Episode 29: Mutual Funds

Investors often use mutual funds to fill out target asset allocations and create well-diversified investment portfolios. In this introduction to mutual funds, we cover the quantity and asset size of available funds. Also, the variety of asset classes, subclasses, and specialty areas you can invest in using mutual funds.

All that and more in this episode on the Wilson Wealth Management YouTube channel.

“How large is the mutual fund business?”

It is extremely large, both in number of funds and assets.

We look at the number of mutual fund and assets under management. In Canada, the US, and the world.

How the mutual fund industry has grown over the years. As investors shift from investing in individual, non-diversified investments into better diversified investment products. As increased competition has continued to reduce product costs. And as investor knowledge has improved over time, resulting in the demand for more customized offerings.

“What are some of the asset classes that I can access with mutual funds?”

Investors can invest in every possible asset class and subclass. Based on your overall investment strategy, shorter term tactics, and to enhance diversification in your base portfolio.

We discuss some of the subclasses and ideas on how to assess them for your portfolio.

Common equity asset subclasses include: market capitalization; growth versus value investing; domestic versus international; developed versus developing markets; hedged versus non-hedged investments; industry sectors.

Perhaps your focus is on quantified data and ratio analysis, such as: price-to-book; price-to-earnings; dividend yield.

For fixed income: government versus corporate; quality; geography; foreign currency versus base; term to maturity; preferred shares versus bonds.

In Episode 26: Fixed Income Allocation, we cover key fixed income investment considerations.

“How can I find the better funds when there are so many available to buy?

We discuss fund ratings and rankings as one tool to compare performance between mutual funds in an investment category.

There are a variety of analyst rating systems. We use Morningstar as an example in this video.

“What other considerations may arise with mutual funds?”

We discuss hedging versus foreign currency exposure. Or investing internationally, at all. Most Canadian investors have a substantial home country bias in their equity portfolios.

Perhaps you prefer a balanced mutual fund, which may match your target asset allocation. Or a target date fund that takes a balanced approach, but rebalances over time until its (and presumably your own) retirement date. So you get everything all in one investment product. Which improves simplicity in your investment management.

Maybe you want alternative asset classes or niche sectors. Private equity, commodities, collectibles, real estate. Or specialty areas such as Environment, Social, Governance (ESG) investments. A hot investment sector currently.

For more on fund basics, please refer to “Mutual Fund Introduction” and “Mutual Fund Categories”. We will delve much deeper into this investment product over the next few episodes.

 

 

 

 

Episode 27: Equity Allocation

What is the Equity asset class? Why invest in common shares? How does your life cycle phase, personal circumstances, and risk tolerance impact your target asset allocation to equity investments?

All that and more in Episode 27 on the Wilson Wealth Management YouTube channel.

“What is Equity as an asset class? What are some of the key subclasses?”

We start off with a quick review of the asset class as whole.

For more detail on equities, please review “Equity Asset Class” and “Common Share Characteristics”.

Then we drill down into the diversification and risk-return characteristics of various equity subclasses.

For example, investing by style. Value versus growth investing. Maybe your focus is on generating dividend income rather than capital gains. Perhaps you want to invest based on market capitalization. Mega companies like Apple, Nestle, and Toyota. Or down to small, micro, or nano capitalized companies.

I discuss differences between domestic and international equities. How the risk-return profile and asset correlations differ between developed, emerging, and frontier capital markets. There may also be differences between developed markets, such as EAFE (Europe, Australasia, Far-East) and the US. As well as between individual emerging markets. India and China are much different than Colombia or Qatar.

Not all equities are equal. Two investors may have the same percent allocated to equities. But the characteristics of that allocation may be vastly different.

Note the difference between “global” and “international”. Domestic equities are from your home market. International equities are from around the world, excluding your domestic market. Global include both domestic and international securities. Useful to remember when assessing investment products.

Next we move back into how your life cycle phase affects your equity asset allocation.

“How should Accumulators utilize equities in portfolios?”

Because Accumulators tend to be young, they have a very long time horizon for investing. At least, for the major goal of retirement. The time horizon means Accumulators can handle enhanced portfolio volatility and expect higher returns over time. This suggests heavy exposure to equities.

For many Accumulators, “heavy exposure” means a 100% equity allocation in their early years. However, as discussed with cash and fixed income, there are other factors that recommend some allocation to the other classes. Diversification benefits and short term objectives are two good reasons.

“What about those in the Consolidation phase?”

Consolidators still have a relatively long time frame until retirement. That suggests equities.

However, Consolidators may have more near term objectives and may now decide to focus on diversification as they have more wealth accumulated.

