Kings of Pain Loaded with Lessons

07/26/2011 7:30 am EST

Focus: GLOBAL

Rob Carrick

Columnist, The Globe and Mail

Much can be learned by looking at mutual funds and ETFs that plummeted during the 2008 financial crisis, writes Rob Carrick, reporter and columnist for The Globe and Mail.

Never buy an investment product without first checking how it performed in 2008.

The financial crisis was the ultimate stress test for mutual funds and exchange traded funds. The crisis didn’t last one precise calendar year, but 2008 was where the most damage was done. The S&P/TSX composite index fell 33%, the S&P 500 fell 23.8% and the MSCI World Index fell 29.4% (both latter indexes measured in Canadian dollars).

The up and down stock markets we’ve seen lately are a far cry from 2008, but they do remind us that it’s important to have an idea of how our investments might perform in a falling market.

Let’s look at mutual funds and exchange traded funds that fell hardest in 2008. Call them the Kings of Pain.

Here are six things we can learn from the Kings:

1. It’s Not All Fun and Games with Commodities
High-flying commodity prices are the main story behind the success of the Canadian stock market in recent years. But reversals in commodity prices can be crushing.

The average natural-resource equity mutual fund was on a multi-year roll of delivering fat double-digit returns heading into mid-2008. By the end of that year, these funds averaged 12-month losses of 45.5%, and several lost more than half their value.

It’s the same story with Canadian equity and Canadian-focused equity funds with big weightings in commodity stocks. Losses of between 40% and 50% were not uncommon.

Rising commodity prices are a function of strong economic growth, which is by no means assured when you look at what’s happening in the United States, Europe, and even China, where the government is trying to rein in growth to control inflation. Don’t give up on commodities, but do monitor your exposure to ensure it’s not excessive.

2. Be Careful How You Get Your Gold
The price of gold has been hitting new highs lately, a reminder of how investors regard it as a haven in uncertain times. But the experience of 2008 shows that investors have to be discriminating in how they buy exposure to gold, or they won’t get the safe-haven benefits.

Gold bullion prices did rise a little bit in 2008, and yet investors holding precious-metal mutual funds lost 40% on average that year. One explanation is that precious-metal funds typically hold a large percentage of their assets in gold-mining stocks, which fell hard in 2008.

Gold stocks are certainly a way to benefit from a rising gold price, but don’t expect to get the same crisis protection as actual gold. For that, you want a gold bullion fund or ETF.

NEXT: 3. Small Stocks, Big Risks

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3. Small Stocks, Big Risks
Canadian small- and mid-cap funds ranked right up there with natural-resource funds in terms of shocking setbacks in 2008. The average loss for the category was about 40%, but harsher losses were not uncommon.

The entire stock market was a disaster area in 2008—even the big blue chips that make up the S&P/TSX 60 index fell about 33%. But the less well established companies in small-cap funds were a fair bit worse.

Note that resource stocks are a popular holding with some small-cap funds, which means you’re getting a double dose of risk.

4. Beware of Currency Hedging
Currency hedging means whatever happens in currencies should not affect your portfolio—for better and for worse. This is great at times when our dollar is rising, and therefore reducing the value of investments from other countries, but bad when the loonie is on a sharp downtrend.

That’s what happened in 2008—the US dollar was the safe currency and investors bailed on others, including the Canadian buck. If you owned non-hedged mutual funds or ETFs, you had currency working in your favor in 2008 (okay, at least it helped lessen your losses a bit).

We’ve already seen that the S&P 500 fell 23.8% in 2008 in Canadian dollars; in US currency, the decline was 38.5%.

What happened if you tracked the S&P 500 using an ETF with currency hedging? The answer can be found in the 40.3% loss posted by the iShares S&P 500 Index Fund, listed on the Toronto Stock Exchange under the symbol XSP.

5. The Math of Losing and Regaining Money Is Cruel, But Not Beyond Hope
Mackenzie Universal Canadian Resource Fund lost a rather sharp 56.2% in 2008, but didn’t it more than bounce back the next year with a gain of 67.4%? Not really. In fact, big losses can only be offset by much bigger gains.

If you own an investment that falls 50% in value, you need it to double the next year to get back to where you started (this did happen to a few funds in 2009).

If you have patience and a good fund manager, you can also make back your losses over time. According to Globeinvestor.com, a $1,000 investment in Mackenzie Universal Canadian Resource in January 2008 would now be worth about $11,042.

6. No Bond or Balanced Funds on the List
One of the best performing categories in 2008 was global bond funds, which benefited from both a rush out of stocks and into bonds, and from the decline of the Canadian dollar. Canadian bond funds averaged a gain of 2.8%.

Balanced funds, which contain varying mixes of stocks and bonds, could not avoid losing money. But the bonds they held had the effect of capping their losses. The average Canadian-balanced fund with a tilt toward stocks over bonds lost 21.3% in 2008, which isn’t even close to King of Pain levels.

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