Cover | Investment

THE BEST AND WORST MUTUAL FUNDS

OK, 2001 sucked. But investors are staying cool-and lowering expectations

KATHERINE MACKLEM January 28 2002
Cover | Investment

THE BEST AND WORST MUTUAL FUNDS

OK, 2001 sucked. But investors are staying cool-and lowering expectations

KATHERINE MACKLEM January 28 2002

There was a time when David Kuracina clicked into his investment account almost every day to have a look at his mounting riches. Kuracina, an elementary school teacher in Ottawa by day, has been managing most of his investments electronically at home in the evening for the past four years. “I could have told you exactly what my portfolio was worth on any given day,” he says. In those good old days—about three years ago—he was worth more money each time he looked. “You know, honey,” he'd say from time to time to his wife, Mary, “we’ve made $2,000 today.”

In 1999, he estimates he made double his income just from growth in the stock market. Sadly, the fun times are long gone. “Now,” says Kuracina, 49, “I don’t click on my account at all.”

Perhaps it’s better not to know.

The only comfort for investors in the despondent stock market of 2001 is that they have plenty of company: almost everyone with money invested in securities last year watched it shrink month by month. The Toronto Stock Exchange 300 composite index, which measures the performance of the broad Canadian equities market, fell by 14 per cent from the year’s beginning to its end.

Canadian mutual funds didn’t do a whole lot better. They started 2001 with a total value of $418.9 billion, as tracked by the Investment Funds Institute of Canada. While the declining markets nibbled away at that figure, the funds managed to squeak up in November and December to close the year at $426.4 billion, a slim 1.8 per cent higher than 12 months earlier. The gain, though, is somewhat misleading. It includes the $28.6 billion Canadians continued to throw into their mutual fund holdings—often through automatic contributions. Stripping out the new money invested during the year, mutual funds last year lost $21.1 billion, or five per cent, in value, the first time in seven years their overall market value declined. Ed Legzdins, head of Bank of Montreal’s mutual funds group, notes that 2001 was a continuation of the poor markets of the last half of the previous year—and stood in sharp contrast to the frothy tops of’98, ’99 and early 2000. “Investors discovered,” he remarks dryly, “both halves of the risk-reward equation.” 

Balancing risk against reward drives the thinking behind Maclean's annual mutual fund rankings, which are compiled by Morningstar Research Inc., a Toronto-based investment research company owned by Morningstar Inc. of Chicago. The tables offer the best and worst funds in eight selected categories based on three important measures: the annual compound return over the last three years, the rolling three-year return over 15 years (or a fund’s life), and a special Morningstar risk/return score. The latter two are new this year, designed to deepen the analysis of funds’ longer-term performance—an ever more critical exercise given the market turbulence of the past year and a half.

The new rolling return measure takes the percentage return from each three-year period, starting in January, 1987, if available, and moving month by month through the total period to December, 2001, to produce a very refined average showing how the fund has done historically over the medium term. The risk/return score (which is not a percentage) compares fund performance over the past three years to government treasury bills, including how often it was better, how often worse. Sometimes, an entire category falls short of T-bills when risk is factored in, producing this year's all-negative scores in the Canadian bond category.

The rankings highlight three-year returns to allow investors to compare a fund’s longer-term performance against that of its peers (funds that have existed for less than three years are not included). This year another change brings that perspective to Maclean's Hot 100 mutual funds, an exclusive best-of-class listing compiled by Morningstar Canada and based on its well-known five-star rating system. The Hot 100, all five-star funds, are now ranked on the basis of their three-year annual compound return.

And just for fun—not advice—there’s a table showing the winners and losers based only on last year’s performance. All tables show returns after deducting management fees (but not sales commissions, if applicable) and are based on total returns, including dividends, to Dec. 31, 2001—disappointing as many may be. In five of the eight categories, the three-year compound return winner scored lower than last year’s. Only the chart toppers in Canadian equity, Canadian small cap and global equity showed better three-year results.

To Morningstar Canada president Scott Mackenzie, a declining market and shrinking investments are not only difficult for investors to swallow psychologically but are tough, in practical terms, to recover from. The science and tech funds—the market drivers of 1999 and early 2000—dropped an average 66.6 per cent from September, 2000, to September, 2001, the sector’s lowest point of the year. An investor with, say, $1,000 in this group at the beginning point would have had only $333 at the end. “In order to get back to the original value of $1,000, the investor must triple his money,” points out Mackenzie. “Not many funds achieve those kinds of returns in a year,” he says. “I mean, that is significant.”

Luciano Degan, a 49-year-old father of two, has been purchasing mutual funds since 1995. “Absolutely, last year was the worst for me,” he says, “and I got hammered.” He'd invested about 20 per cent of his portfolio aggressively in science and technology, and growth funds. Degan’s response to the downturn? He kept plugging money back in. “As the market started dropping, the only disposable income I had I used to top up my RRSPs.” Much of it went into his tech, aggressive growth and small cap funds—the three that had lost the most. “Right now, they are the three that are making more of a comeback,” he says. Degan, a Toronto communications technician, is confident he’s making the right investment choices. “Basically the dip wasn’t going to affect my long-term plans,” he says. “Hey, nothing’s guaranteed, so I just ride it.”

