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A Survey of the Canadian Target Risk Landscape

Morningstar Manager Research1 June 2016

ContentsExecutive SummaryIntroductionAsset AllocationPerformanceConclusionAppendix

Jeff Bunce, CFA Analyst—Manager Research +1 416 484-7821 [email protected]

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Executive SummaryTarget-risk funds continue to rapidly reshape the Canadian mutual fund landscape as they become the preferred investment vehicle for the average Canadian investor. More broadly, flows into fund-of-funds products (of which target-risk dominates) are outpacing sales into stand-alone funds at almost a 6-to-1 clip. Their ascent has been a boon to many asset managers, especially to the banks and other entities with a captive distribution force. What’s less clear is the overall value proposition to the end investor. While the diversified nature of the funds and targeted asset mix are benefits, the funds’ costs and performance leave much to be desired.

The target-risk programs in Canada deploy a diverse mix of asset-allocation strategies, portfolio construction techniques, and underlying fund composition. What’s more, the risks in similarly labeled funds are not necessarily the same. Understanding each program’s quirks and relative positioning within the broader target-risk universe can help investors make informed decisions. This should prove especially useful in ensuring savers reap the full rewards of investing for the long term.

Key TakeawaysFlows into funds of funds (the majority of which are target-risk funds) have dwarfed flows into stand-alone funds. From January 2010 through December 2015, funds of funds rose from 18% of total mutual fund assets to 32%. The five largest banks—RBC, TD, Scotia, BMO, and CIBC—along with Desjardins and Investors Group have been the primary benefactors of this growth.

Many target-risk programs lack truly conservative or aggressive options. On average, the funds within a target-risk program cover 63% of the equity-allocation spectrum. This may leave investors in these programs without a truly conservative or aggressive investment option.

Programs that tout tactical management—the practice of actively adjusting a fund’s long-term asset allocation with the aim of improving risk-adjusted returns—in their marketing materials have shown a greater range of equity allocation over the past three years (10.2%) than those that don’t (5.8%). However, the benefits of tactical management are not yet clear.

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©2016 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. Reproduction or transcription by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited.

A Survey of the Canadian Target Risk Landscape 1 June 2016 of 22

Target-risk funds reduce home-country bias. The average Canadian equity content of target-risk funds (30%) is less than half the estimated average for the domestic equity investor (62%1). What’s more, the exposure to Canadian equity within target-risk funds has fallen by 6.7% over the past three years alone, providing investors with more global diversification.

Layering additional fees on top of those charged by underlying investments is widespread. Based on a sample of 30 target-risk funds with a similar asset mix (approximately 60% equity/40% fixed-income), most layer additional fees on top of those charged by the underlying funds they hold, resulting in a higher expense hurdle to clear.

Most target-risk funds have been mediocre-to-weak performers relative to their category peers. Very few achieve a Morningstar Rating for funds of 4 or 5 stars, while a disproportionate number of funds score 1 or 2 stars. Further, flows have been less sensitive to past performance than stand-alone funds. Historically, 4- and 5-star stand-alone funds garner the greatest inflows, while those with 1- to 3-star ratings suffer outflows. By contrast, asset flows for target-risk funds were positive across all star ratings.

In general, funds with higher allocations to equity outperformed those with lower allocations over the past three years ending December 2015. However, equity allocation alone doesn’t explain everything, as many funds with lower allocations to equity outperformed those with much higher levels. One possible reason for this revolves around how much domestic versus foreign equity a fund contains. Over the three-year period, Canadian equities underperformed significantly versus U.S. and international equities, and this would have weighed on funds more geared towards domestic stocks.

1. Estimate is based on data from the International Monetary Fund’s Coordinated Portfolio Investment Survey and the World Federation of Exchanges as at the end of 2014.

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Introduction

An abundance of information and choice is both a blessing and a curse. On the one hand, more choice is liberating and widely available information empowers people to make informed, intelligent choices. On the other hand, too much information and too many choices can be detrimental and lead to suboptimal outcomes. As psychologist Barry Schwartz has outlined in his book, “The Paradox of Choice,” an overabundance of choice may make decisions more difficult; it paralyses people instead of empowering them—with so many options to choose from, people find it difficult to choose anything at all.

With thousands of funds at their disposal, it's easy to see why investors, or the advisors acting on their behalf, would be overwhelmed with choice. One solution, and a wildly popular one at that, is the target-risk fund. These funds of funds provide a diversified exposure to a range of asset classes aligned with an investor’s risk tolerance. Rather than an investor or advisor having to manage asset allocation and build and monitor their portfolios, they simply pick a target-risk series and defer most, if not all, of this management and decision-making to it. The investor’s or advisor’s focus then shifts to assessing and understanding their own or their client’s risk capacity (which is driven by time horizon and the human and financial capital at their disposal) and risk tolerance (driven by an investor’s ability to weather losses). From here they simply select the fund with the stock/bond mix that corresponds with the investor’s targeted risk level.

While fund companies present their solutions as a simple, hands-off approach to investing, it would be foolish to state that they have resolved the paradox of choice. As is many times the case, when one decision is simplified, another becomes complicated. The popularity of target-risk funds in Canada has spurred asset managers to offer a wide array of options. Approximately 30 different asset managers provide at least one target-risk program. Some firms offer multiple different suites, driving the total number closer to 50. With widely different approaches to asset allocation and portfolio construction, not to mention the differences in performance and price, target-risk funds merely shift the paradox of choice from the individual fund level to the fund-of-funds level. By examining these areas, this paper will help illuminate the differences in the options available and bring focus to the choice that exists.

