What's New

- Gordon Pape

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It has become an almost daily occurrence: yet another U.S. mutual fund company is implicated in the scandal that is rocking the $7 trillion industry to its core. More than a dozen money managers have walked the plank for actions that are deemed to be at the least unethical and at worst blatantly illegal, with many more likely to follow.

One mutual fund giant, Putnam Investments of Boston, has already reached a settlement with the U.S. Securities and Exchange Commission (SEC) over allegations of improper trading. The deal has come under fire from crusading New York State Attorney-General Eliot Spitzer, who says it isn’t tough enough. That should serve as a warning to other companies that regulators are likely to be even more demanding going forward.

Putnam’s SEC settlement is actually the least of the company’s worries. Major clients are bailing out right and left, costing the firm millions in lost advisory fees. The latest blow was delivered by Toronto-based Thomson Corp., which last week dropped the Putnam International Equity Fund from its 401(k) plan, a retirement savings program for U.S. employees. The fund was one of those implicated in the scandal.

Also last week it was announced that Security Trust of Phoenix, Arizona will shut down on March 31 after three senior executives were charged with grand larceny and securities fraud resulting from an alleged late-trading scheme involving a hedge fund. It will be the first money management firm to go under as a result of the on-going investigations.

In other recent developments, a Morgan Stanley branch manager has been accused of securities fraud, apparently because he promoted his company’s funds too aggressively. And Citibank Asset Management said it will repay US$16 million to fund investors because of an improper transfer agent agreement. Stay tuned. There will undoubtedly be more to come.

But what about our own situation? So far, nothing has come to light since the Ontario Securities Commission requested a report from Canadian fund companies on the policies they have in place to ensure investors are protected from such abuses. However, The Globe and Mail recently quoted Stanford economist Eric Zitzewitz as saying that a study that he did suggests there have been trading irregularities in some Canadian-based global stock funds. The OSC has apparentlyt looked at the report but concluded it was too small to be significant. But stay tuned. Where there’s smoke, there may be fire.

Before you panic, however, it’s important to understand what this is all about. So far, the main allegations in the U.S. have focused on two practices. They are:

Market timing. Simply put, this amounts to taking advantage of the fact that the world has many time zones and that stock markets overseas therefore close at different times. This allows for some potential hanky-panky with international funds. Unethical traders can take advantage of the situation by buying fund units just before the Toronto/New York closing time on the basis of the performance of North American markets that day and/or the strength of next-day futures in London, Paris, Tokyo, or wherever. The idea is to take a large position and then flip it the next day for a profit.

After-hours trading. In this case, an investor or hedge fund is allowed to buy fund units after the normal 4 p.m. cut-off, at the closing net asset value for the day. This illegal activity can be very profitable because the buyer has knowledge of how stocks are performing in after-hours trading or of important announcements made after the closing bell.

One positive step you can take to protect yourself against such abuses is to insist on dealing primarily or exclusively with companies that have made a clear statement of policy in regard to such transactions. Fidelity Canada, which is a subsidiary of a Boston company, was one of the first to issue such a statement after the U.S. scandal broke. Among the key points:

No after hours trading. Fidelity says flatly that it does not accept any orders after 4 p.m. at that day’s pricing. “It is a firm and non-negotiable policy, and always has been,” says Fidelity Canada President David Denison.

Barriers to market timing. Fidelity uses two methods to discourage this practice. The first is Fair Value Pricing, which is designed to ensure that the NAV of any fund reflects market conditions as of the close of trading in Toronto. The second, and probably most effective, is a Short Term Trading Fee which is applied in any case where the company believes short-term trading has been disruptive. “We apply mandatory short-term trading fees to Fidelity Far East Fund and Fidelity Japan Fund, which are most vulnerable to time zone arbitrage”, says Denison.

If you are concerned about these practices, ask your investment advisor about the policy of any company you have money invested with, or contact the firm yourself.

Bad as these problems potentially are, there are other abuses in the mutual fund business that are not being actively addressed (at least not yet). In many of these cases, you are not powerless. In fact, savvy fund investors could bring about changes themselves by putting their money where their principles are. Here’s a list to review.

