A fund portfolio for RRSPs

I have been looking through statistics about RRSP contributors in the 2010 Canada Year Book. Some of the numbers are disturbing although not surprising. Essentially, they tell us that relatively few Canadians under 35 are contributing to an RRSP. It is only after age 35 that people begin to get serious about their retirement plans and they are waiting longer to start. The average age of RRSP contributors increased from 43 to 45 between 2003 and 2008, the most recent year for which results are available.

What is even more disconcerting is that the percentage of Canadians who use RRSPs is in gradual but steady decline. In 2002, 27.3% of tax filers claimed an RRSP contribution. By 2005, that number had dropped by a full percentage point, to 26.3%. In 2008, it fell again to 25.7%.

There is no obvious reason why we are seeing these patterns although I can speculate that the prolonged period of low interest rates and two stock market crashes in the first decade of this century have combined to discourage people from saving and investing.

What is clear, however, is that if these trends continue we are heading for some serious social problems down the road as hundreds of thousands of baby boomers reach retirement age with inadequate financial resources. The decline of defined benefit pension plans is further exacerbating the situation.

There’s a lot of the old proverb “you can lead a horse to water but you can’t make him drink” in all this. Over the years, the federal government has put into place two of the most attractive personal savings programs that you’ll find anywhere: RRSPs and the recently-created Tax-Free Savings Accounts (TFSAs). We don’t have any meaningful data for TFSAs yet but based on what we’re seeing it appears that RRSPs are gradually falling out of favour.

My feeling is that we might see a reversal of that trend if RRSP returns begin to improve. I know from the e-mails I receive that many people are frustrated by the weak profits they are earning from traditional RRSP securities such as GICs. But they are afraid to venture into anything more “risky” after seeing what happened during the financial meltdown of 2008-09. These people wouldn’t even consider building their retirement plans around stocks or exchange-traded funds, which are the strategies I discussed in the past two weeks.

My advice in such cases is to create an RRSP based on conservative mutual funds. Yes, there is more risk to capital than simply socking the money into a GIC but over time the rewards will be greater.

I have put together a sample portfolio of funds that I believe would achieve the goal of growth at a reasonable risk. This is a balanced RRSP, with 40% of the assets in fixed-income funds and 60% in equity funds. Increasing the fixed-income weighting will reduce overall risk and vice-versa. All of these funds are recommendations of at least one of my newsletters.

A couple of comments. First, I have chosen these funds on the basis of their long-term risk/reward profile. In some cases, such as the Phillips, Hager & North Total Return Bond Fund, they may underperform their historic averages in the short term. Second, I have not considered minimum initial investment requirements. Small accounts won’t be able to use the PH&N, Beutel Goodman, or Mawer funds so I have suggested alternatives in each case. These alternates may not be on our Recommended Lists. With that, here’s the portfolio — the percentages in brackets are the weightings for each fund.

Phillips, Hager & North Short Term Bond and Mortgage Fund (20%). This is a very low-risk fund that invests primarily in securities that mature in less than five years, although about 10% of the assets are in bonds with terms of five to ten years. Investors hardly ever lose money and when they do it’s not a lot — the worst 12-month decline in the fund’s history was a drop of just over 2% in the year to Jan. 31/95.

Short-term fixed-income funds such as this are less vulnerable to rising interest rates which are likely to be a concern for the bond market in the next few years. So this fund will provide stability for our RRSP portfolio while offering decent returns over time — the average annual compound rate of return for the decade to Jan. 31 was 4.8%. Choose the no-load D units which have an MER of only 0.58%.

Alternate: CIBC Canadian Short Term Bond Index Fund.

Phillips, Hager & North Total Return Bond Fund (20%). I’m sticking with PH&N for our core bond fund. This fund has handily beaten the average performance for the category in all time frames from three months to ten years. It invests in a mix of corporate issues (55% as of the end of January), federal and provincial bonds (37.5%), foreign bonds (0.9%), mortgages (0.3%), and cash (6.3%). The bonds are top-quality: all but about 10% are rated A or better.

The management team is one of the best in the business. They have been reducing exposure to rising interest rates by adding more mid-term and short-term securities to the portfolio so that now only slightly over 30% of the holdings have a maturity of more than ten years. The average term to maturity is 8.8 years and the average duration is 5.9 years.

The fund had a 10-year average annual compound rate of return of 6.1% to Jan. 31 although recent results have not been as high. The MER is very low at 0.57%. Again, buy the no-load D units.

Alternate: TD Canadian Bond Fund.

Fidelity Canadian Disciplined Equity Fund (25%). This has been one of my top choices among Canadian stock funds for many years and it has been on the Recommended List of Mutual Funds/ETFs Update since April 2000. During that time, it has produced solid returns with a reasonable level of risk. That doesn’t mean it is immune from losses — the units fell almost 36% in the market collapse of 2008. But that was the only time between 2004 and 2010 that the fund did not generate double-digit gains from investors. As of Jan. 31, the B units were showing a ten-year average annual compound rate of return of 7.6%, well above the category average of about 5% and more than a percentage point higher than the benchmark S&P/TSX Total Return Index.