Ottawa’s Kuracina is also philosophical about the downturn in the market. One fund he’d held, a U.S. small cap fund, climbed a spectacular 120 per cent in one year, only to fall back to about 30 per cent above the price he paid, which is, as he says, “not bad.” Overall, Kuracina’s six-figure portfolio is down about 25 per cent from its highest point.

He’s not alone in wanting to avoid looking at his portfolio—47 per cent of Canadians with RRSPs who were polled recently said they check market movements less than once a month. Only one in 10 had a look every day, according to the poll, conducted for Toronto-Dominion Bank by Environics Research. “The market doesn’t make me quite as happy as it used to,” Kuracina deadpans, “and I’m in it for the long term. So checking it is neither here nor there.” He’s sticking with equities—he hasn’t, and doesn’t plan to, switch his holdings into safer, less volatile, assets. Again, he’s got company. Seven in 10 investors polled by Environics made no changes last year to their investments. Kuracina says investors in equities pay a price, even though the stock market generally rises over the long haul: “It’s a roller coaster.”

Others couldn’t quite handle the dips. People with new capital to invest put 54 per cent more into super-safe money-market funds than into what’s called long-term funds—mainly the equity and bond categories—according to IFIC. The money markets, a sleepy, slow investment instrument traditionally used as a parking spot for money that will be idle for a short period, offer a very low rate of return—a little above a bank savings account—in exchange for ironclad security. Last year, the Canadian money markets were among the industry’s most exciting features, and provided some of the most spectacular numbers: at $15.7 billion, more new money flowed into them than anywhere else—an eye-popping 2,326 per cent hike over the previous year. By comparison, new investments in the long-term funds —still much larger in total assets than money-market funds—shrank by nearly 50 per cent, to $11.5 billion.

Many investors also held substantial cash positions. According to the Investment Dealers Association, which represents the securities industry, cash in retail investors’ accounts hit a historic high in September and stayed there in October, the most recent data available. The IDA stats show that investors with brokerage firm accounts held $21 billion in cash in those two crucial months—about 17 per cent higher than the same period a year earlier. While the Sept. 11 terror attacks put investors on alert, the securities industry performance had already deteriorated during the summer, says Stan Kumagai, an economist with the IDA. “Investors in the summer months kept a wary eye on signs of slowing activity in North American economies,” Kumagai says. Looking forward, he thinks investments now in money markets could provide a significant boost to the stock market, “when investor interest in equity returns.”

WHAT THE RANKINGS MEAN

THREE-YEAR ANNUAL COMPOUND RETURN: Annual compound return over three years to Dec. 31, 2001. All funds in these tables must have a three-year return history.

AVERAGE THREE-YEAR ROLLING RETURN:

The average annualized return over every three-year period, changing month by month, in the last 15 years or since a fund’s inception. Shows which funds performed best over the medium term.

RISK/RETURN SCORE:

Shows return against the degree of risk a fund has taken over the last three years, relative to the category average. The score uses some clever math to measure the length and magnitude of a fund’s ups and downs against risk-free government treasury bills, and against the averages for the category. A higher number means the fund did better than its peers in the face of market volatility.

AVAILABILITY:

Some funds are restricted to certain provinces or certain professional groups, or have minimum investment requirements.

As attractive as the safe and secure money markets are, and as much as they were the winners in the new sales race, they earned very little in return for their investors. Still, at 3.5 per cent for the category, as calculated by Morningstar Canada, investors didn’t lose money, as they did in most equity categories. Canadian equity, European equity, global equity, U.S. equity, Japanese equity—these fund categories all lost money overall in 2001. The only equity categories in the black were the Canadian dividend and Canadian small cap funds.

Eric Sprott, chairman of Sprott Securities Inc. and the director of his company’s investment policy, tops three of the Maclean's charts, including the Hot 100 with his Sprott Canadian Equity Fund, which posted a three-year annual return of 47 per cent (leading the Canadian small cap list as well), and an exceptional 43.7 per cent return for last year. Another of Sprott’s funds, Sprott Hedge Fund I.P, led the year’s winners list, with an return of 64.2 per cent. “You’ll find it funny when I say I don’t like being invested in stocks today,” says Sprott, who calls himself “probably the most bearish guy on Bay Street.” He likes—profitably—gold and precious metal companies. Through most of 2001, 20 per cent of his portfolio was in cash, he says. Sprott expects the current bear market will last a long time. How long? “The last secular bear market was from 1968 to 1982,” he says.

Outside of the money markets, some investors still made money. At four to six per cent, bonds did reasonably well (everything’s relative). But the year’s winners were the investors wise, or lucky, enough to hold precious metal or income trust funds, the only categories to see double-digit returns. Precious metals, which lost 10.7 per cent in 2000, were up 25.4 per cent last year. Canadian income trust funds, which are mainly invested in real estate and energy trusts, did well for the second year running. In 2000, these funds rose 17.9 per cent; last year, they were up 13.7 per cent. But the two good years followed a couple of bad ones: 0.5 per cent return in 1999 and a loss of eight per cent in 1998.

