With reeling equi-ties markets, immense stimulus packages and colossal deficits in the U.S., clients can be forgiven for being timid about buying a U.S. equity fund. But for those expecting a turnaround, PH&N U.S. Equity Fund, offered by Phillips Hager & North Investment Man-agement Ltd. of Vancouver, and Toronto-based AGF Funds Inc.’s AGF U.S. Value Class Fund offer different approaches to investing in the U.S.

The AGF fund had posted solid performance numbers until mid-2007, but its winning ways seem far removed now. With heavy exposure to the ailing U.S. financial services sector, the $15.7-million fund has been burned during the recent credit market meltdown. The fund’s financial services exposure has averaged about 50% of assets under management since its June 2001 inception, and the exposure remained near that level late last year as management added to positions as prices tanked. To put this in perspective, the benchmark S&P 500 composite index’s allocation to the sector is only 9.8%.

Meanwhile, the $187-million PH&N fund has taken a more balanced approach. Lead manager Carl Lytollis has tended to keep sector weightings closer to the index, making only moderate bets when his bottom-up securities selection guides him to do so. That said, his allocation to the relatively small materials sector has averaged roughly 250% of its benchmark weighting. Also, as of Feb. 28, the fund was modestly overweighted in financial services, with 16.6% of AUM allocated to the sector.

Lytollis and his team use an internal model to assign quality ratings to companies, based on management, financial strength and the industry’s competitive landscape. Irrespective of stock price, the combined quality score for the portfolio must be at least above average. The result is large positions in companies such as Johnson & Johnson Services Inc., which Lytollis categorizes as having a premium valuation but also sustainable, superior growth characteristics.

By contrast, the AGF fund’s investment team at Dublin-based AGF International Advisors Co. Ltd. , led by John Arnold and Rory Flynn, begins its selection process by screening for high dividend-paying stocks that sport low price/earnings ratios and have fallen in price by 30% or more over the past 18 months. The next step involves conducting fundamental research and investing in businesses that the managers consider most attractive.

That screening process leads the managers to buy stocks that are out of favour and, hence, at depressed valuations. With no formal sector constraints, the managers can invest heavily in industries in which they find value. They tend to favour the high yields and typically low price multiples of banks, insurance companies and other financial services-related businesses.

That kind of concentration has led to dramatic swings in performance. The AGF fund lost 51% in the 12-month period ended Feb. 28, making it one of the worst performers in the U.S. equity category. The biggest blows have come from the fund’s holdings of U.S. government-backed mortgage lenders Fannie Mae and Freddie Mac, which were placed in conservatorship by U.S. federal regulators.

Lytollis’s willingness to pay for good names has produced more favourable results for the PH&N fund. Its 30.2% loss in the 12 months to Feb. 28 is much easier to swallow, even though the fund still lags both the category median and benchmark, by 40 and 370 basis points, respectively.

Since Lytollis took over the PH&N fund in July 2005, his overall results have been mixed. The fund has roughly matched the category’s median performance, while underperforming the S&P 500 (in Canadian dollars). For more meaningful analysis of his results, we can look to the similarly managed BonaVista U.S. Equity Fund, a pooled fund sponsored by PH&N that Lytollis has run since 1988. For that mandate, he has generated an average annual compound return of 8.1% (gross of fees) for the 20 years ended Jan. 31, beating the index by 0.3% a year and ranking fifth out of 15 pooled funds for that period.

To be fair, like AGF’s Arnold, Lytollis has fallen into the odd value trap. In the fall of 2007, he made the prescient decision to divest positions in Citigroup Inc. and American International Group Inc. Unfortunately, he waded back into AIG a few months later as the valuation appeared more attractive, only to watch value disappear as the company essentially became property of the U.S. taxpayers.

@page_break@There are other similarities between the AGF and PH&N funds. For instance, both invest in a relatively short list of stocks. This is particularly the case for the AGF fund, which holds only 33 names. The PH&N fund holds 48 companies, with 57% of AUM concentrated in the top 15 stocks.

Also, both funds are close to being fully invested. The AGF fund had 1.2% of AUM in cash as of Dec. 31, 2008, while the PH&N fund had 4% in cash as of Feb. 28. In both cases, this is something of a risk, as having little cash on hand means that if the funds face meaningful redemption requests, managers can be forced to liquidate holdings.

Another similarity is that both funds tend to carry hefty exposure to the U.S. dollar, although the AGF fund has occasionally hedged a portion of its portfolio. Weakness in the US$ vs the C$ would be detrimental to performance. PH&N does, however, offer a currency-hedged version of its fund.

But a key differentiator between the two funds is price. With a 2.85% management expense ratio, the AGF fund is 43 bps more expensive than the median fund in the U.S. equity category. The Series D version of the PH&N fund carries a lean 1.18% MER due to its direct-to-client nature. Perhaps a better comparison is the recently launched Series C version, which is significantly more expensive at 1.97%, because it pays a full percentage point trailer fee to advi-sors. Even still, it’s clearly a much better deal than the AGF fund.

The strategy of the AGF fund may well pay off. The fund could rise to the top again in the event of a financial services-led market recovery. But for investors who wish to stay closer to the mainstream, PH&N’s fund provides prudent management at a bargain price. IE

Brian O’Neill is a Morningstar Canada analyst. With files from analysts Jordan Benincasa and Al Kellett.