1. What a year! By the time the
curtain closed on 2006, the Dow
Jones Industrial Average was up
almost 16.2% and the S&P 500
Index had risen 15.7% (all index
returns are expressed in Canadian
dollars). Meanwhile the S&P/TSX
Composite Index was up 17.3%
for the year, marking the first time
in the past quarter of a century
where Canadian equity investors
have been treated to double-digit
returns four years in a row.
But the real heroes of 2006
were the Latin American, Asian
and European economies, with
the MSCI Latin America gaining a
staggering 42.9%, the MSCI Pacific
ex-Japan returning 32.6% and the
MSCI Europe climbing 33.8%.
Now we’d love to be able to forecast
another three years of prosperity in
both domestic and foreign equity
markets (and no doubt there will
be sectors whose strength will put
recent returns to shame). But we’ll
leave the predictions to the pundits
and, instead, focus on what we’ve
learned over the past year.
Be wary of hot sectors
It is only human to get seduced
by the enthusiasm over the poten-
tial of the top-performing sector
fund. But before you sprint for
the door, consider this example:
Without a doubt, precious metal
funds were on fire in 2006, with
the Morningstar Canada Precious
Metals Equity Fund Index return-
ing a stunning 49.9%. But this
may have cost investors countless
sleepless nights, particularly mid-
way through the year when the
index lost about 10% in May.
If you had invested $100,000
in the fund index, you would have
made a profit of about $50,000,
but only if you had bought at the
start of January 2006 and stayed
the course. However, had you
invested on April 30, you would
have barely broken even (or even
lost a bit) by the end of the year.
You need to be cognisant of
the risks associated with the sky-
scraping returns that some of these
hot sector funds provide. And you
can avoid losing large chunks of
your wealth, while increasing your
portfolio’s expected performance
on a risk-adjusted basis, by limit-
ing these high-risk funds to a small
component of your well-diversified
portfolio.
Patriotic investing is
notthe wayto go
Foreign markets had a better run
than Canada in 2006, thanks to a
combination of market growth and
favourable currency movements (the
Canadian dollar fell against the euro
and the pound). The Morningstar
Canada Asia Pacific Rim ex-Japan
Equity Fund Index had the year’s
second best return with 34.8%, fol-
lowed closely by European Equity
with 33.5% and Emerging Markets
Equity with 31.7%. Compare this
to the Canadian Equity Fund Index
that was up just 15.2% for the
year.
Canadian investors have to be
continuously reminded that ours
is a very narrowly focused market.
Our companies account for less
than 5% of the world’s market
capitalization. We are world-class
leaders in areas like mining and oil
and gas, but lack representation in
other fields such as health care.
Let’s not forget that energy and
materials tend to be cyclical areas
of our economy. And it’s tough to
make a living in the oil patch. Oil
service firms are ultimately at the
mercy of unpredictable commodity
prices. And although these have shot
through the roof this past year, this
can’t last forever.
Yes, the composite index could
rise even further, but it could also
reverse course and fall. How much
higher is it likely to climb if things
continue to go well? How hard is
it likely to drop if we fall on hard
times?We would argue that Canada’s
potential downside might be bigger
than the potential pay off right now.
In fact, we have already seen some
pullback in these cyclical sectors in
the latter half of 2006.
We are not suggesting investors
turn their portfolios upside-down
to get foreign exposure, but rather
to slowly transition their domestic
holdings to foreign. If the time to
diversify abroad is not now, then it
is pretty darn soon.
Incometrusts have
never been a substitute
for bonds
After a remarkable run since
2003, the income trust sector
took a beating in the final leg of
2006 following the government’s
announcement to tax trusts come
2011. We’ve spent most of last
year rattling about why trusts
should not be considered as a
distinct asset class, and the tax-law
change removes the last meaning-
ful difference between trusts and
comparable high-yielding stocks.
These securities were a favourite
among seniors and others seeking
steady income in a low-interest rate
environment. Investors who flocked
to trusts for their hefty payouts now
feel betrayed, but many bought into
trusts under the misconception that
they were as safe as bonds. More-
over, it was almost scary to see inves-
tors piling money into entities that
operate in unattractive industries or
are poorly run businesses to begin
with. Trusts have never been a sub-
stitute for bonds, as some investors
and advisors believed. And hope-
fully, the government’s proposal will
finally dispel that notion.
The income trust fallout is a fur-
ther case in point for our first les-
son: To beware of funds in hot areas
of the market. Most income trust
funds that were severely hurt by the
announcement were heavily invested
in the hot energy and business trusts.
