The Perfect Portfolio

Before you read any further, take this simple test. Pull out your latest brokerage statement. Review all the mutual funds on the list. Do you know exactly how each one fits into your investment plan? Are you satisfied that it represents the precise weighting you want?

If you can answer yes to both questions, you probably don’t need to read the rest of this article. But the odds are that your response to one or both queries is: no. In that case, you need this information. It may be worth thousands of dollars to you in the years to come.

Most mutual fund accounts grow like Topsy. They lack any coherent rationale. Your financial advisor says XYZ fund looks good, so you add it. You read that ABC fund is a hot performer so you buy some units. Someone says bond funds should do well in the coming months so you get one. The result is a mess of unrelated funds that underperforms for reasons you don’t fully understand.

Understand your goals
You need to make a fundamental change in the way you choose your funds. Your goal should be to create the perfect mutual fund portfolio for your needs. It’s not as hard as you might think. You just need to underand what you’re trying to achieve and then have the discipline to do it.

The ideal fund portfolio should achieve the following:

  • Provide potential for steady growth at an average annual rate of at least 8%-10% annually over the long term.
  • Limit downside risk in falling equity markets.
  • Provide some currency protection.
  • Be well-diversified by asset class, style, and geography.
  • For non-registered portfolios, be tax-efficient.

You should review these criteria every time you consider a new fund for inclusion in your plan. If the fund doesn=t meet at least two of the objectives, it should be bypassed.

Let’s review each criterion in detail.

Growth potential

. The biggest mistake many fund investors make is to succumb to greed. It’s the reason that many people got clobbered in the high-tech crash. They saw the huge returns that tech-weighted funds scored in 1998-99 and overloaded their portfolios in that direction. At the same time, they underweighted poorly-performing value funds and fixed-income funds.

A reasonable average annual return over the long haul (say 10 years plus) is 8% – 10% annually. With careful management, 10% – 12% is achievable. If you aim higher than that, you will have to accept a degree of risk that will make most people uncomfortable.

Downside risk.

If you feel that your fund portfolio suffered higher losses than you would have liked in the market tumble, then you may have built in too much risk. The answer is to rebalance your asset mix to put more emphasis on low-risk securities, such as money market funds, mortgage funds, bond funds, balanced funds, and value-oriented equity funds.

However, don’t go to the extreme of making your portfolio so safe that you reduce your return potential to less than 8% annually. Yes, you can bullet-proof your portfolio with ultra-secure funds, but in doing so you will compromise your returns. The key is to find the right balance.

Currency protection

. There is no way of knowing where the loonie will go in the future. But we can say two things with certainty.
  1. Our currency has been devalued by about one-third against the U.S. dollar in the past decade.
  2. Every prediction that the loonie is about to rise to US$0.70 and higher has proven wrong to date.

Of course, all this could change. But if past trends continue, the Canadian dollar will gradually lose more ground against the greenback in the coming years.

That’s why every fund portfolio should contain some currency protection. This is not a case of speculation; it’s a matter of hedging against continued devaluation of the loonie.

This can be achieved by holding mutual funds that invest in U.S. dollar securities. These include U.S. equity funds, foreign bond funds, and U.S. dollar money market funds. Although many of the equity funds can be purchased in either Canadian or U.S. currency units, in fact it doesn’t matter which you choose. As long as the securities in the portfolio are denominated in U.S. dollars, you will get the benefit of any gain that the American currency makes against the loonie.

Of course, our dollar may turn around and start to rise, so you wouldn’t want to hold your entire portfolio in U.S. dollar funds (which you could, even in an RRSP). Decide on a U.S. dollar percentage that is appropriate for your plans (at least 25% is recommended) and be sure that you choose funds that will provide that.

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% 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.

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 at 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.

Flexibility without penalty charges
When you are buying funds for your “perfect” portfolio, think carefully about the purchase options. You want a selection of funds that provides 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, the F units (see What’s New). Some companies offer “low load” fund units. They’re offered mainly to institutional investors but if you’re a good client you may be able to buy them. 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.