Portfolio Construction

• Designing Your Portfolio
• Portfolio Evolution
• Balanced Funds or GICs
• The Four-Component Portfolio
• Sample Portfolios
• Building the Desired Portfolio
• Appendix:  Compound Interest Formulae and Weighted Returns

Designing Your Portfolio

1. Define your goals.
2. Specify a time frame.
3. Estimate the final amount you will need.  Remember to account for inflation; a prudent estimate of inflation going forward is the middle of the Bank of Canada target range, or 2%.
4. Estimate the after-inflation return you require using the compound interest formula (see Appendix). Be realistic; single-digit after-inflation returns are the best that you can expect.  
5. Use the conservative future return estimates in Table 1 below to calculate the weighted returns (see Appendix) of several different portfolios.  Adjust the return estimates downwards to reflect the costs involved with your approach.  A low-cost index or ETF approach will cost about 0.5% for small portfolios and about 0.2% for large ones.  Select the most conservative portfolio that provides a return sufficient for Step 4.  If no portfolio provides sufficient return, you must redefine your goals.  Choose between using less money, increasing your savings rate, or specifying a longer time frame, or some combination thereof.
6. Consult the loss percentages in Table 2 below.  Estimate how much your portfolio could lose in dollar terms over a short period.  Can you tolerate the loss?  Be honest; a 20% loss on a $500,000 portfolio is $100,000.  If the loss is unacceptable, choose a less-risky asset mix and redefine your goals.
7. Repeat Steps 1-6 until you have determined an appropriate asset allocation.
8. Select the individual components to meet your asset allocation in a tax-efficient, cost effective way.
9. Establish rebalancing criteria.
10. Monitor your portfolio to ensure it still meets your needs.  Reevaluate if your needs change.
11. Stay the course.

   If you don't feel comfortable in performing these steps yourself, consider consulting a professional financial advisor.

Table 1.  Expected Real Returns^a,b

1. Bernstein, William, "The Four Pillars of Investing", p. 72.  These returns are after inflation but before expenses.
2. Readers should remember that these numbers are guesses only. There are no guarantees. 
3. Author's estimate.
4. Investors should remember that a significant fraction of the "yield" on income trusts is a return of the investor's own money.  Also, trusts usually have limited growth prospects and unit prices and/or distributions may well drop from current levels.

Table 2.  Risk of Loss^a

1. Bernstein, William, "The Four Pillars of Investing", p. 268.

    The following on-line questionnaires may help investors assess their risk tolerance:

   BMO Investor Profiler
   Edmond Questionnaire
   TD Waterhouse Planner

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Portfolio Evolution

   It may be useful to consider three stages of portfolio evolution:

1. Asset Accumulation - the saving years
2. Early in Retirement - converting to income
3. Later in Retirement - annuitization or gifting

   The asset allocation or location during Asset Accumulation is often different from that desired Early in Retirement.  For example, dividend-paying common stocks may be in the RRSP, even though they qualify for the dividend tax credit.  Some swapping of assets from the non-registered accounts may be required after retirement.  If so, the tax consequences should be examined beforehand so that more tax is not paid than is saved.  Adjusting the portfolio in a tax-efficient manner may take 3-5 years.  As was seen in the section on withdrawal strategies, the sustainable inflation-adjusted portfolio withdrawal rate is about 4%.  Therefore, the retiree may wish to adjust his portfolio so that it provides an overall dividend yield of about 4%. 

   As discussed under withdrawal strategies, if an asset swap or sale from the non-registered account is necessary, the components with the highest adjusted cost base should be sold or swapped first.  Usually, this is a "last in - first out" (LIFO) method.  However, since the CRA will disallow capital losses on transfers to an RRSP, it may be desirable to wait until a security is in a profit position before swapping it.

   Another reason for making a swap early in retirement may be to access high-dividend securities that have been placed in the RRSP during asset accumulation in order to minimize tax drag.  For example, an investor in his mid 40's may have decided to add REITs to his portfolio in order to improve diversification.  He has no immediate need of the income, and will face a tax drag of about 2% per annum if he puts them in his non-registered portfolio.  So, he puts them in his RRSP and puts low-dividend securities in his non-registered portfolio.  Shortly after retirement, he switches the REITs out of his RRSP and low-dividend securities with small capital gains in, paying the capital gains tax on the securities but gaining access to the income from the REITs.  Some of the REIT income will now be tax-deferred.  For this strategy to be worthwhile, the value of the tax saved by deferring part of the tax on the REIT income must be greater than the tax paid on the securities that are swapped.  The investor may later decide to switch the REITs back into the registered account if it is converted to an RRIF in order to meet the mandatory minimum withdrawal requirements.

