Funds hammered by credit crunch: Morningstar

August was not a good month for capital markets, and it showed in the performance of Canadian mutual funds. Morningstar Canada says the majority of its Canada fund indexes had negative returns because of fallout from the sub-prime mortgage crisis in the U.S. and other credit-quality issues.

“Overall, the meltdown in the asset-backed commercial paper sector that began roiling markets in late July continued to drive extreme levels of volatility throughout August among long-term fund categories,” says Jordan Benincasa, fund analyst with Morningstar Canada.

Money market funds, which were prone to liquidity problems in their non-bank ABCP holdings, were hit particularly hard. Morningstar reports that it was one of the worst one-month performances for the domestic category in the past 25 years. Returns did remain positive, but barely so. The Canadian Money Market Fund Index eked out a return of 0.1%, and the U.S. Money Market Fund Index returned a paltry 0.07%.

“With the liquidity crunch, nobody is buying money market funds; the market is essentially dry. A lot of the money market managers are fleeing to quality, and they’re buying up risk-free treasury bills,” Benincasa says. “Because of that, they’re not getting the same yield that they would be a few months ago. The Canadian money market fund category lost about 64 basis points over the last month.”

But money market funds were far from the bottom of the barrel; that distinction went to the Precious Metals Equity Fund Index, which fell 11.54%. Benincasa notes that, traditionally, precious metals funds would be a safe haven during volatility, due to their large exposure to gold.

He says the market dynamic has changed so that short-term gold stock prices can be manipulated by large institutional investors such as hedge funds.

“These funds can provide diversification for a portfolio and serve as a hedge against inflation. But investors should keep in mind that hedge funds are playing a more significant role than usual in stock and commodity prices.” Benincasa says. “Gold is usually a safe-haven during this period, but because there are so many players in the market now, especially with more hedge funds, short-term volatility doesn’t mean gold will actually stand out during a downturn.”

The poor performance of precious metals was a primary cause for the second worst performer, the precious metals–heavy Natural Resource Fund Index, which had a loss of 6.76%. This decline was also due to unexpectedly high American natural gas inventories, which proved unfavourable for oil and gas stocks, Morningstar reports.

Canadian equity also fared poorly because of its heavy weighting in resources. The Canadian Equity Index lost 0.15%, and the slightly riskier Canadian Small/Mid Cap Equity Fund Index lost 3.99%.

Most of Morningstar’s geographic equity fund sectors also suffered losses. Even the previously hot Asian equity categories declined due to heightened concerns that tighter U.S. credit market could lead to a global economic slowdown that would hurt Asian exporters.

July’s top performer, the Asia Pacific Equity Fund Index, fell 2.49%, while the Asia Pacific ex-Japan Fund Index fell 2.77% and the Emerging Markets Equity Fund Index lost 3.41% in the month. The Japanese Equity Fund Index fell 5.02%, beating only the Natural Resource Equity and Precious Metals Equity indexes.

Of the Morningstar Canada fund indexes that did have positive performance in August, all had returns below 2%, with Real Estate Equity leading all other indexes with a 1.9% return, followed by Science & Technology Equity with 1.05% and Health Care Equity with 0.8%.

Benincasa says the decent performance in the real estate sector may surprise some who associate real estate with sub-prime mortgages, but he says the growing geographic diversity of the category has offset any regional downturns, and very few of them invest in the home-building industry, which has been hit hard by the sub-prime mortgage debacle.

“Over the last couple of months, these funds have been doing well,” he says. “They’re not just focused on residential real estate in Canada and the U.S. They invest in a lot of commercial real estate as well as a lot of other types of services such as health care.”

Fixed-income categories also had moderate gains. The Canadian Long Term Fixed Income, Canadian Fixed Income, and Canadian Short Term Fixed Income Fund indexes rose 0.67%, 0.63% and 0.57% respectively.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(09/05/07)

Mark Noble