High fees. Many people complain about high management expense ratios (MERs) but most aren’t following words with action because they are still buying expensive funds. In the U.S., Spitzer is making high fees his latest target, which is somewhat ironic because Canadian fees are much higher than those south of the border.

MERs reflect two types of costs. The first is the management fee plus any bonuses paid to the fund’s advisors. The second is the expenses charged directly to the fund, which may cover anything from brokerage commissions to trailer fees paid to advisors.

Despite growing public awareness, we’ve observed that the general trend is that these fees continue to rise. Every time this happens, it’s money out of your pocket because the costs are deducted from the fund’s asset base before the NAV is calculated. If a fund has a gross return of 11% and an MER of 3%, you end up with only 8% profit.

In some cases, we believe that fees are way out of line. The best way to protect yourself is to be aware of the MER of any fund you’re considering. Do business with companies that combine good performance with low MERs; there are lots of them around. In cases where low-MER options are available, such as the “e” series from TD Asset Management, use them.

As a general rule, don’t invest in a U.S. or global equity fund with an MER over 2.75%. For Canadian stock funds, try to find one under 2.5%. Avoid bond funds that charge more than 2% and never pay over 1% for a money market fund.

Complicated commission structures. Unless you buy a no-load fund, you must pay a sales commission, either immediate or deferred. The main problem is the ever-widening range of choices available in the form of different types of units. There is no industry-wide standardization, something which is badly needed. As a result, investors are often not aware of all their options or the significance of them.

Unfortunately, this involves more homework than most people are willing to put in, including a careful reading of the relevant part of the prospectus. That’s why regulators should take action to require across-the-board standards, if the industry won’t do it voluntarily.

For example, some companies offer what they call a “low-load” option, which carries a reduced front-end load and/or a deferred sales charge schedule with lower redemption fees and a shorter time frame before the DSC falls to zero. This option is usually reserved for high net worth and institutional clients, but an ordinary investor may be able to obtain it in some cases.

Some funds now offer several “series” or “classes”. This is a growing practice among labour-sponsored funds (see the story elsewhere in this issue). These purchase options can be difficult to understand because they relate mainly to the level of compensation paid to the sales person. But making the right choice can result in a much higher return, as we have seen with the Front Street Energy Growth Fund.

As matters currently stand, if you want the best deal you must study the range of purchase options available for any fund in which you are interested, or ask your advisor to lead you through them.

Equity fund bias. The mutual fund industry has a built-in bias to sell you stock funds. Advisors receive higher trailer fees from these funds than from income funds. And a fund company is able to charge a higher MER for a stock fund than for a bond fund, which adds to the bottom line.

Many people have written to us to complain that they are unhappy with the performance of their portfolios. In most cases, it turns out that they were heavily overweighted in equity funds. Perhaps the advisor honestly believed this was the best course. But the financial advantage of going in that direction may have been an influence, even subconsciously.

Regulators could bring an end to this bias quickly by decreeing that sales commissions and trailer fees will be exactly the same for all types of funds sold by a company, regardless of the type. However, that is not likely to happen any time soon. Until it does, the best way to protect yourself is to insist that your portfolio be tailored to your specific needs and risk level. If you don’t want to invest most of your money in the stock market, hold your equity funds to less than 50% of the total portfolio. Older people and those approaching retirement should not exceed 40% in stock funds.

Mutual funds still offer one of the most effective ways for a small investor to build a diversified portfolio. There are problems in the industry, but there are ways you can minimize their impact, if you’re prepared to work at it. A little more help from the regulators would be nice, however.

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The stock market turnaround of 2003 has paid off big-time for readers who track our Ideal Portfolios. All three portfolios advanced in the six-month period ending Oct. 31, but the biggest gains by far were in the Ideal Speculators Portfolio which moved ahead by 30% during the period.

The Ideal Growth Portfolio, which takes a more balanced approach, added 11.49% during the six months. The conservative Safety Portfolio, which held its ground reasonably well during the bear market, trailed with a gain of 5.58%. However, even that is good for a low-risk portfolio that has 60% of its assets in money market, mortgage, and bond funds.

