Individual stocks have been the bedrock of Canadian Edge since the very first issue back in July 2004.

Our premise is we income investors are always better off building our own portfolios than ceding control to someone else. All too often a little digging into mutual fund particulars reveals managers that have less experience, expertise and skill managing money than the average investor.

There’s also the very real question of whether your interests and those of management truly align. Managers, for example, are strictly evaluated on how fund performance matches up with certain benchmarks. How the fund stands at the end of the year when performance is measured is paramount for determining bonuses–and sometimes whether the manager will keep his or her job.

By contrast, income investors make their money buying and holding companies that are growing their businesses and, by extension, dividends. Rising payouts push up share prices over time, delivering substantial capital gains.

But you’ve got to hold on through near-term ups and downs to get there. And most fund managers have short-term natures that don’t allow for patience.

Another drawback of holding stocks through mutual funds is operating expenses.

These can be quite hefty for smaller funds that have fewer investors to spread them over. Funds that do frequent trading also push up costs that come right out of dividends.

Finally, there’s the issue of leverage, which many high-yielding funds use in combination with regular return of capital to maintain high-percentage distributions. Investors get the impression they own a conservative, dividend-paying fund when reality is very little of the distribution is funded by the actual dividends paid by holdings.

Such tactics work in good markets. But when times turn tough they can backfire in a hurry, cutting the funds’ value sharply and forcing management to cut distributions. That typically triggers an exodus of panicked investors, driving down fund prices further.

All that having been said, there are good reasons to own select funds. Some management teams are indeed run by seasoned pros that have been able to dodge the worst of bad markets, and their diversification has steadied returns over time. The result is strong long-term track records that are tough to ignore.

Canadian investors have access to open-end mutual funds that US investors don’t. But investors on both sides of the border can pick from the bevy of closed-end funds and exchange-traded funds (ETF) we track in How They Rate.

Like open-end funds, closed-end funds hold portfolios of securities at the discretion of the manager. Where they differ is closed-end funds trade a fixed number of shares on a major exchange, typically the Toronto Stock Exchange (TSX) rather than accept investor funds directly.

This enables closed-end funds’ management to hold positions through thick and thin rather than be constantly at the mercy of redeeming shares for investors who cash out. And closed-end funds are never forced to invest money at an inopportune time, as open-end funds must whenever there’s an inflow of money.

Closed-end funds can also juice returns in other ways not available to open-end fund managers. One of these is to buy back fund units when their price is below the value of the assets in the fund, or net asset value (NAV). Doing so takes fund units off the market at a price below their worth, which in turn increases the NAV of the remaining units. By contrast, open-end funds always trade at NAV.

Note that all Canadian closed-end funds’ distributions paid to US investors are withheld 15 percent at the border, including to IRAs. Dividends are taxed in the US at a maximum rate of 20 percent, same as common stocks. Dividend tax rates are the same as in 2012 for individual investors with total income of USD400,000 or less and for couples with income of USD450,000 or less.

All dividends are paid in Canadian dollars, and the fund units are priced in loonies as well. You get the same currency exposure you do when you buy individual Canadian stocks.

The table “Fund Rater” highlights the funds tracked in How They Rate as well as a few smaller funds that don’t currently trade in the US under an over-the-counter (OTC) symbol. I discuss each below, starting with the three recommended Mutual Fund Alternatives in the Canadian Edge Portfolio.

Three Kings

I’ve held two of the Portfolio funds since the early days of Canadian Edge: EnerVest Diversified Income Fund (TSX: EIT-U, OTC: EVDVF) and Blue Ribbon Income Fund (TSX: RBN-U, OTC: BLUBF), which was initially one of the Series S-1 funds.

Over this time both funds have produced reliable distributions and total returns. They’ve also been able to successfully shift tactics to cope with numerous challenges.

Both funds maintained high portfolio standards during the boom times for income trust initial public offerings in 2005-06.

That enabled them to control losses during the crash that followed the Halloween 2006 announcement of a 2011 tax on trusts.

Later, the pair was able to adapt their yield-focused strategies to the post-income trust era. Balancing the goals of high yield and capital growth initially did mean distribution cuts.

EnerVest Diversified Income has reduced its monthly distribution by 52.4 percent over the past five years. Blue Ribbon, meanwhile, currently a pays a dividend that’s 17.6 percent less than what it did five years ago.

And that’s even after a 27.2 percent lift announced in October.

Importantly, however, these funds are now paying out in rough proportion to what their holdings earn, augmented by some use of leverage and the occasional capital gain.

Blue Ribbon actually paid a CAD0.10 per unit special cash distribution on Dec. 14, 2012.

EnerVest Diversified Income, meanwhile, has adopted the practice of issuing options to unitholders every year. US investors unfortunately can’t execute these, but they do receive proceeds via a sale by the fund. Warrant offerings are a good opportunity for Canadians to increase holdings cheaply. And used in conjunction with the fund’s regular buyback program, they’re actually accretive to NAV in the long haul.