Description of SampleThe sample of target-risk funds examined in this study includes most of the biggest programs, as well as other notable industry players in the open-end mutual fund universe. In total, 231 funds from 36 target-risk programs and 19 different fund companies representing $243.6 billion in assets (approximately 62% of all fund-of-funds assets) were included in the data set. Except where otherwise noted, the source for data was the Morningstar Direct database and was based on information available as of December 2015. Because the database lacks an identifier for target-risk funds, it’s almost certain the sample is not an exhaustive list, but we believe it is still representative



of the overall universe. Lastly, the commission-based share class was used for analysis and performance purposes as this is the main channel through which the funds are sold.

Funds of Funds’ Share of the Pie Is GrowingThe share of funds of funds, of which target-risk fund assets dominate, has grown dramatically in recent years. From January 2010-December 2015, asset flows into funds of funds dwarfed flows into stand-alone funds by almost 6 to 1 ($191 billion versus $32 billion), according to the Investment Funds Institute of Canada. Such growth has also been stable; funds of funds have not experienced a single month of negative flows over the period, whereas stand-alone funds saw numerous months of negative flows. Exhibit 1 compares cumulative asset flows into stand-alone and funds of funds over the period.

Exhibit 1 Cumulative Net Sales Trend (January 2010 to December 2015)

$Billion

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150

100

50

0

Cumulative Stand-Alone Net SalesCumulative FoF Net Sales

2010 2011 2012 2013 2014 2015

Source: IFIC. Data as of 12/31/15.

Faster growth explains why 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 funds in the country—RBC Select Conservative and RBC Select Balanced—are both funds of funds from RBC’s target-risk suite. By contrast, the two largest funds at the beginning of 2010 were Investors Dividend and Fidelity Canadian Asset Allocation—both stand-alone funds. The only fund of funds cracking the top 10 was RBC Select Balanced.

Refer to Appendix A for a list of fund companies and the cumulative estimated net flows into their fund-of-funds products since 2010.



Construction of Target-Risk Programs and FundsOne way that a provider can differentiate its target-risk program is in the construction of the program itself. Areas where providers can potentially differentiate include:

An open or closed fund architecture (that is, using only proprietary funds or a combination of proprietary and third-party funds);The use of active and passive strategies, including exchange-traded funds; andLevel of diversification within the funds (that is, the number of asset classes and funds used).

Open or Closed ArchitectureOne distinction for target-risk programs is whether they use closed or open architecture. The majority of programs in our sample are closed and built using funds only from the firm’s own suite of offerings rather than using funds from third-party providers. The motivation for having a closed program is clear. The greater percentage of the assets kept in-house, the more the firm makes in fees. Overall, the asset base and the pace of growth of closed programs are greater than in open programs.

Many of the largest firms’ diverse product lineups mean there is no obvious need to use third-party funds. At the same time, the likelihood that the firm has a “best-in-class” fund in every asset class is low. Some programs, such as National Bank’s Meritage or ATB’s Compass, attempt to solve this problem by focusing on manager selection and using exclusively third-party funds. It’s also common for programs to use a majority of the firm’s own funds but then selectively use third-party funds to fill gaps where expertise may be lacking.

The benefit of closed architecture over an open one is the closed program typically offers lower fees. Again, with all the assets in-house, the program provider has more flexibility on pricing and doesn’t necessarily need to build in a fee for itself. Evidence of this can be seen with firms offering both closed and open programs: RBC Select funds (closed) are cheaper than RBC Select Choices funds (open); TD Managed funds (closed) are cheaper than TD FundSmart Managed funds (open); and Dynamic Edge funds (closed) are cheaper than Dynamic Marquis funds (open).

The Use of Active and Passive ManagementThe overwhelming majority of target-risk funds are actively managed, with only a handful built using only passive strategies. The BMO ETF Portfolios, TD Managed Index, and BlackRock Managed are examples. The passive-only strategies are cheaper on an absolute basis than active strategies but not necessarily cheaper versus a stand-alone portfolio built using the underlying ETFs or index funds (more on this in the section addressing fees on pages 14-16).

Often, but not always, target-risk funds use passive strategies to make active bets on specific segments, regions, or sectors of the market where the manager thinks there is an attractive opportunity but where they don’t readily have an active strategy available.

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For example, the Manulife Leaders program utilizes numerous country-specific ETFs such as iShares MSCI Ireland Capped, as well as industry-level ETFs like Technology Select Sector SPDR ETF, to take advantage of shorter-term themes and market opportunities. Franklin Quotential, Invesco Intactive, Mackenzie Symmetry, and Sun Life Granite are among the other programs using ETFs in a similar way. The managers also may use ETFs to easily adjust broad exposure to a particular market without burdening the active funds with large and frequent inflows/outflows. For example, the Manulife Leaders program utilizes numerous country-specific ETFs such as iShares MSCI Ireland Capped as well as industry-level ETFs like Technology Select Sector SPDR ETF to take advantage of shorter-term themes and market opportunities. Franklin Quotential, Invesco Intactive, Mackenzie Symmetry, and Sun Life Granite are among the other programs using ETFs in a similar way. The managers may also use ETFs to easily adjust broad exposure to a particular market without burdening the active funds with large and frequent inflows/outflows.

Level of DiversificationLastly, programs differ by the level of diversification or specialization. One way to measure this is to look at the number of underlying funds being used by target-risk programs. (This can be a somewhat crude measure, because sometimes one asset class is represented by several funds for style diversification, capacity, or other reasons.)

