Creating a winning portfolio (2)

Zoomer | January 1st, 2006

Diversification. There are several types of diversification that need to be considered in building your fund portfolio.Asset mix diversification is the most basic. This is simply the way in which you combine cash (money market funds), fixed income and equity funds in your portfolio. There is no “ideal” asset mix but a 10-40-50 allocation is a reasonable target for a balanced portfolio.

Geographic diversification is essential. Canada is a small market with a weak currency. To tie up most or all of your fund assets in this country is therefore a mistake, unless you prefer to let patriotism rule over pragmatism. At least 40 percent of your fund portfolio should consist of U.S. and international funds.

Style diversification is increasingly recognized as a key to superior fund performance. People with a good percentage of value funds in their equity mix withstood the market turmoil much better than those who were heavily growth oriented. However, growth funds will come back at some point in the future. The ideal portfolio has a mix of both, with some occasional fine-tuning to adjust the balance towards the better-performing style.

Tax efficiency/i> Non-registered portfolios need to take tax efficiency into account in the fund selection process. The last thing you need is to be stuck with a big tax bill each year. For income-oriented portfolios, dividend funds and high-income balanced funds should be considered. They will generate income that is taxed as an advantageous rate compared to interest income from bond funds.

The distribution history of any equity fund should be carefully studied before purchase. Distributions are taxed annually and a fund with a record of high distributions may add a significant amount to your tax bill. Also, consider “umbrella funds”, which allow you to switch money among various “classes” without triggering capital gains tax liability. Several companies now offer them.

When you are buying funds for your “perfect” portfolio, think carefully about the purchase options. You want a selection of funds that provide the flexibility to make changes without triggering expensive penalty charges. Therefore, avoid back-end load funds if possible. No-load funds are the ideal choice, however there are other alternatives. Some companies, such as Franklin Templeton, do have a no-load option for funds that are normally sold only by commission, although an advisor may be reluctant to sell you those units. Some companies offer “low load” funds. They’re mainly for institutional investors but if you’re a good client you may be able to buy that way. Also, some financial advisors will sell front-end load units at zero commission, just to get your business or because you have a large account.

If you must buy funds on a deferred sales charge (DSC) basis, choose families that offer plenty of switching options and make sure you will not be charged a switching fee when you want to move your money.

That may seem like a lot to digest at one sitting, but if you can master these basic rules you can indeed build your Perfect Portfolio. For an example of how one such portfolio might look, check out the accompanying box. Your own numbers may be somewhat different, depending on your objectives, but if you use this is a model you won’t go far wrong.

A SAMPLE PORTFOLIO

Here is a sample fund portfolio that takes into account the criteria discussed in the accompanying article. This is a balanced portfolio that uses as a basic asset mix 10 percent cash, 40 percent fixed income and 50 percent growth. A more aggressive portfolio would increase the growth content while reducing the fixed income segment accordingly. The Model column represents the basic allocation. This remains constant. The Current column represents the fine-tuning to reflect present market conditions. At the time of writing, we favoured value funds over growth funds. This column should be reviewed quarterly.

Type of Security	Model	Current

Canadian Money Market Funds

5.0%

U.S. Money Market Funds

5.0%

Canadian $ Bond Funds

20.0%

U.S. $ or Foreign Bond Funds

20.0%

Canadian Equity Funds (value)

12.5%

15.0%

Canadian Equity Funds (growth)

12.5%

10.0%

U.S. Equity Funds (value)

7.5%

10.0%

U.S. Equity Funds (growth)

7.5%

5.0%

International Equity Funds (value)

5.0%

7.5%

International Equity Funds (growth)

5.0%

2.5%

Totals

100.0%

Buyer’s Guide to Mutual Funds by Gordon Pape and Eric Kirzner, published by Prentice Hall Canada. Available now at a discounted price!