Ride market trends for profits

With all the turmoil going on in the world right now, many mutual fund investors are confused and uncertain about what to do.

During times like these, there’s an old investment precept that’s worth remembering: The trend is your friend.

If you want to maximize your return potential in the short to medium-term, recognize the trends that are in place. Then go with them.

Select best bets
This does not mean dramatically changing your overall portfolio structure. Rather, it means selecting funds within your asset allocation profile that have the best chance of doing well for you in the next 6 to12 months and riding with them until changes are indicated.

Here are some of the trends that are in place right now, and my advice on how to use them to your best advantage:

  •  1) Loonie is rising

  • After several years of steady decline, the Canadian dollars finally showing strength again. This was demonstrated in the reaction to the news of the departure of former Finance Minister, Paul Martin. The dollar dipped half a cent, then quickly rebounded. There are several reasons for this recent turnaround :
    • The increase in the spread between Canadian and U.S. interest rates
    • The strength of our economy compared to that of the U.S.
    • A recovery in commodity prices
    • A perception that Canada is less vulnerable to terrorist attacks
    • A long-overdue world devaluation of the U.S. dollar.

    Our currency has moved past the US$0.65 mark and many economists are now raising their projections for the loonie to the US$0.67-$0.68 range by year-end.

    Setting absolute targets is guesswork at best. But what seems clear is that our currency is on a roll right now. That trend is likely to continue for a while.

    Next page: Increase Canadian assets

    Increase Canadian assets
    I never recommend currency speculation. I have always believed that it is sound policy to hold both U.S. and Canadian dollar assets in your fund portfolio, thus providing a hedge against currency fluctuations.

    However, fine-tuning within a portfolio to take advantage of current circumstances can help improve return potential.

    I therefore advise reducing U.S. dollar money market and bond fund holdings at this point and increasing Canadian dollar assets correspondingly.

  •  2) Interest rates are rising

  • Unless there is a dramatic reversal of economic fortune, the outlook is for interest rates to trend higher over the next one to two years.

    However, the upward movement is likely to be gradual, at least initially, given the uncertainly about the strength of the U.S. recovery and continued low inflation rates.

    What it means
    This trend has two important implications for your fund portfolio:

    • First, money market yields will gradually rise.

    They’ve been very low for a long time and over the year to April 30 the average Canadian money fund gained only 2.5 per cent. The average U.S. money fund did even worse, at 1.8 per cent.

    Those figures should look better by this time in 2003—not dramatically so, but enough to make these funds less of a drain on your overall portfolio performance.

    • Second, bond funds will continue to remain under pressure.

    As interest rates edge up, bond prices soften, making it difficult for managers to turn a profit. The average Canadian bond fund dropped 1.2 per cent in the past six months, although performance has stabilized recently.

    Next page: Minimize your risk

    Minimize your risk
    However, despite the bond market weakness, I do not recommend reducing your overall fixed-income component. Rather, review the funds you are holding to ensure that your risk is minimized.

    Mortgage funds, for example, have held up well in the face of rising rates and as a group actually show a small profit for the past six months. Putting some of your fixed-income assets here would minimize risk and improve portfolio stability.

    Short-term bond funds are also inherently less risky than regular bond funds.

    To improve the return potential of your fixed-income assets, consider adding a high-yield bond fund, such as the Trimark Advantage Bond Fund, which gained 8.5 per cent in the year to April 30.

  •  3) Stock markets are struggling
  • Every attempt at a market rally so far this year has faltered after a week or two. Without a flood of good earnings reports and an improvement in international tensions, such as a meaningful cease-fire between Israel and the Palestinians, this pattern is likely to continue for some time.

    That makes index funds a poor bet right now. These funds perform best during strong bull market conditions, such as we saw between 1998 and early 2000.

    During bear markets, they tend to sustain heavier losses than actively managed funds. During sideways markets, they go nowhere.

    Stock picker’s market
    Right now, we’re in a stock picker’s market. There are profits to be had, but fund managers have to be very selective and must make their moves at the right time.

    The funds that do best in such circumstances are run by people who have strong talents in those areas. They are not “pseudo-index” funds, in that their holdings and returns do not replicate the major indexes.

    To improve the return potential from your equity portfolio, you should hold at least a few stock picker’s funds. Ask your financial advisor to recommend some.

    Three that I recommend: ABC Fundamental-Value Fund (initial investment requirement of $150,000), Saxon Small Cap Fund, and Mackenzie Cundill Value Fund.

    Adapted from an article that originally appeared in Mutual Funds Update.