As of December 2015, the average fund had 14 underlying holdings but the range went from a low of two to a high of 32. The TD Comfort program, for example, has between six and eight holdings across its funds (including cash holdings), including one or two Canadian bond funds, one balanced fund, two global equity funds, and three Canadian equity funds. In contrast, the Fidelity Managed program is quite a bit more diversified, both by number of funds and asset classes. It uses between 18 and 22 funds, including up to eight different fixed-income funds (Canadian bonds, global bonds, U.S. bonds, high-yield, money market, convertible bonds, and floating-rate bonds), four Canadian equity funds, three U.S. equity, three international equity, one emerging-markets, and one global real estate fund. Other programs that use ETFs tactically, such as Manulife Leaders, tend to have even more holdings.

The number of underlying funds held has been trending higher over the past five years. In December 2010, the average number of funds held was 12, compared with 14 in December 2015. There are likely a number of reasons behind this rise. First, as target-risk funds have risen in popularity and as the number of competing programs has increased, firms likely have been adding more resources in response to competitive pressures, giving them the wherewithal to broaden their holdings. Second, some firms have expanded their investment capabilities over the past five years to include new asset classes and have likely reflected these new capabilities in their target-risk funds.

Third, as inflows into target-risk funds have risen dramatically over the past five years, adding more funds to a program can help alleviate capacity issues of existing holdings. The RBC Select



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program has seen its number of holdings increase by between 11 and 18 (depending on the fund) over the past five years, and the aforementioned reasons likely played into this expansion. Some of RBC’s newer capabilities, such as its quantitative funds, as well as a BlueBay fund (a manager RBC acquired in 2010) are now reflected in its funds. Additionally, the large amount of inflows RBC has garnered over the past five years has likely necessitated adding more funds to mitigate some capacity constraints.

Asset Allocation

Many Target-Risk Programs Don’t Cover the Entire Risk SpectrumIn general, target-risk programs are designed with the aim of providing an investor with a solution/fund that aligns with their risk profile. In theory, a complete program would span from a low or conservative risk profile (one with low equity exposure), to a high or aggressive risk profile (one with high equity exposure). One way to measure the comprehensiveness of firms’ lineups is to assess the range of equity exposure between the lowest-risk and highest-risk funds.

Exhibit 2 displays the range of the equity allocations for 36 target-risk programs. The equity allocation is based on a three-year average from January 2013 to December 2015, and the yellow bar reflects the range between the funds with the highest and lowest equity allocations. Note that equity allocation is calculated on a look-through basis such that any equity held in fixed-income funds or balanced funds will be included in the total (conversely, any fixed income or cash held in equity funds will be omitted from equity totals). For example, AGF Elements Yield Portfolio has a three-year average equity allocation of approximately 30%, while the AGF Elements Global Portfolio has an allocation of approximately 96%, for a program range of 66%.

Exhibit 2 Target Risk Programs—3-Year Average Equity Coverage %

Program Equity Range %

AGF Elements 65.95

AGF Harmony 65.77

ATB Compass 72.37

BMO ETF 96.99

BMO SelectTrust 91.81

CI Portfolio Series 49.71

CI Select 70.66

CIBC Axiom 58.99

CIBC Managed 68.42

CIBC Renaissance 73.83

Desjardins Chorus II 51.38

Desjardins Melodia 57.44

0 20 40 60 80 100

0 20 40 60 80 100

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Program Equity Range %

Desjardins SocieTerra 48.94

DFA Portfolios 39.32

Dynamic Marquis 48.49

DynamicEdge 72.33

Fidelity 42.98

Franklin Quotential 64.84

Invesco Intactive 61.23

Investors Group Allegro 60.56

Investors Group Alto 62.07

Investors Group Investors 91.12

Mackenzie Symmetry 91.86

Manulife Leaders 31.31

Manulife Simplicity 44.10

National Bank Meritage 73.78

RBC Select 72.55

RBC Select Choices 57.64

Scotia INNOVA 64.06

Scotia Partners 57.15

Scotia Selected 53.19

Sun Life Granite 48.35

TD Comfort 74.17

TD FundSmart 58.90

TD Managed 58.83

TD Managed Index 65.48

Source: Morningstar Direct. Data as of 12/31/15.

Overall, the typical program covers an equity-allocation spectrum—from its most conservative fund to its most aggressive—of 63%. Four programs (BMO ETF Portfolio, BMO Select, Investors Group Investors, and Mackenzie Symmetry) cover greater than 90% of the equity spectrum and offer a target-risk fund for nearly every investor. Manulife Leaders’ equity spectrum covers just 31%, and really only covers the middle of the risk spectrum, leaving out more conservative or more aggressive investors. To be fair, the program only has three funds. Manulife also offers two other managed-solution portfolios (Manulife Simplicity and Manulife Portrait) that may be suitable for really conservative or really aggressive investors.

The majority of programs start with an equity allocation at or higher than 20%, and only six programs offer a solution with less than 10%, suggesting that most programs are not serving the most

0 20 40 60 80 100

Exhibit 2 Target Risk Programs—3-Year Average Equity Coverage % (Continued)

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conservative of investors (these firms may have other solutions available for these investors outside of their fund-of-funds program). Alternatively, the lower end of the equity-allocation spectrum for most programs (at around 20%-30%) suggests that a low-risk portfolio option should have some equity and that even conservative investors can benefit from an allocation to stocks.

