Hugh McCauley, lead manager of Acuity Pooled High Income Fund, boasts a category-beating 10-year return that has been achieved by no-nonsense investment analysis and the ability to establish firm footholds along the way to avoid giving back any significant gains.

It is that track record that has made McCauley, managing director and portfolio manager at Acuity Funds Ltd. in Toronto, Investment Executive’s Mutual Fund Manager of the Year.

McCauley is justifiably proud of his fund’s performance, but quick to praise the rest of the Acuity fund-management team. He is the lead manager of a team of five portfolio managers who together run every fund in the Acuity stable.

“It’s one thing to have the top numbers with high risk,” he says. “But we also have steady returns and slightly below-average risk.”

Each Acuity manager is delegated responsibility for a handful of market sectors, and is responsible for providing input on opportunities in those sectors for every Acuity fund. McCauley, as the energy expert, for example, is responsible for investment analysis on all securities in that sector, including corporate bonds, convertible securities, small-cap stocks, income trusts and large dividend-paying companies. Other sectors under his watch include materials, health care and information technology.

“When we go into a meeting with company management, we can ask more intelligent questions than a generalist,” says McCauley, an energetic man who talks in rapid-fire fashion. “The more sectors you cover, the less detailed the knowledge on any one sector.”

Before a new name is added to an Acuity fund portfolio, there must be consensus among the team. If one person is against the purchase, his or her concerns must be addressed. Only when everyone is satisfied that the security is a good investment is it added to a portfolio. Holdings are monitored regularly, with formal team meetings once a month and less formal meetings almost daily.

All five portfolio managers at Acuity have backgrounds in science or practical business experience and possess financial and analytical skills, as well as MBAs, CFAs or both. McCauley is a graduate in engineering and physics, for example, while fellow portfolio manager Martin Grosskopf has a master’s degree in environmental science, David Stonehouse is a geological engineer, Warren Fenton has work experience in consumer products and merchandising, and Spencer Mellish has experience in the pharmaceutical industry. In addition, company founder, president and overall strategist Ian Ihnatowycz has an undergraduate degree in science and pharmacology.

“Our team members apply a scientific methodology, and we have a disciplined way of analysing things,” McCauley says. “The scientific training adds rigour to our analysis.”

The high-income fund scored the most points in IE’s multi-pronged analysis. Funds are awarded points for each year of positive returns, for their quartile ranking and for beating the average fund in their asset class each year. IE also factors in cumulative 10-year returns, the management expense ratio and the fund’s correlation to the comparable market index.

Investors have been richly rewarded for owning Acuity Pooled High Income Fund during the past decade, provided they had $150,000 to meet the minimum investment. If they qualified as an accredited investor, they could have gained entry with $50,000.

During the past 10 calendar years, the fund has been top-quartile in every year but 1999, when the technology boom was raging and the market was tossing aside the conservative dividend-paying stocks in its portfolio in favour of alluring “new economy” opportunities. The $1.1-billion fund’s average annual compound return for the 10 years ended Oct. 31 was 15.1%, well ahead of the median Canadian balanced fund’s return of 6.8% as measured by Morningstar Canada. And for those who are fee-conscious, the fund’s skimpy MER of 0.1% means most of the gains end up in unitholders’ hands. There is also a regular mutual fund version of Acuity High Income that has a minimum investment of $500, an MER of 2.36% and lower returns to match.

McCauley, a married father of two children who has been working at Acuity since 1996, graduated with a bachelor of science from the faculty of engineering at McMaster University in 1986; two years later, he obtained his MBA at the same university. Originally, he worked in his father’s small business, which repaired pneumatic equipment. But he also spent time working in science laboratories and manufacturing, conducting an efficiency study for a glass factory.

@page_break@“The average analyst or CFA has never been near a lab or plant floor,” McCauley says. “When analysts look at a tech company, they sometimes have to take management’s word at face value. I’ve been in there with my sleeves rolled up, and have a lot of practical background.”

McCauley also worked for seven years in various roles at Bank of Montreal and TD Bank Financial Group, starting in crisis management, moving through human resources and ending up in the treasury department. His first assignment when he joined Acuity 10 years ago was to examine the merits of income trusts, which, at the time, had not yet soared to popularity.

Assets in Acuity Pooled High Income Fund are divided among three categories with little correlation to each other — dividend-paying stocks, bonds and income trusts. The amount in each asset class can range from 25% to 50%. Currently the assets are allocated 42% to Canadian dividend-paying stocks, 6% to foreign dividend-paying stocks, 26% to government and corporate bonds, and 26% to income trusts. The fund pays a monthly distribution equal to 6% annually.

The income side is conservative, with the majority of assets in federal government bonds and the rest in provincials and investment-grade corporates. On the equity side, whether he’s buying income trusts or stocks, McCauley is interested in the business potential of the issuing entity and considers himself a “growth at a reasonable price” manager. The fund’s stock holdings on average have a lower price/earnings ratio than the S&P/TSX composite index, a higher earnings growth rate and a higher return on equity. The trusts have lower payout ratios than the index and higher cash-flow growth.

“We don’t buy overpriced momentum stocks and we’re not deep-value managers looking for broken-down vehicles or turnarounds,” he says. “We look for growth, and a distinct proprietary advantage.”

Proprietary advantages could be related to a superior technology or to distribution, strength of brand or the ability to manufacture a product faster or cheaper. McCauley also looks for management experience and ability, balance sheet strength, free cash flow and an attractive valuation. Free cash flow can be used to invest in improving the business, make acquisitions, increase dividends or buy back stock.

During the past few months the Acuity fund has been affected by the federal government’s decision to tax income trusts in four years. Because of its heavy weighting in trusts, the fund has fallen a bit. This dip has not affected its impressive achievement in trailing 12-month returns, however. In assessing 152 12-month periods for the past five years, Morningstar found that the best period for the fund showed a 44.7% gain, while the worst showed an 8.3% loss, implying limited downside volatility.

McCauley is not concerned that the tax changes will kill opportunities in the income trust sector. He believes trusts will simply become more like dividend-paying securities. A number of trusts are now trading at less than their common-stock peers, and represent compelling opportunities. He likes to see companies paying out a healthy distribution, yet retaining a good chunk of their cash flow to reinvest in developing and growing the business.

“The ability to distribute an income wins all the time with securities,” McCauley says. “A company must have the excess cash to pay a dividend, and that implies a level of financial discipline.” IE