However, real estate income trusts
are exempt from the proposed tax
laws. As such, well-diversified trust
funds that underweighted energy
trusts and overweighted REITs
didn’t suffer as much – some even
made a little money in November.
Concentrating in any single security
type, geographic region or industry
has its risks; income trusts were no
exception. AER
Bhavna Hinduja is an analyst at
Morningstar Canada.
20 january 2007 Advisor’s Edge Report www.advisor.ca
Investing Smart
Save your client from common mistakes
By Bhavna Hinduja
At only $1.4 million in assets,Leith Wheeler
IncomeTrust Series B is one of the smallest
funds in the Canadian High Income Equity cat-
egory.There are larger and more popular funds
in the income trust space in Canada,but don’t
let this one’s small stature fool you.The fund’s
excellent management team,low fee and distinc-
tive portfolio structure make it a good comple-
mentary option for income-seeking investors.
We like the deep and long-tenured manage-
ment team at Leith Wheeler Investment Coun-
sel.Three of the current five members have
over 20 years of investment experience each.
Furthermore, two of the managers have been
with Leith Wheeler for more than 20 years
and have been managers of the five-star-rated
Leith Wheeler Canadian Equity since its incep-
tion in June 1994.This experience has allowed
them to build a consistent strategy through
various market cycles.
The fund’s low fee is also something to
admire.We are accustomed to seeing small
funds with above-average management-expense
ratios because they have fewer assets over which
to spread fixed costs,but Leith Wheeler has
bucked the trend with an MER of 1.34%.
The team runs a very tight portfolio of
income trusts. As of the end of Decmeber
2006, the fund only held 14 trusts with some
of the top names occupying more than 8% of
assets.While holding fewer names can increase
the stock-specific risk and volatility in the
fund, we like that the managers make mean-
ingful bets on their best horses.They have
indicated that they would like to increase the
diversity of the portfolio, but they are unwilling
to add lower quality names to the fund.
To help reduce some of this risk, the man-
agers concentrate on finding companies that
produce stable cash flows.They have also
focused more heavily on businesses in less
cyclical sectors such as Sleep Country Canada
Income Fund and Lakeport Brewing Income
Fund. As a result of reducing the cyclicality in
the portfolio, the fund often looks nothing like
its benchmark, the S&P/TSX Capped Income
Trust Index. Energy firms currently comprise
more than 60% of the index, but only 8.4% of
the fund (one holding).
Due to its concentration and lack of energy
exposure, this fund can add diversity to an
income-producing portfolio.
Of Note
• This is a no-load fund with a minimum
investment of $25,000.
• Trusts in the consumer sectors account for
53.4% of fund assets but only 8% of the
benchmark.
• The fund’s MER of 1.34% is among the
lowest in the category. AER
Analyst Report:
LeithWheeler
IncomeTrust
By Mark chow
Marketable
Categories
by rudy luukko
Morningstar Ratings based on
proprietary categories created
last year can be advertised in
sales communications by fund
companies, the Canadian Secu-
rities Administrators has con-
firmed in a ruling.
The ruling applies to all pro-
spectus-offered mutual funds in
Canada that are rated by Morn-
ingstar. It resolves a technical
issue that had arisen as a result
of Morningstar’s launch of its
proprietary fund categories
in October after its departure
earlier in the year from the
Canadian Investment Funds
Standards Committee.
Since Morningstar Ratings
are compiled from data that
do not directly correspond to
standard performance periods
as defined under securities rules,
regulatory relief is required in
order to cite the ratings in adver-
tising.The original ruling,issued
in November 2000,required
Morningstar Ratings to be based
on CIFSC categories.
The ruling makes it accept-
able for Morningstar to either
maintain proprietary categories
or, should it decide to do so in
the future, to create common
categories in co-operation with
CIFSC or through similar col-
laborative arrangements with
other fund measurement firms.
Discussions continue
between representatives of
Morningstar and CIFSC-mem-
ber performance measurement
firms, to determine whether a
common category system can
be re-established.
Depending on the age of the
fund being advertised,there are
up to five standard performance
periods normally required in
sales communications.They
are the one,three,five and 10-
year periods,plus the return
since inception.Morningstar
has agreed to provide a one-
year Morningstar Rating to
complement the existing ratings,
although they will not be pub-
lished on its Web site or in its
fund analysis tools such as the
PALTrak software.At the same
time the “since inception”period
has been deemed misleading and
subsequently dropped. AER