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Factor risks
Keep an eye on what impacts portfolio

I'm noticing a disturbing trend among mutual fund investors today. Many are flocking to funds they perceive as safe - i.e. bond, high income, and dividend funds. It's easy to understand the attraction. It's driven by a focus on cash flow now, rather than later, and good recent performance in an otherwise ugly investing environment. But there is a risk

Fund flows

During calendar 2002, investors showed their love for tortoise-like funds, such as balanced, bond, dividend funds, and high income funds. These fund groups attracted more than $6 billion in new investment during 2002 when all funds posted net sales of just over $3 billion - meaning the total of all other categories saw significant amounts flow out.

Net sales of funds for 2002 was down more than 91 percent compared to 2001, but balanced, bond, dividend, and high income funds saw sales rise by about 1/3rd. If we go back to calendar 2000, the total of these now popular categories actually saw investors pull out almost $500 million.

That clearly demonstrates two things: a) that investors make decisions based on recent performance, and b) some fund investors may be setting themselves up for more disappointment going forward.

Factor risks

In a portfolio context, factor risks are simply various factors that impact performance. For example, recall that a government bond fund will be driven primarily by interest rate changes. That seems pretty straightforward.

For a less straightforward example, consider Onex Corp - which trades on the Toronto Stock Exchange under the symbol OCX. It is classified under the "Electronic Components and Equipment" industry, but it has holdings in many different businesses.

While Onex owns interests in Celestica (an electronics manufacturer), it also has significant exposure to automotive, sugar refining, and entertainment. This is clearly a company that is not influenced purely by any one industry.

This same logic should be used in constructing portfolios.

Interest rate sensitivity

Rather than just looking at broad asset class weightings, getting a feel for the many factors that affect investment holdings will go a long way toward controlling risk. However, what many fund investors are doing today is - potentially - setting themselves up for more disappointment if the economy stages even a moderate recovery.

Recall that bond, balanced, dividend funds, and high income funds are attracting most of the money in mutual funds these days. The common denominator among these types of funds is that all are highly interest rate sensitive.

Many investors are shifting the stock components of their portfolios in favour of dividend funds - and high income funds in particular. At the same time, many are also moving significant amounts to traditional bond funds. Problem is, if rates continue their ascent, both sides of such a portfolio will be hit.

Suggestions

As noted in my December Strategy Update, high yield bonds are an ideal home for profits taken from government bonds - allowing investors to take advantage of a potentially attractive opportunity and reduce portfolio interest rate sensitivity.

If you're holding individual income trusts, you may have a preference for the type of government bonds you continue to hold. A CIBC World Markets report (Income Trust Weekly: In Yield We Trust, January 10, 2003) demonstrates that different types of trust have different interest rate sensitivities.

For instance, CIBC asserts that pipeline trusts are more sensitive (i.e. inversely correlated) to the 3-month Treasury bill yield as compared to longer-term bond yields due to the average term of contracts with shippers. Power trusts and business trusts, on the other hand, tend to be more responsive to interest rate changes on the "long end" of the yield curve (i.e. 10 year maturities or greater). As for funds of income trusts, most will tend to be sensitive to longer term rates, but that will depend more specifically on each fund's make-up and whether (in the case of a closed-end fund of trusts) it uses leverage.

Whatever the make-up of your portfolio, being aware of specific factors that impact the various components will go a long way toward making the ride along with way much smoother.

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 dha@danhallett.com
 
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