Some of the more aggressive funds in the Speculators Portfolio scored spectacular gains. Best was the RBC Precious Metals Fund, which surged by 75.2% during the six months. It has a 10% weighting in the Portfolio. The top-performing equity fund was Mackenzie Cundill Recovery Fund, which also represents 10% of the Speculators Portfolio. It gained 46.6%.

Other stand-out performers included RBC O’Shaughnessy U.S. Growth Fund (+38.8%), Mackenzie Universal Canadian Resources Fund (+37.6%), Templeton Global Smaller Companies Fund (+32.2%), Trimark Global Balanced Fund (+24.8%), Synergy Canadian Momentum Fund (+23.7%), Fidelity Canadian Growth Company Fund (+19.8%), and Fidelity Canadian Disciplined Equity Fund (+18.4%).

In fact, only one fund in all of our Ideal Portfolios was in the red for the period: the GGOF RSP International Income Fund, which dropped 2.8%.

The strong performance of the equity funds rewarded investors who were patient enough and had the courage to stick with the Growth and Speculators Portfolios through the lean years of 2000-2002. Since the Ideal Portfolios were created on Jan. 1, 1997, the Speculators Portfolio has emerged as the top performer with an overall gain to date of just under 65%. When you consider the losses incurred during the bear market, that’s a remarkable result.

Here is a review of where we stand and our recommendations for the next six months. All Portfolios were initially valued at $10,000.

Comments: Low interest rates resulted in very small returns from the Altamira T-Bill Fund (+1.4%) and the Phillips, Hager & North U.S. Money Market Fund (+0.3%) but that’s the trade-off for the safety component these funds bring to a portfolio.

Bond funds were also weak, with the best result coming from the GGOF Canadian High-Yield Bond Fund (+2.8%). Note that the CI Mid-Term Bond Fund, which was a 10% holding in this Portfolio, was merged into the CI Canadian Bond Fund in August. We don’t like this fund as much and we are replacing it this month.

Changes: We will drop the PH&N U.S. Money Market Fund from our list because the low interest rates in the States mean that the returns here are only fractional at best. We will shift its 5% weighting to Altamira T-Bill Fund.

Also gone is the CI Canadian Bond Fund. We are replacing it with the TD Canadian Bond Fund, which has been on the MFU Recommended List since January. This fund is an above-average performer over all time frames.

With the Canadian dollar continuing to strengthen, foreign bond funds have not fared well. The GGOF RSP International Income Fund was among the better performers but under current conditions a foreign bond fund isn’t the best choice for a low-risk portfolio, so we’re dropping it. To compensate, we are increasing the weightings of the GGOF Canadian High-Yield Bond Fund to 10%.

The Renaissance Canadian Income Trust Fund added 12.2% during the six months, also above average for its category. This fund is now closed to new investors, but you should retain your existing positions in it. However, new readers or those who are only starting now to track this Portfolio will need an alternative so we will substitute the GGOF Monthly High Income II Fund going forward. We will do the same for the other Portfolios.

Comments: As mentioned earlier, we had excellent results from some of our high-flying equity funds but some of the supporting cast also chipped in with decent gains.

The Northwest Specialty High-Yield Bond Fund, managed by Doug Knight, contributed an 8.5% advance, which was especially important because of its 10% weighting. That was one of the best performances in the High-Yield Bond category for the period. Knight took over the fund in November 2000 and since then he has posted above-average results.

We have been using the Mutual Beacon Fund for our U.S. value holding. However, it has not performed as well as we would like so we are making a switch. The RBC O’Shaughnessy U.S. Value Fund has been much stronger so we will team it with the companion O’Shaughnessy U.S. Growth Fund, which is already in the Portfolio.

We are also somewhat disappointed with AIC Diversified Canada Fund. It gained 10.8% in the latest six months, but that was below average for the category. There are many other good value-oriented Canadian stock funds available, but for purposes of this portfolio we are selecting the new Brandes Canadian Equity Fund. Since its launch in July 2002, it has been a very strong performer. The six-month gain to Oct. 31 was 22.2%, much better than average for the category. The fund is managed by the Charles Brandes organization of San Diego, which previously ran the AGF International Value Fund before resigning the account last year.

