SmartInvesting.ca

List of Articles

Key considerations in picking mutual funds for your RRSP

by Wayne Cheveldayoff, 2006-02-09

The Canadian equity mutual fund landscape is changing, the lines are blurring, and investors wanting to know exactly what they own or are about to buy would benefit from a Sherlock Holmes-type magnifying glass to read all the fine print.

Canadian equity mutual funds used to be pretty standard – 95 per cent equities and about 5 per cent cash. The stocks were at least 70 per cent Canadian, given the government’s 30-per-cent restriction on foreign content for RRSP eligibility.

The government restrictions have been lifted, so an equity mutual fund labeled ‘Canadian’ could have very high foreign content or none at all.

An equity mutual fund is normally thought of as holding stocks, but many have also started buying income trusts – a natural move since income trusts in practical terms are really high-yield equities.

Another innovation of late is that some equity mutual funds have had their prospectuses changed so that they could take short positions in stocks of up to 10 or 15 per cent of net asset value – a little bit of hedge fund thrown in under the mutual fund banner.

If that is not enough to sow confusion and have you reaching for the headache pills, consider that some mutual fund managers have also issued closed-end funds, traded on the TSX, that mimic the returns of their mutual funds. To date, this has mainly been in the income trust sector.

A key difference is that these closed-end funds have the ability to borrow up to 20 per cent of the net asset value – meaning they use leverage to, hopefully, boost returns versus their mutual fund counterparts.

Before you tell your advisor or personal banker to “just put it where you think it makes sense,” consider what the cost would be of not working hard to get the highest return possible.

The RRSP Savings Calculator at www.investorED.ca shows that a $40,000 RRSP, with no further contributions, would increase to $402,506 in 30 years if it obtained an 8-per-cent compound annual rate of return. That would supply $37,706 annually for 25 years of retirement.

But if you were able to squeeze out another 2 percentage points of return each year over 30 years –obtaining a 10-per-cent annual return – the RRSP at retirement would have $697,976 and would supply you with $76,894 annually for 25 years in retirement.

So it obviously pays to peruse the mutual fund stats to get the right managers for your RRSP.

It is true that looking at only last year’s return in judging a mutual fund isn’t the best way to go.

Take, for example, the Sprott Canadian Equity Fund. It has a top five-star rating from Globefund.com and it has handily beat the S&P/TSX total return index in three and five-year horizons. Sprott’s three-year return after fees is 26.6 per cent annually, versus 21.6 per cent for the index. Sprott’s five-year return is 32.3 per cent annually, versus 6.6 per cent for the index.

But if you only looked at Sprott’s one-year return of 13.19 per cent, versus 24.1 per cent for the index, you would probably give it a pass.

This raises the question of why some funds have so much volatility versus the index. Sprott aims to hit home runs, whereas other managers may be content with singles (matching the index). Home-run hitters sometimes strike out.

But if you want to be sure to get the best longer-run returns, you will need to know who the successful home-run hitters are and make sure you have at least some of them on your RRSP’s manager team.

You aren’t likely to do as well if your team consists of managers who are trying to match or exceed the index by a little. Instead of having ‘closet indexers’ in your portfolio, you may be better off with index-related exchange traded funds (ETFs) with rock-bottom management expense ratios (less than 0.5 per cent). At least, then, you will be assured that you won’t underperform the index.

What should be obvious by now is that you need to do a lot of research, or lean on the help of a knowledgeable investment advisor, to make sure you get the right mutual funds into your RRSP.

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. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.

The URL for this page is http://www.smartinvesting.ca/articles/20060209010100.html .


©2006 Wayne Cheveldayoff