Welcome to "Investing: a closer look" where we will be discussing the different types of risk that are associated with various asset classes. Understanding some of these will help you with your own investment strategy.
We all deal with different types of risk in our everyday lives. Investing involves taking risks as well, but understanding what these risks are is an important first step to managing them.
When it comes to investing, many people assume that economical and political risks are the main risk factors. Although they are very important there are other risks you need to consider as well. On this slide we note a variety of risks but there are others such as pandemics or natural disasters sadly that pop up unexpectedly and we have to consider their impact as well.
<On the slide:> A list of various types of risk:
- Economic/Political
- Inflation
- Sector
- Currency
- Interest rate <End slide>
One of the main risk factors associated with cash and fixed income investments is inflation, but what is inflation? Statistics Canada attempts to measure inflation using the Consumer Price Index – a calculation that involves the costs of approximately 600 different goods and services from an average household's annual expenditure on food, housing, transportation, furniture, clothing and recreation. Among other things, this calculation is used to calculate annual increases for the Canada Pension Plan and Old Age Security. As an investor we want to ensure that our returns at least outpace inflation in the long term so that we are truly growing our savings.
<On the slide:> Inflation's impact on various item:
Groceries: Today: $100; 20 years from now: $158
Daily coffee: Today: $2.50; 20 years from now: $3.90
Car: Today: $30,000; 20 years from now: $47,000
Home: Today: $400,000; 20 years from now: $631,000
Figures used for illustration purpose only. Future values assume 2% inflation rate. <End slide>
Think for a moment, if 'John” made a $100,000 investment, how much would it have to be worth ten years later just to keep in line with 2% annual inflation?
If inflation is higher or lower than 2% per year the $122,000 would fluctuate accordingly. The Bank of Canada doesn't want to see negative inflation, also known as deflation, as that discourages spending which has a negative effect on the economy. Japan has experienced this to a degree over the last 30 years and it has caused great issues while Venezuela has experienced hyperinflation where inflation has exceeded over 500 000% which creates even bigger issues as people can't afford basic staples.
<On the slide:> The slide reveals the answer to the previous question: "That's right. $122,000. Your investment would have had to grow by 22% over 10 years just to keep its real value or its purchasing power.
Footnote: Figures used for illustration purpose only and assume 2% inflation rate. <End slide>
Although the North American equity markets are very important, they're not the only markets. Europe and Asia have their own active equity markets, and your group plan may have funds that specialize in markets outside of North America.
Frequently investors have a domestic bias – that is, they're more likely to invest in their own market than other foreign markets. There are a number of reasons why a Canadian investor should consider other markets. The Canadian market (represented by the S&P/TSX) is less than one-tenth the size of the US market – or the S&P 500, who, in turn represent roughly one third of the overall world equity market. Investors would be remiss if they don't consider investing in foreign markets as not only does this provide diversification but could lead to improved returns. One of the challenges the Canadian and US markets have along with most of Europe and Japan is that we have an aging demographic who doesn't need to spend on goods in the same way as other countries whom have a much younger population.
Furthermore, different economies may have very different sector representation. The Canadian economy has a very strong focus in energy and materials.
The slide shows a comparison between markets using a visual that shows relative sizes:
S&P 500:
• Biggest sectors: IT, financials, health care
TSX:
• Biggest sectors: Financials, energy, Industrials, Materials
For illustrative purposes.
<End of slide>
The Canadian Equity market consists of many sectors but they are not equally represented or "weighted" in the index. Some sectors have a larger presence than others. The largest sector by far in the S&P / TSX Composite is the Financials sector which consists of roughly 30% of the index by market capitalization. But keep in mind this could change. At one point energy was the largest industry.
Let's take this idea a step further… During this period of time over 30% of the TSX belongs to the Financials sector, followed by Industrials, Materials & Energy. In comparison, in the S&P 500, Information Technology is first weighting at more than 25%, followed by health care and consumer discretionary. Although the United States are our closest neighbour and biggest trading partner, you can see when we break down our economies by sector, our economies are very different, as they are more influenced by information technology and that has only been increasing over the last several years.
