As conservative income trust investors come to realize they backed the wrong horse, balanced funds will probably continue to pick up the slack. Balanced funds were the biggest market share gainers once again in October — up $1.2 billion — and now account for 26% of total mutual fund assets.

As a group, balanced funds generally hold about 65% stocks and 35% bonds, adding value through both asset mix and security selection. A healthy tilt toward equities, short-term debt and little or no money outside the country has the better performers delivering double-digit annualized returns over the past five years.

A case in point is Acuity Funds Ltd. ’s tiny $62.6-million Acuity Canadian Balanced Fund. Up 34.4% in 2003, more than double the category’s 14.4% average, the offering delivered an attractive 9.9% in 2004, followed by 12.8% last year. Year-to-date to Oct. 31, it is up 6.9%, producing a 13.7% average annual compound return for the past five years — more than all but a few Canadian balanced funds.

Let’s compare it with Dynamic Mutual Funds Ltd. ’s much larger $1.4-billion Dynamic Focus + Balanced Fund, which made profit every single year of the bear market at the turn of the century. More recently, however, after producing a strong 18.8% return in 2003, the fund has lagged most of its peers, producing only 7.5% in 2004 and 10.7% last year. For the 10 months ended Oct. 31, the fund is up roughly 2.6%, producing a five-year average annual compound rate of return of 10.9%.

The two funds receive four- and three-star risk-adjusted rankings, respectively, from Morningstar Canada, but the Acuity fund has been the stronger performer, outstripping the average fund in the category over a variety of periods.

The Acuity fund is managed by Ian Ihnatowycz, CEO of Acuity Investment Management Inc. , who began his career with Confederation Life Insurance Co. of Canada. He’s assisted by Hugh McCauley and David Stonehouse.

With a neutral setting of roughly 65% in Canadian stocks and 35% in fixed-income, Acuity uses a team approach in which managers are responsible for covering two or three sectors using a bottom-up, growth style when it comes to stock selection. The bond portfolio largely mirrors the benchmark in duration and credit risk.

Ned Goodman, lead manager on the Dynamic fund, is CEO at Goodman & Co. Investment Counsel Ltd. and a 40-year industry veteran. Michael McHugh manages the fixed-income side of the Dynamic fund’s portfolio.

Goodman also looks for growth companies, particularly ones trading at a minimum of two-thirds of his fair-value estimate. He uses a valuation model that stresses book value to identify stocks trading at such discounts. On the fixed-income side, many of the corporate bonds held in the portfolio are issued by the companies the fund features in its stock portfolio.

Currently, only about 46% of the Dynamic fund’s holdings are in equities, with 42.3% in bonds and 12.8% in income trusts. About 15% of the stock portfolio is invested in Canada, with the balance almost entirely in the U.S. Goodman is underweighted in energy and financial stocks and slightly overweighted in information technology.

The Acuity portfolio is tilted a bit more toward energy and financials, steering clear of telecom and most consumer companies. Almost 60% of its assets are in Canadian equities; of the 28.8% it holds in fixed-income, less than 3% is outside Canada.

There are only a few common names among the funds’ holdings, and the bigger bets are quite different. Holding roughly 30 stock positions, Dynamic’s top 10 holdings account for 43% of assets. Acuity’s top 10 represent less than 27% of its total, which includes almost twice the number of holdings.

The big difference is the funds’ use of non-Canadian holdings. Goodman takes the Dynamic fund much further across the border, whereas the Acuity fund’s assets are almost exclusively Canadian.

For the Acuity fund, with the exception of a lower market cap, conventional valuation ratios are similar to the average Canadian balanced fund and the Morningstar benchmark. The Dynamic fund also contains more mid-cap stocks than the benchmark, although its 3.4% dividend yield ranks it in the top quartile of Canadian balanced funds.

On the risk side, the Acuity fund has delivered much more volatile returns than most of its peers, and the Dynamic fund profile is clearly the less risky of the two. The Acuity fund has a five-year standard deviation of 8.6, significantly higher than the benchmark’s 6.9 and the Dynamic fund’s 6.3. The two funds’ Sharpe calculations are essentially the same, reflecting the rewards of the more aggressive domestic Acuity portfolio.

@page_break@Both funds are solid offerings, but the Acuity fund comes out ahead — historically, at least. But the Acuity fund’s MER of 2.91% makes the fund more expensive than almost every other product in its category, Morningstar reports. In the past three years, investors would have earned better returns by semi-annually rebalancing a 65%/35% mix of Acuity Canadian Equity and Acuity Fixed Income while paying less in management expenses, Morningstar says. As a result, the analysis firm recommends taking “a pass” on this offering.

If you believe the Dynamic fund’s “different drummer” approach to foreign content is on the money, its low correlation to the benchmark makes it a good offset choice. IE