Canadian balanced funds generated solid returns in 2006, thanks to robust equity markets and benign conditions in fixed-income markets. And, although North American economies are showing signs of softening, managers are generally upbeat about prospects for 2007 and tend to favour equities over bonds.

“Our range for fixed-income exposure is between 40% and 60% — and it’s currently sitting at around 45%,” says Rohit Sehgal, co-manager of Dynamic Power Balanced Fund and chief investment strategist at Toronto-based Goodman & Co. Investment Counsel. “That tells us that we are more positive about the outlook for equities than for fixed-income. The environment for equities remains robust.

“We still see good earnings growth on a global basis,” he continues. “We feel comfortable about valuations. And, more important, the U.S. economy will have a soft landing. These factors tell us that equities will perform well in 2007.”

In aggregate, Sehgal believes Canadian markets should return about 10% in the coming year, although, as an active manager, he will try to exceed that.

“Ten per cent is not too bad — much better than we expect for bonds,” he says.

Bonds should return about 4%, which is similar to last year, says Michael McHugh, portfolio manager at Goodman & Co., who oversees the fixed-income portion of the Dynamic fund.

“We’re probably halfway through a cyclical bull market in bonds, in which yields are declining. But we’ve seen most of that decline,” McHugh says. He expects that long bond yields (which are 4.25%) could be the same at the end of the year, with some choppiness in between.

“We don’t expect the downturn in the U.S. economy to be that significant. An improvement could impact the long end [of the yield curve],” McHugh says.

As for risks, Sehgal concedes that equities markets are in the fifth year of a bull market and could see a correction. “Investors have been pretty aggressive and moving into riskier asset classes,” he says. “At some point, they may rebalance. These are the kind of things we worry about. But when you look at the fundamentals — earnings, interest rates and overall global growth — it still looks pretty good.”

Strategically, 43% of the Dynamic fund’s fixed-income portion is in a blend of investment-grade corporate bonds and commercial-backed securities, with the remaining 57% in a mix of federal and provincial bonds. The bond portfolio’s duration is 6.5 years, which is neutral relative to the Scotia Capital universe bond index.

However, McHugh is an active investor and will adjust the duration to reflect market conditions.

On the equities side, Sehgal is running a 50-name portfolio, although the top 20 names account for more than half the exposure. He favours the materials sector, which represents 20% of the fund; 4% is invested in industrial products and 3% in financial services. He owns names such as Potash Corp. of Saskatchewan, the world’s largest potash producer. That company is expanding production, thanks to strong demand from markets such as China and to burgeoning demand for corn to be used for ethanol production. Purchased last June at $85 a share, the stock was recently trading around $165 a share.

“Our target is $200 in 12 months,” says Sehgal, noting that Potash Corp.’s earnings are growing at 20% a year. “It can increase capacity without much additional cost.”

Within the energy sector, which accounts for about 14% of the fund, Sehgal favours Paladin Resources Ltd. A developer of uranium mines in Australia and Namibia, it has benefited from a run-up in the uranium price to US$80 a pound from US$10 four years ago. Sehgal bought the stock then at $1 a share; it is now trading at $7.80 a share.

“We still see some upside, but not as much as we expected four years ago,” says Sehgal, adding that the share price could hit $10 within 12 months.



There’s a similar emphasis on equities in TD Balanced Income Fund. About 43% of fund assets are invested in fixed-income, which is 7% less than the 50% benchmark, says Margot Ritchie, co-manager of the fund and partner at Jarislowsky Fraser Ltd. in Toronto. There is also 35% in Canadian equities, which is neutral relative to the fund’s benchmark, and 20% in foreign equities, compared with 15% for the benchmark.

@page_break@“Our underweighting in bonds, which we’ve had for some time, reflects the view that we don’t expect much from bonds other than the coupon,” says Ritchie, who runs the fund with James Morton, partner at Jarislowsky Fraser.

Ritchie expects the yield curve may turn downward at the short end if the Bank of Canada cuts rates to offset a weakening manufacturing sector. “The U.S. may wait to cut rates, however, as core inflation is about 3%. But there are concerns about the U.S. housing market. We’re not seeing a lot of changes in the shape of the yield curve,” she says.

