When you purchase a mutual fund or ETF you are buying a share of a pool of specific assets that might include stocks and bonds in a variety of sectors and countries. An index mutual fund or ETF portfolio can give you all the diversification you need in as little as one to four core funds covering your major asset classes.
However, many investors, not satisfied with a minimum number of funds, start adding more and more to their portfolio – dividend stocks, REITs, value stocks, small cap, large cap – thinking they are increasing their diversification.
Do you hold too few eggs in your basket?
How can you tell if your portfolio is properly diversified? Proper diversification maximizes your profits while minimizing risks. A Canadian equity fund may have good diversification in the Canadian equity market, but if you start adding variations of Canadian equities you might find you are duplicating your holdings.
For example, say you hold Vanguard FTSE Canada All Cap ETF and then decide to “diversify” with dividend paying stocks and purchase iShares Canadian Select Dividend Index ETF. By drilling down to the fund holdings, you find that you are doubling your holdings of certain stocks that are common to each fund.
In this example, half of the funds top holdings are duplicated. If instead you bought iShares Core S&P/TSX 60 Index ETF, you would find nine of the top ten holdings duplicated.
Related: Is my two-ETF portfolio too simple?
Not only are you paying twice for the same holdings through the funds MERs, you are increasing your risk profile by having too much exposure to a smaller handful of stocks. (In the example above, Canadian banks would make up almost half of your portfolio.)
Take a look at the composition of your funds, especially if you also hold individual stocks. If you decide to purchase another fund, compare the holdings to avoid falling into the under diversification trap.
If you find you have too much concentration in one area, search for funds that aren’t as closely correlated. But, be careful not to go to the other extreme of over-diversification, which can increase costs and ultimately dilute overall returns.
If you think of saving for retirement as a marathon and not a sprint, investing in an RESP might then be best described as a middle-distance event. That’s because unlike RRSPs, where you hold onto your investments for three or four decades before withdrawing the money in retirement, the process for RESPs is much more condensed – you know your child will need the money at or around age 18 to pay for their university or college education.
Related: How to set up an RESP
Because of this relatively short time frame, RESP investors need to decide how and when to shift their asset allocation from potentially equity-heavy early years into cash and guaranteed products in order to preserve capital when their child needs the money for school.
Target date funds for RESPs
One brilliant and yet under-the-radar solution for RESPs is a target date mutual fund. Target date funds have become popular offerings inside of employer-sponsored retirement savings plans (group RRSPs and defined contribution plans), yet of the big banks only RBC and BMO offer target date education funds for RESPs.
The point of a target date fund is to choose the date that closely matches your retirement (or the year your child is likely to go to college), invest your money and then leave it alone. The portfolio is designed to automatically rebalance as you age (or as the college start date nears) so as to reduce risk. The early years emphasize higher-risk equity funds but as you approach your target date the balance gradually shifts to lower-risk fixed income and money market funds.
RBC introduced target education funds in 2004 and has since grown this family of funds to approximately $1.67B in assets. Meanwhile, BMO’s target education portfolios started up in 2014 and has less than $20M in combined assets.
How do target date funds invest your money?
I looked at the RBC and BMO family of target education funds to see how they invest. Here’s what I found:
|Target fund||Equity %||Fixed income %||MER %|
|BMO Target Education 2035||80||20||1.70|
|RBC Target 2030 Education Fund||70||30||2.03|
|BMO Target Education 2030||70||30||1.60|
|RBC Target 2025 Education Fund||55||45||1.93|
|BMO Target Education 2025||62||38||1.50|
|RBC Target 2020 Education Fund||25||75||1.83|
|BMO Target Education 2020||52||48||1.40|
What about those fees?
These funds come with management fees of between 1.4 and 2.03 percent, depending on the target year, but before you dismiss them outright due to the higher MER, consider what you get for your fees.
We know that many Canadian equity mutual funds charge fees of 2 percent or more for a basket of stocks that closely resemble their benchmark (also known as closet indexers). Investors can easily build a similar portfolio of index funds or ETFs for a small fraction of the cost.
But with a target date fund investors are truly paying for active management, with a fund that shifts its asset allocation to match your objectives. Target date fund investors can take a hands-off approach and not have to worry about making a huge mistake, such as leaving an RESP invested heavily in stocks just before their child needs to access the money.
For those reasons, plus the fact that the bulk of your investment growth comes from a 20% government matching contribution each year, makes the 2 percent fee a lot more palatable inside an RESP.
Can’t you replicate this on your own?
As a do-it-yourself investor I will attempt to replicate this RESP strategy on my own. My “target date”, so to speak, for my oldest child is 2027 and for my youngest is 2030. I’m still focused on growth at this stage, with 85 percent of their RESP funds invested in equities and only 15 percent in GICs.
I use the TD e-Series funds to invest their RESP money. The funds cost nothing to buy and sell, and altogether come with an ultra-low MER of 0.42 percent for an even split between Canadian, U.S., and International e-Series funds.
My plan is to gradually shift contributions into fixed income once my oldest child turns 10. By the time she turns 16, everything will be in cash or GICs.
What I’d like to see
Robo-advisors have an opportunity to tap into the target date fund market by offering an automated solution for investors based on the date that closely matches their retirement or the year in which their children are most likely to go to college.
Investors could get a portfolio of inexpensive and broad-market ETFs and have an online wealth management team to auto-rebalance their portfolio for a cost of less than 1 percent annually. Best of all, you wouldn’t even have to think about it beyond setting up automatic contributions and setting a target date.