Still, some programs lack a true conservative option. For example, the Dynamic Marquis Balanced Income has averaged 44% to equity over the past three years and represents the program’s most conservative option. CI Portfolio Series, CIBC Axiom, Dimensional Portfolio Series, Fidelity Managed, and RBC Select Choices are other programs that have equity allocations starting in the high 30% range.

Further, what is labeled a “conservative” fund at one fund company may contain a much larger equity percentage than another fund company’s “conservative” option. For example, the RBC Select Very Conservative fund averages more equity than the CIBC Renaissance Optimal Conservative fund. In this analysis, nomenclature alone is not descriptive enough to understand a fund’s risk profile, especially when comparing across target-risk programs.

On the opposite end, some programs lack a truly aggressive (equity-heavy) option. Both of Manulife’s target-risk programs cap at just over 60% equity, while some others such as Desjardins’ programs, National Bank Meritage, and Scotia Partners cap at around 80% equity. Further, the definition of an “aggressive” fund is just as fluid as the “conservative” labeling. Even within TD, the naming is not consistent—TD FundSmart Managed Aggressive Growth averaged 80% equity over the past three years, while TD Comfort Aggressive Growth averaged 98% equity.

While a program’s equity range can illuminate whether the conservative or aggressive investor is served, the distribution of funds within the range is useful in determining whether investors with various moderate risk profiles are being looked after as well. Thus, expanding on the previous exhibit, Exhibit 3 takes each fund within a target-risk program and distributes it into an equity quintile based on its three-year average equity percentage. The number in each cell represents the number of funds that fall into the quintile (the darker the shading, the more funds in that bucket).

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Exhibit 3 Target Risk Programs—Fund Distribution by Equity AlocationsNumber of Funds: 1 2 3 4 5 6

0–20% 20–40% 40–60% 60–80% 80–100% Total

1 AGF Elements 0 1 2 1 1 5

2 AGF Harmony 0 2 2 1 2 7

3 ATB Compass 0 1 2 1 2 6

4 BMO ETF Portfolios 1 1 1 2 1 6

5 BMO SelectTrust 1 1 1 2 1 6

6 CI Portfolio Series 0 1 3 2 1 7

7 CI Select 0 2 3 3 1 9

8 CIBC Axiom 0 1 1 4 2 8

9 CIBC Managed 1 1 2 1 2 7

10 CIBC Reniassance 0 2 1 0 1 4

11 Desjardins Chorus II 0 2 2 1 1 6

12 Desjardins Melodia 0 4 3 2 0 9

13 Desjardins SocieTerra 0 1 2 1 0 4

14 DFA Portfolios 0 0 3 2 0 5

15 Dynamic Marquis 0 0 3 1 1 5

16 DynamicEdge 0 2 1 2 1 6

17 Fidelity Managed Portfolios 0 0 2 2 2 6

18 Franklin Quotential 0 1 1 2 1 5

19 Invesco Intactive 0 3 1 1 1 6

20 Investors Group Allegro 0 1 2 4 6 13

21 Investors Group Alto 0 2 3 4 2 11

22 Investors Group Investors 2 1 1 1 2 7

23 Mackenzie Symmetry 1 2 1 2 1 7

24 Manulife Leaders 0 1 1 1 0 3

25 Manulife Simplicity 1 1 2 1 0 5

26 National Bank Meritage 1 4 3 4 0 12

27 RBC Select 0 2 1 1 1 5

28 RBC Select Choices 0 1 1 1 1 4

29 Scotia INNOVA 0 2 1 1 1 5

30 Scotia Partners 0 2 1 2 0 5

31 Scotia Selected 0 2 1 1 1 5

32 Sun Life Granite 0 1 3 2 1 7

33 TD Comfort 0 2 2 1 1 6

34 TD FundSmart 0 1 1 2 1 5

35 TD Managed 0 1 1 2 1 5

36 TD Managed Index 0 1 1 1 2 5

Total 8 53 62 62 42

Source: Mornginstar Direct. Data as of 12/31/15.

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Aside from the 0%-20% bucket, there is a fairly equal distribution of funds across the quintiles (as shown in the totals at the bottom of the table), but there are also areas of concentration or gaps in most programs. For example, Dimensional has five funds in its target-risk program, but rather than being spread out across the five equity quintiles, they are concentrated in two buckets: the 40%-60% and the 60%-80% buckets. CIBC Renaissance has a gap in the 60%-80% quintile. Renaissance Optimal Growth and Income averages 58% equity, while Renaissance Optimal Global Equity averages 95% equity, leaving a 37% difference in equity exposure between them. BMO ETF Portfolios, BMO Select Trust, CIBC Managed, Invesco Intactive, Investors Group Investors, and Mackenzie Symmetry are notable for being the only programs that offer at least one fund in each of the equity quintiles.

Some Programs Tactically Manage Their Equity Allocation While Others Stay Closer to TargetThe examination of equity allocations has thus far been at the program level, but some target-risk fund programs implement tactical management of the asset mix—shorter-term deviations from the long-term target asset allocation with the aim of improving risk-adjusted returns. Looking at the range of equity allocation over time within each fund can provide a sense of which funds are truly tactical and which follow a more static asset allocation. Exhibit 4 displays the three-year range of the equity allocation, grouped by Morningstar Category. A yellow dot closer to zero indicates minimal changes in the equity percentage over the past three years. The higher the yellow dot is on the chart, the larger the historical equity range has been.

Exhibit 4 Target Risk Funds—3 Year Range of Equity Percentage Grouped by Category

Global Equity

Global Equity Balanced

Global Neutral Balanced

Canadian Neutral Balanced

Global Fixed Income Balanced

Canadian Fixed Income Balanced

20%

15

10

5

Source: Morningstar, Inc. Data as of 7/2015.