Because Consolidators do have some capital built up, they have the critical mass to better diversify into niche equities than do Accumulators. An Accumulator be may smart to invest in a cost-effective global equity fund as they build an investment foundation. A Consolidator may look for specific investments to improve diversification or try and take advantage of current trends.

Consolidators may have similar equity allocations as Accumulators, but the breakdown within the equities may differ.

“And for those in their Spending phase?”

As you might guess, being at, or near, retirement age means some shift to safer, more liquid assets. Such as fixed income. So the equity allocation is usually lowered when people become Spenders.

But there can still be a long time period to live. With people often living into their 90s, investors might have 30 years to live off their wealth. With inflation and low returns on fixed income, that means Spenders may still need a decent equity allocation.

But the allocation with equities may change. Instead of higher risk frontier markets or micro-cap investments, there may be a shift into more Blue-Chip investments. Or value stocks that generate dividend income, but still have upside capital gain potential.

“How does an investor’s risk tolerance factor in to the target allocation?”

In two key ways, as we saw above in the examples.

One is in the overall equity target allocation. A person’s circumstances or risk tolerance will drive the overall equity allocation.

If you are young, with a long time horizon, accepted investment theory might suggest 80-90% in equities. Whereas, for retirees, maybe a general level should be 50-60%, then adjusted down as years pass.

Also, what is the overall level of wealth. If you have $10 million in assets and only need $50,000 a year to live on, then you can take a low risk allocation with little allocated in equities. If you have $500,000 saved and require $50,000 annually, then you will need to take on more risk.

That is more the unemotional, rational approach to risk and an equity allocation.

However, your emotional view of risk may adjust the equity allocation further.

For some retirees, 50% in common shares may be too high for their comfort. And ability to sleep at night. They may prefer the safety and stability of cash or fixed income over the higher volatility of shares. Likely, these same investors had relatively low equity allocations even in their younger years. Some people are simply more risk averse than others.

Two is the equity investments within the equity allocation itself.

Do you prefer relatively lower risk equities? Blue-Chip companies. Value stocks. Dividend producers.

Do you gravitate towards higher risk investments? Micro-cap stocks. Growth. Frontier markets.

What about the investment itself? A well-diversified global equity fund. Versus individual companies. Maybe with a focus on small-cap mining companies operating in Africa.

The risk-return profile can vary wildly within an asset class. Your personal risk tolerance will dictate the way you invest within that class. And that can create much different risk levels for the overall portfolio.

A relatively short, but good overview of equity considerations in your target asset allocation. Very useful to compare the life cycle phases between cash, fixed income, and equities. Also, how both your personal financial situation and risk appetite will impact your equity allocation. As a percentage of the entire asset allocation. As well as the riskiness inherent in the equities themselves.

 

 

Episode 26: Fixed Income Allocation

What is the Fixed Income asset class? Why invest in fixed income, such as bonds and preferred shares? How does the phase of your life cycle, personal circumstances, and risk tolerance affect your target asset allocation to fixed income?

All that and more in Episode 26 on the Wilson Wealth Management YouTube channel.

“What is fixed income?”

A quick review of the fixed income asset class. Plus, why investors typically invest in this asset class.

For much more detail on fixed income, please refer to “Fixed Income Key Terms”“Money Market Instruments”“Bonds, Notes, and Debentures”“Typical Bond Issuers”“Corporate Bond Variations”, and “A Few More Bond Types”.

Fixed income issuers often attach special features, usually called “sweeteners”, to make an issue more attractive to investors. If you want to learn about a few common features, please read, “Key Bond Features: Part 1” and “Key Bond Features: Part 2”.

Preferred Equity is usually treated like fixed income for asset class allocations. To find out why, please read, “Preferred Shares” and “Preferred Share Features”.

“How should those in the Accumulation phase of life assess fixed income portfolio allocations?”

Accumulators are relatively young, just starting their careers. With little wealth to invest, what should they allocate to fixed income?

Given that Accumulators tend to have longer time horizons and can handle asset volatility, then relatively lower volatility fixed income, with its low-return, may not be best allocation. At least for the assets not targeted to shorter term objectives.

While fixed income is currently useful for its diversification benefits combined with equities, a heavy allocation here for Accumulators is usually not warranted. But, as we will see below, other factors may arise that make relatively more fixed income prudent.

To refresh on the different life cycle phases, please review “Life Cycle View of Wealth Accumulation”.

“What about Consolidators? How is fixed income for them?”

Consolidators are in the sweet spot of their earnings and careers. With a relatively long time horizon until retirement, there is still no real need to shift into low-risk, stable assets.

