Managed Money Reporter Newsletter — Issue 207, June 2004

Editors: Carl Spiess & Allan McGlade

Carl & Allan's Recommended List Updated

This month, we have made some additions to our recommended funds list. The list is online at:

http://managedmoneyreporter.ca/options/recommended.pdf

We thought we would share some of the rationale for the fund choices we make, and also provide some commentary on why we believe that actively managed funds are still appropriate for most investors.

First, ScotiaMcLeod has an extensive list of recommended funds, and our team of experts perform an initial review of the 2,000 funds that are available and narrow things down to 200 funds. For a description of the process that ScotiaMcLeod uses, please see the "How we analyse funds" (.pdf 29k) from ScotiaMcLeod's fund research department.

From there, Allan McGlade and I review the list, take into account our own meetings with fund managers and our personal and client investment experiences in funds over the last 15 years, and further narrow the list. We then used qualitative criteria like management style (value vs. growth), and also hard numbers like standard deviation, the sharpe ratio (units of return/units of risk), Bellcharts/Morningstar ratings, and correlation measures between funds in each category. We generally also want funds with 3 year performance histories, so that risk measures can be used.

Our goal is to find funds that will complement each other and provide lower risk portfolios, rather than trying to predict which single fund will be the best performer next year. Interestingly, while the long term performance of a fund is important for inclusion in our list, very few of the recommended funds show up on the Top Ten/Bottom Ten rankings, as those tend to be the most volatile funds, and are rarely in our client portfolios.

So this is how we develop Carl and Allan's current personal recommended list. Most of our clients will have many of the recommended funds in their present portfolios. However, many of our clients will hold other funds that are not on the list for individual circumstances. We may in the future choose to further diversify your account by adding one or two of the new additions to our fund list, to your account.

There are two notable changes to long term recommended funds. We have replaced Templeton International Stock fund with Templeton Growth fund. We have also replaced Fidelity Canadian Asset Allocation fund with Fidelity Canadian Balanced fund. In each case they are similar funds from the same fund family and we may not even need to make a change in your account. Many clients already hold both, so we would be pleased to review and likely take appropriate action based on your personal situation.

We will also continue to monitor the funds on our recommended list, and be in touch with you if we think that a future change is required to your funds. This is our performance monitoring commitment to you.

Fred Ketchen Presents Carl Spiess with "Golden Jacket"

Last month, Fred Ketchen, ScotiaMcLeod's Director of Equity Trading, presented Carl Spiess with a ScotiaMcLeod traders jacket. (Prior to 1997, when live trading ceased on the the Toronto Stock Exchange Floor, McLeod traders wore the colourful jackets to easily recognize each other and thus trade more efficiently.)

The occasion was ScotiaMcLeod's Ontario conference, where 400 ScotiaMcLeod advisors joined in 2 days of continuing education. The jacket was awarded to Carl as the top advisor in Ontario. The presentation is expected to become an annual event, with each year's top advisor in Ontario being presented with a McLeod trader's jacket. The bad news being that the advisor may actually be expected to wear it from time to time! (see photo, as Fred looks more than a little bit like Don Cherry!).

On behalf of Carl and the team, a special thank you to all our clients, for letting us serve you. We received this recognition as many clients like yourself have entrusted us to care for your investments, a task we take very seriously. Our team continues to strive for excellence in all aspects of managing your account.

Most Canadian Mutual Funds Outperform their Index over Last 5 Years

Here is some research that Carl Spiess provided to the media recently:

The bear market of the last few years turned the commonly accepted wisdom that "the average fund under performs the index due to high fees" on its head. The start and end point of such calculations are very important when making generalizations, and the data below will provide solid confirmation that over the last 5 years, our clients have been well served even after all fees, in actively managed Canadian equity funds.

Out of the Canadian Equity category in Bellcharts/Morningstar to the end of April 30, 2004, there were 314 funds with a 5 year performance figure. Of those 314, 188, or 59.9% outperformed the Composite index return of 4.9%, each returning 5% or more, net of all fees. The average fund returned 5.6% after the average Management Expense Ratio of 2.87%.