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There are several reasons that a fund may have a high range in equity allocation over time. First, the manager may have made a strategic change towards more or less equity, which would usually be represented by a one-time change in the asset mix. For example, the outlier in the Canadian fixed income balanced Morningstar Category is BMO SelectTrust Income Portfolio. Its wide range (over 15%) apparently was driven by a one-time change in the asset allocation during the summer of 2013 when the equity content jumped by approximately 10%.

Second, the high range may be a result of the manager’s tactical management of the asset mix. For instance, equity allocations for tactically driven Invesco Intactive funds have ranged between 9% and 11% over the past three years. Similarly, Fidelity Managed Portfolios have also had ranges between 9% and 16%, showing an element of tactical management.

Some drift or float from strategic asset allocation is to be expected, as managers need to weigh the benefits of rebalancing or making tactical shifts with the trading costs associated with doing so. With this in mind, the majority of funds fall within a range of 10% and have more or less stuck to their equity allocations over time.

Out of the 36 target-risk programs examined, 11 clearly indicated tactical management as a feature in marketing materials. Exactly what this means will vary by provider, but each looks to take advantage of short- to medium-term market movements to reduce risk or increase returns by adjusting the underlying fund or asset class weightings. The funds in the 11 programs touting tactical management had a three-year average equity range of 10.2%, whereas the funds in those programs that didn’t identify any tactical management had a range of 5.8%, suggesting (admittedly crudely) that the programs which claim to be tactical, really are on a comparative basis. Keep in mind that while tactical management represents another lever the portfolio manager can pull to add value, it is also another area where the manager can falter.

Investors should try to understand the asset-allocation ability, resources, and/or track record the manager has to determine whether tactical management is truly an added benefit to the funds or rather more of a marketing strategy. Investors also need to keep in mind that they’ve set a strategic asset allocation based on their risk profile; any tactical asset mix changes the manager takes should remain consistent with that profile.

In contrast, for many programs that don’t include tactical management as a feature, marketing materials often emphasize the benefits of rebalancing and having a strict adherence to a strategic asset allocation. In this case, the limits or asset class bands used for triggering a rebalancing are important to know. Either way, know what the program is touting as a benefit and evaluate it based on those objectives.

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Target-Risk Funds Reduce Home-Country BiasThe above sections regarding asset allocation focused on the equity allocation both across and within programs as well as over time. The composition of the equity allocation is also an area where programs can and do differ, especially as it relates to the allocation to Canadian equity versus global equity.

Data collected from the International Monetary Fund’s Coordinated Portfolio Investment Survey and the World Federation of Exchanges suggest that 62% of investable Canadian assets were in domestic equities as at the end of 2014. In contrast, the Canadian market represents approximately 3% of the world market capitalization, suggesting a strong home-country bias. However, target-risk funds don’t mirror this makeup. At 30%, the home-country bias of target-risk funds in Canada is roughly half the level of the country as a whole. With so much of investors’ dollars flowing into these funds, it stands to reason that home-country bias in Canada will decline going forward.

Further, the majority of target-risk programs have reduced their allocation to Canadian equities over the past three years, with the typical program in our sample reducing Canadian equity by 6.7%. Exhibit 5 summarizes the home-country bias of each target-risk program as of Jan. 31, 2013, and Dec. 31, 2015. The averages across all programs for each time period are also shown.

Exhibit 5 Home Country Bias: Average Canadian Equity Exposure (as % of Total Equity) Across Target Risk Programs

Program Dec. 2015 (%) Jan. 2013 (%)

AGF Elements 17.4 40.7

AGF Harmony 41.3 40.5

ATB Compass 36.5 41.0

BMO SelectTrust 17.9 45.5

CI Portfolio Series 21.2 27.7

CI Select 28.0 23.7

CIBC Axiom 48.4 49.9

CIBC Managed 30.5 34.2

Desjardins Chorus II 26.3 29.0

Desjardins SocieTerra 28.1 38.2

Dynamic Marquis 22.5 26.6

DynamicEdge 19.9 28.1

Fidelity 28.3 40.5

Franklin Quotential 23.0 25.2

Invesco Intactive 29.6 28.6

Investors Group Allegro 33.6 40.7

Investors Group Alto 40.9 37.4

Investors Group Investors 46.8 47.1

Mackenzie Symmetry 18.0 31.9

0 20 40 60

Jan. 2013 Average: 36.2%Dec. 2015 Average: 29.5%

0 20 40 60


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Program Dec. 2015 (%) Jan. 2013 (%)

Manulife Leaders 18.8 29.1

Manulife Simplicity 21.4 37.1

National Bank Meritage 47.9 53.6

RBC Select 34.2 38.1

RBC Select Choices 32.2 32.6

Scotia INNOVA 28.0 38.0

Scotia Partners 25.5 40.7

Sun Life Granite 23.5 28.9

TD Comfort 41.8 46.7

TD FundSmart 25.1 31.9

TD Managed 25.7 34.6

TD Managed Index 32.7 33.4


In a few instances, the decrease to Canadian equity has been substantial: BMO Select decreased the Canadian equity in its funds on average by almost 28%, AGF Elements decreased it by 23%, and Manulife Simplicity lowered it by 16%. These moves likely reflect a strategic shift to reduce home-country bias while other smaller moves may be the result of a tactical underweighting to Canadian equity as its attractiveness has diminished over the past few years. Some programs, including CI Select and Invesco Intactive, are notable for their slight increases to Canadian equity, but those programs still maintain average allocations overall. CIBC Axiom and Investors Group Alto have some of the higher average Canadian equity allocations, but both programs have some funds that, by design, are Canadian-focused which inflates the overall program average.

