Investors
must do their homework
Driving
instructors teach young drivers to do a true “look over the shoulder” check
before switching lanes. Nine times out of ten, there won’t be any vehicle in
the blind spot but it’s a safety measure that all of us are taught, and few
follow well. Mutual fund investors are constantly reminded, thanks to
provincial securities regulators, that they should thoroughly read a mutual
fund’s simplified prospectus before investing. Again, most of the time,
investors won’t need to look much further than the first two to four pages in
the summary. However, there are instances where you’ll be glad you did even a
routine but thorough investigation (or making sure your advisor has done so) before
investing your hard-earned money.
I was
recently asked by a journalist to provide an opinion on a hot Canadian small
cap fund known as the Norrep Fund (http://www.hesperiancapital.com/norrep.htm),
managed by Hesperian Capital. Since I wasn’t familiar with the fund, I turned
to the prospectus, the annual information form, the annual and quarterly
reports, and other regulatory filings – something investors are always urged to
do but rarely do in thorough fashion. Frankly, I didn’t expect to make any
startling discoveries, but I always go through this process to make sure I do
my due diligence. However, what I found was a bit out of the ordinary and
stands out as a good example of why investors should do their homework before
investing.
First stop,
the simplified prospectus. The summary at the beginning of the prospectus shows
a list of very typical information. However, go about ten or twelve pages deep
and investors will find additional information regarding conflicts of interest.
A
gentleman by the name of Gary Perron controls all of the shares of Norrep Inc.,
an Alberta-based private corporation. Mr. Perron, is also an officer and
director of brokerage firm BMO Nesbitt Burns Inc. It is clearly stated that,
“Mr. Perron will receive the benefit of some or a portion of commissions
payable to Nesbitt Burns Inc. in respect of trades on behalf of the Fund and
sales charges payable to Nesbitt Burns Inc. in respect of sales of Units”. In
case you missed that, the guy that owns Norrep is also a broker who personally
benefits directly from some of the trades put through by this fund. It’s also
worth noting that this fund’s management agreement specifically prohibits Mr.
Perron or Norrep Inc. from making any investment decisions on behalf of the
fund but can still make recommendations to the fund’s portfolio manager,
Hesperian Capital. The potential conflict comes through loud and clear.
As for brokerage fees incurred by
the fund, on behalf of its unitholders, approximately 17 per cent of the total
of such costs were directed to Nesbitt Burns. As the prospectus suggests, Mr.
Perron likely derived some direct benefit from these fees. You won’t find this
information in the prospectus, but the more detailed annual information form
(AIF) contains brokerage information.
In most prospectuses, you’ll see
some statement allowing the fund to buy unlisted stocks or other illiquid
securities (i.e. difficult to sell quickly). However, looking at the fund’s
most recent statement of portfolio holdings (September 30, 2000), investors
will find that this small cap sizzler held about 10 per cent of its assets in
private companies (i.e. unlisted stocks). While that, in itself, isn’t necessarily
cause for concern, it may be if lots of money is pulled out of the fund by
investors and/or if the fund trades heavily.
At the beginning of 1999, this fund
has total net assets of more than $20 million. Despite reporting returns of
44.7 per cent and 31.7 per cent in 2000 and 1999, respectively, the fund still
had just $24 million in assets at the end of 2000. Those numbers just don’t add
up since the growth alone would almost double the asset size over the two years
if nobody bought or sold units of this fund. However, what the annual report
reveals is that more than $11 million has been yanked out (net of any
purchases) of the fund by unitholders over the 1999 and 2000 calendar years.
That’s a large amount considering the size of this fund.
Trading frequency is measured by a
fund’s “turnover rate”. A turnover rate of 100 per cent means the portfolio has
flipped all of its stocks once during the year. However, it’s based on the
value of transactions, not number of stocks. For the Norrep fund, turnover has
averaged 133 per cent over the past two years. While that’s pretty normal for a
small cap fund, it’s still high on an absolute basis.
So, does this fund have any
liquidity risk? I’d say there are some potential risks given the fund’s
significant holding in private companies, the high trading frequency, and the
substantial amounts of money pulled out by investors over the past two years.
They mitigate the liquidity risk to some extent by imposing a 2 per cent
redemption charge on units held less than two years.
It can’t be stressed enough that the
potential conflicts are just that - potential. I know of absolutely no
wrongdoing or questionable activities by this fund, its management, or any
party to which it is affiliated. In fact, the fund has more than 90 per cent
(total return) over the past two calendar years, and is up more than 15 per
cent so far in 2001. That performance has been achieved despite the challenges
it has faced. Hence, it appears the heavy weighting in energy companies and astute
trading has worked quite well, but the risks mentioned do remain. And don’t
forget, it’s a fund that invests in very small companies and it is concentrated
in the energy stocks – a very volatile sector.
I used this fund as an example to
remind investors of a fundamental lesson:
do your homework. Just like the driver who should do a full shoulder
check, investors should read their prospectus and annual report, even though
most are very standard. Blindly buying any investment based on performance or
other superficial qualities could lead your portfolio straight into a head-on
collision. Most regulatory filings (like those used to examine the Norrep Fund)
can be found at SEDAR (http://www.sedar.com).
Dan Hallett, B.Comm., CFP is Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached by e-mail at
dhallett@sterlingmutuals.com. Sterling Mutuals Inc. is registered as a mutual
fund dealer in Ontario, British Columbia and Manitoba.