But we can have even more fun with fund stats, as there are two other Canadian equity categories that also use the TSX as their benchmark. (Note the TSX 60 index is used as a benchmark for large cap dividend funds, the TSX composite is the benchmark for other Canadian equity funds.)

A much higher percentage of Canadian Dividend funds outperformed their TSX benchmark of the TSX60. There, of the 64 funds with 5 year returns, fully 58 or 90.6% of the dividend funds returned more than the S&P/TSX 60's 3.9%. (The TSX 60 has a higher weighting in NT, thus the lower performance of that large cap index.)

Finally, in the Pure Canadian Equity category (funds with no foreign content to help diversify the fund), of the 45 funds with 5 year numbers, 22 of the 45 funds (48.9%) outperformed the TSX composite index after fees, not such a powerful number. But, as this category includes 12 index funds, every one of which falls into the bottom half of that category (as they also have management fees – albeit smaller ones - deducted from their returns), this actually provides the best proof that the expense of active management is worth paying for in tough markets. Excluding those index funds from the 45, we then have 22 out of 33 or 66% of actively managed pure Canadian funds outperforming the composite index after fees, whereas 100% of index funds underperformed their index.

The five year time frame is a good one for these kinds of stats supporting this thesis, just as the 10 year period up to 2000 (with the strong performance of NT up to that point) had been a great one for people wanting to show the under performance that active management will inevitably suffer in huge bull market.

The 10 year numbers do continue to show that the "average" actively managed fund indeed under performed the index benchmarks. As if you could invest in the index benchmarks at no cost! Interestingly, the only index fund with a 10 year number, the TD Cdn Index, after fees, shows a return of 8.0% that is very close to the average active fund's return after fees of 7.8%. That is not a very big performance gap at all.

But the typical client is risk adverse, so what funds best serve that clients needs? Most clients look not only at the return of a fund, but the risk as measured by volatility known as standard deviation. Clients don't really actually measure volatility, rather they bail out of the investments that drop too quickly in value, at precisely the wrong time, and there is no doubt that the risk figures (see std deviation figures) of the index or index funds is higher than the average actively managed fund.

Interestingly, if we measure the return per unit of risk, (a good measure of the value of return per unit of risk is the Sharpe ratio =(return–risk free rate)/volatility ; higher numbers are better) we see that the 3 active fund categories all out perform or equal the index fund in an independent assessment of value after fees per unit of risk. Clearly there are reasons that clients continue to hold record assets in funds; they present real value to investors not just for their absolute returns, but their consistency.

The real test for most clients, and their advisors (who study not only averages and statistics, but also take the phone calls when real people's real money is lost), is how much pain is suffered when markets go down. In the worst 5 year rolling periods in the last 10 years, the indices, below, (and index funds) suffered negative returns of over 9% over the worst 60 month period (see worst 5 year number). There is no 5 year rolling period in the last decade where the average actively managed fund suffered a negative return. Note: that comment does not mean that there were no active funds that suffered a negative return over 5 years, just that the "average" one didn't.

The stats above apply to the Canadian equity category and similar data, albeit not such obvious conclusions, can be shown for US and International equity funds. However, the argument that "costs matter" has validity and the categories where the average active funds have real difficulty outperforming their respective indices is in the money market and bond areas. We'll leave that discussion for another time but we want to be clear: The average Canadian equity fund, even after fees, has significantly outperformed their respective index over the last 5 years. And over longer time frames, the lower risk of the average actively managed fund presents quantifiable benefits to investors.

This brings us to our last point, which is the term the "average" fund. The majority of people do not invest in the "average" fund, whether that fund out or under performs the index. The vast majority of client assets are in above average funds which is quite logical, as people tend to be attracted to the fund managers that perform.

It is time to really look at some hard statistics as the facts really have changed in the last few years Like any product, with mutual funds, there are good and bad ones, expensive and cheap ones. The more people know, the better they will be served.