   When the investor approaches age 69, he or she will have to decide whether to convert his RRSP to an RRIF, and may want to consider purchasing an annuity.  At this time, professional advice should be sought.

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Balanced Funds or GIC's

   Beginning investors may be faced with the problem of where to invest modest amounts of, say, a few thousand dollars, and may be unwilling to take the time to learn how to invest. Two different approaches suggest themselves; both are particularly applicable to all-RRSP portfolios with no non-registered components because they contain interest-bearing components that are taxed at the full marginal rate.

  The first alternative, which may be suitable for young or middle-aged investors with little interest in learning how to invest, is simply to place the entire portfolio in a low-cost balanced mutual fund. Commentator Dan Hallet has recommended funds from Mawer or Saxon for this purpose, while columnist Jon Chevreau has recommended Trimark Income Growth and PH&N Balanced.  Globefund has filters that can be used to check the historical performance of low-cost balanced funds.

   Although the single-balanced-fund approach is not as cost effective as the more sophisticated multicomponent portfolios given below, the additional monetary cost is relatively modest in a small portfolio: an additional MER of, say, 1.5% is only $150/year on a $10000 portfolio.  Some investors may wish the hands-off peace of mind that the single fund provides; a conservatively-managed balanced fund is similar to the portfolio used by many pension fund managers - although they may only pay 1/10 the cost!  Beginning investors can also start off with a balanced fund, then switch to lower-cost alternatives as the portfolio grows.  If the fund is in an RRSP, the switch can be made without triggering capital gains tax.

   Balanced funds may not be a desirable alternative for very elderly investors because of the possibility of short-term loss. An all-GIC portfolio with GICs laddered for, say, 1-5 years, will preserve capital while giving a modest return.

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The Four-Component Portfolio

   Although a number of different portfolio components are listed in Table 1, investors who are early in the asset-accumulation phase can also obtain adequate diversification with a simple, four-component portfolio.  The four components are:

• Canadian Fixed Income (bonds or GICs)
• Canadian Equities (large-cap or large-cap value)
• U.S. Equities (large-cap or total market)
• International (EAFE) Equities

   A separate cash component is not required during asset accumulation because of the yearly contributions.

      An even simpler alternative would be to use a balanced mutual fund, as in the  previous section.  However, the four-component portfolio allows tax-efficient allocation of each of the four components (with the bonds or GICs inside an RRSP), and rebalancing back to the target allocation with the yearly contribution.  It is also cheaper than a balanced fund.

   Estimated returns for several four-component portfolios based on index funds are given here.

   An example of a four-component portfolio is given in the section on portfolio construction.

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Sample Portfolios

   With the above points in mind, let's construct a few sample portfolios.  I will base these all on a 50:50 equity:income allocation, but the equity content of the resulting portfolios can be scaled as necessary.

   Let's use the FPX Balanced to examine how portfolio diversification and dividend income could be improved.

Portfolio 1. Base Case - FPX Balanced

   This portfolio (or its four-component alternative) may suffice during asset accumulation, but it does not have adequate income for a retiree and contains no real-return bonds. 

Note:  Some investors  consider the FPX Balanced to have too high a Canadian equity content and would increase the US and EAFE equity content while reducing the S&P/TSX 60 component.  One alternative portfolio would simply divide the equity portion equally between Canadian, US, and International components.  Another alternative would eliminate the Canadian equity component entirely.  The approach taken depends, in part, on whether the individual has other Canadian assets (such as real estate), and whether he or she wishes to spend a significant amount of time outside Canada and wants extra exposure to other currencies.

   Now, lets add RRBs to improve diversification.  This is perhaps the single biggest improvement to the portfolio, since it adds a large quantity of an uncorrelated asset class, and will significantly reduce the risk.

Portfolio 2. FPX Balanced with RRBs

   The bond ladder gives access to cash at periodic intervals.  As each bond matures, it is rolled into a new five-year bond, along with additional savings and the RRB interest. This portfolio is also quite suitable during asset accumulation. 