Target-Risk Funds: More Expensive Than the Sum of the PartsSimply put: Fees matter. Both Morningstar’s findings and academic research indicate that fund expenses are one of the better predictors of future performance. The higher the fee, the harder it will be for a fund to outperform or achieve a return as high as a similar fund with a lower fee.

Most target-risk series layer additional fees on top of those charged by the underlying funds they hold, resulting in a higher expense hurdle to clear.

Exhibit 6 compares the stated management expense ratios (in the commission-based channel) of 30 target-risk funds with an asset mix close to 60% equity/40% fixed-income, against an estimate of the weighted average management expense ratio of their underlying holdings. Funds with a management expense ratio equal to the weighted average management expense ratio of the

Exhibit 5 Home Country Bias: Average Canadian Equity Exposure (as % of Total Equity) Across Target Risk Programs (Continued)

0 20 40 60


0 20 40 60


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underlying funds would plot on the line, indicating that the fund is not charging any more or any less than the cost of its underlying holdings. Those charging more plot above the line, while those funds charging less fall below. Refer to Appendix B for a table identifying the funds in this exhibit and a description of the methodology used.

Exhibit 6 Comparison of Target Risk Fund Management Expense Ratios to Underlying Funds— Sample of Medium-Risk Funds

Fund MER (%)

Estimated Weighted Average MER of Underlying Funds (%)

0 1 2 3

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2

1


For the most part, the management expense ratios of the target-risk funds in our sample are more expensive than what can be explained by the management expense ratios of the underlying holdings. Five of the 30 funds plotted right on or very close to the line—meaning these funds’ management expense ratios matched or nearly matched the fees of the underlying holdings—and another two funds charged less. Half of the funds in our sample, though, charged a substantial premium—more than 20 basis points—and another eight added a smaller premium.

Not surprisingly, the lowest-cost funds in our sample—BMO Balanced ETF Portfolio and TD Managed Index Balanced Growth—invest passively. While a relative bargain next to their competitors, the gap between their management expense ratios and those of their holdings is among the largest in the sample. BMO’s fund is 1.45% more expensive and TD’s fund is 0.78% higher. This would still be true even after adding an embedded trailer fee to BMO’s underlying holdings to account for the commission-based distribution channel (TD’s underlying holdings already include a trailer). Given their static asset allocations and relatively simple portfolios, these funds arguably are the easiest to replicate. They provide the benefit of rebalancing but beyond that, the value proposition is difficult to discern.

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While the two passive offerings in our sample look relatively attractive on price even with a hefty layer of additional fees, the same isn’t true for funds whose underlying holdings aren’t particularly cheap to begin with. For instance, were TD FundSmart Managed Balanced Growth’s management expense ratio to only reflect the cost of its underlying holdings, it would land in the middle of the pack on price based on our 2.02% estimated tag. But thanks to an additional charge of 0.71%, the fund’s actual management expense ratio, at 2.73%, ranks as the highest in our sample (this is even after TD implemented a fee reduction to the FundSmart Series in 2015).

With a fairly static asset allocation, the passive BMO and TD offerings have a weaker case for their price premium than rivals, like Invesco Intactive Balanced Growth, which tactically manage their asset mixes. The Invesco fund could conceivably boost returns or reduce risk by adjusting its portfolio to reflect market conditions. Its managers face a considerable price hurdle to overcome, however. With a mix of active funds and ETFs, the underlying holdings sum to a 1.54% management expense ratio, versus 2.29% for the fund’s stated management expense ratio—a large 0.75% gap. This disparity shrinks when we tag a 1% commission to the ETF holdings to reflect the fund’s commission-based distribution channel, though it stands at a still-substantial 0.35%.

It may well be that the benefits of savvy tactical asset allocation or even smartly constructed static portfolios are worth the costs. We expect our future research will shed light on this question, but the simple arithmetic of investment costs will always give lower-priced funds an inherent advantage.

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Performance

Performance Doesn’t Drive FlowsFlows into funds of funds (which target-risk funds dominate) in Canada follow a different pattern than flows into stand-alone funds. Exhibit 7 shows flows into the two fund types broken out by star rating2. The majority of flows for funds of funds go into mediocre performers (1-, 2-, and 3-star) and funds with less than three years of history (not rated). In contrast, flows into stand-alone funds are concentrated in better performers (4- and 5-star) as well as newer funds. Further, stand-alone funds rated 3 stars or less have all experienced net outflows, whereas funds of funds flows seem somewhat impervious to poor performance as not even 1-star funds have net outflows. The use of target-risk funds as a managed solution appears to be more important than performance in driving the flows. Further, seven of the top 10 target-risk providers have mostly or completely captive distribution channels, enabling them to sell based on considerations other than performance.

Exhibit 7 Estimated Cumulative Net Flows by Star Rating in Canada—5 Years Ending December 2015

Morningstar Rating Canadian

Stand-Alone Funds Canadian

Fund-of-Funds

Q –14.93 2.35

QQ –31.00 9.94

QQQ –38.12 52.88

QQQQ 7.94 27.25

QQQQQ 48.61 1.72

Not Rated 69.27 39.13


2. The Morningstar Rating is a quantitative assessment of a fund’s past performance. It compares the fund to others within its category on a risk-adjusted basis. And while performance can be analyzed and dissected in numerous ways, the star rating, at a high level, is an indicator of how successful a fund has been at generating risk-adjusted returns.

