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.
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 appreciate 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.
An RRSP that tracks the S&P TSX Index 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 this year’s inauspicious start, 2016 may be great 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 (i.e., 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 greater than 15%. 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 far beyond the Canadian economy, an important way to break out of the limitations of living in a country that constitutes just 2.88% 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.
The graphs, below, of the two most recent large drawdowns for the TSX — June 2008 through February 2011 (Graph 1), and September 2014 through December 2015 (Graph 2) — illustrate the benefits of adding hedge funds to a portfolio, especially when the hedge fund portfolio exposure is in a U.S. dollar-denominated fund of hedge funds. In both instances, the hedge fund index produced a positive return with far less volatility. Aside from the non-correlation benefits of hedge funds, the Canadian-U.S. dollar exchange rate acts as a kind of natural hedge that tends to move in Canadian investors’ favour when the Canadian economy is under duress.
Graph 1: TSX Drawdown — June 2008 through February 2011
Source: Inflection Management Inc.
Graph 2: TSX Drawdown — September 2014 through December 2015
Source: Inflection Management Inc.
When assessing providers for each component, advisors should consider the usual metrics such as beta, standard deviation, Sharpe ratio, and correlation to the TSX, and you should also be aware that some types of investments have specialized metrics that can be useful. 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 and advisors to rethink portfolio construction and embrace asset classes that are less influenced by the equity markets. Family offices and institutions embraced non-correlated alternatives decades ago. It’s time for the rest of the industry to catch up.
Ari Shiff is president and head of research of Inflection Management Inc., a Vancouver-based manager of the ISOF stable of alternative managers.