Recent fund performance figures remind us that considerable variation exists among funds investing in the Canadian equities market.

Although every equity mandate had dropped well into negative territory by the end of 2008, some managers proved to be better stewards of unitholder capital than others. The disparity is largely a function of different investment approaches.

In their respective investment styles, Mark Thomson, senior vice president and director of research with Toronto-based Beutel, Goodman & Co. Ltd., and Eric Sprott, CEO and portfolio manager with Toronto-based Sprott Asset Management Inc., have posted impressive long-term performance numbers. With Thomson at the helm, Beutel Goodman Canadian Equity Fund has exceeded the S&P/TSX composite index’s 4.6% average annual return for the 10 years ended Jan. 31 by 166 basis points. Meanwhile, Sprott Canadian Equity Fund has returned a hefty average annual compound return of 23.3% for the same period. The performance difference is striking, and a closer look reveals big differences in the strategies of these two Canadian equity funds.

Thomson follows a bottom-up stock selection philosophy. He focuses on high-quality, large-cap companies that are dominant players in their markets and that generate significant free cash flow. Through fundamental analysis, he identifies stable companies that he expects to return at least 50% over a two- to three-year time horizon. (For cyclical companies, he needs an expected return of at least 100%.)

An interesting aspect of Thomson’s strategy is his sell discipline. When a stock reaches its target price, he sells one-third of the position. At that point, he re-examines the investment thesis and, if nothing has transpired that would justify a higher fair value price, he sells the remainder.

The Beutel Goodman fund held up relatively well as the market plummeted in the latter half of last year, thanks to defensive consumer names such as Molson Coors Brewing Co. and Shoppers Drug Mart Corp. Looking ahead, Thomson — a financial services sector specialist — is bullish on Canadian banks and insurers. He expects that when a recovery in the market materializes, it will be led by financial services.

Conversely, Sprott is an investor looking to hit home runs. He, too, incorporates a large top-down component in his investment process. Over the years, Sprott has been vocal about his sometimes-controversial macroeconomic opinions. For instance, he believes that today’s financial system is a house of cards, and he has been short-selling bank stocks to reflect this view.

Furthermore, he believes that gold is still undervalued and that energy is in a long secular uptrend (he supports the theory of “peak oil”). Consequently, Sprott searches out small- to mid-cap companies in industries that stand to benefit from his investment themes. He is drawn to names that he believes can double or triple in value, and he is not shy about making large bets.

Moreover, unlike Thomson, Sprott will let his picks ride to capture as much upside as possible. Sometimes, this approach can work against him. A prime example was his exposure to Timminco Ltd., a company that specializes in the production of solar-grade silicon. He held his position in the stock as it climbed to its highs in the $35-a-share range, and through to its subsequent drop to less than $3.

As gold stocks decoupled from the price of gold, Sprott began more heavily weighting the physical commodities, specifically gold bars and silver bullion, in the fund. He has also increased the fund’s cash component, expressing his bearish sentiment.

There is also a clear difference in the amount of risk that each manager undertakes. Despite Sprott’s bearishness, his fund has been a substantially riskier offering. His concentrated bets reflect a handful of macro themes, and the average market capitalization of companies in his fund is less than $200 million. Although the current allocation is very conservative, it’s also a testament to the acute shifts that can occur when little emphasis is placed on diversification. A 10-year standard deviation of 25.2 also reflects the fund’s volatility, far exceeding the 16.1 measure of the S&P/TSX composite index.

At Beutel Goodman, risk management is top of mind. This conservative offering’s aforementioned sell discipline serves to minimize the risk of holding overvalued names. Another good example of Thomson’s prudent approach is the handling of his position in BCE Inc. Many portfolio managers held on to this stock expecting to squeeze out the last few dollars of arbitrage leading up to the company’s privatization. Although Thomson shared the view that the deal was likely to go through, he felt it would be sensible to take his profits from the position — recognizing that the potential downside to the share price would be significant — as the market was signalling that some risks to the deal still existed.

@page_break@To top it off, the two funds have different fee structures. The Beutel Goodman fund charges a rock-bottom 1.20% MER, putting it among the least expensive offerings in its category. Given that fees are the only component that you can be sure will detract from a fund’s performance, this characteristic gives the Beutel Goodman fund an instant leg-up over its peers.

In contrast, the Sprott fund charges a base MER of 2.5% and adds a performance fee on top. This means the fund’s fee can vary significantly from year to year, but at minimum is 130 bps higher than the Beutel Goodman fund.

The performance fee is 10% of the fund’s returns in excess of the S&P/TSX total return index. In the past five years, the MER has ranged from 2.80% to as high as 5.63%. Sprott takes aggressive bets that make it possible for him to hurdle his fees by a large margin — assuming he gets his calls right. Although performance incentives are theoretically intended to align management’s interests with those of unitholders, in reality, most tend to favour the manager. With the base management fee guaranteed even when the fund underperforms, it creates a scenario that can encourage excessive risk-taking.

The contrasting investment strategies of these two funds reveal just how different two similarly dubbed funds can be. While the Sprott fund has achieved significant success, it has done so with considerable volatility and charged hefty fees along the way. The Beutel Goodman fund is a more conservative offering that has posted excellent risk-adjusted returns and would be a better choice as a core holding for most investors. But an investment decision in either one ultimately boils down to an individual’s appetite for risk.



With files from Morningstar Canada analysts David O’Leary and Jordan Benincasa.