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Avoiding mutual funds is not the answer to poor performance. What’s needed is a different approach.

Investors are still shying away from mutual funds. The latest figures from the Investment Funds Institute of Canada (IFIC) show that in September redemptions exceeded new sales by $545 million. That reversed a positive trend that had been taking shape over the summer.

Canadians have more than $470 billion socked away in mutual funds. But the growth rate of the industry has declined considerably from the heyday of the 1990s.

The reasons for this apparent reluctance to commit new money to funds vary from one person to another but we believe that the number one culprit is the weak performance of many portfolios in recent years. We have received numerous e-mails and letters from readers complaining that they lost heavily in the bear market of 2000-02 and are only now seeing their funds return to the values they were at in the late 1990s.

There’s no doubt that bad results turn off investors, no matter what type of security is involved. When stock markets dive, people dump their shares. When interest rates are low, money market instruments and GICs get the axe; when they rise everyone sells their bonds and bond funds. These are natural reactions (although not necessarily wise ones) so it comes as no surprise that weak mutual fund performance would trigger the same results.

But before you turn away from funds, you need to work out a plausible alternative strategy. Socking everything into GICs is definitely not a solution. Interest rates may be on the rise but the returns offered on five-year money by the banks are still very low. If you’re planning to build your own stock and bond portfolio, you need to have adequate capital for proper diversification ($50,000 at a minimum) plus you need to know what you’re doing. We received an e-mail recently from a couple who were learning about the market by investing in penny stocks. That’s an invitation to financial disaster.

Some investors have switched to exchange-traded funds (ETFs) as an alternative because of their lower management fees. We think ETFs, both passive and actively-managed, have a place in most portfolios, which is why we added them to our coverage at the start of this year. But an ETF portfolio contains the same type of risk and opportunity as one invested in mutual funds. Unless you invest properly, you can take a beating.

We think that mutual funds and ETFs continue to be the best choice for most investors, especially those with a limited amount of money available. The diversification and professional management these securities offer can’t be matched by most do-it-yourselfers.

However, to build a successful portfolio you need to use smart strategies that will keep your costs low and protect your assets in times of market volatility. Here is a list of the tactics we recommend; ask yourself honestly how many you are using. If your fund portfolio had been doing poorly, the odds are that you haven’t been following one or more of these basic rules.

Diversify, diversify, diversify. In real estate, we’re constantly told that the three most important factors in buying a home are location, location, and location. In investing, it’s diversification times three.

The investors who were most badly hurt in the bear market were those whose portfolios were top-heavy with equity funds. The people who maintained balanced portfolios suffered much smaller losses and perhaps even managed marginal gains because their profits on bond and income trust funds offset the declines on the equities side.

One of the axioms of successful investing is never to take anything for granted. Even the most experienced professionals don’t get it right all the time. Sometimes stocks go down when they should go up or interest rates fall when they are expected to rise. A well-balanced portfolio provides protection against the unexpected and will ensure that no matter what happens your capital will never be unduly exposed to risk. See the October issue of MFU for our current recommendations for a well-balanced portfolio.

Choose funds based on your risk profile. You can’t invest properly unless you know who you are. Among other things, that means understanding how much risk you are prepared to take. You must always look at the worst case scenario and make sure you are prepared to cope with it. The bear market that began this century was a classic example; many people were convinced it couldn’t happen and were blindsided when it did.

If you are a conservative investor, then for heaven’s sake choose conservative funds for your portfolio. On the equity side, managers like Kim Shannon, Jerry Javasky, and Gerald Coleman should be near the top of your list. Companies like Beutel Goodman have a well-earned reputation for taking a sound, conservative approach to money management.

Always check the style and reputation of the manager of any fund you are considering. If he or she is considered to be a financial gunslinger, don’t put your money in the fund unless you are willing to accept the inevitable volatility that will follow.

