Keep an eye
on what impacts portfolio
I’m
noticing a disturbing trend among mutual fund investors today. Many are
flocking to funds they perceive as safe – i.e. bond, high income, and dividend
funds. It’s easy to understand the attraction. It’s driven by a focus on cash
flow now, rather than later, and good recent performance in an otherwise ugly
investing environment. But there is a risk
During
calendar 2002, investors showed their love for tortoise-like funds, such as
balanced, bond, dividend funds, and high income funds. These fund groups
attracted more than $6 billion in new investment during 2002 when all funds
posted net sales of just over $3 billion – meaning the total of all other
categories saw significant amounts flow out.
Net sales
of funds for 2002 was down more than 91 percent compared to 2001, but balanced,
bond, dividend, and high income funds saw sales rise by about 1/3rd.
If we go back to calendar 2000, the total of these now popular categories
actually saw investors pull out almost $500 million.
That
clearly demonstrates two things: a)
that investors make decisions based on recent performance, and b) some fund
investors may be setting themselves up for more disappointment going forward.
In a portfolio
context, factor risks are simply various factors that impact performance. For
example, recall that a government bond fund will be driven primarily by
interest rate changes. That seems pretty straightforward.
For a less
straightforward example, consider Onex Corp – which trades on the Toronto Stock
Exchange under the symbol OCX. It is classified under the “Electronic
Components and Equipment” industry, but it has holdings in many different
businesses.
While Onex
owns interests in Celestica (an electronics manufacturer), it also has
significant exposure to automotive, sugar refining, and entertainment. This is
clearly a company that is not influenced purely by any one industry. You can
view its various holdings by clicking here.
This same
logic should be used in constructing portfolios.
Rather than
just looking at broad asset class weightings, getting a feel for the many
factors that affect investment holdings will go a long way toward controlling
risk. However, what many fund investors are doing today is – potentially –
setting themselves up for more disappointment if the economy stages even a
moderate recovery.
Recall that
bond, balanced, dividend funds, and high income funds are attracting most of
the money in mutual funds these days. The common denominator among these types
of funds is that all are highly interest rate sensitive.
Many
investors are shifting the stock components of their portfolios in favour of
dividend funds – and high income funds in particular. At the same time, many
are also moving significant amounts to traditional bond funds. Problem is, if
rates continue their ascent, both sides of such a portfolio will be hit.
(Interested
readers may want to refer back to this
November 2002 article on interest rate trends.)
As noted in
my December
Strategy Update, high yield bonds are an ideal home for profits taken from
government bonds – allowing investors to take advantage of a potentially
attractive opportunity and reduce portfolio interest rate sensitivity.
If you’re
holding individual income trusts, you may have a preference for the type of
government bonds you continue to hold. A CIBC World Markets report (Income
Trust Weekly: In Yield We Trust, January
10, 2003) demonstrates that different types of trust have different interest
rate sensitivities.
For
instance, CIBC asserts that pipeline trusts are more sensitive (i.e. inversely
correlated) to the 3-month Treasury bill yield as compared to longer-term bond
yields due to the average term of contracts with shippers. Power trusts and
business trusts, on the other hand, tend to be more responsive to interest rate
changes on the “long end” of the yield curve (i.e. 10 year maturities or
greater). As for funds of income trusts, most will tend to be sensitive to
longer term rates, but that will depend more specifically on each fund’s
make-up and whether (in the case of a closed-end fund of trusts) it uses
leverage.
Whatever
the make-up of your portfolio, being aware of specific factors that impact the
various components will go a long way toward making the ride along with way
much smoother.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling
Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.