Tuesday, 15 February 2011

Five Reasons to Go Beyond the One-Stop-Shopping Portfolio

Readers of last week's post might wonder why an investor might want to do anything else than buy one of the all-inclusive portfolio funds we examined. The simplicity, convenience and effectiveness of those funds notwithstanding, there are a number of reasons that an investor could want to build a more complex portfolio and do the required extra work.

1) Additional Asset Classes for Extra Diversification - We noted that some of the funds had no holdings in REITs, emerging market equities, real return bonds, commodities and/or gold, preferred shares and US / other foreign bonds. Including such other types of less correlated (i.e. tending to move out of sync with each other other) assets will lower the portfolio's variability and increase returns slightly (see this post at CanadianFinancialDIY). The ability to pick asset classes gives the investor the opportunity to deliberately exclude some - like commodities - that are in the more complex all-in-one portfolios but which do not garner universal support as a mainstream portfolio holding (see this post on the pros and cons). Or it allows the inclusion of some that certain investors desire for matching their circumstances, such as retirees wanting real return bonds (see this post for more).

2) Ability to Tailor Percentage Allocations to Each Asset Class - With the all-in-one portfolios, you must take the fund as it is. That is most likely not optimal for every individual. A person's spending goals and risk tolerance should have matching characteristics in the portfolio. For example, as you get closer to the time when the money will be spent, be that retirement or something other, and when the saving goal is closer to being reached, a rising proportion of more and more stable investments (equities > bonds > T-bills) should be in the portfolio. Our post on Asset Allocation has links to tools that can guide you for your own circumstances.

3) More Selectivity in Funds for Each Asset Class - It is not possible to pick which specific funds are held in the all-in-one portfolio to represent each asset class. The internal funds may not be the best in class for each category. As our various reviews of ETFs for such categories as Canadian Bonds, Canadian Large Cap Equity, US Large Cap (S&P 500 or similar), Commodities, and Emerging Market Equity (Canadian- or US-traded) show, there are many choices and differences.

Some equity markets may be better represented by a total market fund instead of only a large cap fund like those based on the S&P 500 (see discussion here) or the TSX 60.

It may be better to buy real return bonds directly and not in a fund, or even individual bonds in a ladder (ladder pluses, fund pluses).

There are arguments for and against funds based on alternative weighting and selection criteria such as equal and fundamental weighting.

Some foreign funds are hedged and others not, another choice which has pros and cons. The investor has many possibilities for making a better portfolio.

4) Rebalancing - All the all-in-one funds rebalance the portfolio quarterly to maintain risk at a constant level. It is possible and perhaps desirable to rebalance less frequently such as once a year, or even less often (as we discussed here) to gain slightly higher returns.

5) Tax Benefits by Splitting Holdings Between Registered and Non-Registered Accounts - When there is no room left in tax-deferred registered accounts, investments generating interest income, such as bonds, should go into the registered accounts while those generating dividends and capital gains, such as equities, belong in a non-registered account (see TaxTips.ca guidelines for which investments in which account). Splitting types of investments up for tax savings is obviously not possible when one fund contains all types of investments.

All these refinements require extra work of course, but the payoff should be a portfolio with better returns (try a compound interest calculator to see how much difference a small extra return can make when compounded over many years e.g. 3.5% vs 3.0% for 35 years gives you 18% more at the end) and less variability that is better adapted to your individual circumstances.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

1 comment:

YourMoney said...

It's absolutely true. The extra work put in will benefit you in the long run. Mutual funds, an attractive investment for many people, can be a little tricky too. And although it may yield some good extra income, few have stopped to think whether they know enough about mutual funds, how they work, and how the people investing your money work.

Investors should reach out to find information and clear concepts about their financial investments.