Although the names may indicate that they have more in common than not, AIC Global Bond Fund and RBC Global Bond Fund are worlds apart. Their portfolio strategies — in particular, their foreign currency hedging policies — are significantly different. So, deciding which fund is more attractive will depend in large part on the outlook for the Canadian dollar.

With $905 million in assets under management as of Sept. 30, the RBC fund, sponsored by Toronto-based RBC Asset Management Inc., is the largest global bond fund tracked by Morningstar Canada.

In contrast, Burlington, Ont.-based AIC Ltd.’s fund has attracted only $29 million in AUM, despite having been around since 1999. But Morningstar has never let size diminish the attractiveness of a fund. In fact, the AIC fund was featured among Morningstar’s Fund Analyst Picks until it was removed in February 2008 amid concerns over net redemptions in AIC’s funds and the lack of risk controls in other mandates.

But, by far, the most important difference between the RBC and AIC funds profiled here is their foreign currency hedging policies.

The AIC fund leaves all foreign currency exposures unhedged, essentially making it a play on foreign currencies strengthening against the C$. Randy LeClair, manager of the AIC fund, uses quantitative and macroeconomic analysis to look for bonds that are trading outside of their long-term ranges, which he defines as two or more standard deviations from their historical averages. He also tracks leading economic indicators such as gross domestic product, inflation, wage pressures and consumer confidence to gauge the potential direction of currencies vs the C$.

The RBC fund, meanwhile, strategically hedges 100% of its foreign currency exposure back to the C$. However, the RBC fund’s team of managers, led by currency specialist Dagmara Fijalkowski and global government bond manager Soo Boo Cheah, use many of the same metrics that AIC’s LeClair does to make tactical bets on currencies they believe are attractive.

But trying to determine which hedging policy is more advantageous is difficult at best.

The RBC fund’s stance has benefited the fund for the better part of the past five years, with the C$ strengthening on elevated demand for commodities. But the financial turmoil and economic uncertainty that has consumed global markets more recently has put a dark cloud over the demand for commodities. This has resulted in a diminished appetite for the C$, which has turned the performance tables against the RBC fund.

In the year ended Sept. 30, the AIC fund posted a return of 6.7%, eclipsing the 2.9% return earned by the RBC fund. But, over the prior four years, the RBC fund had an average annual compound return of 2.4%, while the AIC fund lost 0.8%.

Looking back over longer periods, returns of the two funds have tracked closer together. We would expect that to happen, because currency effects have a tendency to cancel each other out over the long run. Over the past nine years, a period that has seen significant moves for the C$ in both directions, the AIC fund had an average annual compound return of 2.8%, vs 2.3% for the RBC fund.

Although this doesn’t bolster the case for hedging, the strategy does reduce return volatility. In the past five years, standard deviation for the AIC fund stood at 7.5, vs 2.7 for the RBC fund.

In addition to different hedging policies, the two funds also differ at the sector level. The AIC fund sticks predominantly to Canadian government bonds (federal and provincial) and supranational issues (such as those from the World Bank, International Monetary Fund and regional development banks) that are denominated in foreign currencies, virtually removing credit risk from the equation.

The third table from the top shows the AIC fund as having 35.7% in corporate bonds. But these are all supranational entities, which have credit ratings more akin to those of government debt than corporate debt. As well, the data suggest that the AIC fund has 68.5% in Canadian bonds, but this is because debt issued in foreign currencies by Canadian issuers is classified as Canadian content.

These issues also affect the RBC fund, but to a much lesser extent.

The RBC fund’s approach is more colourful. Fijalkowski and Cheah draw on the expertise of RBC’s deep fixed-income team to generate ideas. At the end of May (the most recent date for which holdings data is available), the fund had 48.1% of AUM in corporate bonds and modest exposure to high-yield and emerging-markets debt.

@page_break@On a stand-alone basis, corporate debt (investment-grade and high-yield) and emerging-markets bonds are much riskier than government bonds, which has been evident during the ongoing credit turmoil. But in normal credit environments, these investments can help boost returns in a diversified bond portfolio, with marginal increases to overall risk.

It’s also worth noting the differing levels of holdings concentration in these funds.

The AIC fund heavily concentrates AUM in its top 15 positions — as of June, these accounted for 93% of its AUM. Regulation generally doesn’t permit holdings of a particular issue to be greater than 10% of a fund’s AUM. But AIC applied for and was granted an exemption that allowed the fund to invest up to 20% of its AUM in securities issued or guaranteed by any government or its related agencies, as well as supranational issuers with high credit quality.

In the case of the RBC fund, holdings are much more scattered. As a way to keep risk in check, the fund’s policy limits the investment in any individual non-investment-grade issue to 2% of AUM and to 5% in any other single corporate issue.

For the most part, duration management and interest rate anticipation strategies are used sparingly at both firms.

The RBC fund places a heavier focus on credit risk analysis and getting the sector right, whereas the AIC fund is more concerned with finding the currencies that provide the best relative value.

Despite the different portfolio strategies, either fund can provide portfolio diversification. Over the past five years, both funds have shown a low degree of correlation to the median equity funds in the Canadian, U.S. and global equities categories.

In fact, the AIC fund is negatively correlated with the median Canadian equity offering, which isn’t surprising because domestic equity funds tend to have healthy doses of C$-friendly commodity stocks. But bear in mind that correlation measures look backward; there’s no guarantee that the relationships will hold up.

Also consider the management expense ratio of the funds. The RBC fund’s MER of 1.68% is one of lowest among actively managed global bond funds requiring an initial investment of $10,000 or less. Not surprising, the much smaller AIC fund comes with a higher MER. At 1.92%, it’s only six basis points lower than the category median. Although quibbling over the 24-bps difference between the two funds seems petty, the expected return from bond funds is much lower than for equity offerings, so every tick counts.

At Morningstar, we think both funds have investment merit. If you’re bearish about the C$, the AIC fund is the more attractive offering. But if you are looking for a broad, actively managed bond offering, then we give the nod to the RBC fund and its lower MER. IE



Philip Lee is a senior fund analyst with Morningstar Canada in Toronto.