Speaking of the AGF fund, it too has been a laggard despite posting a six-month gain of 10%. Saxon World Growth Fund would be a good choice here but the $5,000 minimum is too high for small portfolios. So we are going to recommend Mackenzie Cundill Value Fund (“C” units) which can be acquired for a minimum investment of $500. It gets a 10% weighting.

Comments: Every fund in this Portfolio contributed to the fine results. The lowest gains were posted by AIC Diversified Canada and AGF International Value Fund, both of which are being replaced this time around.

We have some concerns about Synergy Canadian Momentum Fund, even though it posted an advance of 23.7% over the latest six months. The Synergy funds have now been taken over by CI. David Picton still remains at the helm of this fund but we are not sure whether he will continue to function as effectively in the new corporate environment. We will retain the fund in the Speculators Portfolio for now but we will be watching it closely.

Changes: Many of the changes here reflect those previously dealt with in our comments on the Safety and Growth Portfolios.

The Renaissance Canadian Income Trusts Fund, now closed to new investors, will be replaced with the GGOF Monthly High Income II Fund. Brandes Canadian Equity Fund will be substituted for AIC Diversified Canada.

We’ll increase our U.S. equity exposure by adding RBC O’Shaughnessy U.S. Value Fund to this Portfolio as well.

There’s no way of knowing how long the gold rush will continue but while it does we’ll keep riding the RBC Precious Metals Fund.

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A NEW LOOK FOR LABOUR FUNDS

After the terrible losses of 2000-02, venture capital funds are regrouping to offer new alternatives to wary investors.

Any way you look at it, it’s been a bad run for labour-sponsored venture capital funds. The long bear market took its toll on most of the entries in this category, leaving investors shell-shocked and wary of throwing good money after bad.

Over the three years to Oct. 31, the average labour-sponsored fund lost more than 11% annually. Not a single fund was in positive territory during that period, with the worst performer of the lot being Triax Growth Fund, which had an average annual loss of 36%. Some funds have looked better recently although, as a whole, the category is still in the red over the past 12 months.

Despite the abysmal results, investors continue to pour in money. During the last RRSP season, gross sales were $266 million and current estimates are that they could rise about 10% to the $300 million range in the 2004 selling period, which runs from Jan. 1 to Feb. 29.

The attraction is the tax breaks these funds offer. Depending on where you live and the type of fund you buy, you can deduct up to 35% of your investment from your income tax payable. Add your RRSP deduction to that if the units are purchased for a registered plan and the federal and provincial governments will reimburse you for over 80% of your investment, depending on your tax bracket. That’s a pretty strong incentive.

But keep in mind that you’ll receive the RRSP deduction regardless of where you invest your money. Only the labour-sponsored fund credit is unique to these funds. The promotional literature often adds the two tax breaks together, but that can be misleading. Focus on the labour fund credit alone to get a more accurate perspective.

If you do that, you’ll find that the credit falls well short of compensating for losses incurred over the years in a poorly-performing fund. Unless the investment offers a reasonable chance of profitability, you’re better off passing.

Many labour funds will use the same old tried and true methods to market their funds in the upcoming RRSP season, counting on the tax breaks to offset the stigma of bad performance. But a few are moving in a different direction, and they are worth looking at. Here are some that we believe show promise for 2004.

IPM Funds. This is a new line of labour funds that has been created by two veterans of the old Working Ventures Canadian Fund, Julie Makepeace (president and CEO) and John Willson (chief financial officer). The three funds in this group offer a radically different approach to the traditional structure of funds of this type, on the basis of information contained in the preliminary prospectus. (The company principals are not allowed to comment on the funds until the offering is approved, but the prospectus is a public document which can be viewed at www.sedar.com).

Specifically, this involves such things as a more transparent fee structure, performance bonuses paid only after unitholders receive distributions (such bonuses have become a sore point for many labour fund investors), and closing the funds after the initial distribution period. This is especially important because venture capital funds operate on a J-curve principle, which means that most of the profits come in the later stages. If new money is continually added to a pool, it had the effect of extending the rising side of the J-curve farther into the future.

