Reader C.G. asked the following question (slightly edited) on asset allocation:

I have recently taken over management of my investment portfolio and will convert it over time to an ETF-based portfolio. Can you direct me to sources that will provide me with a proper understanding of asset allocation, stocks-vs.-bonds etc.? Most books are very informative but they do not give Canadian information. The only one that I know of is the Canadian edition of the book by Dan Solin. Are there other Canadian sources and if so, would you subscribe to their recommendations?

There are many excellent booksUnconventional Success, The Little Book of Common Sense Investing, Four Pillars of Investing, Random Walk Down Wall Street etc. come to mind – that provide guidance for developing your own asset allocation. Paul Farrell, a columnist on MarketWatch.com tracks a number of sample passive portfolios that you could use as a model. However, it is true that these portfolios are targeted toward American Investors.

Your asset allocation should ideally have at least four classes: cash, bonds, real estate and equities. Canadians can follow US recommendations on how to split the portfolio among the four major asset classes. The allocation to cash and bonds is driven mainly by your risk tolerance. Real estate is a bit of a special case and the % suggested by experts is all over the map ranging from 0% to 20%.

Canadian investors are in a different boat compared to Americans on how to split their equity portion between domestic and foreign. The US stock market is well diversified compared to ours which is concentrated in Financials and Resources. If we allocate the exact proportion to Canadian markets as our weighting in world markets, we would allocate only 3%.

Many studies have shown that investors worldwide have a home country bias and tend to overweight their respective domestic markets. We have one very good reason to overweight (compared to a 3% equity allocation) our equities: dividends from Canadian corporations are taxed favourably. Dan Solin, for instance, suggests putting 10% of the equity portion in Canadian equities. Personally, I have a target of 20% of total allocation in domestic stocks. I don’t have a very good reason for that exact percentage.

Dividing the foreign equity portion is very simple: I just split US, other developed markets (EAFE) and emerging markets according to their respective world market capitalization. Here are some resources for Canadian investors:

  1. Search for Sleepy Portfolio on this website.
  2. Larry MacDonald’s blog post on Canadian lazy portfolios.
  3. Efficient Market Canada article on foreign asset allocation.
  4. Investing Intelligently’s Passive ETF Portfolio.

This article has 16 comments

  1. What is the rationale for having any cash in your portfolio at all? Won’t bonds always perform better than a GIC or a high-interest account?

  2. Cash plays two main roles – 1. Liquidity and 2. Opportunity

    Liquidity is important if you need to make a withdrawal from your investment account and don’t want to sell any securities at an inopportune time.

    Opportunity refers to the ability to take advantage of any opportunities in the market – again, without having to divert funds from other investments which may not be right to do at the time.

    With respect to “what is cash”, many people do not just leave Cash as Cash – rather it is invested through a high-interest savings account, cashable GIC’s or money market funds. Banker’s Acceptance’s and T-Bills are used a lot as well.

    And, NO: bonds will not always perform better than cash or GIC’s. If interest rates are rising, you will lose money in bonds (the bid/ask of the bond will fall). If you don’t want to subject your CASH to interest rate risk, you would not put them in bonds as your first choice.

    If you held your bond to maturity, then yes you will make money – but then this would represent the fixed income portion of your asset allocation, and not CASH.

  3. Thanks for the good response, where does all my money go.com

    Still, if I’m in a passive portfolio (no need for opportunity) and in it for the long-haul, e.g. an RRSP, (no need for liquidity) – the I’m guessing I don’t really need any cash portion?

  4. Canadian Capitalist

    WDAMMG: Thanks for responding to Joe’s question.

    Joe: I view all our accounts as one big portfolio. So yes, I may not have any cash portion in the RRSP account, I would hold some cash elsewhere in a taxable account just in case, we get a very good buying opportunity.

  5. Joe – I tend to agree that cash isn’t always a good asset to own.

    I read an interview with William Bernstein (Four Pillars) and although he says it’s not worth having more than 75% in equities because of the risk/reward profile, in a taxable account it might make sense just to have 100% equities. If you are earning 4% on your cash and paying 40% tax, then the net return is only 2.4% which is not very good.

    This advice would apply to a long term passive investor. The other points that were mentioned about having cash for buying opportunities, emergency fund etc are perfectly valid as well.

