This RRSP season, you can give your portfolio a gift – the potential for better returns and reduced risk. (photo from 401kcalculator.org via Wikimedia Commons)
Many RRSP portfolios struggled in 2015 to produce returns sufficient for the goals of retirement building and wealth preservation. An over-reliance on equities, and particularly Canadian equities, left many RRSPs in negative territory and, so far in 2016, the stock market has continued to erode savings. But, this RRSP season, you can give your portfolio a gift – the potential for better returns and reduced risk.
The concept of what we call a registered retirement savings plan (RRSP) was introduced by the federal government in 1957 to encourage Canadians to save for their retirement. Although the rules have changed over the years, the basic benefits are every bit as valuable today as they were at inception: the ability to contribute pre-tax dollars and thereby reduce income for taxation, and the ability to compound gains within an RRSP while deferring taxes on the gains.
Many of us are good about setting up our RRSPs when we’re young, and dutifully contribute the maximum allowable each year. Typically, our RRSP accounts start out as just another brokerage account with an emphasis on long-only stock investing. But, by the time we reach our 40s, those RRSP dollars can start to add up. For top-earning Canadians contributing the maximum allowable, an RRSP account can hit $500,000 by middle age and keep going from there.
In addition, our risk tolerance changes as we age and our runway of remaining working years shortens. Conventional wisdom is that longer-term investment vehicles like RRSPs can take on more risk, as greater volatility over the long term often yields greater return. Unfortunately, this notion fails to anticipate how long it can take to overcome the drag of a negative year, and the fact that when a major loss occurs late in a life, there may not be enough time for wealth to catch up to needs. Consider, for instance, the unfortunate plight of anyone who had to rely on their RRSP in late 2008, before the Federal Reserve and its counterparts stepped in and refloated stock markets.
The collapse of stock markets in 2008 and 2009 prompted many to take their RRSP money out of the market and rethink their risk tolerance. The disappointment of 2015’s performance will likely reinforce that wariness of the equity markets. An RRSP that closely tracks the TSX would have been down 8.32% last year. That account will have to appreciate by 9.08% just to get back to the values at the beginning of last year. Given average return expectations of 8% per year, it will take 13 months just to recover, let alone get ahead. (And the numbers get worse if you go back further – the TSX is still below the high it reached in 2008.)
Even after our inauspicious start, 2016 may be a great year for equities, or it could be a repeat of 2015 (or worse). Either way, the safer, more reliable route to a more secure portfolio is to decrease downside volatility by employing two of the touchstones of risk mitigation: diversification and non-correlation. Both allow portfolios to absorb and offset downdraft periods, while benefiting from the correlation between return and risk (most assets with a higher-return profile also carry a higher-risk profile).
One of the greatest sources of volatility for a portfolio is the particular market or strategy it’s primarily invested in. The TSX, as an example, has historical volatility of more than 15%, which is quite high. To offset this inherent risk, it’s necessary to incorporate additional components that are both uncorrelated to the TSX and to each other.
Finding diversified, uncorrelated components is easier than you may think. There is a range of non-equity investment options available for RRSPs. Real estate, infrastructure and lower-risk funds of alternative funds can all be beneficial components of a balanced RRSP portfolio. Even the traditional RRSP component of Canadian equities can be turbocharged by replacing a long-only mandate with a long-short manager. And all of the above are available to accredited investors in bite-size pieces appropriate to an RRSP.
As with all portfolios, when constructing an RRSP portfolio, it’s important to distinguish the particular characteristics of each component so the portfolio achieves the greatest possible appreciation with the least possible risk. Real estate and infrastructure both have valued histories as long-term wealth generators with lower volatility, but they usually come with liquidity restrictions, and each is subject to cyclical trends. Funds of alternative funds can combine lower risk and reasonable liquidity while offering access to a range of investment themes far beyond the Canadian economy, an important way to break out of the limitations of living in a country that constitutes less than 3% of the world’s GDP. Long-short equity can achieve market neutrality and have great liquidity, but even some of the better Canadian funds can be highly volatile.
Your investment advisor should be able to suggest suitable choices for each component, and you can evaluate those recommendations (and come up with alternatives) by doing some internet research of your own. When assessing providers for each component, you and your advisor should consider the usual metrics such as beta, volatility, standard deviation, Sharpe Ratio and correlation to the TSX. While the names may be new to you, the concepts are easy to grasp and very useful when comparing performance over time. When it comes to choosing a fund of alternative funds, identify a manager with a proven record of nimbleness, as he or she will have to keep updating the mix of exposures to benefit from evolving market conditions.
Many pundits agree we are likely in the final innings of history’s longest equity bull market. Additional headwinds may result from bonds and credit, beginning a long overdue tightening cycle, which many are expecting will increase volatility. Now is the time for investors to rethink portfolio construction and embrace asset classes that are less influenced by the equity markets. Sophisticated investors like family offices and institutions embraced non-correlated alternatives decades ago. It’s time for the rest of us to catch up.
Ari Shiff is president and chief strategist of Inflection Management Inc. (inflectionmanagement.com), and manager of the Inflection Strategic Opportunities Fund. He has more than 20 years experience in hedge funds and can be reached at [email protected] or at 604-730-9147.