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Pay attention to style in choosing equity mutual funds for your RRSP

by Wayne Cheveldayoff, 2004-02-06

A properly diversified RRSP portfolio should have its equity mutual funds diversified on the basis of the style being used to manage them.

Not every style performs well at the same time. For instance, in the 1998-2000 market bubble, growth and momentum managers easily outperformed value managers. But in 2001 and 2002, value managers outperformed, as value-oriented mutual funds didn’t fall as much as the others.

In 2003, it was the turn of small cap managers (investing in companies worth under $1 billion) to perform better than the rest.

These cycles – where one style does better than the others for a while and then falls behind – have occurred with regularity. But history provides little guidance about the future timing of each style’s peak performance.

It is best, therefore, for investors wanting steadier performance in their RRSPs to have a little of each style in their portfolios.

This diversification approach will also move investors away from the self-defeating behaviour of chasing performance.

Unfortunately, investors too often choose mutual funds on the basis of their recent good performance. However, if this good performance reflects the style being used and the style is peaking, then future performance could very well lag behind.

A couple of practices by mutual fund equity managers make it difficult sometimes for investors to be sure of the style of any particular fund. One is known as “style drift,” which refers to the situation where a manager, seeing his or her particular style is out of favour, will buy stocks that don’t technically belong in the fund in an attempt to push up performance. For example, in the late 1990s stock market bubble, a few value managers had such surging stocks as Nortel in their funds when the stocks should have only been in growth and momentum funds.

Another practice that clouds the picture is “closet indexing.” Some equity fund managers pay more attention to trying to duplicate the performance of the index they are measured against than in sticking with their advertized style.

Such practices are thought to be the exception, rather than the rule. But their existence underlines the importance of taking a close look at any fund in the portfolio or being considered for it, perhaps with the help of a knowledgeable investment advisor, and then sticking to those funds that are clearly in one style camp or another.

The growth style of investing, which is probably the most common, is focused on choosing companies where sales and/or profits are growing rapidly and, most importantly, have the prospect of continuing to grow rapidly.

Some fund managers put a twist on this style, saying they want “growth at a reasonable price.” This effectively means they want growth but don’t want to pay too high a price. It usually involves balancing off growth prospects against the price-earnings multiple for individuals stocks.

What sometimes leads to confusion is that this is not that far off from the twist put on value investing by some value managers who say they are seeking “value but with some growth potential.”

Value managers focus on buying as cheaply as possible, using ratios such as the price of the stock versus the book value of the assets in the business, or other measures like earnings, cash flow, dividends, and return on capital. The idea is that undervalued, hidden gems will turn into star performers.

Those with a “deep value” style look to buy stocks in distress (with the potential of recovery of the company) or stocks valued well below book value. One drawback of the value approach is that stocks are usually valued low for a reason and often stay that way for a long time, so value investors have to be patient.

Small cap managers, with their focus on companies with market capitalization under $1 billion, usually are seeking growth situations, although some use a combination of both value and growth or the hybrid styles attached to them.

Perhaps the least employed style, although one that has been very successful, is “momentum.”

It is unfortunate that there are only a few momentum funds in Canada and the style is poorly represented in portfolios because not only does this style make sense intuitively but also because earnings momentum has been shown to explain a large part of the reason for why stocks go up in Canada.

Momentum managers focus on companies where earnings are accelerating, good news is being released and analysts are upgrading the stock. At the first sign of a problem, the manager sells the stock, on the assumption that bad news, once it starts, is followed by more bad news.

Thus, the momentum style is one of jumping on board a bandwagon, going along for the ride and jumping off at the first sign of trouble. It makes a lot of sense.

The momentum style is similar in many respects to the growth style of investing but momentum manager are quicker to sell than growth managers (who would tend to reason that the bad news is only a temporary bump in the road upward).

Attention to style is part of an approach investors should always follow in dealing with the various players in the investment world – namely, know what you are paying for. If you can’t figure out a fund’s style and see evidence it is sticking to it, it may be best to move on to another fund.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff