The document discusses several new types of investment products available in Canadian markets: 1) Fundamental index funds which weight stocks based on fundamental factors like sales and cash flow rather than market capitalization as traditional indexes do. Proponents claim they outperform traditional indexes but high fees could outweigh any gains. 2) Leveraged funds which use derivatives to magnify returns but also magnify losses, increasing risk. Upside leverage funds also exist but with higher fees. These products are best used to complement existing portfolios. 3) T-class funds which pay a monthly distribution with a portion treated as return of capital to be more tax efficient. However, distributions may exceed fund growth in poor markets and quoted

1. A wave of innovative investment
solutions has swept the Canadian
markets over the past year or so and
it’s often quite difficult for typical
investors to turn off the noise of
some of these seemingly promising
products. Are these viable invest-
ment options for which investors
can substitute traditional mutual
funds? Can they be used to comple-
ment their existing portfolios?
We don’t pretend to have a
definitive answer since we have yet
to see the long-term performance
of these products, regardless of
the claims made by the fund com-
panies. But it would be useful to
discuss the pros and cons of some
of the most interesting new prod-
ucts to hit the market recently.
Fundamental
index funds
To put it lightly, indexing is on a
roll. The charged-up performance
of the equity markets in general
over the past couple of years has
drawn a lot of investors to index
funds. And now attempting to
carve a niche in the Canadian mar-
kets are Claymore and Pro-Finan-
cial, who have recently launched a
bunch of index funds that follow
fundamental indexing methods.
These have made quite a splash
in Canadian markets, but how are
they different from our traditional
index funds? Instead of ranking
stocks according to their market
capitalization, these index funds
use fundamental factors such as
sales, cash flows, book value and
dividends as a measure of a com-
pany’s size to determine its weight
in the index.
These start-up firms contend
that their ranking systems are
superior to those of the traditional
index funds.They argue that expen-
sive stocks are overweighted in the
cap-weighted models because as
the share price of a stock rises,
the greater its weight in the cap-
weighted model.
While they claim that fundamen-
tal indexing outperforms traditional
indexing, based on back-tested
results, investors should remember
that this doesn’t guarantee future
outperformance.
Furthermore, we’d pay close
attention to their price tags. As
with any index funds or exchange-
traded-funds, any outperformance
could easily be swallowed up by
high fees. The management fee
(excluding fund expenses and trail-
ers) for the Pro-Financial product
is 1.6%. On the other hand, the
Claymore product is structured as
an exchange-traded-fund and can
cost as much as 1.4% (excluding
brokerage commissions).
In comparison, most typical
index funds are priced around the
1% range. We don’t yet know the
effective MER on these offerings,
but typically, we would be unwilling
to pay significantly more than we
would for traditional index funds.
Leveraged products
There has been a proliferation of
funds that offer investors magnified
returns through the use of deriva-
tives. Products such as Horizons
BetaPro and CI’s non-principal
protected note, Harbour Foreign
Equity EARN, attempt to produce
a certain multiple of the underly-
ing index’s daily returns. For exam-
ple, Horizons BetaPro S&P/TSX
60 Bull Plus aims to double the
returns of the S&P/TSX 60. So
if the index gains 5% on any given
day, this fund would gain 10%.
Note that the objective of these
funds is to produce returns corre-
sponding to the daily and not the
monthly or annual performance of
the underlying index. As a result,
their month-end or annual returns
will not necessarily be the multi-
plier times index returns.
But investors should remem-
ber that magnified returns such as
these come at a price in the form
of risk of capital loss. For exam-
ple, should the index fall 5%, the
Bull Plus fund would lose 10%.
Therefore, in this context, inves-
tors should pay particular atten-
tion to the fine print because the
various options may have different
risk/return profiles.
Where the BetaPro lineup mag-
nifies both gains and losses, there
are products that offer leverage to
the upside but not to the downside.
For instance, CI’s Harbour Foreign
Equity EARN note is tied to the
performance of the CI Harbour
Foreign Equity fund and offers 1.5
times the upside without magnify-
ing the downside. But then again,
this option comes with a higher fee.
We think it’s an interesting
concept, but we believe that the
purpose of such funds is to com-
plement a well-diversified portfolio
and enhance existing investment
strategies. They should not be
viewed as core holdings. Nor are
these funds for everyone. In fact,
we’d imagine that the roller-coaster
ride that comes with such prod-
ucts would be nauseating for most
investors. And the importance of
fees for these products can’t be
stressed enough and should be a
key issue to consider.