Currency differences impact the everyday lives of Canadians as we import so many products. Dramatic changes in currencies could affect your overall returns with funds that are invested in foreign countries. Some plans offer hedged funds that mitigate that risk so you are only affected by the returns in their respective market and not by changes in their currency. But appreciate that sometimes those currency moves could help your overall returns so you may not want that hedge.
<On the slide:> A bar chart that shows how currency exchange affects returns.
Footnote: For illustrative purposes. Graph shows impact of a nonhedged investment if the Canadian dollar weakens against the USD. <End slide>
Let's take a look at two comparable funds – a Global Equity Fund and an International Fund. The Global fund has over 50% in the North America market whereas the International fund has only about 9% in North America, as international funds in Canada must have less than 10% exposure to Canada and the US. If you truly want exposure away from North America, then the international fund will give that to you. If however, you want a substantial part of your fund to have North American assets as a bedrock, then the Global fund is your answer.
Different companies are obviously sized differently – and you can divide them up into three broad categories – Small, Medium and Large capitalization which measures them based on their total market value. Some funds will only specialize in companies in just one of these categories and other funds invest across the board. For example, on the Sun Life platform, there are funds that only invest in "small cap" companies and the fund manager is looking for those undiscovered opportunities that are set to grow... At various times during economic cycles, different sized companies may outperform. For instance historically, coming out of a recession, small cap often outperform as they can be more agile and reactive than larger companies, while large cap funds typically do better during recessions as larger companies are typically able to handle debt load better.
<On the slide:> A visual representation of company size categories, shown in circles:
Large: +$10B (biggest size circle)
Medium: $2-10B (medium size circle)
Small: <$2B (smallest circle) <End slide>
Okay, we've talked a lot about equities. But bonds play an important part in your investment mix. What are some of the key factors that affect your bond values?
It is a common misconception among the average investor that bonds and bond funds are risk free. They are not. Investors need to be aware of two main risks that can affect a bond's investment value: credit risk (or the ability of the issuer of the bond to repay the debt) and interest rate risk which speaks to the risk associated with changes in interest rates. (tied into monetary policy where the Central Bank may decide to increase or decrease interest rates).
One of the key factors affecting bond prices and therefore Fixed Income funds is credit quality – which is the ability of the issuer of the bond to repay the debt. For example, let's say the issue is the Canadian government – you have good reason to feel confident about their ability to meet their debt obligations and not default of their debts, which is why their bonds are considered high quality in terms of credit risk. But if instead the bonds have been issued by Jonny's Hardware Store, you may feel a little more uncertain and possibly consider his bonds a low or medium quality in regards to credit risk. In practice, there are three categories of credit qualities: Low, Medium and High and you can find out how your fixed income fund invests across these three types from the Morningstar page. Some bonds do not have their credit quality rated by an official ratings agency and they fall under the "Not rated" category. This does not mean they are low quality. It just means that the fund manager has yet to make a judgement as to their quality.
The other important factor impacting bond values are interest rates. Pause for a moment and think… when interest rates rise, what typically happens to bond values?
Typically, when interest rates rise, bond values drop and vice versa. Some investors are confused by the inverse relationship between bonds and interest rates - that is, the fact that bonds are worth less when interest rates rise and vice versa. But the explanation is essentially quite straightforward: When interest rates rise, new bond issues come to market with higher yields than older securities, making those older ones less attractive. Hence, their prices go down. When interest rates decline, new issues come to market with lower yields than older securities, making those older, higher-yielding ones worth more. Hence, their prices go up. As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it. To reduce the overall risk of interest rate volatility, the bond manager will typically invest in a well-diversified portfolio made up of government and corporate debt instruments, with various maturities. You can view the breakdown between various types of bonds, as well as the top 10 holdings, by going to your Morningstar fund reports available online within your account.
<On the slide:>
(1) Up and down arrows showing the inverse relationship between Interest rates and bond values. (2) Up and down arrows showing how shorter- term bonds have less risk than longer term bonds. <End slide>
This chart shows the relationship and performance of different asset classes over a seven year period from 2016 to 2022. The point of this is to simply illustrate that no asset class consistently outperforms another year after year. In fact, sometimes, last year's best performer may be one of the worst performers this year. This is why it is important to not 'chase returns'. A better strategy is to come up with an appropriate asset mix or allocation that corresponds to your risk tolerance. By coming up with an asset allocation and regularly rebalancing your investments, you can capture gains when one asset class outperforms another. An appropriate mix of asset classes can also help even out your investment returns over the long term.
