When our analysts meet with domestic stock managers, we often hear one thing: Canada's investing sandbox is too small. Canada's piece of the global market stands at less than 5% of the total, and it's narrowly focused, with financials, energy and materials stocks ruling the roost. Versus most other developed markets, Canada is more vulnerable to commodity price fluctuations, which tend to go through boom-and-bust cycles. Moreover, many of the world's greatest companies are located somewhere else, often just south of the border.
There's an obvious solution to this problem: Make the sandbox bigger. Broadened geographic boundaries let domestic-oriented managers play in sectors like technology and health care, which aren't much represented in the local market. Wider sector exposure should smooth volatility over the long haul. It also means more currency diversification since the Canadian dollar and other currencies, especially the U.S. dollar, don't always move in lock-step.
Investors can make their sandbox bigger by combining their all-Canadian funds with U.S. or other international offerings. Global funds, which give managers freedom to invest wherever there's opportunity, are another possibility for more adventurous types. Conservative investors, though, may not want to venture as far afield. This camp may want to keep one foot in Canada and another outside of it. In this case, the Canadian Focused Equity category, which houses large-cap funds with 50% to 89% Canadian equity exposure, provides prime hunting ground.
Generally speaking, Canadian Focused Equity funds provide the diversification benefits they promise. By definition, their geographic exposure is broader, and they aren't as heavily concentrated by sector. On average, Canadian Focused Equity funds sport smaller energy and financials weightings and a higher tech stake than their purely domestic counterparts in the Canadian Equity category. Lighter energy and financials exposure means the Canadian Focused Equity funds are less driven by economic cycles: on average they hold 38% in cyclical Morningstar sectors, versus 47% for the Canadian Equity norm.
Investing outside the country appears to give Canadian-focused managers exposure to better-quality companies. While Canada has its fair share -- our big five banks are highly entrenched and very profitable, for instance -- volatile commodity prices mean energy and materials stocks have a tougher time maintaining high profitability and growth. As a result, the Canadian Focused Equity category scores more highly on profitability measures like return on equity, while earnings have grown more quickly.
It's worth noting the Canadian Focused Equity group excludes small- and mid-caps. The Canadian Focused Small/Mid Cap Equity group includes them, though the diversification benefits look smaller. On the whole, that group isn't that much more diversified by sector than pure Canadian Small/Mid Cap Equity funds, nor are its quality and growth characteristics superior. Top-tier companies are typically large caps, which obviously don't play much of a role in this category.
Not a uniform lot
Because the definition of the category is broad, it's a bit of a hodgepodge. Some funds barely meet the standards of the group. Investors Canadian Equity and TD Canadian Blue Chip Equity 
flirt with the 90% top-end limit for domestic equity exposure. Practically speaking, these are Canadian funds with a U.S. garnish. At the other extreme are funds where Canadian equities are more a side dish than main course. Canadian stocks make up 45% of CI Signature Select Canadian , for example, and 40% of Mackenzie Cundill Canadian Security . (These funds will eventually move categories if their Canada weighting persistently remains below 50%.)
Just as the Canadian equity stake can vary, so can the composition of the rest of the portfolio. Canadian Focused Equity managers typically don't venture far: The U.S. represents the biggest weighting outside Canada, averaging around 25%. Some funds have much larger U.S. bets, though. RBC North American Value has around 50%, while Fidelity Canadian Large Cap and Dynamic Power Canadian Growth have 40% or more. A smaller slice of the category is more adventuresome. Invesco Canadian Premier Growth invests nearly 30% in Europe, while CI Signature Select Canadian has almost 20%.
The variety of investment approaches can make for difficult comparisons. A mostly-Canada fund will perform differently than one more evenly split between Canada and the U.S. -- a fact that was on full display in 2013. With both the U.S. market and dollar rallying, funds with heavy Canadian weightings had a tough time competing. Investors Canadian Equity landed in the category's bottom decile, but with its 12.5% return (for the C series) roughly matching the S&P/TSX Composite Index's return, its showing was more middling than awful viewed next to a more fair comparison point.
Meanwhile, some U.S.-heavy funds don't look quite as impressive upon heavier scrutiny. Mackenzie Cundill Canadian Security's 26% gain in 2013 placed it in the category's top quartile, but that return matches a 50/50 split between the TSX and the S&P 500 Index. Others punched well above their weight. With only about 25% in the U.S., Fidelity Canadian Large Cap returned 36% for the year, surpassing the 33% gain of the S&P 500 (in Canadian dollar terms).
Category medalists
The Canadian Focused Equity group is among the trickier categories our analysts evaluate from a performance perspective. Morningstar's qualitative Analyst Rating assesses a fund's long-term prospects versus its peer group and benchmarks. In this case, the peer group holds less sway. In relatively heterogeneous categories, comparisons end up being apples to oranges. While we won't ignore performance versus the category, we'll create our own benchmark that reflects the fund's investment strategy and historical portfolio allocation. If a fund's geographic split has averaged 60% Canadian/40% U.S., for example, we'll measure long-term performance versus a 60% TSX/40% S&P 500 custom benchmark. We'd like to see the fund beat its peers, but unless we have confidence it can beat an appropriate benchmark, we won't give it a positive ratingof Gold, Silver or Bronze.
Which funds in the category have earned medals? These three make the grade.
CI Signature Select Canadian 
: Signature's Eric Bushell and his team try to win with a top-down approach. It's tough to make correct macroeconomic calls consistently -- their cautious outlook has contributed to lacklustre returns in recent years -- but the group has generally gone on the defensive at the right time, as in 2008 and 2011. Signature benefits mightily from a 34-person team, which includes macro specialists and seasoned stock and bond specialists, giving them a broad set of inputs to formulate their views.
Mackenzie Ivy Canadian 
: Especially averse to downside risk, Ivy focuses on quality companies that can weather a storm. Despite its concentrated portfolio, this fund has been the category's least volatile, as measured by standard deviation. Management's conservative style will likely lead to modest results in up markets, but because the fund has been able to hang on to its gains in down markets, it's been able to succeed over the long haul.
RBC North American Value : Managers Stu Kedwell and Doug Raymond, who also run Neutral-rated RBC Canadian Equity , enjoy the flexibility to invest in Canada and the U.S. based on where they see opportunity. After using RBC's quantitative screening tool to winnow their investment universe, Kedwell and Raymond look for companies with high returns on invested capital, and while value-oriented, avoid turnaround plays. Kedwell and Raymond have put their flexibility to good use, with benchmark- and peer-beating long-term returns.
