Investment funds that focus on domestic or emerging markets equity made healthy gains in the second quarter of 2007. However, most other segments of the retail fund market lost ground or were limited to modest gains during that period, according to preliminary performance data released today by Morningstar Canada.

The Asia Pacific Rim ex-Japan equity fund index had the best return among all Morningstar Canada fund indices for the quarter with 6.9%, buoyed by double-digit gains on the Hong Kong, Shanghai, Taiwan and Seoul stock markets. Individual funds’ currency hedging policies would have played an important part in their actual returns during this period, since the Canadian dollar appreciated significantly relative to most currencies in that region: the loonie gained 6.4% versus the Korean won, 6.5% against the Chinese yuan and 8.5% versus the Hong Kong dollar. This would have diminished the performance of those funds that don’t hedge their currency exposures.

The strongly performing Asian markets also contributed to the 5.5% quarterly return of the emerging markets equity fund index, which ranks in fourth place. On average, Asian equities made up nearly half the assets held in the funds in this category as of May 31. The Brazilian market, another major component, also helped; the Bovespa Index of the Sao Paulo Stock Exchange returned 18.7% for the quarter. And unlike its Asian counterparts, the Brazilian currency mostly held its ground against the surging loonie by losing only 1.7%.

The second best performing fund index for the quarter was natural resources equity with 6.7%, followed by Canadian small/mid cap equity with 6.4%. There is considerable overlap between these two fund categories; on average at the end of May, Natural resources equity funds held nearly 68% in Canadian content, while the average fund in the Canadian small/mid cap equity category allocated more than 40% of its portfolio to resources. Meanwhile the Canadian Anchored small/mid cap equity fund index, whose constituent funds can invest up to 49% in foreign content, gained 4.3%. These three categories also boast the best year-to-date returns among all fund indices.

“Dwindling gas supplies and an increase in merger and acquisition activity have driven the resource rally over the past quarter,” said Morningstar Canada fund analyst Bhavna Hinduja, in a news release. “The S&P/TSX capped energy index and the S&P/TSX capped materials index gained 10.3% and 8.5% respectively over this period. In contrast, the slump in precious metals equities has continued to hinder the performance of more broadly based natural resource funds.”

Funds that invest in larger cap Canadian stocks also performed well over the past three months, due in large part to a plethora of takeover offers in the market. The Canadian equity fund index returned 4.8%, ranking fifth overall, while Canadian high income equity came in sixth with 4.5% and Canadian anchored equity was eighth with 3.1%. “What we are seeing are Canadian markets that have been increasingly vulnerable to buyout activity,” Hinduja said. “Alcoa’s unsolicited offer for Alcan in May sent the latter’s stock price up by more than 35% in a single day and up 48% for the second quarter. Similarly, BCE gained about 23% over the past quarter in the midst of a takeover battle between various private equity groups, pension fund organizations and rival wireless service provider Telus.”

At the bottom of the rankings, the real estate equity fund index lost 11.1% for the quarter, more than any other category. Most of the damage was done in June, when the fund index lost 7.2% (also worst overall) amid declining REIT values both in Canada and in the U.S. “Higher bond yields make income-generating investments such as REITs less attractive to investors,” Hinduja said. “The 10-year U.S. Treasury bond yield rose to a five-year high of 5.3% in June, up from 4.6% at the end of May. The market may very well be catching up with the ongoing speculation of further hikes in interest rates that will potentially lessen the appeal of REITs.”

The second worst performer for the quarter was Japanese equity, which lost 8%. The Nikkei 225 index actually rose almost 5% during that period, but for Canadian investors that gain was wiped out by the yen’s 13.8% depreciation versus the Canadian dollar over the three months. The yen has also weakened against some of the world’s major currencies, including a 6.1% drop against the euro, as inflation data caused worries that interest rates in Japan, which remain among the lowest in the world, would not rise as quickly as anticipated.

@page_break@Among other major equity fund indices, European equity started the quarter with a 2.2% gain in April but subsequently lost 0.8% in May and 1% in June, reducing its quarterly return to 0.3%. Meanwhile, the U.S. equity fund index gained 0.5% and 0.6% in April and May respectively, but lost 2.2% in June for a loss of 1.2% for the quarter. These lacklustre returns, combined with that of Japan, held the global equity and international equity fund indices to losses of 0.8% and 1.2%, respectively.

The second quarter of 2007 was not kind to unitholders of fixed income funds. The six fund indices that focus on fixed income securities were mostly flat in April, and all of them lost ground in both May and June. The best performer in this group for the quarter was Canadian short duration fixed Income with a 0.7% loss, while the worst was Canadian inflation-protected fixed income with a 5.7% drop. Similarly, the two fund indices that track bond-tilted portfolios were also in negative territory for the quarter.

Final performance figures will be published next week.