|Contributed by: martingale |
According to modern financial theory capital is allocated efficiently to global markets overall. That is, the total market capitalization of both companies and countries is roughly optimal. This is the theory behind index funds that are weighted by market capitalization. The overall maximally efficient RRSP portfolio would be to hold a global portfolio of equities roughly in proportion to global market capitalization. How would one go about doing this in and RRSP in a cost efficient manner? In this article I'll look at the breakdown of global market capitalization and discuss the factors that would affect your own particular global equity RRSP allocation. We'll conclude with a list of Exchange Traded Funds (ETFs) that would suit this allocation, and the proportion of your portfolio that you could consider allocating to each of ETF.
To see why a market capitalized index makes sense in your RRSP, consider the case of two countries each with 50% of the available global capital invested in them. Suppose that a higher expected return could be earned by putting slightly more capital into one of those countries than the others--the argument is that some investors will eventually notice this opportunity for improved growth and move some extra capital into the country with the superior opportunities. Capital will keep moving to the best investment until there is no further advantage to be had from investing there. At that point, the allocation of capital will be efficient: Each country will have an amount of capital invested in them that maximizes the overall return relative to the overall risk.
Presumably this serves as a good guide for an investor: If you want to allocate your investments globally in the most efficient way, you ought to follow the global allocation of capital to equity markets. We do know what the overall allocation of capital looks like. According to The Economist (2006, world in figures), it looks something like this:
If we summarize that by market index we come up with roughly this global equity allocation:
|USA||US Total Mkt.||46%|
|Foreign developed||MSCI EAFE||41.5%|
|Foreign emerging||MSCI Emerg. Mkt.||9.5%|
|Canada||TSX Total Mkt.||3%|
Now, if you simply want to follow the global equity allocation you could invest your money along those lines and get the overall optimal result. However, that might not be your personal optimal result. Your situation differs somewhat from the hypothetical "average global investor", and as a result, your portfolio should differ in some ways too. This is just a good starting point. In particular, here are some of the likely differences between you and the average global investor:
It is my opinion that you should satisfy the last two constraints by adjusting the ratio of your bonds to your equities. You can manage your risk tolerance and your financial objectives better by deciding at the outset what portion of your portfolio ought to be allocated to equities, and what portion ought to be allocated to short-term bonds. That is a much better way of managing risk than choosing among equity asset classes.
- You are a Canadian
- You may have specific current spending needs
- You are an individual with retirement/savings objectives
- You have your own particular tolerance for risk
Your specific income and savings needs may cause you to do a variety of interesting things. You might want to put some money into REIT's, or into other income generating trusts. You might want to put an extra two or three percent into gold or oil stocks as a hedge against high energy prices or a recession (though, if you over-invest in the Canadian market, you have implicitly done both of those already). Nevertheless, the majority of your equity portfolio, its backbone, should be globally diversified.
There is one constraint, however, that does impact your global equity choices: You are a Canadian. This has two interesting effects. First, you experience Canadian economy risk: If the Canadian economy suffers, your home declines in value and your employment opportunities are limited. On the other hand, it is much cheaper for you to invest in Canadian equities than in foreign equities--you do not have to pay exchange rate fees to convert your money (including dividends!) and you probably pay a slightly lower commission to buy and sell Canadian equities than foreign ones.
We can estimate these costs: You will lose about 2% overall to exchange rates when you receive a US dividend in a typical Canadian discount brokerage account and use that money to purchase a US security. You will also pay about 15% more to purchase a US security than you will pay to purchase a Canadian security. Over a 25 year period, then, a Canadian investment will return about 20% more than an equivalent US investment, due to exchange rates. That extra 20% is a powerful argument for investing heavily in Canada; on the other hand, your exposure to Canadian economic risk is a powerful argument against doing so.
My feeling, considering all of this, is that you ought to hold perhaps three to five times as many Canadian equities as the global allocation would suggest--bumping your Canadian equities to perhaps 10% or 15% of your total portfolio, up from the global average of 3%. Remember that you also likely hold a significant number of bonds in Canadian dollars, so your net total Canadian position across all of your investments will be quite a bit more than the 10-15% of your equities.
Factoring in all of that, we come up with this suggestion for a typical Canadian investor's diversified equity portfolio:
|Market||Percentage||Low-cost ETF available|
|USA||43%||US:VTI - Vanguard Total Market Index|
|EAFE||38%||US:EFA - iShares MSCI EAFE|
|Canada||10%||TSX:XIC - iUnits capped TSX index|
|Emerging||9%||US:EEM - iShares Emerging Markets Index|
Note that this represents just a portion of your total portfolio. You would separately determine the proportion of bonds that you would hold in your portfolio, and the proportion of "hedge" and "income" investments that you require (presumably REIT's, trusts, gold, and so forth). The above is simply intended to provide you with a guide in determining how to allocate equities in a globally diversified way that is consistent with investment theory, and your own personal situation within the global economy.