Again, fixed income is more a diversification tool than an investment to generate returns. That said, in times of falling interest rates, fixed income can offer some very healthy returns.

There may still be a role for shorter term objectives, where they do want that certainty and liquidity. As well, as Consolidators approach retirement age, then adding to the fixed asset allocation may make sense.

“What sort of fixed asset allocations for Spenders?”

Spenders are at, or near, retirement. They rely on pension income, supplemented by cash flow from investments. At this phase of life, there is more interest in stable, liquid investments. Like fixed income.

The problem for Spenders is that people continue to live longer. Investors used to allocated 80-90% in fixed income and cash equivalents upon retirement. But that assumed retirement at 65 and life ending at 72. Fine if there is only 7 years remaining.

People now often live into their 90s. If your time horizon is 30 years, trying to do so with a 90% fixed income portfolio may be difficult. You likely want to still invest in higher risk (higher return) equities as you need to grow your assets. As well as to keep ahead of inflation, which often ravages fixed income yields. For today’s 65 year old investors, 30-40% in fixed income might be warranted. Then slowly adjusted upwards as the years pass by.

“What about personal circumstances and its impact on allocations?”

Identical issues as with cash.

Everyone is in a different situation. That will impact the optimal fixed income asset allocation.

Perhaps you require a fixed amount monthly for living expenses. Or have health issues that need to be addressed. Your personal status will determine, to some extent, what you need in monthly net cash inflows and asset safety. In turn, that will dictate the asset allocation and specific investments to best meet that cash flow requirement. In interest or dividends. Or possibly in an annuity.

“And investor risk tolerance? Does that affect the target asset allocation?”

Your personal risk tolerance also guides your investment decisions.

Some young investors prefer no allocation to fixed income. They want all their capital invested in higher return assets. The benefits of diversification are less important to them than higher expected returns. With long time horizons to manage volatility, this may be reasonable. But likely less than an optimal portfolio should hold.

Conversely, other investors may prefer safety and stability in their portfolios, regardless of age and personal situation. Again, their risk tolerance may create a desire for more fixed income than is optimal.

In most cases, risk tolerance is more emotional. Based on factors such as personality, past experience, etc. Much less on taking a purely ration approach to risk management. To refresh on investor risk issues, please refer to “What is Your Risk Tolerance?” and “Investor Profiles”.

As with cash, there are some generalizations that are useful for investors to factor into their own target asset allocation. But there are also unique, personal aspects that will alter that general allocation.

That is why it is crucial for investors and/or their financial advisors, to develop comprehensive Investor Profiles before beginning the target asset allocation. The unique circumstances of the investor must be factored into the allocation equation. Otherwise, a poor investing plan will be created.

For additional information on fixed income asset allocations, please refer to “Asset Allocation: Fixed Income (Part 1)” and “Asset Allocation: Fixed Income (Part 2)”.

 

Episode 25: Cash Asset Allocation

What is the Cash and Cash Equivalents core asset class? Besides potential diversification, why invest in very low-return CCE? How does your life-cycle phase impact cash investments? What about personal circumstances and cash flow needs? Does one’s risk tolerance impact cash holdings?

All that and more in Episode 25 on the Wilson Wealth Management YouTube channel.

“What is Cash and Cash Equivalents (CCE)? Why is it a core asset class?”

CCE covers liquid assets, usually with maturities under one year. Liquid, safe, low volatility, but also with very low investment returns.

It is considered a core asset class, due to the importance of maintaining some liquidity. CCE is very useful for emergency reserves. As well as short-term financial objectives, cash outflow requirements, and to have on hand for investment opportunities that arise.

For additional detail on CCE, please refer to “Cash and Cash Equivalents”.

“What are the CCE considerations for those in the Accumulation life cycle phase?”

Accumulators tend to be relatively young, just starting their careers. With little wealth or CCE on hand.

While CCE provides little return, there are reasons why Accumulators need CCE in their portfolio. Compared to the other life phases, in relatively higher percentages of the asset allocation.

“What are the CCE considerations for those in the Consolidation phase of life?”

Consolidators are typically older, in the prime of their careers and earnings. They have some wealth accumulated and cash inflows should cover recurring outflows. Consolidator cash requirements are much different than for an Accumulator.

However, CCE still is important. In meeting short-term financial objectives, such as buying a new home or paying for a child’s education. Also, in this phase of life there are often investment opportunities. It is useful to have liquidity on hand to take advantage.

“What are CCE considerations for those in their Spending phase of life?”

CCE issues for Spenders also differ from Accumulators and Consolidators.

