Proper asset diversification is key to long-term investment success
With recent stock market uncertainty and fluctuating bond yields, many investors are wondering whether the tried-and-true principles for stock and bond allocations in an RRSP portfolio still hold. For example, bond funds, like the iShares Universe Bond Index ETF (TSX: XBB), are believed to have lower volatility ratings than stock funds, yet bond prices have recently fallen as yields have risen. And the solid returns from equity funds like the iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC) over the past couple of years have recently begun to flag. What’s an RRSP investor to do?
It’s true that the highest-quality bonds, usually rated “AAA” by rating agencies, are safe. But this means they are “safe” in terms of the potential for default. In other words, the issuer of the bond is highly unlikely to renege on interest payments to bondholders. In the case of top-rated government, or “sovereign,” bonds, such as those issued by the Government of Canada or the U.S. Treasury, the possibility of default is remote indeed.
Essentially, though, bond fund risk is really interest rate risk. It’s a result of the inverse relationship of bond’s price to interest rates – a bond’s price will fall if general interest rates rise and vice versa. Recently, because interest rates have been inching up, bond prices have been falling. For example, the passive, index-tracking iShares Universe Bond Index ETF (TSX: XBB), with its MER of 0.3%, has a 3-year average annual compounded rate of return of 4.28% to the end of December. But in the final six months of last year, the fund lost -2.44% in the general bond market selloff.
In actively managed bond portfolios, such as those you’ll find in many fixed-income mutual funds, managers will adjust their holdings in an effort to mitigate interest rate risk. They do this in various ways, including tilting bond holdings to longer or shorter maturities, or investing in bonds with different risk ratings, in different regions or countries, or attempting to anticipate interest rate moves – all depending on the mandate of the fund as set out in its prospectus.
Some funds can be quite successful at this, for example, the PH&N Core Plus Bond Fund Series O, an actively managed fixed-income fund with a 3-year annualized return of 6.17% to the end of December, and a decline of only -0.82% in the final six months of 2016. This fund has a virtually invisible MER or 0.06%. (Note that this and other funds mentioned in this article are for illustration only. They are not intended as investment recommendations. See the disclaimer below.)
On the other hand, equity investments like the passive, broad-index-tracking iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC) can produce solid returns when markets are rising. This ETF, for instance, posted a 3-year average annual compounded rate of return of 6.99% to the end of December, and gained 10.2% in the last six months of the year. It has an MER of 0.05%. So it would indeed be tempting to sink your RRSP contribution into this, based on its recent performance.
But building an effective RRSP portfolio involves much more than an either-or choice between whatever is currently hot in fixed-income or equity funds. At a minimum, you should consider diversifying your investments among both types of asset classes so that your overall portfolio risk is reduced. In addition, remember that your RRSP is your retirement nest-egg. It’s not place for speculating on the direction of interest rates of the health of the stock market.
To get around the either-or decision, some investors resort to a balanced fund. These are actively managed mutual funds that hold both fixed-income and equities in a proportion that changes based on the manager’s outlook and that is constrained by the mandate of the fund, as described in its prospectus. Sometimes, a balanced fund can outperform both pure equity or fixed-income funds, while showing a lower overall volatility rating (standard deviation). For example, the Mackenzie Canadian Growth Balanced Fund Series A posted a 3-year average annual compounded rate of return of 11.35% as of the end of December, owing mainly to the managers’ hefty 60% weighting to equities. Yet its average 3-year standard deviation was 6.92%, for a Fundata volatility ranking of 4/10, compared with 8.3% (5/10) for the iShares XIC. But the price you pay for this performance is an MER of 2.28%.
As you can see, getting a cost-effective mix of fixed-income and equity assets to fit your risk-tolerance profile and longer-term investment objectives for your RRSP can be a complex undertaking. If you’re confused about how to put it all together and what to include in your RRSP, I’d suggest consulting a qualified financial advisor. But do it soon. The final day for making your 2016 RRSP contribution is March 1, 2017.
© 2017 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice. Securities mentioned are not guaranteed and carry risk of loss.