Ultimately these funds are only as good as their holdings. EnerVest Diversified Income’s portfolio right now is focused in large capitalization stocks, especially banks and big natural resource companies. Blue Ribbon, meanwhile, has stuck more to dividend-paying stocks, particularly former income trusts. In fact its top six holdings at last count were Canadian Edge Portfolio recommendations, as were eight of its top 10.

Reliance on superior dividend stocks means Blue Ribbon relies less on leverage than EnerVest Diversified Income does to pay dividends. The tradeoff is a lower yield and smaller market capitalization (CAD277 million versus EnerVest Diversified Income’s CAD1 billion), which also means a higher expense ratio of 1.8 percent versus 1.34 percent for EnerVest.

The funds also don’t have significant overlap. And that makes them a nice pair for mutual fund investors to hold in tandem.

Both funds had their worst years by far in 2008, with EnerVest Diversified Income dropping 37 percent in Canadian dollar terms and Blue Ribbon giving up 33 percent.

And both fell a bit following the announcement of the trust tax in 2006, with Blue Ribbon down 6.8 percent for the year and EnerVest Diversified sliding 17 percent.

EnerVest Diversifed Income also had a negative 2011, though the fund’s up years have generally bested those of Blue Ribbon.

My expectation is both funds will continue to generate solid returns, based on sound strategies, high-quality portfolios and seasoned management. Buy Blue Ribbon Income Fund up to USD12 and EnerVest Diversified Income Fund up to USD14 if you haven’t yet.

The third Portfolio fund is First Asset Pipes & Power Fund (TSX: EWP-U, OTC: FAPPF).

I added it about a year ago to provide a pure play on the safest of the How They Rate sectors, and investors have since been rewarded with steady performance and a dividend increase.

Another boost is likely to be announced in mid-February.

First Asset Pipes & Power is a good deal smaller than either Blue Ribbon or EnerVest Diversified Income, weighing in at just CAD67.82 million.

That means generally low volume that could make the fund tougher for US investors to buy.

Those that do succeed, however, will land a steady investment with exposure to a range of buy-rated energy infrastructure and power generation companies–the two most reliable How They Rate sectors of recent years.

Drawing from these sectors means management is able to rely on dividends from holdings to fund distributions rather than debt leverage. The top six holdings all raised their payouts in the last 12 months. Big yields and limited turnover also allow the fund to keep its expense ratio relatively low at 1.77 percent despite its small size.

First Asset Pipes & Power’s track record also reflects steady performance. The worst year since inception was 2008, as is the case with most funds.

But the loss of just 13.6 percent was barely a third that of its peers, and every year since has produced solid returns.

When I recommended the fund last year it actually traded at a slight premium to NAV. Today that’s gone to a discount, providing a good time to buy in.

My target remains USD8.50 for those who don’t yet own First Asset Pipes & Power.

Picks and Pans

As for the other nine funds in the table, the most attractive is First Asset Canadian REIT Income Fund (TSX: RIT-U, OTC: None).

As the name suggests, the fund holds Canadian real estate investment trusts, which have been the steadiest How They Rate sector the past five years by far. It also holds stakes in other real estate companies such as Brookfield Office Properties Inc (NYSE: BPO, TSX: BPO).

The fund is about twice the size of First Asset Pipes & Power, with a market capitalization of CAD134.12 million, and has the same low expense ratio at 1.58 percent of assets.

It’s been consistently profitable year-in, year-out for investors, with the exception of 2008, when it dropped 43.6 percent.

That year’s performance suggests the fund held more at the time than Canadian REITs, which did a much better job of holding their value during the crisis.

Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF), for example, actually produced a positive total return of 5.2 percent in Canadian dollar terms in 2008.

The fund’s dust-off that year also reflects a series of dividend cuts management was forced to make, from CAD0.077689 per month in January to just CAD0.049526 by December.

This volatility is food for thought for investors worried about another market meltdown, as high-quality Canadian REITs did largely maintain their payouts in 2008. But the fund appears conservatively positioned now. Those who want to own a basket of REITs without picking their own can do a lot worse, especially since it trades at a slight discount to NAV. Buy First Asset Canadian REIT up to USD13.

Two entries in the table are actually ETFs: CurrencyShares Canadian Dollar Trust (NYSE: FXC) and iShares MSCI Canada Index Fund (NYSE: EWC). For US investors these ETFs have the advantage of trading on the New York Stock Exchange (NYSE).

iShares MSCI Canada, which holds a basket of large-cap Canadian stocks, has a market capitalization of USD4.78 billion. Meanwhile, CurrencyShare Canadian Dollar is also quite liquid at USD493 million.

ETFs typically own the good, bad and ugly of the sector they represent. As such, they make useful benchmarks and possible tools for hedging large portfolios. But they’re poor substitutes for diversified portfolios. That’s certainly the case for both of these.

But those who want a pure bet on the loonie can buy CurrencyShares Canadian Dollar up to USD100–or parity with the US dollar. iShares MSCI Canada is a buy up to USD28 as a generic bet on Canada.