Spenders are close to retirement and want to enjoy life. They probably have wealth accumulated, but may no longer have employment income to increase their capital. They may wish to increase their stability and portfolio liquidity, including increasing cash balances.

While some costs are no longer an issue in retirement, such as mortgage payments, other new expenses may emerge. Health care, world travel, helping finance children and grandchildren. Again, having that certainty of CCE investments is often desirable for Spenders.

“How can personal circumstances impact CCE allocations?”

Many personal issues fall under a life cycle phase. But some may be common across many phases of life.

Regardless of age, people often have short-term planned expenditures. For an Accumulator, getting married, having a baby, buying that first home. For a Consolidator, maybe a lake house or rental property. Sending a child to college. For Spenders, a trip to Europe.

There are also the unplanned costs. Job loss, vehicles that need replacing, health issues. Part of the emergency reserves is held to cover these unforeseen expenditures.

Tied in to unplanned costs can be the type of job you hold, where you live, etc. If you work in a cyclical sector, such as oil and gas, maybe you have strong employment in boom times. However, if the oil industry suffers, you may be prone to unemployment. If you live in the Caribbean, maybe you run the risk of hurricanes. That can also impact employment or repair costs.

“How does one’s risk tolerance impact the CCE allocation?”

Some people have a high risk tolerance. They will want the bare minimum in CCE, due to its low returns. If there is an actual problem, they will figure it out then. For now, not a consideration.

Others may want to have more than might be necessary in CCE. They sleep better knowing all possible problems can be covered.

Where you are in your life phase, your personal circumstances, and personal risk tolerance, can all impact the amount you allocate to CCE. There is no “one size fits all” for CCE. Consider your unique situation and allocate based on that.

For more information on this section, please read “Life Cycle View of Wealth Accumulation”, “Asset Allocation: Cash (Part 1)”, and “Asset Allocation: Cash (Part 2)”.

 

Asset Allocation: Equity

The final core asset class is equity. Cash and fixed income the other two core classes.

Technically, equity includes preferred shares. However, I normally include preferred shares in fixed income. In fact, many offered preferred features look very much like fixed income. And investors normally buy preferred shares for the income stream, not capital gains. As such, we will equate common shares with equity for now.

We can utilize percentage target asset allocations for common share equities.

Once again, the “right” allocation is determined by your own comprehensive investor profile. It will be unique to your needs, desires, and circumstances. Keys include your current financial situation, phase in the life cycle, and risk tolerance.

Here are a few thoughts from my side.

Common Shares

Common shares traditionally have the highest risk and expected return of the three core asset classes. Though, as we saw earlier, within any asset class itself, there may be a wide variance in expected risk and return scenarios.

Some common shares distribute dividends and may be purchased for an income stream. But most common shares are acquired for capital appreciation potential, rather than pure income generation.

Common shares are more suitable for investors who can handle higher volatility in their investments. This may include investors with long time horizons, those that do not require immediate liquidity, and those with more aggressive levels of risk tolerance.

Equity for Accumulators

Common shares are well suited for Accumulators.

Accumulators generally have the longest time horizon of any investor group, so they can more readily ride out the fluctuations of higher risk assets. At times, liquidity may be an issue for Accumulators owning common shares. But if they properly plan their cash reserves, that should not be a major concern.

With the highest expected returns and the fact that Accumulators can handle the higher risk, it should make sense that Accumulators invest 100% of their wealth (less any cash reserves) in common shares.

Too Much of a Good Thing

It may seem to make sense, but probably not the best strategy in actuality.

That is because of the risk reduction benefits in diversifying one’s investment portfolio across multiple asset classes.

The Magic Number

As an Accumulator, wealth allocated to cash equivalents may be proportionately high. Say 20%. If you allocate another 5-25% in fixed income, that leaves between 55-75% available for common shares.

Probably a good range for most Accumulators.

Of course, your risk tolerance may lead you to increase or decrease the amount you allocate to common shares.

Further, as you consider investing in alternative asset classes, that will also impact your allocation to common shares.

Equity for Consolidators

Common shares are also very good investments for Consolidators.

The same rationale applies to Consolidators as to Accumulators. Those with relatively long time horizons should focus on higher risk investments.

The Magic Number

Consolidators have already accrued some wealth. Cash reserves, as a percentage of accumulated capital, will be less than in the Accumulation phase. Say 5% in cash equivalents. I suggested 10-30% in fixed income for the generic Consolidator in a previous post. That would leave 65-85% for common shares.

That seems to me a decent range for a Consolidator with a moderate risk tolerance. If your personal risk level differs, you should adjust the percentage accordingly.