Assuming approval of the prospectus, IPM will offer three distinct funds in 2004, each geared for a specific type of investor.

The Terra Firma Income Fund will invest most of its money in debt securities to help provide financing for companies. These may include bonds, subordinated debentures, and convertible debentures. These securities will have a higher credit risk than government or investment-quality corporate bonds, but on the risk scale of labour funds this one will fall into the more conservative category. This fund is the most likely to pay distributions sooner rather than later, perhaps as early as the end of the 2005 fiscal year. Note that distributions will come in the form of additional units, not cash.

The Terra Firma Equity Fund will focus on later stage companies. The fund will be managed by CastleHill Ventures, which is a little-known but well-respected firm that handles large accounts for wealthy individual investors. The portfolio will be well diversified, with no emphasis on any specific economic sectors. It will rank in the middle of the risk scale among this trio.

The highest-risk option will be the Emerging Companies Fund, which will be overseen by Harbinger Investment Group. As the name suggests, it will focus on early stage companies, with special emphasis on technology, telecommunications, and biotechnology. This fund will be eligible for Ontario’s extra 5% research fund tax credit.

All these funds will be available only in Ontario and will be sold through financial advisors. There will be three classes of units: front end load, low load, and no load units with a lower MER for fee-based accounts (equivalent to “F” units in regular mutual funds). If they are successful, the plan is to offer a new series each year.

While we like the structure and the transparency of these funds, investors should keep in mind that they have no track record. So initially it might be wise to stick with the options at the lower to middle range of the risk scale.

ROI Fund. This is a new fund that was launched just prior to the 2003 RRSP season. Its goal is to invest in “mature, stable companies within mature sectors”. Specifically, the fund zeros in on manufacturing, health services, and financial services. Like the new Terra Firma Income Fund, the technique is basically to invest through debt. This is designed to preserve capital and provide distributions to investors. Management has pledged not to take a performance bonus unless distributions are paid to investors (although they will accept their base management fee of 2.5%). The fund, which is still very small, closed its first investment in May 2003, a $1.53 million five-year subordinated debenture with Morrison Financial Services of Toronto. It’s too early to get a reading on performance, but we will watch this one with interest. You can find out more at their website: www.roifund.com. The fund is sold only in Ontario.

VenGrowth Traditional Industries Fund. Here’s another newcomer that is using debt financing as a way of reducing risk for investors. This new entry from VenGrowth is being launched for the 2004 RRSP season. It will invest in existing companies with good revenue (no start-ups) and will hold subordinated debentures that are expected to yield between 10% and 14%. The idea is that will protect the asset base of the fund and provide steady cash flow. The fund will also acquire a small equity position in companies selected by the managers. The goal is to eventually exit with a total return of 18% to 20% on each placement. Conservative investors who want the labour fund tax credits but don’t want to expose themselves to big losses should take a look at the various offerings of this type. This one has the advantage of being available across Canada.

Front Street Energy Growth Fund. This one contains more risk and offers less of a tax break than the new batch of debt-based labour funds. Nonetheless, it is well worth considering as it offers excellent potential for capital gains in a short period of time. In fact, this fund shows a one-year gain of over 30% to Oct. 31, making it far and away the top performer in the category.

This entry was launched in July 2002. It is managed by two veterans from the glory days of Altamira, Frank Mersch, who scored huge gains for Altamira Equity for many years, and Norm Lamarche, who is widely respected in the investment community for his knowledge of the resource sector. The style of this duo suggests that the fund will be very active and potentially higher risk, but it also has the potential to produce impressive results, as we’ve already seen. The initial focus is on new companies that are being set up or acquired by proven executives in the energy field who have been displaced or bought out by the many mergers and acquisitions that have taken place in that sector in recent years.

The fund is available across Canada, however it does not qualify for any provincial tax credits. You’ll receive the federal 15% credit, nothing more. That adds considerably to the real cost of acquiring units, and the amount of money you are putting at risk. But, so far at least, Mersch and Lamarche have more than compensated for those negatives with their performance.

The fund is sold through investment advisors. You can also learn more at the website, which is located at www.frontstreetcapital.com

We are adding this fund to the MFU Recommended List as our top pick in the category for 2004. But remember, it is only suitable for more aggressive investors.