   Now let's replace the large-cap S&P 500 with a broader representation of the US market by substituting the Vanguard VTI ETF based on the Wilshire 5000: 

Portfolio 3. FPX Balanced with RRBs and Wilshire 5000

   We could also substitute a S&P/TSX Composite (previously the TSE 300) based ETF or index fund for the S&P/TSX 60 to get broader representation of the Canadian market.  However, with the more-narrowly-based Canadian market, any improvement will be quite modest.  A better approach (see below) is to include Canadian value stocks.

   As the investor approaches retirement, he may want to start building a position in Canadian dividend-paying stocks:

Portfolio 4.  Enhanced Income with Dividend Growth

   This portfolio uses the "Dividend Growth" strategy described in the section on Canadian stocks to add income.  The S&P 60 units have been partially replaced by bank and utility stocks.  This change also gives a value emphasis to the Canadian equity allocation.

   After retirement, the investor may wish to replace his remaining S&P/TSX 60 units with REITs and trusts to further boost income, provided that the S&P/TSX 60 units can be sold without incurring a major tax penalty: 

Portfolio 5.  Further Enhanced Income with REITs and Trusts

1. Investors should consult Betting on a Shrinking Resource before purchasing an oil and gas trust at this time.

   This portfolio can provide a dividend income approaching the 4% sustainable withdrawal rate. The oil and gas trust is a "lifestyle hedge" that shields the investor from energy price swings, but may decrease in value as the oil is consumed.

   Finally, the investor may wish to increase the value and small-cap weightings of his US holdings to further improve diversification and capture the extra return (if it persists).  Again, this change will only be made if it can be done without incurring a tax liability.

Portfolio 6.  Value and Small-Cap American Exposure^a,b

1. A similar U.S. weighting can be obtained with 3.5% Wilshire 5000, 1.5% U.S. Small Cap, 2.5% U.S. Large Cap Value, and 2.5% U.S. Small Cap Value.
2. If the investor wants a simpler portfolio subdivision including only small cap exposure, alternative possibilities are 5% U.S. Large Cap and 5% U.S. Small Cap or, as an equivalent, 7% Wilshire 5000 and 3% U.S. Small Cap.

   Further portfolio construction could include: adding an actively-managed Canadian small-cap mutual fund; adding US REITs; replacing the EAFE funds with individual European, Pacific ex-Japan, and Japanese funds; adding emerging market funds; or adding actively-managed international value or small-cap mutual funds.

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Building the Desired Portfolio

   Once the portfolio components have been determined, the investor must then establish a brokerage account (if he or she doesn't already have one) and purchase the desired components.  A DIY investor will probably wish to establish an account at a discount brokerage in order to minimize costs.  RRSP accounts should be consolidated at the same dealer if possible to facilitate swaps between registered and non-registered accounts.  The investor must then decide which securities or funds to use and which components will be inside and which outside the RRSP, and must evaluate the costs (such as deferred service charges) and/or delays (due to GICs held at existing institutions) in establishing the final asset allocation.

Example 1.  Ed is in his mid thirties and wishes to start DIY investing. He has an RRSP worth $10K and no non-registered investments. He wishes to add to the RRSP using monthly contributions.  The RRSP is currently in Canada Savings Bonds, and there are no costs or delays associated with moving it.

As discussed in the section on ETFs, with a modest investment amount and the desire to add monthly contributions, low-cost index funds are a better alternative than exchange traded funds. Ed reviews Bylo's list of low-cost Index Funds and decides to use the TD e-funds for his portfolio.  [The TD e-funds are used for illustration purposes only.  There are other suitable funds; also, if Ed had more than $150,000 to invest the CIBC Index Funds would have a lower expense ratio.]  He establishes an account at TD Waterhouse and transfers his existing RRSP.  He wishes to replicate the four-component portfolio listed above, using the FPX Balanced for his target allocation and adding the cash component to the bond index.  He purchases the following funds:

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Ed's Portfolio¹

Canadian Bond: TD Canadian Bond Index - e	50% ($5000)
Canadian Equity: TD Canadian Index - e	25% ($2500)
US Equity: TD US Index - e	10% ($1000)
EAFE Equity: TD International Index - e	15% ($1500)

1.  Index funds from other vendors could also be used.

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Since both the RSP and non-RSP International Index e-funds have the same MER, it doesn't matter which one he uses from a cost basis.  However, the non-RSP version has no currency hedging and tracks the MSCI EAFE Index (in C$) more closely.