-40 -20 0 20 40 60 80$Billion

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Performance of Target-Risk Funds Has Been Weak to Mediocre at BestExhibit 8 shows the distribution of target-risk funds by their star ratings. While it’s not unexpected to see the 3-star rating as the most populated bucket, it is somewhat surprising to see a higher proportion of funds rated 1 or 2 stars compared with those rated 4 or 5 stars. (By definition, there will be fewer funds with 1- and 2-star ratings than 3-stars in a category, but the target-risk funds in our sample span multiple categories, allowing for potential skews in the distribution.) By this chart, there are very few target-risk funds of funds that excel in their categories. In fact, over 74% of the funds are rated 3-star or less and only just 13% are rated 4- or 5-star. The remaining 13% of funds do not have a star rating as the track record on these funds is too brief (the star-rating calculation requires at least a three-year track record).

Exhibit 8 Target Risk Funds—Distribution of Morningstar Rating

Morningstar Rating Number of Funds

Q 11

QQ 63

QQQ 95

QQQQ 26

QQQQQ 3

Not Rated 29


Any number of factors could be tripping these funds up and resulting in mediocre performance, but the following may be the most likely and may be operating in tandem:

The target asset allocation of these funds may not line up with the majority of other funds in the same category, which could result in different risk-adjusted profiles. However, this could be as much a benefit to some funds as a hindrance to others.

Diversification may be playing a role. Target-risk funds are generally more diversified by asset class than the typical balanced fund in their category. While that may lead to improved risk-adjusted returns over the long term, it may not be evident in the time periods included in the star rating.

As examined in the pricing section of this report, the management expense ratios on some of these target-risk funds are above average, creating a higher hurdle to overcome. All things being equal, an above-average price will result in lower returns.

Lastly, mediocre performance of target-risk funds may stem from the underlying funds themselves. This could especially be the case for closed-architecture programs where a firm only uses its own

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0 25 50 75 100

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funds. Like the jack-of-all-trades who masters none, the likelihood that a firm will have superior, best-in-class funds across all asset classes is low. So while it’s likely that a few funds will produce above-average performance, it’s also likely that others will produce below-average performance, potentially resulting in washed-out performance overall.

Equity Allocation Doesn’t Foretell PerformanceGiven that stocks have generally outperformed bonds in recent years, it’s not surprising that target-risk funds with higher equity stakes generally delivered higher absolute returns than those with lower stakes. Equity exposure alone doesn’t explain everything, though. Exhibit 9 illustrates the dispersion of three-year returns based on the funds’ equity weightings over the period. While the median fund in the 80%-100% grouping handily outperformed the median 40%-60% fund, the top third of the 40%-60% cohort performed at least as well as the bottom third of the 80%-100% bracket despite having markedly less exposure to stocks. For example, the three-year return of the Manulife Simplicity Global Balanced fund was 10.4%. With an average equity allocation of 51%, it easily beat the 6% return of Invesco Intactive Maximum Growth Portfolio, which averaged an 87% equity allocation.

Exhibit 9 Target Risk Funds—Dispersion of Returns Within Equity Allocation Quintile

80-100% Equity60-80% Equity40-60% Equity20-40% Equity0-20% Equity

16

12

8

4

3-Year Return %


This suggests that using equity allocations may not be a sufficient means of assessing or determining a fund’s risk level. For instance, target-risk funds using low-volatility and/or dividend income-oriented strategies instead of higher-volatility core equity mandates could hold higher levels of equity while still delivering a lower risk profile. That said, this period is too brief to draw definitive conclusions, and it’s possible this pattern may not hold over longer time periods. Furthermore, the

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three years ending December 2015 were, for the most part, a relatively strong period for equities with lower-than-normal levels of volatility. As well, funds with higher foreign equity content would have also benefited over those favouring the Canadian market.

Conclusion

As the mutual fund industry in Canada continues its shift to managed solutions such as target-risk funds, the importance of understanding each program and what it offers will continue to grow. As demonstrated, there are significant differences between programs and funds such that relying on labels such as “conservative” to understand the investment is not sufficient. An examination of the underlying asset allocation and fundamentals is warranted, and while the equity-fixed income split may be a good starting point in understanding risk, it too won’t tell the whole story.

In addition, a thorough examination of the fees on these funds would indicate investors are largely being placed at a disadvantage, as most funds examined charged a premium over the cost of the underlying holdings. On this front, it would certainly appear as though there is room for improvement.

While some areas of target-risk fund construction were explored in our study, we didn’t closely examine asset-allocation methodology. Because the strategic asset mix is the main determinant of long-term returns, further research will focus on the methods that asset managers use to construct portfolios. In addition, while we explored the prevalence of tactical asset allocation, we want to monitor how managers are executing this approach. Given the difficulty investors historically have had in making top-down bets, we plan to test the success of tactical approaches against static mixes.

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Appendix

Appendix A Cumulative Estimated Net Flows ($Million)—January 2010 through December 2015

Name Fund-of-Fund

RBC 42,360TD 27,806BMO 18,6621832 Asset Management (Formerly Scotia) 12,524Desjardins 12,429

CIBC 7,394Investors Group 6,018Mackenzie 5,561Fidelity 4,883Invesco 2,745

National Bank 1,941Dynamic Funds 237Franklin Templeton –791AGF –1,438


The five big banks (RBC, TD, Scotia, BMO, and CIBC) along with Desjardins and Investors Group have been the biggest drivers in the growth of fund-of-funds assets. Each of the firms at the top of the table benefit from a captive sales audience in their branch networks, which they tap to sell their fund-of-funds products. RBC’s funds of funds are the undisputed champ, having gathered the most assets since the start of 2010. It’s not surprising then that RBC Select was the largest target-risk program in Canada as of December 2015.

