Choosing the right asset mix

The choice of assets — cash and money market instruments (cash equivalents), bonds, equities, investment funds or alternative investments — is based on the risk-return characteristics of each asset type relative to the risk profile of the client.

“There is no magic formula for determining the right asset allocation for each individual,” says Kevin Chong, financial advisor at RGI Financial Inc. in Markham, Ont. “Knowing the client’s risk profile provides guidance on the proportion of growth, income and safe assets that should be held in the portfolio, but that alone is not sufficient to determine asset allocation.”

Other factors — such as marital status, taxation level, children’s ages, immediate cash-flow needs and personal circumstances — must also be considered.

Jordan Zinberg, investment advisor at RBC Dominion Securities Inc. in Toronto, employs an integrated approach to asset allocation. While the client’s risk profile is extremely important, it is not viewed in isolation, he says: “It is essential to examine the risk profile in combination with several other factors, such as market conditions, income requirements, market experience and tax circumstances, before recommending an asset-allocation policy.

“We do not use asset-allocation models nor do we believe in cookie-cutter portfolios,” Zinberg says. “While circumstances among clients may be common, every person is unique — and so every portfolio is unique.”

Nor is there a “secret pattern” that determines which asset class will outperform in any given period. “The most successful strategy is to allocate the portfolio based on the risk characteristics of each asset class,” says Sanjiv Sawh, executive vice president of Investment House of Canada Inc. in Toronto. “Different asset classes react differently to economic conditions so there will usually be some portion of the portfolio that will perform well at any one point in time. For this reason, the asset mix should, as far as possible, comprise investments that are not correlated.” (See page D5.)

Essentially, the right combination of asset classes can help reduce the impact of market volatility. It is, therefore, important to understand the characteristics and behaviour of different assets in varying market and economic conditions.

> Cash and money market instruments. Cash and cash equivalents are liquid and the least risky, but they have the lowest returns, which are based on the level of interest rates. The risk in investing in cash and money market instruments increases in an inflationary environment, which makes the real rate of return unattractive. “The portion of the portfolio that is allocated to cash and money market is generally based on the need for liquidity,” says Chong.

> Fixed-income securities. Bonds or fixed-income securities are weakly correlated to equities. They are used to reduce overall portfolio volatility and smooth out returns, a function of interest rates and inflationary expectations. When interest rates fall, bond prices rise; when inflation is rising, interest rates tend to rise — with the converse also holding true. A change in interest rates will usually have a greater impact on the price of a bond with a longer duration. High-yield bonds — unlike government bonds — are more closely correlated to equities. Their performance is linked to the performance of the issuer, which typically is a corporation.

> Equities. Equities are the most risky investments but they offer the greatest payoff. Large-cap equities — stable, “blue-chip” names — tend to perform well in a strong, low interest rate economic environment, which facilitates higher corporate earnings and dividend payouts. Smaller companies, which generally grow faster than their larger counterparts in favourable economic conditions, are usually more susceptible to rising interest rates, which increases borrowing costs to finance their growth. Sector-specific equities are subject to cyclical forces such as demand, supply and capital expenditure, which influence the performance of the specific sector. Foreign equities enhance diversification and, consequently, can reduce risk.

“The general rule is that as the client’s risk tolerance increases, so does the proportion of equity investments to fixed-income investments in the portfolio,” Sawh says. “Income-type investments tend to be less volatile than equity investments. Even though the value of fixed-income investments moves in the opposite direction to interest rates, the movement is generally more predictable than with equities.”

@page_break@Theoretically, conservative or risk-averse investors may be allocated up to 80% in fixed-income and cash equivalents, and 20% in equities. Conversely, risky or aggressive investors may hold up to 80% in equities and 20% in fixed-income and cash, while moderately conservative investors may hold a 50/50 balance.

There are also varying risk profiles within each asset class. Different stocks have different risk implications, while bonds are rated based on quality and risk. The same can be said of mutual funds, with volatility varying within the same fund type. This means that besides addressing a client’s risk profile with an appropriate asset allocation, it is also prudent to select investments within the asset class to reflect the overall risk tolerance. The classification of an investment within this asset class, whether equity or income, will depend on the underlying investments and in the structure of the vehicle itself, says Sawh.

“The asset mix of an aggressive investor would not comprise 80% specialty funds. But it would include core equity funds, as well as funds that have a specific geographical or size bias,” Chong adds. “Typically, in a well-diversified, aggressive portfolio, specialty funds would not be more than 10% of the mix.”

> Alternative products. Alternative asset classes and structured products should also be factored into asset-allocation decisions. Hedge funds, which are a dynamic collection of alternative strategies that derive their returns from the active management of other asset classes, are meant to reduce risk and enhance returns. They are not correlated to traditional asset classes but can introduce substantial risk to a portfolio if the underlying strategy fails to perform in line with expectations.

“We may suggest option strategies or hedge funds for more sophisticated clients, but only if there are reasons for these asset classes to be included in the portfolio,” says DS’s Zinberg. “It all comes back to the fundamental rule of knowing your client. With the ever-increasing universe of products available, and the blurring of the line between income- and equity-oriented securities, it is extremely important to ensure that clients understand what they are holding and where it fits into the overall picture.”

Other asset classes, such as income trusts and business and real estate investment trusts, which provide a predictable stream of income based on corporate earnings and return of capital, may also be part of the asset mix.

“Income trusts are positioned as high-yield equities, and we always ensure clients understand this,” Zinberg says. “Many retail investors think that income trusts are bond equivalents. They are quite surprised to find out that the yields are not guaranteed.”

Principal-protected notes offer a guaranteed return of principal. But unfavourable market conditions, including changes in interest rates and poor performance of the underlying basket of investments to which notes are linked, could eliminate any return on principal. These notes also may not have a secondary market.

“Alternatively, some clients with a longer time horizon may wish to invest in real estate, whose value is a function of the economic environment and interest rates,” says Chong. “Flow-through investments, which offer a tax credit, might be recommended for high net-worth clients who have a high tax bill.”

Once the asset mix is selected, many advisors measure the portfolio against a relevant benchmark and a predictive model using software tools to ensure that the client’s objectives will be met.

Says Chong: “Models tend to provide a range of probable returns and the potential risk associated with achieving the returns.” IE