Not So Attractive

ACTIVEnergy Income Fund (TSX: AEU-U, OTC: ATVYF), Aston Hill VIP Income Fund (TSX: VIP-U, OTC: BVPIF), Triax Diversified High-Yield Trust (TSX: TRH-U, OTC: None) and Utility Split Trust (TSX: UST-U, OTC: None) all rate holds at current prices.

ACTIVEnergy has been a generally solid performer over the years. And its portfolio of energy producers, pipelines and service companies provides broad exposure to the oil and gas sector. It has a reasonable expense ratio of 1.72 percent as well.

The problem as I see it is a current yield of 8 percent-plus for the fund that’s nearly twice the average payout of its holdings. That implies use of leverage and other fair-weather tactics to maintain the current yield, which is never a sustainable strategy. I like the holdings but prefer to own them individually. ACTIVEnergy rates a hold.

Aston Hill VIP was long rated a sell in How They Rate for much the same reason, i.e. a fund distribution that far exceeded what its actual holdings were paying out. The result was a cut in the fund distribution from a monthly rate of CAD0.07 to CAD0.045 effective with the November 2012 payout.

The yield now is in line with the Aston Hill VIP’s dividend income, which should make it more sustainable. But despite some solid holdings such as CE Portfolio pick Shaw Communications Inc (TSX: SJR/A, NYSE: SJR), this isn’t really a Canadian stock portfolio.

In fact more than 20 percent of the portfolio was recently US stocks and the fund has a substantial US dollar hedge position as well. That makes Aston Hill VIP a hold.

Triax Diversified High-Yield’s market capitalization of CAD22 million likely makes it impossible for most investors to buy on either side of the border. The current yield is also out of proportion to what the portfolio holdings are paying on average.

The fund’s greatest claim to fame was nearly doubling in value in 2009. But that’s not enough reason to buy it, particularly with its expense ratio of 2.37 percent. Hold Triax Diversified High-Yield if you own it, but otherwise pick something else.

Utility Split Trust is smallest of all at just CAD16 million in market capitalization, though it has been able to hold its expense ratio down to 1.73 percent. The fund’s portfolio is far more attractive than most, focused mainly on energy midstream and power generation companies. And the yield appears well in line with that of its holdings, making it therefore sustainable.

Utility Split was a big loser in its first two years of operation, shedding nearly half its value in 2007 and 2008. Since then, however, it’s been clearly in an uptrend, though there hasn’t been a dividend increase since early 2009.

The big question, though, is why anyone would go through the hassle of trying to buy this fund rather than the much larger First Asset Pipes & Power. This is a good fund but the latter is the better bet on the basis of liquidity alone. Utility Split Trust is a hold.

Finally, two funds in How They Rate coverage continue to rate sells: EnerVest Energy & Oil Sands Trust (TSX: EOS-U, OTC: EOSOF) and Precious Metals & Mining Trust (TSX: MMP-U, OTC: PMMTF).

In EnerVest Energy & Oil Sands’ case, the reason is purely that there are better alternatives for betting on oil sands development. To begin with, the expense ratio of 2.54 percent is high and the market capitalization is microscopic at barely CAD7 million, which would make the fund difficult for anyone to buy.

The fund’s primary appeal is the huge gains it has run up in good years, including nearly doubling in value in 2009 and rising another 58 percent in 2010.

Virtually none of the fund’s current distribution, however, is actually covered with distributions from its holdings. In fact many top holdings don’t pay dividends at all.

Sooner or later a fund with a very small asset base that pays out more than its investment income is going to have to cut its distribution or vanish. Although management has recently reaffirmed that it will continue to pay CAD0.0417 per month in distributions for 2013, this looks like one to avoid. Sell EnerVest Energy & Oil Sands if you haven’t yet.

As for Precious Metals & Mining, its market capitalization is much more substantial at CAD169 million. But so is the sharp 12.6 premium of its market price above its net asset value.

The high premium is likely due to fact that the fund pays a yield of better than 19 percent, making it attractive to yield chasers. But it also collects basically no dividends from its holdings. Consequently, every dollar paid out to unitholders has to be taken from the value of the fund or by some other leveraged means such as borrowing and/or writing options.

Admittedly, it’s been a tough 12 months for metals and mining stocks, which has made it difficult for management to fund the dividend with capital gains. And there have certainly been some big years for this fund, including a 131 percent gain in 2009.

Until we do see faster economic growth and a return to popularity for metals and mining stocks, however, Precious Metals & Mining is going to be in what amounts to liquidation mode–forced to satisfy the yield craving of its investors by essentially selling the furniture/eating the seed corn.

The fund had a negative total return of about 13 percent last year, despite its huge dividend. But my view is there’s still great risk here. Barring a sharp recovery in metals and mining stocks a dividend cut is inevitable, followed by a mass exodus that will turn today’s hefty premium to NAV into a considerable discount, and magnify losses.

If you want to bet on a mining stock recovery, stick to individual mining stocks, which are quite cheap now across the board. Sell Precious Metals & Mining Trust if you haven’t yet.