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Picking Funds for Retirement

Learn how to analyze the fit of funds for your portfolio with the Sharpe ratio, standard deviation, and create your own risk profile – and why these parameters matter

Ian Tam, CFA 18 February, 2020 | 1:10AM
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Sunset and intersection

This article is part of the Morningstar Retirement Week special report

When selecting funds for your tax-sheltered accounts RRSP (or TFSA) remember that the idea behind these shelters is to keep assets tucked away and pay a reduced tax rate (or no tax) when you eventually cash in these assets in retirement. The most important thing to understand is your risk profile, not just when picking new funds, but also while reviewing your current holdings.

Financial theory tells us that broadly speaking, there are two forms of capital: human capital and financial capital. When you are young with little savings but have many years of potential earnings ahead of you, you have lots of human capital, but little financial capital. The opposite becomes true the closer you near retirement. This concept is analogous to the amount of risk you can take – younger investors can afford more risk, as they have more human capital to offset potential losses in financial capital. Investors nearing retirement cannot afford to take the same risks, as they become increasingly reliant on their financial capital once retired.

This said, the type and the combination of funds for your retirement account is arguably a more important decision than the fund itself. Conveniently, Morningstar sorts mutual funds and ETFs into standardized categories based on the underlying holdings of the funds. These tables will give you an idea of the historical risk and return profiles of ten such categories. Together, these ten categories make up two-thirds of ETF and mutual fund assets tracked by Morningstar Canada.

Performance chart

In the second column of the table, you can see the standard deviation of returns for each category. Categories with high standard deviation have exhibited more volatile returns than those with lower standard deviation. The Sharpe ratio is a measure of risk efficiency. Or put another way, per unit of risk, how much return are you making? The chart is a convenient illustration of this point and plots each category return versus standard deviation. For example, Canadian Equity funds (blue triangle) have a higher return but take on much more risk than Global Fixed Income funds (turquoise diamond). Higher returns require more risk.  

Finally, the worst quarter and max drawdown for each category are also shown in the table as a tool for self-reflection. As an investor, can you stomach a 55% reduction in your portfolio (in the case of US equity)? As cliché as it sounds there truly is no reward without risk and having realistic expectations of your return is vitally important when planning for retirement.

Investment growth

 

Training returns chart 3The above chart and table illustrate the relative performance of the categories themselves. Remember that the categories are calculate as average net-of-fees returns of the funds that make them up – the categories themselves are not investable. For reference I’ve also included an equity index as well (S&P/TSX Composite TR Index). Notice that the longer term returns for most categories are thwarted by the one-year trailing returns, largely driven by the equity markets in 2019. If you have some years left before retirement, focusing in on these longer-term return figures will provide a more realistic expectation of what you might receive for investing in a fund within each category.

Finally, remember that this data looks at each category in isolation, whereas your retirement portfolio will likely contain funds from multiple categories and hence the overall risk in the portfolio will be different because of diversification. For example, a standalone investment in Canadian equity fund might itself be considered too risky for a retiree. However, a combination of Canadian equity and Canadian fixed income will lower that risk exposure due to the low correlation between those two asset classes.

It would be ill-advised to select funds strictly based on past performance of the categories, as they do not necessarily equate to what happens in the future. However, the above should provide a reasonable idea of the relative risk between categories.  In the next installment of this series, I will focus in on some of the best-rated funds within these categories.

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About Author

Ian Tam, CFA  is Director of Investment Research at Morningstar Canada. 

 

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