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Where's the best growth?

Small- to mid-cap funds outperformed dividends and equities over the past 15 years, KEITH DAMSELL reports

Quick! What sector posted the best average annual returns over the past 15 years? Dividend funds? Nope. Income? Wrong again.

Canadian small-to-mid cap equity funds were up an average of 11.2 per cent annually since 1989. The results bested the 10.2-per-cent average annual return posted by Canadian dividend funds and were a full three percentage points ahead of the 8.2 per cent average annual reported by Canadian equity funds.

"There is less of a following and therein lies the opportunity," said Irwin Michael, president of I. A. Michael Investment Counsel Ltd. Small- and mid-cap companies "tend to fall between the cracks . . . the market is imperfect and that's where you find anomalies."

ABC Fundamental Value Fund, described by Mr. Michael as the firm's "go for it" fund, was the second-best mutual fund over 15 years, reporting an average annual return of 17.4 per cent. The $463-million fund has a heavy weighting in small- and mid-cap companies with about two-thirds of all new investment dollars ending up in small- and mid-cap firms, he said. Major holdings include media company CanWest Global Communications Corp. and income trust Timberwest Forest Corp.

A mix of research from the University of Western Ontario and Saxon Funds Management Ltd. found that from 1950 to 2000, Canadian small-cap stocks posted returns of 3- to 5-per-cent higher annually than their large-cap rivals. That volatility creates opportunity, said Shaun Little, Saxon's vice-president of marketing. The Toronto fund company's Saxon Small Cap Fund reported an annual average return of 12.3 per cent over 15 years.

"There are excess returns coming to small caps," Mr. Little said.

In contrast to the dark horse 15-year winning streak posted by small- and mid-cap funds, the sector's celebrated loser was -- surprise! surprise! -- Japanese equity funds. The group reported a dismal average annual loss of 2.5 per cent over 15 years. The 25 worst-performing funds over the same period include five funds with an Asian equity focus, including the Investors Japanese Equity Fund, down an average of 3.8 per cent annually, and the AGF Japan Class Fund, off an average of 1.2 per cent annually.

"Japan has really fared poorly," said Mark Chow, a mutual fund analyst at Morningstar Canada. Deflation, weakness across the financial services sector and corporate Japan's unwillingness to restructure operations is behind the Nikkei 225 index's poor returns, he said.

Going forward, 2005 is looking much like 2004, sources across the industry said. While fund flows are expected to improve, investors are wary and will continue to demand the security of income and yield products and funds. For example, Franklin Templeton Investments and TD Mutual Funds report continued strong demand for last year's winners: Tried-and-true income, dividend and balanced funds.

The stock market's downturn in 2000 through 2002 is "still fresh in people's minds and people are cautious and conservative," said Dan Richards, a mutual fund marketing consultant.

Income trusts captured the investment community's imagination last year.

Assets under management in income trust mutual funds were up a stunning 67 per cent in 2004 to $15.5-billion from $9.3-billion a year earlier.

Fund returns for the asset class were an average 21.2 per cent last year.

Standard & Poor's decision to add more than 50 trusts to the S&P/TSX composite index later this year is expected to accelerate interest and the market is responding. In the fourth quarter, income trust issues jumped 128 per cent from the previous quarter to a value of $6-billion.

The heated market has prompted Bill Procter, manager of the Mackenzie Maxxum Dividend Growth to reduce his exposure to trusts. The $1.1-billion fund has cut its trust weighting to 20 per cent, down from about 24 per cent.

"Trusts have outperformed for five years and you wonder how long that outperformance can last," Mr. Procter said, adding that he questions S&P's move to add trusts to the index.

"Would you throw convertible bonds into the TSX [composite] index? I don't think so," he said. "But a convertible bond is not that much different than an income trust."

Leslie Lundquist, manager of the Bissett Income Fund, a $953-million fund that holds 39 trusts, expects rocketing valuations will make for a volatile year.

"We could have weakness but I don't think it is going to be long-term weakness . . . but even as I say it, I feel my insides cringing," she said.

Meanwhile, there are a handful of boutique fund companies working hard to cater to investors' ever-changing tastes.

For example, two-year-old Van Arbor Asset Management Ltd. of Vancouver has developed a stock-picking methodology that has so far resulted in double digit returns at lower costs to the unit holder. Van Arbor's Canadian Advantage Fund and U.S. Advantage Fund hold 20 stocks each. A series of variables determine what stocks are dumped and bought.

Investors are "absolutely" looking to try something new, said Andrew Parkinson, Van Arbor's president and chief operating officer. "We are seeing a lot more interest . . . people are drifting back into equities."

© 2007 The Globe and Mail. All rights reserved.

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