Keep your costs low. Sales commissions and management expenses eat up a significant portfolio of your profits. The less you pay, the more goes into your pocket.

Shop the no-load fund market first to see if you can build a satisfactory portfolio without paying any commissions at all. Some of the big banks have some first-rate no-load offerings, as do some of the boutique houses (see accompanying article).

If you must choose a load fund, avoid deferred sales charge (DSC) units. They look attractive on the surface but you end up sacrificing flexibility. Many investors held on to losing positions through the bear market because they didn’t want to incur DSC charges on top of the losses they had already suffered. Ask advisors to buy front-end load units at zero commission for you. They’ll make their money on the trailer fees.

Pay special attention to management expense ratios (MERs). They have been on the rise, in some cases dramatically so. AGF American Growth Class, for example, has moved from an MER of 2.69% in 2001 to 3.08% today. That is way out of line for a fund of this type. As we note in our review of Investors Group in this issue, some of their funds also have very high MERs. Unfortunately, there are many similar stories in the industry.

Look at the boutique firms. There are exceptions but, generally speaking, the best combinations of high performance, reasonable risk, and low costs are found in the boutique fund companies, not in the behemoths that dominate the industry. These small firms don’t spend a lot of money on advertising and in most cases the minimum investment requirement is higher than for the mass-production houses. But if you have the money, this is where you should be looking.

Here are our choices for the top boutique fund houses in Canada.

Our Investors Portfolios struggle through a tough period with indifferent results.

It wasn’t a great summer for either stocks or bonds and our three model Investors Group Portfolios reflected that.

Over the six months to Sept. 30, all three were within a point and a quarter of break-even. The ultra-conservative Safety Portfolio was the only one to finish on the plus side of the ledger, with a gain of 0.42%. The Balanced Portfolio slipped 0.52% while the Growth Portfolio, the most aggressive of the three, was off by 1.25%.

There were no real stand-out performers in any of the portfolios. The best result was turned in by Investors Canadian Natural Resource Fund, which added 9.6% during the period. Investors Canadian Large Cap Value Fund also turned in a credible performance with a gain of 4.3% while Investors Real Property Fund added 3%. Most of the others were within five percentage points of break-even, with the exception of Investors Pan-Asian Growth Fund which slipped 10%.

Here’s a run-down on how our three Portfolios stand after five years of tracking.

 These Model Portfolios were launched five years ago, in the fall of 1999, with a starting value of $10,000 each. The mix of funds has been adjusted semi-annually to reflect evolving economic conditions and changes within the Investors Group line-up.

Granted, that five-year period encompassed the bear market of 2000-2002. Nonetheless, we are not overly impressed with the results posted by these Portfolios.

The Safety Portfolio, which emphasizes money market and fixed-income funds, came out ahead by a wide margin, with a total gain of 28.54% over the period. That works out to an average annual compound rate of return of about 5.1%, which is not bad for a low-risk portfolio and is slightly better than the 4.9% annual gain posted by the Investors Income Portfolio during the same period.

Our Model Balanced Portfolio produced an average annual gain of just under 4% while the Model Growth Portfolio was slightly better. However, our Growth Portfolio handily beat the company’s own Investors Growth Portfolio, which added only 0.55% a year over the same period. It is fund-of-funds portfolio that is constructed along the same lines as ours, although obviously not as effectively.

At this point, we will end our five-year portfolio tracking study, although we will of course be revisiting Investors Group from time to time to report on new developments and funds to watch. If you have money invested with this organization, here are some conclusions that you may wish to keep in mind going forward.

Choose low-risk funds. Our tracking clearly shows that IG’s more conservative offerings produce the best and most consistent results over time. While there are a few good equity funds in the mix (see accompanying article), you have look very hard to find them.