As a rule, there is a 40%-90% weighting in higher-yielding investment-grade corporate bonds of companies such as Royal Bank of Canada and Bank of Nova Scotia. The curent 48% exposure is at the lower end of the range. The remaining 52% is primarily in Government of Canada bonds for liquidity purposes.

Lately, Ritchie and Morton have moderately extended duration, which is now neutral relative to the benchmark Scotia Capital universe bond index. “With the U.S. housing market concern coming more into focus, we’re saying that, some time next year, interest rates could start to move lower. We didn’t want to be short,” says Ritchie.

Running a 100-name equities portfolio (including about 60 non-Canadian stocks), Ritchie favours the financial services sector, which makes up 34% of the fund.

“We like the banks because they have had a great run in the past year, with a lot of capital markets activity,” says Ritchie, noting that she and Morton have long emphasized large-cap, blue-chip companies that have predictable earnings and high cash flows. “The banks have also benefited from the income trust tax ruling change. People have been selling off income trusts and moving into higher-yielding stocks that happen to be in financial services sector.”

Just as important, the banks have been increasing their dividends, and they may continue to do so, says Ritchie, noting that TD fund has large holdings in Scotiabank and Royal Bank. “There is room to boost their payouts,” she says.

Conversely, Ritchie is slightly underweighted in the energy sector, although she does favour Talisman Energy Inc. and Nexen Energy Inc., which have been held in the fund more than five years.

“Both have excellent leverage, exceptionally strong management and diversified assets. They are not expensive on a cash-flow basis. That is what we’re looking for,” she says, noting that those stocks are trading at about four to 4.5 times 2007 cash flow.

In a similar vein, she has taken an interest in the oilsands, acquiring Canadian Natural Resources Inc. last year. “We are reasonably constructive on this sector,” she says.

On a bearish note, however, Ritchie is underweighted in the materials sector, including so-called “deep” mining stocks: “We thought the commodities were very well priced and factoring in the best outlook, plus there was downside risk.”



Cautious optimism is the view expressed by Stephen Binder, portfolio manager with Boston-based Fidelity Management & Research Inc. , who oversees the equities portion of Fidelity Canadian Balanced Fund.

“I’m cautious because the past two years have been pretty good. They have been driven by energy and metals markets,” says Binder, who is strictly a bottom-up inves-tor and tends to avoid macroeconomic calls. “We could see a correction, however, because there are high natural gas inventories that could feed back into gas prices becoming weaker than expected.

“If the economy slows, that could hurt my thesis on oilsands, which could be too optimistic,” he continues. “But I don’t think it will be too bad, so I am keeping the oilsands’ exposure. And I still like the valuations. The resources side could take a pause, but the other parts of the economy should do OK.”

The Fidelity fund is close to its target of 50% equities, which is composed of about 90 stocks. There is also 34% in Canadian bonds, 13% in foreign bonds and 3% in cash.

As of Oct. 31, the top equity holdings in the fund included Nexen Energy, Potash Corp., Canadian Natural Resources, Royal Bank, Manulife Financial Inc. and Rogers Communications Inc.

Although the Fidelity fund had large holdings in Falconbridge Ltd. and Inco Ltd. — both of which have been acquired by foreign concerns and taken private — Binder took his profits and invested some of the proceeds in oilsands plays such as Canadian Natural Resources. But he remains concerned that the remaining materials sector names are riskier.

“It’s hard to find opportunities in the mid-cap names. I’m a little cautious there,” he says. However, he is bullish on Potash Corp., whose stock has had a significant run-up in the past year. “Hopefully, the stock is not too expensive so it can still do well in the months ahead.”

Banking stocks have also appreciated significantly in the past few months, and Binder acknowledges that their valuations are on the high side. “Their earnings could do all right, but the stocks could pause here. They still have reasonable fundamentals, however,” says Binder, noting that one of his favourites is TD Bank Financial Group. “It keeps growing its earnings, so that should drive [the share prices].”

The fixed-income portfolio, which is composed of 80% federal and provincial government bonds and 20% investment-grade corporate bonds, has a neutral duration.

But David Prothro, fixed-income portfolio manager for the fund, is shifting away from a barbell approach, in terms of emphasizing short- and long-term maturities, and is focusing instead on the mid-range of the yield curve.

Prothro is keeping most maturities within three to seven years, based on his belief that rates will probably not change quickly at either the short or the long end. IE