At a time when the domestic stock market is flying high, Canadian investors are still huddling close to the ground in the relative safety of balanced and income-oriented mutual funds.

Recent data from the Investment Funds Institute of Canada show the percentage of assets held in the balanced fund category is higher than at any time since IFIC began compiling detailed data in 1990. Such funds have also been steadily gaining a bigger share of Canadians’ investment dollars for 15 years.

As of July 31, balanced funds accounted for 21% of the $544.5 billion Canadians held in mutual funds — approximately double the 10.4% share of the market they held in
1990, when Canadians’ total fund assets were a mere $25 billion.

“Canadian stock indices have done well recently, but investors continue to be risk-averse,” says Erwin Go, IFIC’s manager of statistics in Toronto. “People are staying away from volatile investments.”

Sales have been particularly strong in balanced and income fund categories since the technology boom imploded in 2000, when many investors saw their portfolios evaporate. At that time, many people were tilted disproportionately toward equities and, within that category, growth stocks. Investors still bear the scars of their market losses and are reluctant to venture into the equity category again.

Balanced funds, conservative dividend funds and income trust funds offer an attractive compromise. These funds provide equity exposure in a different form, but the income they throw off is perceived to add a dimension of safety and, typically, acts as a volatility dampener.

“Anything paying out income is hot,” says James Gauthier, fund analyst at Dundee
Securities Corp. in Toronto. “Across the board, sales look bleak for equity funds, although some of the performance numbers are nice.”

Net new fund sales, excluding reinvested dividends, for the seven months ended July 31 show $7.4 billion flowing into the Canadian balanced fund category, followed by $7.1 billion into dividend funds and $4.6 billion into bond and income funds. By contrast, the Canadian equity category showed net redemptions of $891 million, with U.S. and foreign stocks also experiencing a flood of redemptions.

The redemptions in the Canadian equity category occurred despite heated action in a market fuelled primarily by energy stocks. In fact, the market has been doing well for some time, showing an 18.6% average annual gain for the S&P/TSX composite index for the three years ended July 31.

“Historically, with fund sales, there has been a lag between recovery in performance and recovery in sales, and it tends to create the effect of investors buying high and selling low,” says Rudy Luukko, investment editor at Morningstar Canada in Toronto.
“An element of human nature comes into play.”

Canadians have also become gun-shy when it comes to buying specialty funds and, despite stellar returns in resources and energy funds as well as in emerging markets such as India and China, they are not being tempted to plunge into funds concentrating in those areas.

Resources funds, for example, began to rise shortly after the tech collapse, after years of investor neglect sent their unit prices to undervalued levels. As of July 31, the category shows a five-year average annual compound return of 20.7%, according to Morningstar. However, IFIC sales figures show a thin stream of $351 million in net new sales for resources funds in the first seven months of this year.

Luukko says Canadians who already have exposure to the equity market may be getting all the resources exposure they need, particularly if they’re in a Canadian equity fund that follows the S&P/TSX index (energy stocks account for more than a quarter of the index’s weighting). He says advisors may want to drill into portfolios to determine just how exposed their clients are to energy through equity funds, as well as check out income trust funds that may be heavily represented in the sector.

Gauthier warns that, after the impressive performance of the past few years, income trust funds may be due for a cooling-off period, and some investors may have unrealistic expectations of continued capital gains. Morningstar’s income trust fund index shows an average annual gain of 21.3% for the past three years, including gains and distributions, which has outperformed all equity categories. But, Gauthier says, income trusts are typically designed for a distribution in the 6%-8% range and are not built for growth.

@page_break@Competing income vehicles, such as guaranteed investment certificates and Canada Savings Bonds, have been paying such paltry rates of interest that investors have been forced to seek higher returns elsewhere, even if income trusts and balanced funds are a few rungs higher on the ladder of risk than the old standbys

“People tend to go from one side of the boat to the other, and they may be overweighted in income investments right now,” says John Boeckh, senior vice president of marketing at Toronto-based Guardian Group of Funds Ltd. “But when they’ve been enjoying 20% annual returns with less volatility, it’s hard to say they’re doing the wrong thing. It’s a risk/return tradeoff. And while they’ve bought income products as a safe haven, they’ve enjoyed healthy returns, and it’s been a pleasant experience.”

Guardian Group was ahead of many of its competitors in introducing funds with an income component, and the popularity has contributed to a doubling of its assets in the past three years to $5.4 billion. Balanced funds have also been popular sellers at the big banks, and money is funnelling into the category through the banks’ massive branch networks, as well as through independent advisors.

“There’s a blurring of the lines between equity and income categories with investments such as income trusts and high-yield corporate bonds,” says Boeckh.

At Toronto-based AIM Funds Management Inc. , the biggest selling fund is Trimark Income Growth Fund, a balanced fund with a five-year average annual return of 11%.
“People are committed to the idea of a balanced portfolio, and this fund offers one-step diversification,” says Dwayne Dreger, AIM’s vice president of corporate affairs. “The safety and convenience are appealing.”

Balanced funds are a reasonable option for advisors who don’t want to be held responsible for losses in client portfolios, which can sour relationships and sometimes lead to client defections. Rather than aggressively putting clients into the latest hot product, which can be just as volatile on the downside as on the upside, many advisors focus on helping clients develop a suitable asset mix, sticking to it through occasional portfolio rebalancing.

“If you can offer a solid balanced fund, there is less business risk as an advisor,” Dreger says. “The selling proposition is not to do heroic things and make clients richer than the guy across the street, but to achieve reasonable returns with less risk.

“Advisors are adding extra value through regular client meetings or advice on estate planning or tax issues. A good balanced fund is a way to take care of the security selection and sidestep all kinds of problems if the stock market does funny things in the future.” IE