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Weekly Insight

Next year's portfolio

TORONTO (GlobeinvestorGOLD) —It’s time to start planning for 2006. That means reviewing your portfolio, seeing how well your mutual funds are performing, and making appropriate changes. To help you in the process, I’ve been spending time doing research to find the funds I believe will do best in the year ahead. First up: Canadian equity funds.

There’s something of a paradox here. The past three years have been very good for these funds and at first glance it looks like investors have been taking advantage of the bull market. For example, over the 12 months to Sept. 30 statistics from the Investment Funds Institute of Canada show that the total assets of all units in their “Canadian common shares” category rose 21.3 per cent to $131.5 billion. Since Jan. 1, 2003, which is about the time the market run-up began, the increase in total assets is 53.1 per cent.

But a closer look at the numbers shows that while the stock market was rising, people were bailing out of Canadian equity funds. During the most recent 12 months, for example, redemptions outpaced new sales by almost $1.6 billion. That pattern has been consistent for several years. It seems to be a hangover from the great bear market of 2000-2002. People who got burned by stock funds at that time are reluctant to get back in while others are selling as the funds in their portfolios regain pre-2000 levels.

This means that many mutual fund investors have missed out on one of the best runs we’ve seen for some time. The average Canadian equity fund with a foreign content component showed an annual compound rate of return of almost 18 per cent for the three years to Oct. 31. For “pure” Canadian stock funds – those with little or no foreign content – the average was 17.5 per cent. Those are great numbers. Too bad so many folks haven’t benefited from them.

Will we see more of the same over the next three years? Probably not! Neither bull markets nor bear markets run forever and but this latest bull seems to be moving steadily forward. The S&P/TSX Composite Index rose 24.3 per cent in 2003. In 2004, the pace slowed to 12.5 per cent. Year-to-date (to Nov. 18), the gain for 2005 is 16 per cent, which means that unless we see a sharp correction in the last six weeks we’ll surpass the 2004 advance.

That’s encouraging but there are many question marks about 2006. Energy stocks now form the largest single component of the Index and they are trading at near-record highs. If there is a fall-off in the price of oil next year due to a weakening of the world economy, our energy stocks will be hit and the Index will be dragged down with them. The value of the loonie is another major consideration; the higher it goes the greater the negative impact on the bottom line of many of our companies. And, of course, our close economic and commercial ties with the U.S. make us vulnerable to any slowdown there.

Taking all this into account, my advice is to focus on value-oriented, low-volatility Canadian equity funds in the year ahead. They may lag a bit if the markets surge but they do a better job of protecting wealth in sideways or down markets. Here are three of my top recommendations. All are rated $$$$ in my On-Line Buyer’s Guide to Mutual Funds.

AIC Canadian Focused Fund: There’s not much to cheer about at AIC these days. The company has experienced heavy redemptions due to the poor performance of many of its funds, but this one is an exception. Manager James Cole has guided it to a fine one-year gain of 22.6 per cent (to Oct. 31) through some judicious stock picking. The three-year average annual compound rate of return is 17.9 per cent. Financial service companies like Manulife and TD Bank account for 43 per cent of the holdings, but that's down from a 65 per cent financials weighting at the start of the year so Cole has been taking some profits. Energy giants like Suncor and Canadian Oil Sands Trust are also well represented. The manager keeps the portfolio small, with only 10-15 positions. This requires a high level of due diligence in stock selection but Cole clearly has the smarts to pick winners. Risk is better than average for the category. This is one of AIC's best choices right now.

CI Canadian Investment Fund: This is one of the best Canadian equity funds around. Period! If you are a conservative investor who is seeking a fund that offers a classic low-risk/high-return combination, your search is over. This one fits the bill perfectly. It became part of the CI organization in July 2002 as part of the deal with Sun Life that saw all the Spectrum and Clarica funds moved into the CI camp. Wisely, CI retained Kim Shannon as manager and she continues to do a first-rate job. Her investment style is a conservative buy-and-hold value approach, with a focus on blue-chip stocks.

The real test of her investment acumen came during the bear market of 2000-2002 and Shannon passed with flying colours. The fund did not lose money in a single one of those years – the worst performance was a break-even in 2002. That's remarkable in the light of what happened to most stock funds over that period. When the markets recovered, Shannon still continued to shine. Normally, low-volatility funds such as this will tend to lag behind when markets are strong but this one has ridden the crest of the wave. Over the three years to Oct. 31, it posted an average annual compound rate of return of 16.8 per cent, more than two percentage points better than the category average. In the latest 12-month period, the advance was 18.2 per cent. Meanwhile, the risk rating remains much better than average. This fund is a good choice for a conservative investor who prefers a low-risk approach and it is especially well suited for an RRSP or RRIF.

IA Canadian Conservative Equity Fund: This has always been a solid, low-risk performer and its value style is especially well suited to the current investment climate. The portfolio is very blue-chip oriented, with an emphasis on Old Economy stocks, such as BCE, Fortis, Manitoba Tel, and banks. The management team targets companies with good earnings, book values, and steady dividends—all key factors in selecting value stocks. The fund held up very well in the bear market with the only losing year being 2001 when the value declined 2 per cent. Since then it's been nothing but profits. One-year gain to Oct. 31 was 20 per cent, well above average, and the three-year average annual compound rate of return was 15.8 per cent. In fact, all performance figures going back two decades are above average. Not many people know about this fund, but it’s a worthwhile entry for conservative investors. The safety record is very good. This used to be a no-load fund but it is now sold on an optional front- or back-end load basis through investment advisors.

As always, check with your financial advisor before taking action.

This article first appeared on GlobeinvestorGOLD.com. If you'd like to profit from the insight of more than 30 financial experts and columnists, including Gordon Pape — sign up for a free trial to GlobeinvestorGOLD.com.

© 2007 The Globe and Mail. All rights reserved.

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