T-class funds
Investors who hold a portion of
their investments in non-registered
accounts or those who require regu-
lar cash flows agonize over their tax
bill. They often focus exclusively
on their pre-tax returns, neglecting
to consider the tax implications of
their investments.
Many fund companies have
now started offering tax-efficient
– or T-class – versions of some of
their existing funds, which pay a
set monthly amount based on the
manager or fund company’s realis-
tic expectation of the fund’s future
performance. Typically, a portion
of this distribution is treated as
a return of capital, which is not
immediately taxable.
On the flip side, the return-of-
capital amounts are deducted from
the cost base of the fund.This will
increase the capital gain when the
fund is eventually sold. The other
downside is that in periods of
poor performance, the fund value
may not grow enough to offset the
amounts distributed. This would
result either in a drop in the fund’s
net asset value per share or a dis-
tribution cut. So you have to make
sure the fund’s payout is realistic,
and remember that the quoted dis-
tribution rate is not guaranteed.
But overall, this is a good option
for someone who wants a predict-
able, tax-efficient income stream.
Currency-neutral
foreign funds
As more and more investors
embrace foreign markets to diver-
sify their resource-heavy, home-
biased portfolios, they are often
faced with a challenging decision
— to hedge or not to hedge the
foreign currency risk. Though
there is no definitive answer, it is a
widely held belief that over a very
long period (say, 25 years) currency
fluctuations tend to wash out.
But for investors who are more
averse than others to the risks asso-
ciated with currency movements,
particularly for those who have a
shorter time horizon, currency-
neutral funds could be a viable
option. In the past year, several
mutual fund companies have intro-
duced currency-neutral versions of
their existing foreign fund line-up.
The down side is that investors
who buy into these funds give up
some upside potential in periods
of a depreciating loonie. AER
Bhavna Hinduja is an analyst at
Morningstar Canada
20 April 2007 Advisor’s Edge Report www.advisor.ca
Trendy Investing
The Canadian fund industry is awash
with new and innovative products
By Bhavna Hinduja
RBC Asset Management took us by surprise last January
when it capped RBC O’Shaughnessy Canadian Equity – a
fund that has built a solid track record and captured the
attention of the Canadian mutual fund market – because
of liquidity issues.
Lead manager James O’Shaughnessy then tweaked his
model and RBC released this all-Canadian offering. Despite
these changes to the model,we expect this new offering
to produce respectable results like O’Shaughnessy’s other
mandates have done.
After studying years of historical stock data,
O’Shaughnessy identified a number of quantitative met-
rics that successful stocks tended to have. His approach
is based on the assumption that historical trends tend to
persist and that today’s stocks with these same charac-
teristics will be tomorrow’s winning stocks. His purely
quantitative approach identifies those stocks that meet
his stated criteria. He then purchases these stocks for
his portfolio in equal weights and his funds stay fully
invested at all times. O’Shaughnessy rebalances the
portfolio biannually, usually in December, to add and
drop names that no longer meet his investment criteria.
The original Canadian equity offering began experi-
encing liquidity problems much earlier than many other
broad-based Canadian equity funds due to a kink in
O’Shaughnessy’s screening process, and it was closed to
new investors at just over $2 billion in assets under
management.
Meanwhile most diversified Canadian equity offerings
can handle several billions of dollars before coming close
to experiencing liquidity issues.
The problem was that the screening process selected
only stocks with larger market capitalizations, based
on the assumption that larger stocks are more liquid.
While O’Shaughnessy found that this generally held true,
a significant number of these large companies weren’t
liquid enough.
Realizing this, O’Shaughnessy decided to cap the
offering and then tweaked his model to only select stocks
with sufficient trading volume. He also made other subtle
refinements to the model, designed to weed out both value
traps and overvalued growth names.
Another notable difference is obvious from the new
fund’s name. RBC O’Shaughnessy All-Canadian Equity
carries no foreign equity exposure, while the original
offering maintained 20% exposure to U.S. equities.
One other thing to keep in mind is that this fund comes
with a higher price tag than the original.This is a clear-cut
case of a fund company charging more simply because it
can.While one might argue that the price increase is justi-
fied given the track record O’Shaughnessy has built, we’ve
seen other more unitholder-friendly firms decide not to
take advantage of that opportunity and keep fees low for
their investors. AER
David O’Leary is manager of fund analysis at
Morningstar Canada
Analyst’s Report:
O’Shaughnessy All-Canadian Equity
O’Shaughnessy tweaks his investment strategy in order to
open his doors to more Canadian equity dollars
By David O’Leary
It is a widely held belief
that over a very long
period (say,25 years)
currency fluctuations
tend to wash out.