Risky Business: Part 2 - Investing (Canada): 4/20/1998

The number of Power Performers surged with the continuing bull market this past month. To the end of March there were an amazing 48 Canadian mutual funds that averaged over 20% annual compound returns for each of the 1 year, 2 year, 3 year and 5 year periods! In fact, the number has gotten so large that I've divided my chart into two categories, my regular Power Performers and now my Super Power Performers.

The Supers are the funds returning better than 25% in each of those time frames. There are four of them, two Canadian Equity Funds (AIC Advantage & Bissett Small Cap) and two American Equity Funds (AIC Value & MD U.S. Equity). And there are several more lurking in the wings, just a hair breadth away of joining this elite bunch. They are AGF American Growth, BPI American Small Companies, Ethical North American Equity, McLean Budden Pooled American Equity, Spectrum United American Growth, Fidelity European Growth and the PH&N Dividend Income Fund. All of these meet the Super criteria in three of four time frames and are within 2 percentage points in the last one.

In my humble opinion, everyone should have at least a third of their mutual funds in one or more of these funds. They are a diverse group, covering Canadian, American, European and Dividend Income Funds. (Even a Sectoral Fund if you consider AIC Advantage to be sectoral, which I don't.) There should be something here for just about anyone's portfolio.

Now on to Part 2 of Risky Business. This month we look at Duff Young's method of assessing mutual fund risk.

Risky Business (Part 2)

As mentioned last month, I find the volatility ratings listed in the Monthly Mutual Fund Tables in both the Southam papers and the Globe and Mail to be gibberish. Or at the very least, not very useful. You see a ranking of 1 to 10 or HI, AV & LO, but what does it really mean? Does anyone besides math professors actually understand "standard deviation"? I thought as much!

Last month we looked at an interesting method of measuring consistency (which is related to risk) called the Fund Counsel Quotient™. Devised by mutual fund gurus Levi Folk and Richard Webb, the FCQ™ stripped a fund's five year performance of its best year and compared the new result to the actual. If the five year performance was skewed by one particularly good year, it would show up in the FCQ.

This month we look at an excellent method of risk assessment devised by Duff Young, author of Fund Monitor 1998.

The Fund Monitor

If there's anything that bugs Duff Young in assessing mutual funds, it's what he calls "ending-date bias" in the standard measures of performance. Here's an exaggerated example of what he means. Suppose there was a fund that returned absolutely nothing - 0% - for four years, then got real lucky in its fifth year when it returned 150%. An investment of $1000 would have sat idle for four years, then grown to $2500 in the final year. Calculating out the annual compound returns for several different time periods would give us the following:

Fund	1 Year	2 Year	3 Year	5 Year
One Year Wonder Fund	150.0	58.0	35.9	20.2

Well, by golly! That one qualifies as one of my Power Performers! In fact, any particularly spectacular year can skew the compound annual return figures. That is the theory behind the Fund Counsel Quotient discussed last month.

But do any funds actually produce such lop-side numbers in one year? Actually, yes they do. And more often than you think. Here's a list of funds that returned better than 100% in a particular year and the year they did it:

Fund	Year	Return
Bissett Small Cap	1993	102.4
C.I. Pacific	1986	110.6
Cambridge Resource	1993	159.1
Cambridge Special Equity	1993	110.5
Dominion Equity Resource	1993	119.1
Dynamic Canadian Growth	1993	107.6
Goldfund	1980	154.7
Multiple Opportunities	1993	138.6
Universal Canadian Resource	1993	135.4

You'll note that seven of these nine funds posted their spectacular returns in the same year, 1993. Of the nine, only the Bissett Small Cap Fund is performing well today. Some of the others even have negative returns for the five and ten year periods! Woof woof! Dog City! Sort of reminds you of those one hit wonder rock bands, doesn't it?

In his book, Fund Monitor 1998, Duff Young gets a better handle on consistency and risk by looking at three factors. First he includes year by year quartile rankings of each fund compared to its peers in the same category. He represents this ranking graphically with a square with a solid line filling a quarter of the square horizontally. A line in the bottom quarter of the square means it is a fourth quartile performer for that year. A line at the top tells you it is in the first quartile or top 25%.

The row of quartile performance squares lets you see at a glance whether a fund is consistently in the top 50% of funds in its class year by year. It also lets you know if a fund had a couple of bad years previously but is now performing with greater consistency.

The second factor Young looks at is the fund's worst percentage drop. Although past performance is no guarantee of future performance, an investor may want to limit his downside risk by seeing what the worst scenario has been historically for that particular fund. Not only does Young list the largest loss for each fund, he also lists the length of time it took for the fund to recover the lost value.

For example, my favorite fund, AIC Advantage, started its biggest drop - 30% - in September 1987. It took 44 months for the fund to regain the lost ground. Of course, the older a fund is, the more likely it is to have undergone a significant drop, particularly if it went through the 1973-74 bear market or the 1987 crash. Even the venerable Templeton Growth Fund lost 27% starting in Seprember 1987 and took almost two years to recover.

The third factor Young includes in his charts is the percentage of time a fund is losing money. Every fund has its ups and downs. How often it is down can be an important factor to consider.

Many newer funds, of course, show no time losing money at all. This makes these funds an "unknown" entity to some extent. It's also a good reason to have older funds with established track records forming the core of your portfolio.

Duff Young is not without his anomalies. For one thing, his ranking of funds against their peers sometimes produces what might seem to be a strange result. The 20/20 Canadian Resources Fund, for example, has been in the top two quartiles of performance for four of the last five years. However, it loses money 50% of the time and it took over ten years to recover from its biggest drop of 59%. Nevertheless Young includes it in his "Best for 1998" chapter of fund profiles. Granted, the biggest drop and recovery time ran from 1980 - 1990. Maybe I'm as anomalous as Young as I own shares in this fund as well.

The big surprise for me was that Young did not include AIC Advantage in his list of "Best for 1998". He declines to give quartile rankings for the fund, saying it has no peers to compare it to, and he declines to give it a star rating (he rates funds with one to five stars). He even has a nasty little aside on page 118 alleging that AIC is badly managed. My personal holdings in AIC Advantage tripled in three years. If I've been assaulted by bad management, well, dang it, kick me some more! I'm laughing all the way to the bank!

In spite of these anomalies, I find Young's risk assessment methods intriguing and useful. In assessing a fund for investment, a prudent and cautious investor should look at performance first of all, followed by consistency as measured by Folk & Webb's FCQ ratio and downside risk as measured by Duff Young's listing of the biggest drop and percentage of time losing money.

If you don't want to shell out $16.95 for Young's book, visit his website, The Fund Monitor. All of his charts are available there. Please note, though, that the site does not function properly with browsers older than IE 4 or Netscape 4. From his site you can order a copy of the book for only $7.00.

Links to Sites Mentioned This Week

Disclaimer: As with all my columns here, I should re-iterate a precaution. I am not a professional financial advisor. I am a financial journalist and editorialist. The views in these columns are my personal opinions.

American Readers: Looking for a broker who can sell you Canadian stocks? One of my brokers is licensed to sell securities to Americans in 26 states. She works for Canaccord Capital which is an excellent company with a superb research department. They are particularly knowledgeable on resource issues. Send me a note if you want to get in touch with her.

Have you checked out The Daily? Links to daily Canadian busines and investment news and commentary.

You're invited to get my weekly emailed Newsletter in which I let you know what the upcoming article will be and of any significant changes and additions to this site.