If you want to make the March 1 deadline for RRSP contributions and are leaning toward a mutual fund, you ought to get started now on your research. Of course, we're talking about the March 1, 2106 deadline.
If you burn the midnight oil, you should be able to sift through the 4,500 or so Canadian mutual funds in less than 100 years. And, with any luck, who knows, you may have a 50-50 shot at outperforming those boring index funds that you can buy in about 3.7 seconds.
Getting through the mountain of mutual funds may seem a daunting task, but to simplify matters the kind people at Morningstar Canada rank funds with cute little red stars, just like your kindergarten teacher used to do. Funds are ranked from one star to five stars, based on risk and return.
For a simple explanation of the rating system, go to www.morningstar.ca and click on 'Morningstar Rating' - but first, may we suggest you complete your PhD in mathematics?
Due to deadline pressures, we can only provide a short excerpt of Morningstar's explanation of its system: " ... If a fund has at least three years but less than five years' history, its overall rating is equal to its three-year rating. If it has at least but less than 10 years' history, it's overall rating is equal to 60-per-cent five-year rating and 40-per-cent three-year rating ... " But before you run out to chase the hot money and load up on five-star funds, a word of caution.
Even Morningstar discourages investors from putting too much stock in the star rating system that many investors have become obsessed with. The fact is, if your fund company has been blowing its horn about its Morningstar five-star rating, it may be a lot of hot air. Quite often, a much maligned one-star fund will kick the living daylights out of a celebrated five-star fund.
Star-gazing investors backed up the truck last year when Canadian mutual fund assets swelled to a record $570 billion. But historically, only about one-third of North American mutual funds beat the major market indexes - so investors should be prepared to do some serious digging as they scout for new funds or dump underachieving funds with exorbitant fees.
There are no shortcuts for investors bent on separating the wheat from the chaff. If the manager of a five-star fund has jumped ship to manage a one-star fund, you should know about it. You should also know what the fund manager eats for breakfast, whether he knows that P/E does not stand for pathetic equity and whether he has booked his vacation during the next stock market crash. Even legendary fund manager Peter Lynch had the temerity to fiddle on a golf course in Ireland while the market and his funds were crashing mightily in 1987.
Morningstar bombards investors with reams of statistics and numerous analytical tools. In its so-called Quicktake Reports are stats on NAVPS (net asset value per share), management expense ratio, tax-adjusted returns, asset weights, geographical weights, top 10 holdings and the fund manager's phone number so you can holler at him. However, the report neglects to provide a pie chart to illustrate how the fund performs during a full moon.
Yet, it's those little red stars that really catch the imagination of investors despite the fact research shows that five-star funds are only marginally better than the others.
A recent study by Morningstar Inc. showed that those American funds with five-star ratings as of June 30, 2002 had an annualized return of 10.1 per cent in the three-year period through June 30, 2005. During the same period, the Dow Jones Wilshire 5000 benchmark index had an annualized return of 10 per cent. All other rated funds underperformed that index, but were only slightly inferior to the five-star funds in terms of returns.
Four-star funds had annualized returns of 9.3 per cent, three-star funds had returns of 9.2 per cent, two-star funds had returns of nine per cent and one-star funds had returns of 8.1 per cent (five-star funds are those rated in the top 10 per cent in risk-adjusted returns in their category and one-star funds are those rated in the bottom 10 per cent).
Those statistics are based on the three-year period since Morningstar revamped its rating system by putting more emphasis on a fund's performance compared to its group (ie. small cap, etc.). According to Morningstar, the new system has improved the correlation between high ratings and positive returns but the results still aren't convincing in terms of their value in choosing funds.
Fund managers in Canada had a particularly tough time outperforming the market last year. Our own unscientific research of the 2005 performance of 755 Canadian equity funds listed by Morningstar show that only 27.7 per cent of them beat the S&P/TSX Composite Index's return of 21.9 per cent.
That result reflects on the fact that many fund managers were underweight as the energy sector surged last year, or carrying a substantial weighting of U.S. stocks in a year when the American markets were generally flat. The pure Canadian equity funds, those with all their equity holdings in Canada, fared much better than other Canadian equity funds with almost half of them - 48.2 per cent - outperforming the S&P/TSX Composite Index.
Ironically, the cream of the crop of Canadian equity funds last year didn't even get a single star from Morningstar, which only gives star ratings to funds with three-year track records. According to Morningstar's stats, the top-performing Canadian equity fund in 2005 was a small, unheralded Vancouver-based fund, the Van Arbor Canadian Advantage Fund.
Van Arbor portfolio manager Andrew Parkinson boasted a return of 35.4 per cent with his portfolio of large-cap and mid-cap stocks (for Parkinson's top picks, see Pro's 3 Stars on Page 12).
However, Parkinson did not get close to the podium when the award for Morningstar's 2005 fund manager of the year was announced late last year. That honour went to Kim Shannon, manager of the "five-star" CI Canadian Investment Fund, a large-cap portfolio that barely outperformed the S&P/TSX Index in 2005 with its 22-per-cent return - that, for a fund with a lofty management expense ratio of 2.34 per cent. The award recognizes long-term consistency and low volatility.
There may be a lesson there. Don't get caught star-gazing when you do your research and get cracking so you can make that RRSP deadline. The clock is ticking. A century may seem a long time, but you know how time flies.
* SAGE WORDS: "Over the long haul, more than two-thirds of money managers are outperformed by the stock indexes. The funds are run by individuals who are just as susceptible to the herd instinct as anyone else. They all tend to follow the bull up - and a bear market down."
- Canadian investment guru and author Andrew Sarlos, in Fear, Greed and the End of the Rainbow (1997).
(Gyle Konotopetz can be reached at gyle@businessedge.ca)
