Market Commentary

Summer 2011

Thursday, June 30, 2011

The second quarter started strongly but faded quickly with the S&P/TSX Composite Index shedding 5.15% over the course of the quarter. Dragging the index lower were signs of weakness in the U.S. economy, monetary tightening in China and worries about Greek debt default – all of which introduced risk that the global economy could slowdown. The prospect of a decline in global growth negatively impacted cyclical resources, a key component of the Fund.

Against this difficult backdrop, EnerVest Diversified Income Trust managed to outperform the S&P/TSX Index by 46 basis points, or 0.46%, as stock picking overcame negative sector performance. The benchmark fell 5.15% for the three-month period compared to the Fund, which declined 4.69%.

Within the equity component, the most notable change was an increase in our exposure to materials over the quarter. The primary beneficiaries of this move were major gold producers which took their lumps over the quarter and now represent great value. In addition to finding attractive entry points for existing gold producers, the move is also anticipatory in nature. We believe the US dollar will continue to weaken – it’s already fallen 4% against a basket of world currencies year-to-date and by almost 11% over the past five years – and gold tends to move inversely to the greenback.

We are also of the view that the U.S. debt-ceiling debate could move to the forefront and put further downward pressure on the U.S. currency, especially as euro-zone debt concerns fade with the recent decision to bail out Greece. Because equities of gold producers are now significantly cheaper compared to gold bullion, we fortified the Fund’s existing positions among major gold producers, and also added a new gold company IAMGOLD Corp. to the portfolio. Increased exposure to major gold producers is one reason the average market cap of the Fund rose from $21 billion to $24 billion over the three-month period.

Financials now rank as the Fund’s largest sector allocation. Standing at number two is energy and number three is materials. Both the materials and energy sectors felt the brunt of the general “risk-off” trade that dominated market sentiment in May and June. Top energy holdings Suncor Energy Inc., Canadian Natural Resources and Husky Energy Inc. all closed lower at the end of the quarter as did Barrick Gold Corp., GoldCorp Inc. and Yamana Gold Inc.

With sector allocation working against the Fund this quarter, outperformance was left to individual stock selection. Among the top contributors were Annaly Capital Management Ltd., TELUS Corp., Cineplex Inc., Black Diamond Group, Intact Financial Corp, and Brookfield Infrastructure.

New positions in the portfolio included Groupe Aeroplan, Canadian Natural Resources, IAMGOLD Corp., and Manulife Financial. Complete exits included Crescent Point Energy, Keyera Corp., and Total SA.

The fixed-income component of the Fund slightly increased over the quarter from 13% to 14%. The increase was reactionary in nature as equity markets were becoming “frothy” at the start of the quarter, with investor sentiment peaking as markets advanced on lighter volumes. In the near-term, the stock market registered overbought by many measures so we took some profits in many of our REITs while at the same time boosting our fixed income exposure. In addition to opportunistically increasing allocation to bonds, we sought to reduce risk in the portfolio by adding more Investment Grade issues.

To improve portfolio yield, the Fund continued executing a covered call writing strategy in the second quarter. With the demise of the income trust category, the portfolio manager writes call options against small fractions of several of the portfolio’s holdings. For a given stock that a call option is written against, generally 80-90% of the capital appreciation potential is retained. This enables the Fund to generate additional yield without significantly compromising the opportunity for portfolio appreciation.  The stocks the portfolio management team selects to write call options on are those stocks it believes will trade sideways or neutral short-term. At the end of the second quarter, call options had been written against 11.9% of the stocks in the portfolio.

Looking ahead, the portfolio management team believes the portfolio is well positioned for the next 12 to 18 months, particularly in areas of energy and materials. The team looks for a resumption of growth – albeit slow – in both the U.S. and euro-zone countries. In China, we are also of the view that current monetary tightening will have its desired effect, and the People’s Republic of China’s central bank will take its foot off the brake to refocus on continued growth.