To help investors understand the fees involved in Mutual Fund investing, and to demonstrate some of the value received in exchange for those fees, we recommend looking at an excellent new publication from Mackenzie Financial, Fees and Mutual Fund Investing .pdf 208k.

Please email or phone (416-863-RRSP or 1-800-387-9273) for more information on this topic. We look forward to answering any questions you may have about your investments and fees.

Fun with Numbers

This month, we look at the importance stable returns, instead of chasing last year's hot performer.

Return	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Simple Average of single years
Boring Fund	8%	8%	8%	8%	8%	8%	8%	8%	8%	8%	8.0%
OK Fund	20%	-5%	20%	-5%	20%	-5%	20%	-5%	20%	-5%	7.5%
Risky Fund 1	100%	-50%	100%	-50%	100%	-50%	100%	-50%	100%	-50%	25.0%
Risky Fund 2	-50%	100%	-50%	100%	-50%	100%	-50%	100%	-50%	100%	25.0%
Actual Values											Actual Annual Compound Growth Rate
$10,000	10,800	11,664	12,597	13,605	14,693	15,869	17,138	18,509	19,990	21,589	8.0%
$10,000	12,000	11,400	13,680	12,996	15,595	14,815	17,779	16,890	20,268	19,254	6.8%
$10,000	20,000	10,000	20,000	10,000	20,000	10,000	20,000	10,000	20,000	10,000	0.0%
$10,000	5,000	10,000	5,000	10,000	5,000	10,000	5,000	10,000	5,000	10,000	0.0%

The interesting part about this, is how important it is not to lose money. The lower the risk (volatility) of a fund, the better, and often, slow boring, steady returns wind up providing the best long term growth. This is why funds that shoot up 100% in a year, are unlikely show up on Carl & Allan's recommended list.

Due Diligence - Meeting with George Morgan, Templeton Growth Fund

Recently, your investment team had an exclusive presentation from George Morgan, manager of Templeton Growth fund, the largest international fund available in Canada. Templeton Growth is one of those funds, that clients either love or hate, largely depending on when they bought into it. For one of our clients, who invested in the fund in 1972, his returns have been remarkable. See the fund brochure (.pdf 1025k) and graphic, right, for a 50 year perspective.

For clients who invested 5, 4, 3 or 2 years ago, frustration would be a more common term. (However, the clients who invested last year, are very pleased with their investment performance.) George was quite sympathetic to the lack of real nominal return over the 2-5 year time frame, but was clearly pleased with his relative performance vs. the indexes over the same time frame as shown in the slide to the right.

George is continuing the Templeton philosophy of buying a diversified portfolio of the best companies in the world, with a 5 year view to their future potential.

For those curious to hear more from George and the rest of the Templeton Management team, the Annual meeting is Thursday July 22, 1:30pm at the Metro Toronto Convention Centre. To register or find out more, please visit: www.franklintempleton.ca

Fund News

New LSIFs Out in Ontario

The big news for Labour Sponsored Fund investors was hidden deep in the recent Ontario Budget. There is now a restriction on the formation of new LSIF funds for the Ontario market. This is a result of the plethora of new funds introduced in the last few years, and the low amount of capital that the new funds raised, which will hamper their ability to invest and generate returns in the future. We hope that a future development as a result of this will be the merger of smaller LSIFs and the ability to switch between any LSIF funds. See a related article from the Fund Library

CI Winds Up 7 Funds

CI recently completed the merger and windup of 7 funds. The seven funds that were terminated each had a similar mandate and the same portfolio manager as the fund into which it was merged. All changes have been reflected on client statements, and we continue to be pleased when smaller potentially underperforming funds are merged into larger funds which continue to be actively managed.

Mutual Fund Reporter Recommended Website of the Month

To Find out more about the Toronto Stock Exchange, get stock quotes, and review the TSE's history, as it is now the TSX, please visit:

http://www.tsx.com/

For more on the Toronto Stock Exchange's history including how, in 1997, the Toronto Stock Exchange became the largest stock exchange in North America to choose a floorless, electronic (or virtual trading) environment, please visit:

http://www.tse.com/en/pdf/TSXHistory.pdf