Note that there are three types of purchase options. This can be confusing as the differences relate to sales commission and dealer compensation. However, a look at the first-year performance numbers shows that your selection can have a big impact on returns. The Series I shares, which have a 10% maximum redemption charge if you cash in before eight years, had a one-year gain of 36.3%. The Series III shares, which have no redemption fee, had a gain of 30.8%.

We recommend the Series I shares, since very few people cash in before the end of the eight-year holding period because doing so requires repayment of your tax credits.

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ANOTHER VIEW OF INDEX FUNDS

We received the following comment on our recent article on index funds, which we felt would be of interest to readers.

Reader comment: Regarding the article in the November issue on index funds, it states that 80% of active funds in Canada outperformed the S&P/TSX Total Return Index for the three-year period ended Sept. 30.

Given that Nortel represented approximately 40% of the TSX index at its peak and managers were in most cases limited to a 10% exposure, a more representative index to compare how active managers fared against the index would be to look at the performance relative to the capped indices.

I looked at BellCharts data for the three-year period ended Oct. 31 and it includes 419 Canadian equity funds in the group. Only 40% of the funds outperformed the capped S&P/TSX 60 Index and only 48% managed to beat the Composite Index.

Another issue that makes comparisons difficult in the Canadian market is the foreign content limit which allows a manager to have up to 30% in U.S. or international stocks in the portfolio. This would have negatively impacted performance over the past few years.

The best area to look for indexing returns compared to active managers is the more broadly-based U.S. market where these issues are not a problem. Again, using BellCharts data for the past three years, some 66% of U.S. funds in Canada have failed to beat the S&P 500 (274 funds in the group). This was in an environment where the annualized three-year return for the S&P 500 in Canadian dollars is minus 12.6%. – S.J.M., CFA

Response: Your analysis well illustrates the difficulty in trying to draw meaningful comparisons between the performance of index funds and actively-managed funds. That’s why we never advise against investing in index funds, but rather suggest that readers understand what is involved and the potential pitfalls.

There is no doubt that, historically, U.S. index funds have fared better than Canadian index funds. The reasons you cite are among the main factors for this, but the breadth of the U.S. market is also an important consideration. As we mentioned in the article, the higher the weighting of any single security or group of securities in an indexed fund, the greater the chance for a skew in the returns. – G.P.

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The sale of the Co-operators Mutual Funds to Industrial Alliance coincided with several of the funds reaching their third anniversary, making them eligible for a formal rating. Here are some of the better ones.

NEWCOMERS

IA CANADIAN BOND FUND $$$

So far, this relatively new fund has been an above-average performer. The gain for the year to Oct. 31 was 6.1% while the three-year average annual compound rate of return to that date was 7%. Both numbers are better than the norm for the Canadian Bond category. However, on the minus side the risk level is slightly worse than average. About 55% of the portfolio is in federal and provincial bonds with 30% in corporate issues and the rest scattered around. The management team is with Co-operators so this group may be changed now that Industrial Alliance is in charge, although IA says that for now the current managers will remain.

IA CANADIAN BALANCED FUND $$$

This fund is best suited for investors looking for acceptable returns with below-average risk. The portfolio is well balanced, with about 52% of the assets in equities as of Oct. 31. The three-year average annual rate of return to that date was 1.2%, about one percentage point above the norm for the category. The one-year advance of 8% was slightly below par. Risk is much better than average. The fund is currently under the direction of James Blake and Jim Lorimer of Co-operators.

IA CANADIAN CORE EQUITY FUND $$

This fund is not in the same league as the companion Canadian Conservative Equity Fund, and that one should be your first choice if you invest with this group. The focus of this fund is on large-cap companies. The fund's mandate allows it to hold U.S. large caps as well as Canadian ones, but you won't find many American issues in the portfolio right now. The big banks and energy companies dominate the portfolio, with financial service firms accounting for 27% of total assets. Despite a 15.4% gain in the year to Oct. 31, the fund's results are slightly below average. However, a good safety rating earns it a $$ debut rating.

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