal's website implies a 68 per cent equity weighting, while the actual equity exposure is 54 per cent. Their site also says the fund holds just 3% in cash. Technically, that's true but it doesn't count the cash holdings of each individual fund. In fact, this portfolio of funds holds almost 20 per cent in cash. While I'll give Royal credit for dropping this fund's MER from 2.36 to 2.02 per cent over the past five years, the performance continues to suffer. Why?
Well, for starters, there isn't very good style diversification in this fund. Royal's best core Canadian equity fund, Royal Canadian Value, is simply left out of this portfolio but it would have provided better diversification and better performance (in my opinion) at a lower cost than the one they chose. Also, the Royal RSP International Index fund and European Growth funds both have lots of exposure to large cap European stocks. Not a great match.
Filters for equity funds
For bond and balanced funds, I basically went by cost but for equity funds my filter for finding the worst funds was much different. Based on all funds that exist today, I looked back in time to find the funds with consistently the worst relative performance. Specifically, I looked at how each fund did compared to its peers, ranked by quartiles, in each calendar year. (1st quartile means a fund performed in the top 25 per cent of its group. 4th quartile funds performed in the bottom 25 per cent of its group.) Funds that were third or fourth quartile for each of the last six calendar years, were awarded membership to the hall of shame. Relying on Morningstar Canada's database and my first-hand knowledge of mutual fund history, I've also done my best to ensure no meaningful manager changes occurred during the period studied.
Canadian equity funds
Another fund managed by Sagit Investment Management makes this dubious list, Cambridge Growth. Its nearly 5.5 per cent MER notwithstanding, this fund's record is just plain ugly. For eight consecutive calendar years, this fund has been beaten by at least half of its peers (i.e. third or fourth quartile performance each of those years). The fund's annualized returns over the past fifteen years and since its 1966 birth are minus 8.5 per cent and positive 0.7 per cent per year, respectively.
A fund with a substantial amount of assets that made the list is the Clarica Canadian Small/Mid Cap fund. Well-respected Perigee Investment Counsel runs the fund and its fees are below average, so I actually don't know what's behind this fund's lack of performance. Even so, its poor record is something to be aware of.
Foreign stock funds
AGF RSP Equity Allocation is another sizeable fund that makes this list. Lead manager Steve Way uses a computer model developed by Salomon Smith Barney to pick the best mix of countries based on valuation, risk, and momentum metrics run on various countries. However, rather than picking stocks in each country, the fund uses index futures to simply get index exposure - opting not to even try adding value by picking good stocks. It sounds good, but the problem is that is hasn't worked for many, many years. There will be times when this approach works well, but I'm not sure that it is worth waiting for when so many other quality alternatives are available for global equity exposure.
While it's difficult to pick tomorrow's winning funds, it is much easier to toss out the dogs. To be honest, with more than 4,000 investment funds available for sale, I can confidently say that fully 90 per cent can be tossed out - still leaving hundreds of funds from which to choose. That's a good start to narrowing the overwhelming universe of investment funds.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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