Fund returns vary widely in Q2

Staying home turned out to be an all-right strategy for Canadian investors in the second quarter of 2007, but venturing into emerging markets was also worth the trip, according to fund performance data compiled by Morningstar Canada. Investing in the rest of the industrialized world, however, would have been a little disappointing.

Investors were rewarded for riding out the rough spots in Asia in the first quarter, as the Asia Pacific Rim ex-Japan Equity index topped the charts in June, posting a return of 6.9%, thanks to market recoveries in Hong Kong, Shanghai, Taiwan and Seoul.

Even better gains were realized by those holding currency-hedged funds, as the Canadian dollar soared against its Korean, Chinese and Hong Kong counterparts.

The dollar had less of an impact on the broader Emerging Markets Equity fund index, however, as the loonie gained only 1.7% against the Brazilian real, the home currency of one of the largest emerging equity markets outside of Asia.

The Emerging Markets Equity index gained 5.5% in the month, powered by the strength of Asian stocks and juiced by Latin America, with the Brazilian Bovespa Index posting a staggering 18.7% rally in the quarter. That was enough to push the Emerging Markets index into fourth place.

For investors with a taste for the familiar, Canadian equity investments paid off as well. The Natural Resources Equity index was in a close second place, gaining 6.7%, while the Canadian Small/Mid Cap Equity index returned 6.4%. Due to the nature of the resource sector, there is a great deal of overlap between these indexes, and small resource companies make up more than 40% of the latter index.

The more diversified Canadian Anchored Small/Mid Cap Equity fund index gained 4.3% in the second quarter, with returns watered down slightly by foreign holdings. Foreign equity positions can reach as high as 49% of the entire portfolio in this category. These three fund indexes — Resources and the two Small/Mid Cap Equity indexes — have posted the strongest year-to-date returns.

“Dwindling gas supplies and an increase in merger and acquisition activity have driven the resource rally over the past quarter,” said Bhavna Hinduja, Morningstar Canada fund analyst. “The S&P/TSX Capped Energy Index and the S&P/TSX Capped Materials Index gained 10.3% and 8.5% respectively over this period. In contrast, the slump in precious metals equities has continued to hinder the performance of more broadly based natural resource funds.”

Healthy returns were not limited to the smaller cap equity funds, though, as several high-profile takeover bids drove up the share values of some of Canada’s biggest names. Bids for Alcan and BCE helped to drive returns of the Canadian Equity fund index, which gained 4.8%.

“Alcoa’s unsolicited offer for Alcan in May sent the latter’s stock price up by more than 35% in a single day and up 48% for the second quarter,” says Hinduja. “Similarly, BCE gained about 23% over the past quarter in the midst of a takeover battle between various private equity groups, pension fund organizations and rival wireless service provider Telus.”

The Canadian High Income Equity ranked sixth for the quarter, gaining 4.5% while the Canadian Anchored Equity index returned 3.1%.

Not all sectors were rosy in the quarter, however; in fact, some were downright gloomy. The Real Estate Equity fund index plummeted 11.1% in three months, making it the worst-performing index. The culprit in this case was the market’s conviction that the Bank of Canada, and possibly the U.S. Federal Reserve, would again raise interest rates.

The prospect of rising interest rates sparked a sell-off in the bond market, as fixed income investors freed up cash ahead of the issue of higher-coupon bonds. As the price for existing bonds fell, yields improved. Suddenly, the yields on REITs in both Canada and the U.S. did not look nearly so attractive, and the market sold them off.

Almost all of this activity took place in June, with the Real Estate Equity fund index falling 7.2% in that month alone.

Things weren’t a whole lot better in Japan, as the long-anticipated economic recovery was postponed for at least another quarter. The Nikkei may have gained 5% between the end of March and the end of June, but a 13.8% depreciation of the yen against the loonie resulted in a loss of 8% for the Morningstar Japanese Equity index.

Again, the interest rate bogeyman had his hand in the works, as tame inflation data raised concerns that the central bank would not be raising rates any time soon.

Fixed income fund indexes took a beating, with Canadian Short Duration Fixed Income posting the best return: a 0.7% loss. Not so bad when you consider that the Canadian Inflation-Protected Fixed Income suffered a 5.7% drop.

The European Equity index, which had been one of the strongest performers in recent years, slipped 0.3% in the first quarter, while the U.S. Equity index fell 1.2%. The Global Equity and International Equity fund indexes lost 0.8% and 1.2%, respectively.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(07/04/07)

Steven Lamb