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Why you should pack your RRSP with equity funds this year

Don’t get too conservative on your RRSP, says this Canadian mutual fund advisory. It also features two dull funds that are getting brighter.

We’re heading down the stretch in RRSP season and, for the first time in five years, we’re making that run through very risky markets. Does this means that investors should hunker down and avoid all risk in their RRSP shopping?

For mutual fund investors, the short answer is: no. At least, that’s the opinion of one of Canada’s leading fund letters, the Canadian Mutual Fund Adviser. Don’t give up returns for safety.

This advisory also thinks it’s time to look at a couple of conservative funds that look a bit plain when the market is high, but grow a lot more attractive when the markets get ugly. We’ll consider these funds a little later.

First, several reasons why you can be too safe for your own good.

Bond funds are a drag

Many people are in the habit of buying GICs or bond funds with their yearly RRSP investment even at the best of times. This year even more investors may be inclined to follow this strategy as the markets tremble.

Think again, says this advisory. This is precisely the time to add equity funds to your RRSP. The editor calls on some underwhelming statistics to show that bond funds can actually be a drag on your portfolio.

“The average Canadian Fixed Income Fund returned just 1.9 per cent last year. Meanwhile, the average management expense ratio for these funds was 1.74 per cent. Add in taxes and inflation to this mix, and the real value of your investments in these funds would have declined last year.”

By all means own some fixed-income investments with maturities up to five years, says the advisory, but own these securities directly so you control your maturities. Stay out of bond funds.

On the other hand, equity funds may be a better investment now than they were six months ago.

Right hand vs. left hand

The advisory contends that, “despite the recent volatility of stocks, we think they are less risky investments now that they’ve declined substantially in value from the record highs they reached last fall.”

Then there’s a common investment phenomenon in which the right hand and the left hand aren’t on the same page. All too many investors “think of their ‘personal assets’ and their ‘RRSP portfolio’ as if they had nothing to do with each other,” adds the advisory. “In fact, you can maximize profit and keep taxes to a minimum by thinking of your RRSP as the tax-deferred part of your personal assets.”

While taxes on all earnings within an RRSP are deferred, you do lose out on certain tax advantages, like the dividend tax credit and reduced tax rate on taxable capital gains.

Taxes are also a good reason for keeping fixed-income securities (as opposed to fixed-income funds) in your RRSP.

Making money, not hiding it

It is not uncommon to hold several months worth of income in a money-market fund or bank account against the danger of an unexpected cash drain. These reserves may sit untouched for years.

In the meantime, you’re earning interest on those cash reserves, and paying tax on the interest at your full marginal rate. “Far better, we think, to hold the cash reserves within an RRSP,” says the advisory. “You can always dip into your RRSP if necessary.”

In fact, if you’re considering taxes alone, it’s better to hold equities in your taxable account and fixed income securities in your RRSP.

But taxes cannot be your only consideration. You’re investing to make money, not just hide it from the tax collector.

Thus you should also consider “current and prospective returns, the outlook for inflation and other factors,” says the advisory. “At times it makes sense to invest RRSP funds solely in interest-bearing investments. That was especially true in the 1980s, when interest rates were much higher than they are today.

“But things have changed. Interest rates have come way down, and equities, in our view, offer good value for long-term investors now.”

This year especially, says the Canadian Mutual Fund Adviser, you should “weigh the added profit potential, the added risk and the inflation hedge you get by investing RRSP funds in stocks rather than interest-bearing investments. Do that and we suspect you may shift at least part of your RRSP into equities.”

Now it’s time to look at a couple of funds that are about as exciting as a glass of hot milk. But, to borrow one of the great clichés of the investment trade, for that very reason they will let you sleep soundly.

Recommending no-fun funds

When the stock market is on a roll, it’s easy to get bored with conservative equity funds, says this advisory. Of course when the market tanks, they get a little more engaging.

For that reason alone, they should form the backbone of every conservative investor’s fund portfolio through good times and bad.

The advisory has kept two such funds in its list of the Top 40 Canadian funds for over a decade despite their rather mediocre results. It also gives them low marks for artistic merit. “Mackenzie Cundill Canadian Security and Mackenzie Ivy Canadian almost seem to take the fun out of mutual fund investing.

“But we not only suggest holding these funds. We strongly recommend both as good candidates for the core Canadian stock-fund portion of your portfolio if you prefer more defensive funds.”

Graham’s value strategy

Mackenzie Cundill Canadian Security was one of the first funds offered by Peter Cundill & Associates when it set up shop in the 1970s with a mandate to pursue the value investment strategy of Dr. Benjamin Graham.

It invests in securities that trade below their estimated intrinsic value, which is determined by studying financial statements, business prospects, management strengths and potential catalysts that could boost a stock’s price. Preservation of capital is the hallmark of its approach.

That is, before you make money, be sure you don’t lose it. And in fact, the fund has made money, a very decent 9.9 per cent annual compound since its inception in 1979. But it rarely figures among the leaders in its category — Canadian Focused Equity. Over the past three years, its Series C (the only units open for purchase) have returned just 4.9 annually.

The fund did very well, however, in the bear market years of 2000 to 2003. “With its contrarian, value-investing style, it tends to outperform in flat and declining markets,” observes the advisory. Seems to be pretty much what we’re in now.

A quarter of its portfolio is in financial stocks, but not the banks and other victims of the current credit mess. Instead, it has companies like Fairfax Financial Holdings and M1 Developments, one of the multiline insurance firms that have stayed away from toxic debt.

On the other hand, it is heavily invested in inflation-proof stocks like consumer staples and utilities, with 11 per cent of its portfolio in cash and a further four per cent in fixed-income investments.

Hold it now while the market is troubled, says the advisory, and keep on holding it over time, especially if you’re not keen on risk.

Even more conservative

The Mackenzie Ivy Canadian Fund, says the advisory, is even more conservative than Mac Cundill Canadian Security (yawn). And it has taken some flack of late due to its relatively weak performance.

But the advisory thinks the criticism is misplaced. If you’re looking for “steady, consistent, moderate gains, and you place great importance on capital preservation and low volatility, we think Mac Ivy Canadian is an excellent selection.” It’s particularly well suited to those who are thinking of taking some or all of their money out of the equity market in the next five to ten years.

As with the previous fund, this one gives you a better chance of preserving your capital over that time frame that most other Canadian equity funds. And it also did well in the bear market of 2000 to 2003. As the market slumped this past summer in the wake of the first subprime mortgage scare, this fund perked up and performed well.

Two-thirds of the fund’s portfolio is invested in defensive sectors of the economy. A sizeable 28 per cent rests in consumer staples like PepsiCo, Diageo plc (the world’s largest liquor company) and Shoppers Drug Mart.

The Canadian Mutual Fund Adviser expects this fund to hold up well if the markets continue to decline. In a climate of uncertainty, this is about as worry-free as an equity fund can get.

On the face of it, it seems like we’re pulling in two different directions here. This is not the time to be too conservative with your RRSP — buy stock funds. But it is the time to buy conservative funds.

In fact, it all amounts to the same thing: avoid risk now and look for profits in the long run.