Do you have the mutual fund adviser six-pack?

When people criticize the financial industry in Canada, the target of their wrath is usually high fees and underperformance. These are huge issues and, of course, they go hand-in-hand. But the more I work with new clients who arrive after using other advisers, the more I’ve come to appreciate a different problem. I can’t understand why so many mutual fund advisers seem incapable of building a portfolio with a coherent strategy.

This seems almost ridiculously easy. Is it so difficult to pick one fund for each of the major asset classes (bonds, Canadian stocks, US stocks, international and emerging market, real estate) and then assign a target weight to each? Instead I see what I’ve dubbed the “adviser six-pack.” No, not the guy at Investors Group with the ripped abs. I’m talking about the portfolio built from a half-dozen mutual funds thrown together randomly. It’s like the adviser swallowed the Morningstar database and then threw up in the investor’s account.

“Hmm, how about a few thousand bucks in the Mackenzie Growth Fund (the sales rep just visited and gave me Leafs tickets), a few more in the CI Canadian Investment Fund, and a sprinkling in the RBC Canadian Dividend (ooh, dividends). Add a small sliver in the BMO Asian Growth & Income (that one’s done well lately). And I’m going to put that recent RRSP contribution into the TD Monthly Income and the Fidelity Monthly Income because, hey, monthly income.”

Determining a strategic asset allocation is the first and most critical step in creating an investment plan. But if you’ve got the adviser six-pack, no one has given your asset mix a moment’s thought. This kind of portfolio design has more in common with a harried homemaker who improvises dinner with whatever happens to be in the fridge.

Give me one reason

There is no magic formula for an optimized portfolio, and investors can quibble about which asset classes to include and the proportion assigned to each. But there needs to be a thoughtful explanation for your choices.

The point here is not to agonize over trivial details like whether emerging markets should be 8% or 10%. The idea is to look at each of your holdings and ask, “What role does this play in the portfolio, and is this an appropriate weighting?” Every ingredient should be there to increase the expected return or dampen the volatility (or both). And it needs to be large enough to make an impact, but not so large as to expose you to excessive risk. If it doesn’t fit all of these criteria, then it shouldn’t be in the portfolio.

Yet the adviser six-pack often includes two or more Canadian equity funds that are highly correlated and could easily be replaced by a single holding. It includes balanced funds that make little sense as a small component of a large portfolio. And often it has tiny holdings (1% in gold, or $1,000 in a couple of individual stocks) that cannot possibly have any meaningful impact, other than to increase costs and complexity.

Here’s how I would explain the Complete Couch Potato portfolio, a six-pack of index funds. The equity portion—which is the driver of growth—is divided about equally between Canadian, US, and international stocks for maximum diversification. There’s an allocation to REITs because real estate tends to have a low correlation with the rest of the equity market. The fixed income component is designed to lower volatility with a broad mix of investment-grade government and corporate bonds, plus some real-return bonds, which act as an inflation hedge and have low correlation with other asset classes.

Your portfolio may look quite different from this one, and that’s fine, as long as you have a reasonable strategy and an efficient process for carrying it out. If you can do that, you’re way ahead of the adviser six-pack.

Dan Bortolotti is an investment adviser with PWL Capital in Toronto. His Canadian Couch Potato blog can be found here.