December 26, 2005

Three resolutions for your portfolio
Three ways to improve your investments in 2006

Many of us make New Year's resolutions around health, fitness, and other life goals. Included in the latter category should be resolutions for your investment portfolio. Here are three suggestions that most investors can benefit from - that is if they're taken more seriously than the gym memberships that are often dropped by February.

Scale back on Canada

Canadian markets have led the world stock market recovery. Accordingly, investors have become insatiable when it comes to Canadian investments, particularly those that are yield-oriented. With the exception of October's uncertainty with respect to income trust taxation (thank you, Ralph), investors continue to trip over themselves to plough money into dividend and other income oriented funds.

Dividend funds (a broad class that includes income trust funds) attracted nearly $10 billion in new money for the first 11 months of this year (nearly half of total fund net sales). This is an increase of 57% over the same period in 2004. (Sales of all long term - i.e. non money market - funds increased by 56% year-over-year.)

The emphasis on these funds is understandable given the performance during the bear market, but such funds don't always provide downside protection. (See the bottom of second page of this January 2004 article for historical bear market data on today's most popular fund class.)

Past investor behaviour and fund data are two reasons to think hard about moving more money into foreign markets. Another is that overseas stocks are relatively cheaper than their North American counterparts. (See the December issue of Advisor's Edge magazine for more on this topic.)

The bottom line here is to take profits from assets that have outperformed over the past few years and add to those that have underperformed. It's a very simple rule that is very difficult for most people to actually implement. But it's key to enhancing long-term returns and controlling risk.

Don't buy a product just because you can

Principal protected notes - a.k.a. structured notes and equity linked notes - have remained popular with investors despite a strong stock market recovery. Investors are drawn to these instruments for their combination of capital protection and potential upside (above standard GICs).

In some cases, as with hedge fund linked notes, investors figure it's a risk free way to invest in a more complex asset class. But what investors (and advisors) must remember is that a big reason for the existence of such notes is that it's the only way to allow smaller investors to get access to hedge fund strategies.

I've not reviewed every note issue but I've seen several of them - and I have not yet seen one that I would recommend. Don't get lured in simply by the 'this product is the only way to get access to this asset class' line. It may be true and may be good, but a product's mere availability to smaller investors is not the same as it having solid investment merit. (Check out this May 2004 article for more on linked notes.)

Stop misbehaving

Canadian stock funds (including everything except dividend and trust funds) have returned an estimated 6.8% annually over the last dozen years (ending November 30). That figure is weighted by fund size and includes funds that no longer exist. Investors in those same funds have experienced a nearly identical 6.7% annually over the same period. But this is in a category that has generally seen strong performance since Canada is at a high point today.

The news is not so good for U.S. and other foreign stock funds (which includes many specialty categories like health care and science and tech). U.S. stock funds boast a solid 8.3% annualized return since the end of 1993, while investors in those funds have earned just 4.9% per year over the same period. Clearly, the higher volatility and poorer recent returns has accentuated investors' intolerance for poor short term performance.

Other foreign stock funds have returned a much smaller 4% per annum over the past twelve years. Investors, however, have seen returns of just 2.6% per year. Tech funds really drag down this number but the point remains that investors have traditionally missed out on the returns available to them because they get lured into hot funds only after a strong multi-year run.

Related to the first resolution is the advice to resist the urge to jump into what has done really well over the past three to five years. Past performance is an important factor to consider, but not in that way. Find ways of looking forward and assessing future potential and act accordingly. If nothing else, simply look at what the masses are doing because it's usually the wrong course of action. This advice won't work all the time but it should serve well over time.