Appendix B Comparison of Fund Management Expense Ratios to Underlying Funds— Sample of Medium-Risk Funds

Name CategoryFund MER

(A)

Wtd Avg MER of Underlying Funds

(B)Difference

(A–B)

AGF Elements Balanced Portfolio Canada Global Neutral Balanced 2.33 2.42 -0.09BMO Balanced ETF Portfolio A Canada Global Neutral Balanced 1.71 0.26 1.45BMO SelectTrust Balanced Port A Canada Global Neutral Balanced 2.38 1.99 0.39CI Portfolio Series Cnsrv Balanced Canada Global Neutral Balanced 2.41 2.16 0.25CI Select 40i60e Managed Port Corp Cl A Canada Global Equity Balanced 2.32 2.17 0.15

CIBC Managed Balanced Portfolio Canada Global Neutral Balanced 2.25 1.78 0.47CIBC Renaissance Optimal Growth & Income Port Canada Global Neutral Balanced 2.09 2.10 -0.01Desjardins Chorus II Growth Canada Global Neutral Balanced 2.01 2.21 -0.20Desjardins Melodia Bal Gr Port Canada Global Neutral Balanced 2.30 2.30 0.00Desjardins SocieTerra Growth Portfolio Canada Global Neutral Balanced 2.45 2.26 0.19

DFA Global 60EQ-40FI Portfolio A Canada Global Neutral Balanced 1.51 1.52 -0.01Dynamic Marquis Balanced Growth Portfolio A Canada Global Neutral Balanced 2.55 2.10 0.45DynamicEdge Balanced Gr Port Canada Global Neutral Balanced 2.33 2.18 0.15Fidelity Balanced Portfolio Series A Canada Global Neutral Balanced 2.43 2.25 0.18Franklin Quotential Bal Growth Port A Canada Global Equity Balanced 2.30 1.65 0.65

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Name CategoryFund MER

(A)

Wtd Avg MER of Underlying Funds

(B)Difference

(A–B)

Invesco Intactive Balanced Gr Port Canada Global Neutral Balanced 2.29 1.54 0.75Investors Group Allegro Moderate Portfolio A Canada Global Neutral Balanced 2.53 2.42 0.11Investors Group Alto Moderate Portfolio Ser A Canada Global Neutral Balanced 2.53 2.41 0.12Manulife Leaders Balanced Growth Adv Canada Global Neutral Balanced 2.47 1.73 0.74Manulife Simplicity Global Balanced Adv Canada Global Neutral Balanced 2.58 2.03 0.55

National Bank Meritage Growth Class Canada Global Neutral Balanced 2.51 2.12 0.39RBC Select Balanced Portfolio Sr A Canada Global Neutral Balanced 1.94 1.76 0.18RBC Select Choices Balanced Port Sr A Canada Global Neutral Balanced 2.16 1.87 0.29Scotia Partners Balanced Growth Canada Canadian Equity Balanced 2.29 2.07 0.22Scotia Selected Balanced Growth Canada Global Neutral Balanced 2.02 2.05 -0.03

Sun Life Granite Balanced Port A Canada Global Neutral Balanced 2.25 1.67 0.58TD Comfort Balanced Growth Portfolio–I Canada Global Neutral Balanced 2.02 2.01 0.01TD FundSmart Mgd Balanced Growth A* Canada Global Neutral Balanced 2.73 2.02 0.71TD Mgd Balanced Growth Port A Canada Global Neutral Balanced 2.30 2.00 0.30TD Mgd Idx Bal Growth Port–I Canada Global Neutral Balanced 1.58 0.80 0.78

Source: Morningstar Direct. Data as of 12/31/15. * The management expense ratio for two of the fund's underlying holdings were estimated because no comparable mutual fund

was available. To be conservative, a fee of 2.75% was used for the TD Opportunities Pool and a fee of 2.00% was used for the TD Income Opportunities Pool. Even bumping the estimated management expense ratios of those two funds up by 0.50% each still results in the total fund management expense ratio being 0.64% more expensive then what's explained by its holdings.

Price Comparison MethodologyTo arrive at the weighted average management expense ratio of the underlying holdings, each target-risk fund’s holdings were analyzed at December 2015 (except CI Financial funds, which only had holdings data available as of September 2015). The management expense ratios of each of the underlying funds were multiplied by their weight in the target-risk fund and then summed up to get a total. In instances where a target-risk fund invested in institutional or fee-based share classes, the equivalent commissioned-based fund was substituted into the calculation. For ETF holdings, the stated management expense ratio was used. Any cash or directly held securities were assigned a management expense ratio of zero. In certain instances, an underlying fund’s management expense ratio was not available. In these cases, an estimated management expense ratio was calculated based on the stated management fee plus the maximum administrative fee plus taxes. In the event that this information was not available, then the management expense ratio of a similar fund from the same fund company that invests in the same asset class was used as a proxy. When the management expense ratio of a similar fund was used, the estimate was rounded up to the nearest 0.25% to add an extra buffer so as to try to overestimate the management expense ratio, rather than underestimate it. K

Appendix B Comparison of Fund Management Expense Ratios to Underlying Funds— Sample of Medium-Risk Funds (Continued)

a survey of the canadian target risk landscape - … · conclusion appendix jeff bunce ... monetary...

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