Sector rotation is a gamble fund managers will eventually lose

In our new report, Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds, we spotlight the top 10 Canadian mutual funds for your portfolio.

But that’s not all. We also show you how we selected these funds, and strategies you can use to find funds that are capable of weathering a market slump, and profiting anew when the market turns up again.

Perhaps more importantly, we show you what danger signs to look for when investing in mutual funds. For example, we think you should avoid funds whose managers practice a sector-rotation approach.

Sector rotation will eventually steer you wrong

Managers who practice sector rotation try to underweight or overweight sectors of the stock market, depending on their forecasts for the economy, or other factors.

Sector rotation can work in any one year, say. But in any one decade, the top funds are generally run by conservative managers who focus on long-term growth in the economy (these are the types of funds we spotlight in Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds).

Few sector rotation investors succeed over long periods because they need to guess right twice. In other words, they have to pick the top sectors, and they need to pick the stocks to rise within those sectors. Consistently succeeding at both is extremely difficult.

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There are many theories about which sectors will outperform at any given stage of the economic cycle. But trying to pick winning sectors — and staying out of other sectors — seldom works over long periods. Managers who practice sector rotation often wind up with heavy holdings in the worst-performing sectors. This can be devastating to the fund’s portfolio, even if it confines its investments to well-established companies.

Let our rating system do the work for you

Rather than looking at funds that employ strategies like sector rotation, we carefully selected the funds you get in Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds by looking at the stocks the funds hold and by thoroughly assessing each fund’s strengths and weaknesses in several other key areas. We then awarded each fund a rating (Aggressive, Conservative or Income) to give you a sense of how appropriate it is for your investment goals.

Determining the top mutual funds is more complex than judging individual companies. When we judge the investment quality of an individual company, we take nine key factors into account.

These are: a record of profit; a record of dividends; an influential industry position; balance-sheet strength; geographical diversification; freedom from business cycles; freedom from excess regulation or insider abuse; ability to profit from lasting secular trends (such as global economic liberalization); and the ability to cash in on habitual customer behaviour.

A fund’s diversification is key to judging its investment quality

We start by looking at the quality of the fund’s holdings, based on our nine key factors. Then we look at the degree to which its holdings are spread out across the five main sectors of the economy. Funds that focus on narrow segments are more risky or aggressive than those that diversify, even if they focus on a conservative area, such as Utilities.

We then look at where the mutual fund invests. Canada, the U.S., Japan and parts of Europe offer conservative opportunities. Most investments elsewhere in the world involve extra risk. We also look at the fund’s trading frequency and its use of derivatives or leverage; both of these cut quality and raise risk.

Most other fund-rating systems make the mistake of focusing too heavily on performance. The problem here is that low-quality funds can be great performers for long periods. But when the winning streak ends, horrendous losses can follow.

We wrote Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds to help keep you out of these “time bomb” funds and steer you toward the high-quality funds that will likely lead to long-term investment success. Click here to find out how you can download your copy and get started right away.