In the financial press you may often see an ongoing debate about active versus passive investing. It is important to understand the difference…
Many investors like the idea of passive or index investing. With a passive approach you're typically trying to track or replicate some sort of market benchmark or indices. The benefits of investing in an index fund are that you simply follow the performance of that particular market. If the market goes up, so does your fund. Also the fees for index funds are generally lower than actively managed funds. With actively managed funds, the fund manager is using their research and analysis to attempt to outperform some sort of market benchmark or indices. As a result of the additional research and analysis involved in actively managing a fund, the fees associated with these funds are generally higher. As an investor, you need to ask yourself, do you want to passively follow a market (and pay lower fees) or do you believe that an active manager will be able to outperform the markets over the long term even with the higher fees?
It's important to know the different types of fees that you may be paying. In the retail world, mutual funds may charge front-end loads or deferred sales charges on their investment funds. These are fees paid either in advance of purchase or upon selling and would be in addition to the Management Expense Ratio (or MER) that everyone must pay annually on their funds. In your Sun Life group plan, the Sun Life funds are 'no load' funds. You would be responsible for paying the annual Fund Management Fee which is equivalent to the Management Expense Ratio, although in group plans, the FMF is typically much lower than the retail world as you're part of a group plan. One other fee that that you need to be aware of is Sun Life's 30-day short term trading policy. If you transfer into a fund, then back out of a fund within 30 calendar days or one month there could be a 2% penalty based on the amount that you transferred. If it has been more than thirty days then you don't need to worry about this. The short term trading policy isn't meant to discourage members from trading in their accounts. We encourage it. It is simply meant to discourage people from day-trading or market-timing in their accounts. Remember, in a retirement plan, if you can balance your risk tolerance with your time-horizon, you should be able to select investments that will allow you to ride any market ups and downs without too much panic.
In order to understand market volatility, it's important to keep abreast of current economic conditions, both here in Canada and around the world.
Sun Life Global Investments publishes regular market commentaries and insights on their website. These may range from analysis of world political and economic events to Sun Life Global Investments strategies for dealing with current risks in the market. The more you learn about some of these concepts, the easier they should become.
<On the slide:> sunlifeglobalinvestments.com
• Publishes regular market commentaries and insights.
• Analysis of world political and economic events.
• Sun Life Global Investments strategies for dealing with current risks in the market. <End slide>
Remember, good investing is built on a solid foundation. You have to have an asset allocation that you understand and that ties in with your comfort level of risk. This could be through a Help me do it approach, such as a Target Date or Target Risk fund, or you could be selecting your funds in different proportions from the Let me do it options. Either way, this first step of correct asset allocation is going to have the biggest impact on how your investments perform.
And remember your fees – use your group plan as a way to get lower fees on your investments. The Morningstar pages in your mysunlife.ca account will give you a wealth of information about the funds you have available. You can find out information such as how they're managed, their top holdings and in which sectors and countries they hold their investments.
<On the slide:> A list of available resources:
• Asset allocation tool
• Fund and fees
• Morningstar®
• Ask an expert
Below these bullet points are key investment questions to consider:
• What is your comfort with risk?
• What are your short, medium and long-term goals?
• When will you need to draw on your savings?
• Is my investment portfolio well diversified? <End slide>
Investing with confidence doesn't have to be difficult. Remember in a retirement plan you should focus on your time horizon and tolerance for risk when selecting investments. The other thing to recall is that time typically helps mitigate risk – and most of us, at least initially have time on our side when it comes to saving for retirement.
<On the slide:> Thank you! The information provided is of a general nature and can not be construed as personal financial or legal advice. Neither Sun Life or its affiliates guarantees the accuracy or completeness of any such information. This information should not be acted on without obtaining counsel from your professional advisors, including a lawyer, notary, tax professional, or financial advisor (registered as Financial Security Advisors in Quebec) as may be applicable to your individual situation.
Group Retirement Services are provided by Sun Life Assurance Company of Canada, a member of the Sun Life group of companies. <End slide>