How to build a mutual fund portfolio

Whether you invest in equity mutual funds or directly in stocks, you need to diversify your holdings and balance them to suit your own investment circumstances and objectives. Below we show you how to do that, using just five of the funds from our ‘Top-40: Canada’s Best Mutual Funds’ list.

MutualFundPortfolioMutual funds have what you might call ‘personalities’, just like people. That’s especially true of the best funds, such as the five from our Mutual Fund Planning Guide that are discussed below.

Managers of the best mutual funds are aware of their own all-too-human limitations. They know better than to act on whim or impulse. They do what they say they are going to do, which is usually what they do best. By sticking with funds like these, investors know what they are getting into when they invest. Using this knowledge, you can match your mutual-fund holdings to your investment temperament and objectives.

How to assess risk in a mutual fund

When we asses risk we look beyond mathematical measures of past performance. We also look beyond the simple appeal of the hottest investment concepts of the day. Instead, we look at fund portfolios the way an experienced stock investor looks at his or her own individual holdings. You should only take on a degree of risk that you can knowingly and willingly accept.

Take foreign investment. Geographical diversification cuts risk, of course. But foreign stocks as a class also expose you, and fund mangers, to risk that you don’t get in Canada. These include language barriers, unpredictable legal systems, currency devaluations, and so on.

Managers of foreign equity funds flatter themselves when they think they can overcome all these obstacles, even while operating at a distance and through interpreters. But the performance record shows that it’s difficult enough for many mutual-fund managers to get it right here in Canada let alone far-flung countries and regions. (Most fund managers know how to make money anywhere in buoyant years, of course, but setbacks inevitably occur.)

Small-cap and junior companies are another area of potential risk. Investment in junior companies can and often does bring higher profits than you get in larger, better-established companies, at least over periods of five to 10 years or more. But juniors also expose you to greater risk of loss when your choices (or fund’s choices) go bad. Then too, in a market setback, funds that invest in junior companies often suffer more than those that invest in senior companies.

At all times, we think you should stick with mutual funds that are run by experienced, successful managers, such as those funds in our Mutual Fund Planning Guide. But you should also plan to invest in a variety of funds to achieve balance in your overall holdings.

How much in each?

All five of the funds discussed below are buys. But you still need to decide on the right proportions. A conservative investor who is highly safety-conscious might wish to apportion her funds as follows:

Mawer Canadian Equity              40%
Leith Wheeler Canadian Equity    25%
Capital Group Global Equity        30%
RBC Emerging Markets Equity      5%

Mawer Canadian Equity Fund takes a highly conservative approach. So an investor with a greater risk tolerance might wish to invest less in it and more in the other three, such as:

Mawer Canadian Equity               30%
Leith Wheeler Canadian Equity     35%
Capital Group Global Equity         25%
RBC Emerging Markets Equity    10%

If you’re a more aggressive investor, you might wish to place greater emphasis on riskier funds. Rather than invest in Mawer Canadian Equity Fund, then, you could choose IA Clarington Canadian Small Cap Fund. You might also want to invest more in a specialized fund such as RBC Emerging Markets Equity Fund. An aggressive investor’s portfolio, therefore, might be apportioned as follows:

Leith Wheeler Canadian Equity          35%
IA Clarington Canadian Small Cap     30%
Capital Group Global Equity              20%
RBC Emerging Markets Equity         15%

The key is to apportion your fund holdings to fit your overall financial plan. You may diversify by picking funds at random. But to balance you need to consider what kind of assets each fund holds, and invest with that in mind.

Buy funds in the right proportion

Now let’s take a closer look at these five funds. All five are buys, but you should buy them in proportions that are right for you, as we suggested above.

You don’t have to buy all your funds at once, needless to say. But you should vary the sums you put in each fund according to the amount and kind of risk you are willing to accept in your portfolio.

■ Mawer Canadian Equity Fund (Fund code: MAW106(NL)) is a very conservative fund. It’s less volatile than the average fund in its category, but slightly more volatile than the S&P/TSX Composite Index.

Mawer Canadian Equity invests mostly in larger-capitalization Canadian companies. The fund invests in wealth-creating companies, or those whose return on capital exceeds their cost of capital.

The fund invests a considerable amount of its portfolio in the less riskier financial (39.1%) and utility (9.4%) sectors. Riskier manufacturing and resource stocks account for about 37 per cent of the portfolio. Consumer stocks, which are somewhere in between, make up nearly 10 per cent of the portfolio. Cash accounts for nearly five per cent. On balance, the portfolio is defensively positioned.

■ Leith Wheeler Canadian Equity Fund (Fund code: LWF002(NL)) is a conservative fund that invests in Canadian common shares. It uses a value investment approach with the view to protecting capital while offering superior investment growth.

Leith Wheeler, however, is a considerably more volatile fund than Mawer Canadian Equity. That’s probably because it invests more of its portfolio in the higher-risk manufacturing and resource sectors (about 44%) and less in cash (0.4%). But it delivers first-class returns over the long term.

■ We consider Capital Group Global Equity Fund (Fund code: CIF843(FE)) a core, conservative multi-country fund. As a global equity fund, it can invest anywhere in the world, giving you the diversification you need to reduce risk. Though its investment philosophy is value oriented, the fund’s portfolio includes growth-oriented stocks.

The fund’s geographical breakdown is as follows: the US, 45.3 per cent; emerging markets, 16.5 per cent; Europe, 16.3 per cent; Japan, 5.7 per cent; the UK, 5.3 per cent; Canada, 4.5 per cent; the Pacific Basin ex-Japan, 1.8 per cent; and cash, 4.6 per cent.

The fund invests in all industry sectors with the exception of real estate.

■ We consider IA Clarington Canadian Small Cap Equity Fund (Fund codes: CCM520(FE), CCM521(DSC), CCM975(LSC)) an aggressive offering. That’s because the fund invests mostly in small-cap Canadian companies, which, though they can often deliver superior returns over time, are more vulnerable to economic setbacks and other negative events.

Despite the higher risk of investing in smaller companies, the fund’s managers take steps to mitigate risk. For one thing, they invest in smaller- and medium-sized companies that have sustainable competitive advantages. Plus, they seek companies with lower valuations that grow faster than the market, and also typically pay a dividend. They also limit industry sector weights.

■ We consider RBC Emerging Markets Equity Fund (Fund code: RBF499(NL)) a higher-risk regional fund.

For one thing, it’s the most volatile offering of the funds we’re discussing here.

For another thing, emerging markets can be subject to risks that you don’t typically find in North America. These can include more corrupt legal systems, under-developed economies, different financial-reporting standards, and so on.

That said, the under-developed nature of emerging markets also holds out the possibility of more rapid economic growth, which should greatly benefit companies that operate in these areas of the world. On the whole, we believe emerging-markets equities have the potential to deliver stronger returns than developed-markets equities over the long term.

RBC Emerging Markets Equity Fund is well positioned to capture some of these returns. Over the past year, the fund’s value has increased nearly 30 per cent. It invests in companies located or active in emerging markets. Among the countries the fund is invested in now, China has the heaviest weighting in the portfolio, followed by South Africa, India, South Korea and Taiwan.

This is an edited version of an article that was originally published for subscribers in the January 19, 2018, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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