Although Ed is very nervous about investing in equities because of the volatility, he recognizes that his time horizon is very long and decides that for now he will use his monthly contributions to add to his Canadian index holdings.  Ed decides to use 5% absolute/25% relative for his rebalancing thresholds; if one of the holdings varies from the nominal level by 5% absolute (e.g.. from 50% to 45% or 55% for the bond index) or by 25% relative (e.g. 7.5% to 12.5% for the US RSP Index), he will rebalance by redirecting the monthly contributions appropriately until the holdings are back to their nominal percentages.

   Another simple portfolio could be made by assigning 40% to a bond index and dividing the remaining 60% equally between Canadian, US, and EAFE equity index funds.  Investors who feel the FPX Balanced is too heavily concentrated in Canada may prefer such a distribution.  Alternatively, investors with significantly larger portfolios (say, $50-$100K) could divide the bond component equally between a bond index fund and RRBs.  Other variations include the substitution of a Canadian dividend fund for the Canadian index fund, or the use of a bond or GIC ladder instead of a bond index.

   Most investors will face a situation significantly more complex than Ed's. They may have GICs at several institutions, mutual funds with delayed service charges, and registered and non-registered holdings.  Each current holding will be needed to considered individually to decide if it should be retained (in general,  high-cost holdings should be replaced  by lower-cost alternatives if the payback time for switching costs, including taxes, is less than one year.)  Consolidating the accounts may take several years.  It may, for example, be desirable to take advantage of a market low to replace unwanted mutual funds by index alternatives without triggering capital gains taxes.  On the other hand, if a mutual fund is outperforming in the current difficult market conditions (as some value-based funds are), there may be no need to replace it. 

Example 2.  Pat is 58 and has a $1,000,000 portfolio, which he has decided to start managing himself.  The non-registered portion is $600K, and contains mutual funds and several individual stocks.  The registered portion is divided between an RRSP and a locked-in RSP (LRSP) from a previous employer; both consist of a six-year bond ladder (75%) and some international mutual funds (25%).  Overall, the portfolio is 40% in mutual funds with an average MER of 2.5%.  The total mutual fund expenses therefore amount to $10000 per year.  None of the mutual funds has delayed service charges (DSCs) associated with redemption.

Pat decides that he will transfer his account to a discount brokerage.  Pat is nearing retirement, and feels that the portfolio combined with his pension will now meet his post-retirement income needs at a 4% withdrawal rate.  He therefore decides that he must reduce his equity (high-risk) allocation, now 60% of his portfolio.  His new allocation will be a 40%:60% high risk:low risk split.  He also wishes to include US TIPs in his RRSP.  He sets the following allocation targets:

• 14% Canadian equities
• 13% US equities
• 13% EAFE equities
• 20% RRBs
• 10% US TIPs
• 25% normal bonds and preferred shares
• 5% cash

When the account arrives at the discount brokerage, he changes the RRSP and LRSP allocations immediately, selling all the mutual funds in these accounts and investing half the proceeds in the 2021 Government of Canada RRB and the remainder in US TIPS.  As the bonds in the bond ladder mature, he plans to divide the proceeds (and his yearly RRSP contribution) between RRBs and TIPs until his targets are reached.  This will take five years.

Changing the non-registered account requires more evaluation because of the tax costs associated with embedded capital gains.  For each mutual fund, Pat must calculate the current adjusted cost base (initial cost plus additional investments and reinvested dividends) and estimate the tax due on a sale at the current price.  He then calculates the MER savings and the payback period for the tax due.  He decides that any mutual fund with an MER payback time of one year or less will be sold.  This results in two value-oriented mutual funds being retained, one holding mainly US stocks and one holding international stocks.  Since Pat's portfolio is large and will now change only slowly, ETFs are more suitable than index funds for the indexed portion of the portfolio.  Since his remaining value mutual funds will provide a value bias, and all the ETFs will be in his non-registered account, he chooses the Vanguard VTI ETF and the Barclay's EFA ETF for the remaining target allocation to his US and EAFE investments.

Pat's remaining Canadian equity allocation is mainly accommodated by his direct stock holdings.   However, he decides to increase his investment in utility stocks because of his pending retirement.

The remainder of the cash from the sale of the mutual funds above the 5% cash allocation is used to buy preferred shares in his non-registered account as a tax-efficient substitute for bonds. 

Pat calculates that he will save $6K per year in MER costs.  He has also decreased his portfolio risk preparatory to retirement, increased his income, and improved his portfolio diversification.

   In complex cases like Pat's, considerable evaluation is required.  Some investors may wish to consider consulting a fee-only financial planner in order to establish a multiyear plan that meets their objectives. 

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