Editor's note: This week's three-part series on target-risk funds, authored by manager research analyst Jeffrey Bunce, begins today with an overview of the dramatic growth of these funds of funds and how asset managers are seeking to differentiate themselves amid intense competition. The series is based on a research paper released this month by Morningstar Canada's manager-research team. The series will continue on Wednesday with a focus on fees, and conclude on Friday with an examination of past performance.
Net flows into funds of funds, which target-risk assets dominate, has grown dramatically in recent years. From January 2010 to December 2015, asset flows into funds of funds dwarfed flows into stand-alone funds by almost six to one ($191 billion versus $32 billion), according to the Investment Funds Institute of Canada. Moreover, this growth has been stable. Funds of funds have not experienced a single month of net outflows over the period, whereas stand-alone funds have had numerous months of net outflows.
Fund-of-funds assets rose from 18%, or $122.5 billion, of total mutual-fund assets in Canada in January 2010 to 32%, or $392 billion, in December 2015. During this time, fund-of-funds assets have more than tripled while stand-alone fund assets have increased by a much more modest 49%. The largest mutual funds in the country -- RBC Select Conservative Portfolio and RBC Select Balanced Portfolio -- are funds of funds with target-risk mandates. By contrast, the two largest funds at the beginning of 2010 were Investors Dividend and Fidelity Canadian Asset Allocation -- both stand-alone funds.
The robust growth of target-risk funds, while the growth of stand-alone funds has languished, serves only to elevate the importance of these funds to Canada's asset managers. At the same time, competition has increased in lockstep. More than 30 asset managers now offer at least one target-risk program. Some firms offer multiple target-risk suites, driving the total number of programs close to 50.
While some asset managers, such as those owned by the big banks, can leverage the distribution might of their branch networks, others need to differentiate their investment strategies to attract assets. Most asset managers use either exclusively in-house strategies to build their fund-of-funds portfolios, or else a combination of in-house capabilities with a sprinkling of some outside managers to fill gaps. Rarer are programs, such as National Bank Meritage and ATB Compass, which rely exclusively on funds managed by third-party sub-advisors as the building blocks for their target-risk portfolios.
Most target-risk programs use underlying funds that are actively managed, and pass along higher fees than what index-fund portfolios charge. But a few target-risk programs, such as BMO ETF Portfolios and TD Managed Index Portfolios, differentiate themselves by using passive building blocks and charging lower fees.
The most meaningful way for these programs to differentiate, however, may be through asset allocation. The typical program offers five or six funds that range from more conservative (i.e. less equity) to more aggressive (i.e. more equity). However, the range of equity allocation that each program covers varies substantially.
For example, the Manulife Leaders program is made up of only three funds and has a narrower range of strategies. Based on a three-year average ended December 2015, the difference between the lowest and the highest equity weightings in this mini-suite of funds is only 31 percentage points. In contrast, Mackenzie Symmetry, with its seven funds, covers a range of more than 90 percentage points between its lowest-risk and highest-risk funds. Accordingly, the Mackenzie program is suitable for a wider range of investment objectives and investor risk profiles than the Manulife program.
Mackenzie is just one of a small number of target-risk providers that covers the full equity spectrum. In fact, on average, the Canadian target-risk suites of funds surveyed by Morningstar had a difference of 63 percentage points in equity exposure between their most conservative and most aggressive target-risk funds.
This may leave some investors in these programs without a truly conservative or aggressive investment alternative.
Some target-risk programs set themselves apart through tactical asset allocation -- the practice of actively adjusting a fund's asset mix with the aim of improving risk-adjusted returns. For instance, the equity allocation for each fund under the Fidelity Managed Portfolios banner has varied between nine and 16 percentage points over the past three years, showing an element of tactical management.
Indeed, asset managers that promoted tactical asset allocation in their marketing materials have shown a greater range of equity allocation over the past three years (10.2 percentage points) than those that don't (5.8 percentage points). Keep in mind though, that while tactical management represents another lever the portfolio manager can pull to add value, a bad market call can hurt returns.
The composition of the equity portfolio is also an area where programs can and do differ, especially as it relates to the percentage of Canadian versus foreign equity. The trend over the past three years ended December 2015 is for reduced Canadian equity exposure. Typically, the managers decreased their Canadian holdings as a portion of total equity by 6.7 percentage points. But programs differ quite meaningfully on where they currently sit.
For instance, AGF Investments cut its Canadian equity stake across its funds under the Elements banner by 23 percentage points, and now those funds have, on average, just 17.4% in Canadian stocks. This is well below the roughly 30% average per program. Meanwhile, TD Comfort funds have one of the higher allocations to Canadian equity. And, despite lowering it as a percentage of total equity over the past three years by about five percentage points, Canadian equity still makes up almost 42% of the equity portions of the TD Comfort funds.
