Equity funds hammered in 2011, data shows

After two consecutive years of solid gains, equity funds in Canada realized mostly negative returns in 2011 amid the global economy's rollercoaster-like volatility, according to new data from independent investment research firm Morningstar Canada.

Among the 22 Morningstar Canada Fund Indices that measure the aggregate performance of equity fund categories, only the Real Estate Equity and Health Care Equity categories ended the year in positive territory, with increases of 12.1 per cent and 7.1 per cent respectively. Most other fund categories posted double-digit declines. Fixed income funds posted impressive rises.

"Funds in most equity categories struggled under the uncertainty that accompanied natural disasters, the European debt crisis, and continued turmoil in the Middle East," says Adam Fisch, a Morningstar Canada fund analyst in Toronto. "The biggest losers were in Asia, which is not surprising given the earthquake in Japan which weighed on the region, and some of the measures by the Chinese government to cool the economy to prevent inflation there late in the year.

"The European debt crisis really weighed on that region as well."

The Morningstar Greater China Equity Fund Index suffered a 21 per cent decline for the year, while the fund indices that track the Emerging Markets Equity, Asia Pacific Equity, and Asia Pacific ex-Japan Equity categories dropped 18.7 per cent, 16.5 per cent, and 15.1 per cent respectively. Though market losses in the region were more severe, Canadian fund investors benefitted from currency effects that saw the loonie lose ground against the Hong Kong dollar and the Chinese renminbi.

But the worst performer among all Morningstar Canada Fund Indices was the one that tracks the Precious Metals Equity category, which declined 24.5 per cent for the year. "Despite gold having another solid year, up more than 10 per cent, precious metals stocks failed to move in step as investors displayed a lack of appetite for risk," he adds.

Lack of confidence in global markets also led to declining commodity prices, which hit Canadian equity funds particularly hard considering the significant weight that resources occupy in Canadian portfolios.

The energy sector in Canada lost 14.8 per cent in 2011, while the materials sector lost 21.2 per cent; these two sectors together account for roughly half of the domestic stock market. As a result, the Morningstar Canadian Equity Fund Index posted a decline of 10.4 per cent, while the Morningstar Canadian Small/Mid Cap Equity Fund Index dropped 10.2 per cent. The best-performing domestic equity fund category was Canadian Dividend & Income Equity, which declined just 1.1 per cent owing to a much smaller exposure to resources by the category's constituent funds.

"In terms of (Canada), small and mid cap suffering energy resources were the riskier areas investors were less comfortable with given the volatility and lack of certainty in the market."

Despite a constant barrage of negativity throughout the year, the U.S. stock market proved resilient, signalling that when the going gets tough, many investors still see the U.S. as a safe haven.

The S&P 500 Index eventually closed out the year with a modest positive increase of 2.1 per cent. For Canadians who hold funds in the U.S. Equity category, this translated into a decline of 0.8 per cent after incorporating currency effects and fund fees.

"There were some that expected the debt in the U.S. to cause investors to lose faith in U.S. treasuries but that wasn't the case," he says. "U.S. treasuries ended up performing very well for the year as did fixed income in Canada. Investors were feeling unsure about the equity markets and they tried to generate some returns where they were able to."

The Morningstar Canadian Long Term Fixed Income Fund Index had the biggest increase among all fund indices with 17.3 per cent, while Canadian Inflation-Protected Fixed Income was second with 14.9 per cent. The broader Canadian Fixed Income category rose 7.4 per cent for the year.

"This is a reflection of investors looking for something less volatile than equities," Fisch adds. "Those investors that are expecting low interest rates for the foreseeable future would gravitate towards those categories."

Meanwhile, the 11 fund indices that track balanced or target-date portfolio categories had varying performance that depended greatly on the proportion they allocated to bonds versus equities. Performance ranged from a 4.2 per cent rise for the 2015 Target Date Portfolio fund index, which has constituent funds that hold mostly bonds and cash, to a 6.7 per cent decline for Tactical Balanced, the report states.