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Headache-generating stocks still needed in RRSPs

by Wayne Cheveldayoff, 2004-01-09

How to invest in stocks? It’s a question that most RRSP investors find quite difficult to answer, especially after the scary market gyrations of the past few years.

It doesn’t help that many still have a lingering headache from watching the major stock indices sink for three years in a row before rebounding sharply in 2003.

But for anyone looking to have a comfortable retirement, there’s really no way to avoid investing in stocks, which historically have produced long-run average returns of 8 per cent annually.

Bond yields, currently around 4 per cent, are just not high enough to rapidly build an RRSP to the desired level, especially for those starting later in life.

The approach you should take with stocks in your RRSP really depends on what kind of investor you are.

For those who want to close their eyes, buy and forget about it, the best route is through mutual funds (chosen, of course, with the help of an investment advisor).

The standard equity mutual funds are baskets of stocks selected by experienced portfolio managers. In one purchase, you get a market-savvy professional working for you and instant diversification, which is important to minimize risk.

If you want to direct your investments to one sector, like energy, precious metals or banks, you can do this through selecting a sector mutual fund.

Mutual funds can be a good place to start, but they have two main drawbacks. First, performance is erratic. While they’re all supposed to know what they’re doing, unfortunately fund managers have good years and bad. A manager could beat the broad market index by a mile one year and then fall behind miserably the next.

Second, there is a hefty fee of 2.5 to 3 per cent a year deducted by the mutual fund company to pay the manager and compensate investment advisors. Some investors don’t even know about this fee, known as the management expense ratio (MER), because it isn’t visible anywhere on the statements they receive.

But sub-performance by managers is avoidable if you are willing to learn a bit about alternatives, such as index investing. Many advisors don’t discuss index investing because they prefer the on-going 1 per cent annual trailer fee from mutual funds over the very modest, one-time commission associated with buying an index security.

This is despite the fact that many studies have shown that the returns from “passive” index investing often exceed the average returns of “active” mutual fund managers.

With index investing, you can invest in broad-based indices or sector indices and they all charge a fee of around 0.5 per cent annually, a saving of about 2 per cent a year compared to mutual fund MERs.

Some financial institutions offer deposit-type investments linked to the performance of a stock index. The advantage is that if the market drops, these give your money back after a set period like five years, but there is also a limit to the gain you would receive if the market soars.

Segregated funds offered by insurance companies also offer a guarantee, in this case to return 75 or 100 per cent of the initial investment after 10 years, and such a guarantee could mitigate a stock market depression, such as the 14-year decline experienced in Japan. But such funds have annual MERs of at least 0.5 per cent higher than standard mutual funds, putting them at 3 per cent or more and acting as a sizeable drag on performance.

Investing directly in stocks can work for those who want to “take the bull by the horns” and learn a lot more about the market.

But in order for it to work well, investors must practice the same approach as professional fund managers: (1) do your research; (2) diversify your holdings; and (3) have the discipline to sell quickly to preserve capital if the investment is not working out.

A successful do-it-yourself strategy is to seek out dividend-paying companies that have a record of increasing their dividend over time. This type of approach tends to yield the type of steady growth with low volatility that RRSP investors need.

Some investors who do their homework and use stop-losses have had great returns from specializing in technology, gold or oil and gas stocks, especially junior companies in these fields. But the volatility and potential losses could also be quite high.

However, the best equity investment strategy for RRSPs may lie with specialty business income trusts. Many of the trusts are solid, stable businesses that generate significant cash flow each year, most of which is paid out to unitholders. The trusts are involved in a very diverse range of businesses, including making pet food, operating fast-food franchises, processing fish caught off the East Coast, and manufacturing and distributing the cheques we use for our bank accounts.

Like for any business, there can be trouble for trusts, and a few took a tumble in 2003. But cash distributions have generally been in the range of 7 to 12 per cent annually with relatively low risk, which fits with RRSPs objectives.

With careful selection, the riskier trusts can be avoided. For instance, what could possibly go wrong for a couple of existing trusts that rent out water heaters to homeowners. Are people going to stop using hot water? The cash yield for these trusts is about 8 per cent annually.

These income trusts underline a key point that may have been obscured in all the volatility of the past few years. For those who take the time to do the research, there is money to be made in stocks.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at

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©2004 Wayne Cheveldayoff