The credit crisis and the ensuing economic slowdown are underlining the virtues of global diver-sification of RRSP portfolios, experts say.

But global diversification may not be an easy sell to clients who have enjoyed strong returns on Canadian equities since 2003 and who have seen returns from global funds eaten away by the rise of the Canadian dollar. But evidence is coming in that going global is the approach clients should take in the coming years.

Case in point: with the recent big drop in both oil prices and the C$, global mutual funds fared much better than Canadian equity funds in the three months ended Sept. 30. While the former were down by an average of 11.3% during that period, the latter fell by 17.9%.

These results support analysts’ belief that diversification by sector and geography is the best long-term protection against market volatility that your clients can find. That’s because diversification provides exposure to a range of countries, some of which will do better than others, and to all business sectors, which the Canadian public-company universe does not.

In addition, global diversification provides an opportunity to invest in the best companies around the world in any given sector. The bottom line, analysts say, is that over the long term, global portfolios tend to have less volatility and somewhat better returns than Canada-only investments.

The only potential negative is the reduction in returns in C$-terms when our currency is rising. This, however, is offset by the positive impact when the loonie goes down — and history indicates that the ups and downs of currencies usually offset each other over time.

The other thing against which clients must be protected is inflation. But concerns about inflation are moot right now, with the global economic slowdown dampening inflationary pressures. Once the crisis is over, however, and economies begin to experience healthy growth, inflationary pressure will re-emerge. As such, you need to factor inflation assumptions into your clients’ investment decisions — or they may find themselves without enough money in retirement. The standard assumption of 2%-3% inflation is probably fine, but there are advisors who are assuming an inflation rate of 4% generally, and 10% for health and education costs.

DIVERSIFICATION IS KEY

Here’s a look at how you can protect your clients’ RRSP assets from market volatility, exchange rate movements and inflation:

> Market Volatility. Global diversification is particularly important for Canadians, says David Runkle, director of quantitative research at New York-based Trilogy Global Advisors LLC, which manages a number of funds sponsored by CI Investments Inc.

Canadians need to realize that if their portfolios mirror the S&P/TSX composite index, they are making a bet on oil prices and not on the broad Canadian economy, he says, noting that 70% of the volatility in the index can be explained by movements in the price of oil.

Although there’s nothing wrong with a bet on oil, it shouldn’t be a client’s main strategy. So, that begs the question: what is the best approach for clients to take?

Most publicly traded companies in Canada are in the resources or financial services sectors, which together account for 75% of the S&P/TSX composite. So, there are a number of important sectors or subsectors to which an investor can’t get much, if any, exposure in Canada. This includes health care, in general, and pharmaceu-tical companies, in particular, as well as automobile manufacturers and many industrial and consumer product subsectors. There are some information-technology companies in Canada but they are lightly weighted in the index.

In fact, Canada accounts for just 3% of the value of global equities markets, so confining a client to Canada means he or she will miss out on the opportunity to buy excellent companies, even in resources and financial services.

This means the equities portion of a portfolio should be broadly diversified, by both sector and geography. Because there are usually some parts of the world that are doing well when Canada isn’t, downside risk is minimized.

The problem, of course, is convincing clients of this. Those who have focused their equities investing solely on Canada have done well during the 2003-07 period. For the five years ended Sept. 30, Canadian equity funds had an average annual compound return of 9.7%, appreciably higher the 0.9% annual return for global equity funds during the same period.

@page_break@However, for the three years ended Sept. 30, the picture isn’t as rosy. The average annual return for Canadian equity funds was 2.1%, just slightly higher the 1.9% return delivered by global funds. And, if oil prices stay low, global equity funds are likely to outperform in the next few years.

Furthermore, having all your eggs in the Canadian basket can mean that when clients need to sell, they may have to do so at a time when Canadian stocks are down more than global equities. Canadian stocks, as measured by the S&P/TSX composite, are a lot more volatile than indices from countries that don’t have a high energy component.

> Exchange Rates. The easiest way to avoid the negative impact of currency movements is to stick to Canadian investments. But the benefit of that is offset by the difficulty of diversifying properly by sector and the inability to invest in the best global companies.

