To review, an IPS is like a portfolio blueprint. It sets out the client’s risk tolerance, liquidity needs, time horizon and asst mix as a benchmark for future meetings regarding portfolio performance.
Many people have heard the phrase “putting a little water in your wine”. In essence, the phrase means someone is trying to get away with something- like trying to fob off a glass of fluid as being 100% wine when in fact it is 80% wine and 20% water. Most consumers wouldn’t be able to tell the difference, so the person selling the “wine” could presumably increase profit by 20% by engaging in this little trick.
It should go without saying that any self-respecting vintner or restaurateur would never engage in such shady conduct. It’s just unethical. Imagine if it did happen, though. Furthermore, imagine if the person trying to pass off the “wine” as being 100% pure wine went on the record to say he was serving only the purest and best wine to his valued customers. Once the word got out, that person wouldn’t have much credibility, would he? If the analogy of lost respect works with wine, would it apply to mutual funds, too?
There is just no end to the number of firms and advisors that go on and on about the critical importance of strategic asset allocation in portfolio design. Most advisors and firms go on to materially misquote the groundbreaking research that they use to support their claims, but that’s another matter. Just as any vintner committed to quality wine would never put water in his wine, any mutual fund advisor committed to asset allocation would never use impure funds when designing portfolios- especially those that are governed by an Investment Policy Statement (IPS). To review, an IPS is like a portfolio blueprint. It sets out the client’s risk tolerance, liquidity needs, time horizon and asst mix as a benchmark for future meetings regarding portfolio performance. Most advisors naturally stress the importance of the asset allocation section in particular.
Imagine if the funds used to construct these portfolios were in fact, impure. In short, imagine if advisors were figuratively putting a little water in their wine by using (for instance) a Canadian Equity fund that had 20% of its holdings in U.S. equities. It would come as no surprise to most readers that most Canadian equity funds have significant non-Canadian holdings. In fact, in the mid 1990s, this little wrinkle was often carted out as a “benefit” since Revenue Canada (Now CCRA) had a highly restrictive 20% foreign content limit on RRSP investments. Putting foreign content water in your Canadian content wine was a great way to lift risk-adjusted returns.
As we fast forward to the present, however, much has changed. There are now a number of excellent products that are 100% RRSP eligible. The most notable of these are the iUnits exchange traded funds offered by Barclay’s Global investors. On top of that, there are a number of excellent RRSP eligible index funds (from Altamira, for instance) that allow you to gain de facto foreign exposure without having to worry about the new 30% foreign content limit on registered plans. In short, RRSP foreign content limits are higher and easier to circumvent than ever before. What was once a “benefit” may now be a millstone.
You see, most supposedly reputable advisors now use IPSs to govern their asset mix decisions. If one were to use a conventional (i.e. impure) Canadian equity fund for exposure to the Canadian equity asset class, the foreign content impurity could severely impede the ability to manage the mix. These same supposedly reputable advisors never seem to get around to mentioning that they are putting water in their wine when they insist they are committed to strategic asset allocation. For instance, a portfolio might contemplate a 25% weighting in Canadian equities and then go on to use a Canadian equity fund that is 20% invested in foreign equities to get that exposure. Do you see the problem? The overall portfolio will actually overstate Canadian equities by 5% and understate foreign equities by the same amount. How’s that for a commitment to strategic asset allocation? All of this is being “poured out” with a sanctimonious attitude toward process and a strict adherence to the principles of strategic asset allocation. Don’t believe it for a minute. Next time you see an Investment Policy Statement, ask the person who has written it if he goes around putting water in his wine, too.
John J. De Goey, MPA, CIM, FCSI, CFP is a Senior Financial Advisor with Assante Capital Management Ltd., member CIPF and an instructor with The Knowledge Bureau. He is also author of “The Professional Financial Advisor”. The views expressed are not necessarily shared by Assante. email@example.com