While this is a good starting point, I would offer a couple of potential amendments.

First, as you age within the Consolidation stage of life, you may want to slowly lower your risk tolerance over time. This reflects your ever reducing time horizon and the desire to begin generating a fixed income stream for retirement. One that also improves portfolio stability and liquidity.

Second, as you increase your wealth and investment expertise, you probably will want to consider alternative asset classes. Real estate is common for investors. There are many other classes as well. The extent that you allocate a portion of your capital to alternative assets will also impact the percentage allocated to common shares.

Common Shares May Provide Alternative Asset Class Exposure

I will note though, that most investors never need to consider alternate asset classes. A well-diversified portfolio of common shares tends to cover many other classes.

For example, you own a passive index fund covering Canadian common shares. How about iShares Core S&P/TSX Capped Composite Index ETF (XIC)? Yes, this is part of your equity asset allocation. But the fund itself provides nice exposure to alternative asset classes. A top 10 fund holding, Brookfield Asset Management’s business involves real estate, renewable power, and private equity. Barrick Gold is another significant member of the index. As is Nutrien. There are multiple Real Estate Investment Trusts (REITs) within the index, providing real estate exposure. And so on.

Do not believe you require adding specialized alternative asset class products to get exposure in those sectors.

Equity for Spenders

During retirement, there will probably be little income from employment or business. Spenders will normally need to live off their savings and pensions. As such, Spenders desire liquid, low risk investments, that provide a constant stream of cash flow. This suggests a shift from higher risk equities into lower risk fixed income assets.

And many Spenders do lower their component of common shares to a minimal amount.

But I do not think this is prudent for most investors.

An Ever Lengthening Time Horizon

Despite the natural inclination to lower your risk tolerance and seek safe investments, you should not completely succumb to this approach. The main reason is today’s life expectancy.

Traditionally, people worked until 65 and then retired and lived off pensions. That was not a problem previously. According to U.S. National Center for Health Statistics, National Vital Statistics Reports, in 1950 the U.S. life expectancy was only 68.1 years of age. Three years from retirement to (average) death did not require significant savings.

But by 1970, life expectancy had risen to 70.8 years. By 1990, it was 75.4. For 2010, 78.3 years. And for 2020, life expectancy is projected at 79.5 (81.9 if you are female).

If you retire with same assumptions that they used in 1970, you may fall 9 years short in your ability to live.

That means you may need to work longer than 65, start saving much earlier to accumulate more wealth, and/or increase the level of risk in your retirement portfolio to compensate for a longer life.

The Magic Number

For the generic Spender, by retirement you may have about 10% allocated to cash equivalents and another 30-40% in fixed income. That leaves about 50-60% for common shares and alternative asset classes.

As the generic spender moves through the Spending phase, the percentage allocated to higher risk equities should decrease over time. A gradual reduction to 20-30% in common shares may be appropriate for the average Spender.

How fast you adjust your allocation depends on your financial situation, risk tolerance, and personal circumstances.

Perhaps you retire at 65 with $100,000 in capital and plan to live another 20 years. At a 5% return, an annuity would pay you $657.22 monthly Not great.

But if you had accumulated $500,000 in capital, that same annuity would provide $3286.09 monthly. Much better.

And if you had saved $2,000,000, your annuity would pay $13,144.35.

If you have accumulated closer to $100,000 than $2,000,0000, you may need to take on additional risk comfortably live through retirement.

If you could earn 10%, rather than 5%, your $100,000 annuity would pay $957.05 monthly. And at a 15% return, your annuity would pay $1300.53 monthly. Both are an improvement over $657.22 at 5%.

Personal circumstances also play a role in your allocation decision.

If your family all lives to 100, you may want to plan on a longer life than the average.

If you live in a location with a high cost of living, you may need to generate greater returns to keep up with inflation and higher expenses. For example, retiring in the Cayman Islands is a more expensive prospect than living out your days in Saskatchewan, Canada.

Conclusion

Those are my thoughts on target asset allocation considerations for common shares, fixed income, and cash equivalents.

Some general asset allocation principles that make sense for most investors.

Invest in higher risk and return assets when you have long time horizons. Shift into more liquid investments that provide a fixed income stream as you age and require safety. Diversify across asset classes to lower portfolio risk.

However, your personal circumstances will play a huge role in the right allocation for you.

Your current financial situation, investment objectives and constraints.

Your investment time horizon, phase of life cycle, and risk tolerance.

These variables are unique for each investor. They do not easily fit into a generic asset allocation calculator. They must be considered both separately as well as in their entirety.

That is why attention to your comprehensive investor profile is crucial.