    Mike

  6. Nice article. I am also recently working on an asset allocating in an ETF based portfolio and decided on following:

    US = 40%
    CAN = 30%
    EAFE = 20%
    EM = 10%

    This will make up the core of the portfolio (60%). I am leaning to a total 70% equity allocation.

  7. Personally I have 70% in Canada, because many of our business have international presense. For instance, IGM, Great West, Manulife, Scotia bank, TD, Talisman and the pipelines. And if no direct presense, at least strong correlation such as with the railways.

    And as already mentioned, dividend tax credit.

  8. Agreed on the comments on holding cash. Theory is one thing, but in practice I don’t see any benefit to a long term investor in holding cash in an RRSP or in a taxable account because of the tax treatment and the non-need for liquidity long term. In a taxable account I would rather hold a portfolio of preferred shares, and in sheltered accounts bonds and debentures. The pref’s will be more or less as stable as corporate bonds and will have the preferential tax treatment.

    By the time you start withdrawing funds though, cash plays a more important part of asset allocation as liquidity is more important at this stage.

  9. A few comments…
    (1) A colleague of mine once said something like, “we need money but we don’t need cash!” I think it’s a matter of personal style.
    (2) Home country bias means you have no currency risk. This could be a good thing or a bad thing depending what you want.
    (3) Many foreign indices are only available through USD denominated ETFs and many are hedged (so if you DO want the currency exposure you lose out). For example, I have XIN, which is in CAD but it’s 100% hedged to CAD 🙁

  10. Thomas, I do believe if you buy IVV (S&P500 denominated in USD traded on AMEX) you are right there are currency effects, and if you bought the XIN version on the TSX you have the product hedged – however for international exposure if you bought EFA on the AMEX you would not necessarily have those same CAD/USD currency effects.

    What happens is that you buy the basket of securities today and your Canadian dollars are converted to USD to purchase the shares because they are on the AMEX. Once the money is with Barclays, it is converted to the underlying currencies of the investments. So for EFA, there are 21 countries and 11 currencies. If we isolate out just Australia for example, you are converting from CAD -> USD -> AUD over the course of a few seconds. Your exposure to USD/CAD fluctuations is, according to Barclays, 1 bp (virtually nothing).

    Once you have purchased the shares the CAD/USD currency effect becomes nil. The basket of international stocks has no tie to fluctuations between CAD and USD. The tie is between the international currencies and the CAD – if you are reclaiming your funds ultimately in CAD dollars.

    At that point (if you redeem), you would go from AUD -> USD -> CAD. Again, only an instantaneous exposure to CAD/USD fluctuations.

    So if the part of your EFA in Australia goes up in value in terms of the equity AND the AUD goes up relative to CAD, you win twice and get the currency exposure.

    In other words, Thomas if you are looking to currency exposure internationally, feel free to buy EFA without worrying what the USD does – it will have no bearing on your investment. The international currencies relation to CAD WILL HAVE the currency effect.

  11. Sorry, amend XIN in the first paragraph to XSP.

  12. Canadian Capitalist

    Thomas: Like WDAMMG says, you could buy IVV, which is 0.15% cheaper to own if you don’t want currency hedging. Even better, you could buy VTI and get exposure to the entire US market including small caps.

    I’ll suggest VEA over EFA. They track the same index but VEA is 0.20% cheaper to own.

  13. WDAMMG: How can you say, “you would not necessarily have those same CAD/USD currency effects”?? If you’re buying it in USD of course there’s currency effects. Your mark on Macquarie bank is going to be AUD -> USD -> CAD every day. So you’re not just taking the AUD/CAD exposure you’re taking the AUD/USD compounded by the USD/CAD.

  14. Canadian Capitalist

    Thomas: WDAMMG is right. If you buy VEA which trades in US dollars but holds unhedged positions in global equities, you are affected by the CAD exchange rate with those global currencies, not against the USD.

    In your example, you are affected only by the AUD-CAD exchange rate, not the fluctuation between USD-CAD. Here’s an excellent post on this topic from Canadian Financial DIY:

    Link

  15. CC: Thanks.
    WDAMMG: Sorry for the confusion.

  16. No problem – I had the same reaction when I first spoke to the reps at Barclay’s! 🙂