HEDGING IS COSTLY

Hedging against currency movements is an option, but it costs money. And if the C$ is falling, your clients can miss out on the benefits. For example, if a client had bought U.S. stock on Sept. 30 for $10,000 and it stayed at the same price, it would have been worth $12,290 on Oct. 22 — a 22.9% gain simply because of the drop in the C$.

It’s important to remember that the loonie is a petrodollar that goes up and down with the price of oil. This means, generally speaking, that the C$ goes down at the same time as energy stocks fall. As such, clients who are diversified geographically will find that returns on their foreign equities will be enhanced by the lower C$, offsetting the lower share prices on the Canadian side.

It should also be noted that there are global equity funds that are hedged against currency movements. This means unitholders don’t get the negative impact of the rising C$. Of course, it also means that you don’t benefit when the loonie goes down, but the trade-off may be worth it for some clients’ peace of mind.

The enhancement of returns from a drop in the C$ also applies to fixed-income funds. Indeed, Runkle highly recommends investing in global bonds. This is essentially a play on currencies, as interest rates don’t usually differ a lot around the world. This strategy can, therefore, provide good returns when the home country is taking a beating.

> Inflation. Inflation currently is not a major concern. That’s because central banks and inves-tors are worrying about a serious global recession and deflation. Deflation is worse than inflation, as it discourages consumer spending; shoppers put off making purchases in the expectation that prices will come down even further.

But as Andrew Beer, manager of strategic planning at Winnipeg-based Investors Group Inc., points out, your clients will still be experiencing inflation in their daily lives, particularly for the cost of services. Health and education costs continue to rise sharply, while property taxes may also increase. And none of this is likely to go away.

“The long-term outlook is reflationary,” says Paul Vaillancourt, senior vice president and director of portfolio strategy at Franklin Templeton Managed Investment Solutions, a division of Franklin Templeton Investments Corp. in Calgary. Once healthy global growth returns, inflation will reappear.

The industrialization of countries such as China, India and other emerging nations is putting tremendous inflationary pressure on food, energy and metal prices. If there is a global recession, growth in these regions will pause — but not for long. When growth resumes, so will the appetite of the increasing middle class for better-quality food, cars, appliances and housing. (There are two billion people in China and India alone.)

This means that you should assume that inflation will average 2%-3% a year. And, as mentioned earlier, some analysts are even suggesting inflation of 4% generally, and 10% for health and education.

The higher the inflation assumption, the higher the return clients will need from their portfolios. This means many clients will need a substantial portion of their portfolios in equities.

It also means that achieving inflation protection is particularly difficult for conservative clients who gravitate toward guaranteed-income products, the returns on which may not cover rising prices, Beer points out. But persuading such clients to diversify their portfolios so that their returns will be sufficient to protect them against inflation won’t be easy. They will be reluctant to increase equities investments during a bear market, but you might be able to persuade them to buy real-return bonds.

RRBs provide a coupon plus a payment that covers the rise in the consumer price index. That means clients are guaranteed that their returns will be more than inflation. But the actual return depends on the price at which the bonds are purchased, which depends on the inflation expectations in the market. So, if the price assumes 2% inflation and inflation turns out to be only 1%, the return will be lower than expected.

Segregated funds with a guaranteed minimum withdrawal benefit are also a possible inflation protector. (See page B16.) They pay a certain percentage of assets annually for life, provided that withdrawals don’t start until age 65. The money is invested in a combination of equities and fixed-income — usually a seg fund mirrors a mutual fund — and if the assets increase at least as much as inflation each year, then purchasing power is maintained.

Real estate funds are another option. Housing prices have cooled off in Canada, but they haven’t plunged as they have in the U.S. — and the latter is not expected to happen. So, clients may be open to investing in a real estate mutual fund, particularly as these invest in a variety of properties, including apartment buildings, shopping malls, office buildings and other commercial and industrial real estate. The rents charged for some of these are likely to continue to increase even if there is a hiatus in appreciating property values. IE