In the face of this bad-news year, Canadian investors, like Kuracina and Degan, showed a lot of backbone. At the same time that the banks and mutual fund companies did complete 180s on their advertising campaigns—ads proclaiming double and sometimes triple-digit returns in big bold letters were replaced with timeless sage advice, such as “Buy. Hold. And prosper”—investors stood their ground. Along with the 71 per cent of investors in the TD-Environics poll who said they made no changes to their portfolios, three quarters said their willingness to take risks stayed the same. Four out of five said they will continue to manage their investments in the same way they did last year. Statistics from the Investment Funds Institute bear this out. Redemption rates, the amount of mutual funds investors cashed in, were significantly less in 2001 than in previous years. “Although 2001 was quite volatile, investors seem to have decided to stay put and ride out the storm instead of redeeming their investments,” says Susan McGavin, who prepared a year-end report on the industry for IFIC. Investors also have realistic expectations about future performance, says Patricia Lovett-Reid, managing director of TD Asset Management. She adds: “Investors are poised rather than panicked.”

There’s no doubt, the frenzy is over. Online trading has fallen off dramatically. There’s been a real shift in demand for good investment advice. More than 40 per cent of Canadians who trade online use a professional financial adviser, according a study conducted by Gómez Canada, which monitors companies’ Internet services. “Advice is an immediate priority,” says Don Rolfe, a Gómez director. Among the respondents to the TD-Environics poll, three-quarters said they sought professional advice in 2001.

Cliff Monar, a former diehard day trader, is back in an office, working once again for someone else. Monar, 36, earned his living from 1997 to 1999 trading stocks from a computer in his den in Calgary, and says he made more money staying home than he would have in an office job. But towards the end, as the market lulled, he was just breaking even—covering his brokerage fees and other expenses. It wasn’t enough. “Treading water just doesn’t cut it,” Monar says. As he considered a return to the job market, he got a phone call from an energy company where he’d worked before. He traded in his “sweats and jammies” for a casual business outfit and took the job.

In the early days of mutual funds, back in the 1980s, investors in the then-novel instrument were often referred to as GIC refugees. As stock markets began to tank around the world in 2000, questions were raised about how long investors would stay put. Would they flee and become mutual fund refugees? It hasn’t happened, at least not in Canada. “We’re seeing the emergence of a more rational investor,” says Lovett-Reid of TD Bank.

A clear sign that the hot market is finished and that investors’ expectations have fallen back to earth is the performance of David Chilton's book, The Wealthy Barber. As the stock market tumbled, sales of the book, an enormously popular investing guide, shot up the charts. In the last six months of 2001, its sales were 50 per cent higher than in the whole previous year, says Terry Palmer, vice-president at Stoddart Publishing Co. Ltd. The book, which has sold a phenomenal 1.5 million copies in Canada in the 13 years it’s been in print, champions a cautious, conservative approach to investing. “I sound like a broken record,” Chilton says. “You can’t get rich quick.”

If there’s one consistent message from the experts to investors, it is: don’t try to time the markets. But money should start going back into equities, advises Legzdins of the Bank of Montreal. Investors have cleaned out much of the risk in their portfolios, and it’s probably time to put some of it back in, he says. It’s better to have a handle on the future direction of the market than to try to time it, he says. “Were somewhere near the trough,” Legzdins says. “It’s not important to know exactly when it is.”

Morningstar s Mackenzie says investors should study the mutual fund charts only after they’ve decided which sectors or families of funds they want to be in. He echoes Legzdins on market timing. “Those who time the markets correctly are the lucky ones,” Mackenzie says. The concept of “portfolio” is coming of age, he adds. With the volatility of the market, investors are beginning to see that a reasonable mix of investments is the correct way to proceed. Diversity has become a key message. IFIC CEO Tom Hockin says the years 1998 to 2001 “are a fabulous case study about the importance of diversification.”

Another fairly consistent piece of expert advice is to invest part of a portfolio outside Canada—a strategy that Canadians now use surprisingly sparingly. A Royal Bank of Canada study says the average foreign content in an RRSP portfolio is 9.9 per cent, well below the allowable limit of 30 per cent. Over the past year, says Legzdins, “people reverted to what they know best—and that is the Canadian market.” IFIC’s numbers back that up. In 2000, 87 per cent of the new money going into mutual funds poured into foreign assets, and the rest was invested domestically. This past year, it was the precise reverse— 87 per cent of total sales in 2001 were domestic. “It’s a huge swing,” says Legzdins, who advises investors to raise their foreign content.

The disappointment of 2001—RRSP holders told the TD-Environics pollsters that last year they were gunning for an 11.5 per cent return on average—has translated into a lowering of expectations. This year, Canadians with RRSPs hope to achieve, on average, an 8.9 per cent return. Given that the historical average is somewhere in that ballpark, investors have clearly come back down to earth. **

With Michael Snider and Meg Floyd in Toronto