Equity funds in Canada suffered a fifth consecutive month of overwhelmingly negative returns in September amid high volatility and bleak economic news.

This led to dismal results for the third quarter of 2011 for all 23 of the Morningstar Canada Fund Indices that track equity categories, with 16 of them losing more than 10%, according to preliminary performance data released Tuesday by Morningstar Canada.

The worst-performing fund index was the one that measures the Greater China equity category; it lost 20.5% during the quarter, with the bulk of the losses coming in September. “Chinese banks and property developers have come under significant pressure recently, and this weighed meaningfully on the funds in this small category. Regulators are creating a tighter credit environment in the country amid fears of a rise in bad loans,” says Morningstar fund analyst Nick Dedes.

The flight from risk has been a recurring theme during the past several months, and the biggest losers among investment funds were those that target riskier asset classes. The second-worst performer in the third quarter was the Morningstar Natural Resources Equity Fund Index with a 17.3% loss, while Emerging Markets Equity was third from the bottom with a 16.8% drop. Moreover, the four fund indices that track small- and mid-cap equity categories were also among the bottom dwellers with losses ranging from 13.9% to 15.5%. “It’s not surprising to see these more volatile asset classes rank among the worst performers in a period where equities appear to move more on the latest headline instead of individual company fundamentals. Investors have been particularly spooked by sovereign debt woes out of Europe and are taking risk off the table,” Dedes said.

Even gold funds, which had been one of the few categories to post positive returns so far this year, suffered significant losses in September as gold prices plummeted by about 10%. The precious metals equity fund index lost 12.1% in September, wiping out its gains from the previous two months and resulting in a 3.7% loss for the index during the quarter.

Sector-diversified domestic equity funds also suffered the bulk of their quarterly losses in September after posting relatively benign losses in August. The Canadian equity fund Index lost 8.3% last month — with most of the damage occurring in the energy and materials sectors — leading to a 12.9% loss for the quarter. The Canadian dividend & income equity fund index fared better with a 9% quarterly loss, while Canadian focused equity was down 13.6% for the three-month period.

Results for foreign equity funds were slightly worse than those of their domestic counterparts. The U.S. equity fund index lost 11.2% in the third quarter, while the indices that measure the Asia Pacific equity, global equity, international equity, and European equity categories lost 11.6%, 12.2%, 14.8%, and 16.2%, respectively. Currency effects generally favoured Canadian investors in these funds, with the Canadian dollar depreciating against the U.S. dollar, the UK pound, and most Asian currencies.

The best performer among equity fund indices, and one of only two that posted a gain in September, was Japanese equity with a 2.8% gain in September and a 2.6% loss for the quarter. Currency movements were particularly beneficial here from a Canadian investor standpoint, as the 11.4% loss of Japan’s Nikkei 225 Index for the quarter was largely offset by the yen’s 12.8% appreciation against the loonie. “Despite intervention efforts by the Japanese government, the yen has rallied strongly against most major currencies and likely continues to receive safe-haven flows through this period of economic strain,” Dedes says.

By contrast, bond funds had strong returns last quarter as investors, somewhat predictably, flocked to the perceived safety of the asset class. “Risk aversion is currently trumping the less-than-compelling low yields in fixed-income instruments,” Dedes says. The best performer among the 43 fund indices was Canadian long term fixed income with a 9.8% gain, followed by Canadian inflation-protected fixed income, Canadian fixed income, Global fixed income, and Canadian short term fixed income with gains of 4.3%, 3.8%, 2.8%, and 1.7%, respectively.

Final performance figures will be published next week.

IE