Investment funds that focus on small-capitalization equities and those that target specific sectors dominated the performance rankings in the third quarter of 2009.

As well, many foreign stock markets outperformed their Canadian counterpart during the third quarter, but a strengthening Canadian dollar dampened those gains for the funds that invest in those markets.

All but two of the 43 Morningstar Canada fund indices advanced during the quarter, including 13 indices that posted double-digit gains, according to preliminary performance data released Friday by Morningstar Canada.

Leading the pack was the Canadian small/mid cap equity fund index with a 17.1% return, while the slightly more diversified Canadian focused small/mid cap equity fund index finished third with 16% and the global small/mid cap equity fund index had a fifth-place 15.2% return.

Also at the top were four sector-specific fund indices: real estate equity ranked second with 16.5% and financial services equity was fourth with 15.6%, while natural resources equity (14.8%) and precious metals equity (14.2%) finished sixth and seventh, respectively.

“Risk taking was rewarded in the third quarter, particularly in September when economically sensitive sectors like precious metals and natural resources, as well as small-caps and emerging markets, posted the strongest gains,” says Esko Mickels, fund analyst for Morningstar Canada. “Investors flocked to lower-quality companies that had been among the hardest hit by the financial collapse.”

Among foreign equity fund categories, the emerging markets equity fund index gained 12.3% for the quarter, while European equity and international equity were up 12% and 10.5%, respectively. Those results fall well short of the returns posted in local currency terms by market indices like the UK’s FTSE 1000 (20.8%), France’s CAC 40 (20.9%), and Mexico’s IPC (20%) because the Canadian dollar appreciated significantly against many foreign currencies.

Another casualty of currency effects was the U.S. equity fund index, whose 7% return for the quarter is less than half that posted by the benchmark S&P 500 Index (15.6%). Over the same period, the loonie gained 8.4% against the U.S. dollar. “The general increase in risk taking boosted the Canadian dollar because it trades as a risk currency, as opposed to the U.S. dollar which is traditionally seen as a safe haven. The loonie is also tied to commodity prices, which have increased as the markets advanced,” Mickels says.

Also reflecting the market’s renewed appetite for risk were the performances of the various fixed income categories. The high yield fixed income fund index, whose constituent funds invest in lower quality issues, had its second consecutive double-digit quarterly return with a 10.3% gain, while, the more conservative bond categories had modestly positive returns. “The fixed income markets continued to show signs that confidence is returning, as a number of new issues came to market and credit spreads closed,” Mickels says.

The only fund indices that failed to gain ground in the third quarter were Greater China equity, down 0.5%, and Japanese equity, down 3.1%.

Morningstar Canada’s preliminary fund performance figures are based on the change in funds’ net asset values per share during the month, and do not necessarily include end-of-month income distributions. Final performance figures will be published next week.

IE