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Mutual funds light on energy could still be keepers

One consolation, if you were a victim of opportunistic price gouging at the gas pump yesterday, is that you could be making big money off soaring oil prices.

Check your mutual funds. If your equity fund manager's big on oil, then your gains should be something like the 25 per cent or so posted by the S&P/TSX composite index in the year to July 31. If your manager has shunned oil, then you're probably in investing purgatory.

Minimizing energy exposure in an equity fund is an incredibly gutsy call, even if it looks alarmingly wrong right now. Managers who do this are almost certainly doomed to underperform their benchmark, which means they risk angering their employers, plus advisers and investors.

It's a no-win situation -- for now. Later, who knows? A decision to lighten up on oil today could be seen as a prescient move when oil prices come down from their peak. This is why you should be careful about selling an equity fund with a disappointing performance that can be traced to too few energy stocks.

Funds that are low on oil haven't lost money in the past year, or anything like that. Certainly, the situation isn't anything like the one in 1999 and early 2000, when funds that avoided technology stocks looked utterly inept. But when the stock market is up 25 per cent and your fund is up 9.7 per cent, it has to hurt.

That's the situation faced by people who own the $2.2-billion AIC Diversified Canada Fund, which had 6.5 per cent of its assets in energy stocks as of June 30, while the benchmark Canadian stock indexes were at about 25 per cent. Much the same fate has befallen unitholders of the $2.2-billion Mackenzie Cundill Canadian Security Fund, which had an oil weighting of just 3.9 per cent and a one-year return of 13.4 per cent.

Some numbers punched up by analyst Tilly Cheung show a pattern of disappointing -- although not disastrous -- performance among funds with low oil weightings. The 44 Canadian equity and Canadian equity (pure) funds with less than 10 per cent of their assets in energy averaged 13.3 per cent in the 12 months to July 31, just a bit over half what investors could have made with a no-brainer index fund or an exchange-traded fund based on a benchmark Canadian stock index.

A few funds did superbly without much oil. Examples include Northwest Canadian Equity, up 28.7 per cent over the past 12 months with slightly more than 10 per cent of its assets in energy; AIM Canadian First Class, up 30.2 per cent with a 12.6-per-cent oil weighting; and, Dynamic Canadian Value Class, up 35.5 per cent with 13.3 per cent of its holdings in energy stocks.

But the general rule is that without a significant energy component, a fund has little chance of keeping pace with the past year's stock market surge. That's the story of widely held funds like AIC Diversified Canada and Mackenzie Cundill Canadian Security, as well as:

The $5.4-billion Mackenzie Ivy Canadian Fund, up 13 per cent on an oil weighting of 8.2 per cent, as of June 30.

The $2.1-billion Trimark Canadian Endeavour Fund, which has dumped all its energy holdings and made 15.5 per cent in the past year.

The $1.4-billion Trimark Canadian Fund (SC version), which was limited to a return of 13.5 per cent by a 5.9-per-cent energy weighting.

The $407-million Templeton Canadian Stock Fund, up just 9.5 per cent in the past year as a result of a 6.2-per-cent energy weighting.

In going light on oil, fund managers are essentially saying they think the energy sector is overvalued and ripe for a correction. One way to judge the likelihood of a manager being right in this call is to see what happened to his or her fund during and after the tech bubble.

Trimark Canadian Endeavour lagged as the bubble grew in 1998 and 1999, sort of like it's doing now. Then, it reeled off an awesome five-year stretch of above-average returns. For anyone worried about the stock markets after the oil boom peaks, this fund's a keeper.

While AIC Diversified Canada has great 10-year numbers, returns since the tech boom are decidedly below average. Selling this fund is reasonable if you're of the opinion that its decision to duck the energy sector is part of a broader strategy that just isn't clicking.

Before you dump any fund because of its weighting in energy, ask yourself this: As an investor, do you put the emphasis on squeezing as much as possible from a rallying stock market or on keeping an even keel through up and down markets?

Many of the funds that are low on energy are the even-keel type, which means today's weak returns are to be expected. If you don't making a killing on high oil prices, at least there's the consolation of knowing you won't get burned when energy stocks fall.

© 2007 The Globe and Mail. All rights reserved.

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