It’s a somewhat unusual fund because it is a cross between an index fund and an actively-managed one. This fund is indexed to the sector weights of the S&P/TSX Composite Index so lead manager Andrew Marchese does not need to concern himself about which sectors of the Index are likely to outperform. All he has to worry about is stock selection.

In the year to Jan. 31, the fund posted a gain of 25.6%, more than three percentage points above the category average. That’s important because Robert Haber, who had managed the fund since its inception, handed over the reins to Mr. Marchese early in 2009 and the new manager did not miss a beat.

The portfolio is heavily weighted to blue-chip stocks such as the banks, Suncor, Potash Corp., and Power Corp. and is well-diversified. I like the transparency of the stock isolation concept and regard this fund as an RRSP cornerstone.

Alternate: None required. You can take a position for as little as $500.

Beutel Goodman Small Cap Fund (5%). Small-cap stocks tend to outperform blue-chips over time, although they will display more volatility along the way. For example, the large-cap S&P/TSX 60 Index added only 2.5% over the three years to Feb. 18. The S&P/TSX Small Cap Index gained 15.5% during the same period. That’s why I have included a position in a small/mid-cap fund in this portfolio.

The fund holds a well-diversified portfolio of stocks (generally between 30 and 60), with a market float of less than $1.5 billion. It has managed to beat the average fund in its category the majority of the time, making this a top selection among small/mid-cap funds.

Like virtually all equity funds, it was hit hard by the stock market collapse of 2008-09 but it fared much better than most of its peers. The fund dropped almost 35% in the 12 months to Oct. 31/08 but has since staged a powerhouse recovery. In the year to Jan. 31 it posted a gain of 28.9% compared to an average advance of 25.5% for the category as a whole. Over longer time frames it has done very well for investors with a 10-year average annual compound rate of return of 14.2%, almost five points better than the category average.

The company warns on its website that this fund is suitable only for more aggressive investors. However, we can live with that since the weighting in the portfolio is only 5%. And in fact this fund is managed more conservatively than most others of its type — which is what we would expect from Beutel Goodman. Overall, you’ll find a good blend of growth and value here, along with below-average risk (in relation to small/mid-cap funds generally) and good returns.

Alternate: Dynamic Small Business Fund.

Dynamic American Value Fund (15%). This fund has been a first or second-quartile performer every year since 2003 and even though it was not immune to the crash of 2008-09, it performed better than most others of its type. The good news is that all the losses have been recovered. The fund generated a gain of 16% in the year to Jan. 31 and was showing a two-year average annual compound rate of return of 15.8% to that point with below average volatility.

Manager David Fingold takes a value approach to securities selection, buying stocks trading below their intrinsic value and selling when they become fully priced. The portfolio is quite concentrated (about 30 positions) and he places large bets on stocks he likes. For example, 6.2% of the fund’s assets were invested in IBM as of the beginning of February with another 6.1% in Oracle.

The fund employs currency hedging to reduce the exchange risk when the loonie rises and that has helped to boost returns to above average over most time frames. The five-year average annual compound rate of return, which roughly corresponds to the period of Fingold’s tenure, is 2.1% compared to an average loss for the category of 2.8%, a difference of almost five percentage points. I like this fund for an RRSP because it offers a good combination of decent returns and moderate risk.

Alternate: None required. The minimum initial investment is $500.

Mawer World Investment Fund (15%). This is a true international fund (as opposed to a global fund) in that it invests in equities outside North America, specifically Europe, the Pacific Basin, and Latin America. It has been a first or second-quartile performer in every year but one since 2002 but like all equity funds it was hit by the steep drop in global stock markets in the fall of 2008.

The good news is that this fund fared better than many of its peers and has recovered well. Over the year to Jan. 31, it posted a gain of 13.6% compared to a category average of 9.1%. It also beat the benchmark MSCI EAFE Index (Canadian dollars), which was up 9%. The fund’s returns are better than average over all longer time periods as well. The average annual compound rate of return for the 20 years to Jan. 31 was 8.2% compared to a 5% category average.

The U.K. has been the favourite hunting ground for the managers over the past few years, with a 25% portfolio weighting as of the end of January. The Netherlands is next at 8.5%, mainly through positions in Fugro N.V. and Royal Dutch Shell. The current emphasis is on industrials (30%) and financials (16%). Emerging markets make up 16% of the asset mix.

Alternate: Templeton International Stock Fund

If you’d invested in this portfolio a decade ago, you’d have earned an average annual compound rate of return of 5.4% to this point. That’s a very respectable result especially since Dynamic American and Mawer World Investment generated very small profits during that period. I expect both to do better in the next 10 years.

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