Consistently review your portfolio. Sit down with your IG representative at least twice a year and review every fund in the portfolio. Make sure it fits your objectives and, even more important, that it is the best one of its type currently being offered. Investors Group has overwhelmed its advisors and clients with a dizzying array of options, with funds managed by an array of companies including AGF, Beutel Goodman, Goldman Sachs, Franklin Templeton, Fidelity, Mackenzie Financial, Great-West Life, and, of course, Investors’ own in-house team. Trying to select the right Canadian equity fund, for example, can involve wading through more than a dozen candidates. Combine that with the various classes of each fund on offer and you have a dog’s breakfast.

Look elsewhere for income. One of the things we find puzzling about this company, especially given the demographics of its client base, is that it does not offer many attractive income funds of the type that older investors are increasingly seeking. There is nothing equivalent to an income trusts fund in the 335 listings that appear for IG on Globefund. The best choice for income is Investors Canadian High Yield Income Fund, which produced a cash yield of 4.5% in the year to Sept. 30. However, recent distributions have varied significantly, from 7.24c a unit in August to 1.54c per unit in September. Swings of that magnitude make budgeting difficult for people who depend on their investments for income.

Here are our final Investors Portfolio recommendations.

Portfolio changes:  In the Safety Portfolio, we added 5% to the Government Bond Fund weighting, dropping the IG AGF International Bond Fund to compensate. In all three portfolios, we replaced the IG AGF Canadian Balanced Fund with the more consistent IG Beutel Goodman Canadian Balanced Fund.

We increased the position in the Canadian High Yield Income Fund in the Balanced Portfolio to provide more cash flow and dropped the North American Growth Fund from the mix.

In the Growth Portfolio, we added 5% to the Canadian Natural Resource Fund and the Mergers and Acquisitions Fund, dropped the Pan-Asian Growth Fund, and reduced the North American Growth Fund to 5% from 10%.

You have to search through a lot of chaff to find a few grains of wheat in the line-up of this Winnipeg-based company.

Investors Group offers a lot of equity funds. The problem is that most of them are mediocre or worse. Here are our picks for the top choices from their extensive line-up. We looked especially for consistent, above-average performance over several years, combined with reasonable risk.

IG Beutel Goodman Canadian Equity Fund. As we have commented elsewhere in this issue, Beutel Goodman is one of the best boutique money management houses in Canada. The company uses a conservative, value-oriented approach that works to protect capital in bad times and to provide reasonable returns when markets are strong. Over the year to Sept. 30, this fund gained 16%, slightly above the category average. It would have done even better except for the absurdly high MER of 3.22% which Investors Group charges. The equivalent fund bought directly from Beutel Goodman has an MER of 1.34% and a one-year gain of 19.1%.

IG Beutel Goodman Canadian Small Cap Fund. If you want a growth component in your IG portfolio, this has to be part of your mix. Over the past five years, it shows an average annual gain of 14.3%, more than double the category average. But again, you’ll pay through the nose for it, with an MER of 3.21% compared to 1.34% for the original Beutel Goodman Small Cap Fund.

IG Templeton International Equity Fund. It’s been a tough slog for international funds but this one has done better than most. True, it only gained 2.2% annually over the past three years but when you consider than the category average was in the red, that’s not bad. The MER is 3.19% but the gap is not as significant as with the Beutel Goodman funds when compared to the 2.98% MER of the Templeton International Stock Fund.

Investors Euro Mid-Cap Equity Fund. We like this one a lot. It has been a consistent first-quartile performer since its launch in mid-2000 and the three-year average annual compound rate of return is an impressive 13.9% compared to a virtual break-even for the category as a whole. If you want to invest in Europe, add this one to your mix.

Investors European Equity Fund. This one has the same manager as the Euro Mid-Cap Fund, Martin Fahey, and he has to rate as one of the emerging stars in the IG organization. The results are not as outstanding as those of the more focused Mid-Cap Fund, but they are well above average. Choose this one if you prefer a more broadly-based portfolio.

