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Benefit From Market-Beating Funds Without the Fees

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A recent trend in personal finance has been the shift away from mutual funds and actively managed investment products to indexing funds in the form of exchange-traded funds (ETFs), which are passively managed.

Active management, so the theory goes, cannot consistently provide returns that exceed the performance of the index — typically measured against the S&P 500 Index. Due to the relative underperformance of active management, the indexing crowd is skeptical of the fees associated with said management and believes that the best way to outperform is to mitigate costs.

The indexing movement has led to a race to the bottom with regards to fees; the iShares Core S&P 500 Index ETF (TSX:XUS) has a management fee of 0.10%, while Vanguard’s S&P 500 Index ETF (TSX:VSP) charges a mere 0.08%. Naturally, the mutual fund industry, which typically charges in excess of 1%, has struggled with the upending of its business model and the erosion of its credibility as competent money managers.

There are, however, a select group of Canadian mutual funds that have continuously proven themselves to be market beaters. This article will examine the top-performing Sentry Small/Mid Cap Income Fund, which has delivered 10-year returns that have exceeded funds tracking U.S. equity. Further, this article will demonstrate how investors can benefit from the strategy of high-performance funds to enhance their own returns without paying so much as a cent in management fees.

Methodology

A mutual fund can only perform as well as the sum of its underlying holdings. Equally, the performance of any given fund will correlate most closely with the holdings that are given the heaviest weightings. Funds publish quarterly reports that summarize the contents of their portfolios, so this information is readily available.

Turning to our fund of interest, the top 15 holdings constitute 43.65% of the fund. In other words, nearly half of the returns generated by the fund will be derived from only 15 securities. Stocks with smaller weightings will move the portfolio, but they must make significantly larger price movements to affect the fund.

Of the top holdings, nine are names listed on the TSX: Cargojet Inc. (TSX:CJT), CGI Group Inc. (TSX:GIB.A)(NYSE:GIB), Chemtrade Logistics Income Fund (TSX:CHE.UN), Enerflex Ltd. (TSX:EFX), Great Canadian Gaming Corp. (TSX:GC), Morneau Shepell Inc. (TSX:MSI), Parkland Fuel Corp. (TSX:PKI), TFI International Inc. (TSX:TFII), and Waste Connections, Inc. (TSX:WCN)(NYSE:WCN).

Together, the aforementioned stocks make up more than 20% of the portfolio. By making just nine trades, a nominal expense, an investor could replicate a portion of the performance of the Sentry fund without paying a management fee. For a higher level of correspondence to the fund, an investor could add some of the less-heavily weighted holdings to further mirror its composition.

Analysis

Even if an investor intends to draw inspiration from a leading fund, it is still necessary to evaluate the stocks individually to determine if they are good investments. Blindly following a fund’s strategy may not suit an individual investor’s objectives, be that for income, growth, or the search for value.

An income investor employing the strategy of the Sentry fund may want to be overweight Chemtrade and Parkland, as they offer yields of roughly 8% and 3.6%, respectively. Conversely, a value investor might be drawn to Enerflex’s price-to-earnings multiple of about 15 and price-to-book ratio of around 1.1. Growth investors may look to Cargojet’s five-year earnings growth of approximately 34%, or to Waste Connections, which has more than doubled its revenue in the same time frame.

Conclusion

Many investors have dismissed mutual funds entirely, be it due to lacklustre and inconsistent performance, or because they perceive fees as being unjust and detrimental to long-term returns. That being said, not all funds are created equal, and some funds have delivered stellar returns.

Investors can employ the strategies of the very best funds to help them manage their own portfolios, all at a reasonable cost and with the ability to customize their holdings to suit their individual preferences. No single fund manager or investor can see the future and always beat the market, but being open to the ideas of others can help with the process of building and managing a great portfolio.

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Fool contributor James Watkins-Strand has no position in any of the stocks mentioned. Enerflex and CGI Group are recommendations of Stock Advisor Canada. Morneau Shepell is a recommendation of Dividend Investor Canada.

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