Investors Global Fund. This isn’t a head-turner by any stretch of the imagination, but it is a respectable entry if you want a well-rounded global portfolio. Returns are slightly above average with risk slightly lower than average.

Investors Mergers and Acquisitions Fund. We don’t know of any other fund quite like this one. Manager John Campbell of CWC Management seeks out companies whose stock appears ready to profit from mergers or acquisitions and he has shown himself to be very astute with his picks. The fund has a three-year average annual return of 9.1% and a one-year gain of better than 17%. It can be somewhat volatile, however. Most of the assets are in U.S. and Canadian companies.

Investors U.S. Opportunities Fund. This is basically a small-cap U.S. fund, although it is not officially classified that way. It isn’t a barn-burner but it has managed to produce above-average returns over the past five years with an annual gain of 4.6%. Worth a look if you want a fund like this in your portfolio but it is mainly for more aggressive investors.

Ivy Canadian, DSC costs, and income trusts confusion.

Queries value of Ivy Canadian

Q - Is Mackenzie Ivy Canadian still a good investment fund? – S.N.

A – It depends on what you are looking for. The fund remains on the MFU Recommended List with a Buy rating, but it is most suitable for those for whom protecting capital is a high priority. The manager, Jerry Javasky, employs a very conservative style and will hold a large percentage of cash when he sees trouble ahead for the markets. As of Sept. 30 his cash position was 13.4%, which is high by the standards of most equity funds but not unusual for him.

The result is a fund that tends to hold its ground well in falling markets. During the bear market, for example, it finished in the red only once, a modest 4.7% decline in 2002. However, when stocks are strong this fund tends to lag the field. In the latest 12-month period it gained only 9.9%, well below the category average of 15.5%. Over the long term, results are slightly better than average. Combined with low volatility, that makes this a good choice for conservative, long-term investors. But if you want a fund that is going to generate double-digit returns, look elsewhere. – G.P.

Unhappy with advisor

Q - If we are not happy with our financial advisor and we want to transfer our money into a self-directed RRSP account what are the consequences? The money has been invested (without any surprise) in companies like Mackenzie, CI, Trimark, etc., which all have DSC costs. Do I have to pay the DSC charges (as per the descending scale)?

It does not seem fair that if someone is not doing a good job I still have to pay to get my money out. What is the point of getting a financial advisor? The money is always "stuck"!

Can I get around the charges? Is there any recourse? – J.D.

A – Of course you can avoid the deferred sales charges. You don’t have to sell your fund units at all – simply instruct your advisor to transfer the assets to your new self-directed RRSP. The company that you use for the plan should complete all the paperwork for you.

Once the account is transferred, if you are not happy with the portfolio composition you can avoid paying DSC by switching the assets to other funds within the same group that are better suited to your needs.

For future purchases, the best way to avoid this problem is to stick with no-load funds or buy on a front-end load basis with the lowest possible commission. – G.P.

Which income trusts fund?

Q – The October issue of MFU recommended both the EnerVest Diversified Income Trust and the Dynamic Focus+ Diversified Income Trust Fund. My question is which one would you recommend for an RRSP and why?

 Thanks for your excellent efforts on behalf of the average investor in your columns. – E.M., Nanaimo, BC

A – For starters, let’s again clarify the difference between these two choices. EnerVest is an exchange-traded fund (ETF) that trades on Toronto under the symbol EIT.UN. When we recommended it last month, it was trading at $7.40; it closed on Oct. 29 at $7.46.

Dynamic Focus+ is a mutual fund. You would buy units in the usual way, either through an advisor, mutual fund dealer, or discount broker. We did not formally recommend it but noted that among the income trust mutual funds we examined, it was our preferred choice.

Both of these funds invest in a portfolio of income trusts but there are some differences worth noting. Let’s look at each in more detail.

EnerVest is a large fund, with $1.1 billion in assets. Monthly distributions are currently being paid at the rate of 7c a unit, which works out to a projected cash flow of 11.3% over the next 12 months based on the recent trading price of $7.46. The payments have been at that level since May 2000, which is a good sign. Management estimates that about 60% of the 2004 distributions will be received on a tax-deferred basis if the units are held outside an RRSP.

The fund has done well in recent years but a look at its long-term record shows a fair amount of volatility in the market price. The shares traded as low as $5.98 in 2003 so you need to be aware of the potential downside.

EverVest’s main attraction, and the reason we chose it as our top pick, is the high cash flow which is of special importance to investors seeking regular income. However, cash flow is generally not a high priority for RRSPs and of course the tax advantage is lost in the plan.

The Dynamic fund, which with $1.7 billion in assets is even bigger than EnerVest, also offers strong cash flow, with distributions of 8c a month. However, based on a recent NAV of $15.01, the cash yield at 6.4% is much less than that of EnerVest. Also, the tax advantages of the Dynamic fund are less, so the loss within an RRSP is not as significant.

The MER of the Dynamic fund is 2.39%, compared to about 1.4% for EnerVest, which is worth taking into account.

The Dynamic fund does not have as long a record as EnerVest, having been launched in July 2001. Therefore, we do not have a sense of how volatile it may be when the income trust sector experiences a prolonged correction. What we do know, however, is that the bulk of the profit so far has come from capital gains, not income. The average annual compound rate of return over the three years to Sept. 30 is a very high 24.5%. That kind of performance makes it the best candidate for a growth-oriented RRSP. For non-registered accounts and RRIFs, EnerVest would be the better choice. – G.P.

A thank you note

It’s always nice to get positive feed-back from our readers. Here’s a note that arrived in our inbox just before press time.

“Thank you for your recommendations on RBC O'Shaughnessy Canadian Equity Fund and RBC O'Shaughnessy U.S Value Fund; both are up about 5% since I purchased them in late August 2004. I just wanted to say Thank you. – K.M., Red Deer, AB

We add two CIBC income funds to our Database.

CIBC GLOBAL BOND INDEX FUND   $

The mandate of this fund is to track the performance of the J.P. Morgan Global Government Bond Index, excluding Canada. It manages to do this while achieving full RRSP eligibility through the use of derivatives and buying bonds issued by supra-national financial institutions such as the World Bank. The fund got off to a good start but it has faltered recently, dropping 4.3% in the six months to Sept. 30 as the Canadian dollar rose. That pulled down the longer-term results to below average. Euro-denominated securities lead the portfolio with 38% of the assets, but it was the 24% position in U.S. dollar securities that pulled it down. The best we can offer here is a $ rating.

CIBC HIGH YIELD CASH FUND   $$

If you're looking for somewhere safe for your money, this is a good spot. Just don't expect much in the way of returns. The fund is officially classified as a short-term bond fund but CIBC actually positions it somewhere between a money market fund and a short-term bond fund. This makes performance comparisons with the rest of the category somewhat misleading, but no matter how you look at it they're low. Over the year to Sept. 30, unitholders gained just 1.7%. The three-year average annual compound rate of return was 2.2%, so you can see that as long as rates stay low there is not a lot here. Distributions are paid monthly and have been running about 1.3c a unit recently. If capital protection is at the top of your priority list, it is worth a look but you won't get rich.

I have just had a new book published by Penguin Canada and for a change this one has nothing to do with money. It’s called Quizmas and it’s a collection of Christmas-related trivia questions, combined with some of my personal reminiscences of Christmases past. With the help of several family members, including one of my granddaughters, we’ve put together more than 700 multiple-choice questions for both children and grown-ups that I hope will bring some extra family fun to the holiday season.

Actually, we’ve been playing Quizmas at our own house for several years. At the suggestion of my youngest daughter Deborah, who co-authored the book with me, I make up 20 new questions each year and pass them around. The person with the highest score wins a little prize – and, more often than not, it is one of the kids.