How one advisor uses index funds amid RRSP season’s contribution influx

Each month at WP we offer a slate of articles and content pieces that go deep on a particular topic. This January, we’re exploring the use of index funds.

The year always starts busy for financial advisors. Clients have come through the end of their year, many of them receiving a final bonus from their employer, their business, or their personal corporation. They want to check in with their advisors and they want to maximize their RRSP contributions. The answer to this busy season, for many advisors and DIY investors, is to park those contributions in index funds until the dust settles and a more complex asset allocation can be executed. Percy MacDonald, though, sees potential risks in that approach.

MacDonald is a Wealth Advisor with CI Assante Wealth Management Ltd. in Halifax. He explained that while index-tracking products like ETFs have their place in asset allocation, they can come with certain drawbacks. Moreover, he stressed his belief in paying for alpha through actively managed products. He explained how he prepares for this busy season to avoid the issues that may come with parking contributions in a big index fund, or in cash.

“Everybody flocks to an [index] ETF, but a lot of individuals don’t understand what an ETF actually is,” MacDonald says. “I think a lot of financial influencers have told people to buy a couch potato portfolio that they claim will set them up. But that doesn’t take into account what’s going on in somebody’s life cycle, whether they’re trying to de-risk, move to cash, move to equities, or tailor something based on a person’s financial plan.”

MacDonald accepts the idea that these voices for pure passive investing have grown stronger in the past three years as successive bull markets made everyone in an index fund feel like a genius. He argues, though, that we are starting to approach some of the late-cycle conversations held in 2017 and 2018. There may be a growing case for active alpha generation, especially if that offers downside protection in a market correction.  

That is not to say MacDonald doesn’t use index ETFs at all. He sees a place for them on the shelf of his model portfolios. He notes that these products can help create efficiencies and save on costs for clients. Depending on the client’s risk tolerance, time horizon, and meld well with active strategies aimed at generating alpha. He notes, though, that the use of those passive products is integrated within a broader view of model portfolios that can suit specific clients in specific life moments, especially when long-term accumulation is not the priority.

MacDonald notes, too, that indexing has become increasingly sophisticated. Passive index-tracking products can now offer sector-specific access to certain equity or fixed income market subsegments. While it may be possible to cobble together those index tracking products he highlights the issues of KYP and KYC regulations that can make these investments more challenging, especially when their own management structures or underlying indexes see shifts in allocation that might put a client in a position that doesn’t match their goals.

Certain ETFs, MacDonald says, can skew outside of what an ordinary investor may expect from their allocation. He notes the example of many Canadian equity ETFs which are free to allocate up to 49 per cent into US stocks. Investors may think they’re buying Canadian equities at a moment when the country’s value tilt might deliver upside, only to learn that almost half of every dollar they’re investing is headed for an expensive US market. MacDonald will counter those trends with active allocations towards more explicitly 100% Canadian strategies.

While equity markets have rewarded passive investors, fixed income has been more problematic in recent years. Alpha in that sector has been derived largely through active strategies aimed at maximizing income or finding pockets of price appreciation. One of the key goals MacDonald has for his alpha generating allocations is to protect against the downside, something he argues that actively managed fixed income allocations can help with.

On the whole, MacDonald sees a place for index tracking ETFs, but argues that the specific balance of indexing and active alpha generation comes down to the client. During the busy days of January, he avoids the temptation to park capital in index funds, preferring to lay the groundwork with his clients at the end of the prior year so when their additional RRSP contributions come in January, he knows exactly where that money will go.

“We've met somewhere in the last three to six months to talk about what's going to happen when that RRSP contribution is going to be made,” MacDonald says. “We've had that conversation to say what's going to happen with that money when it happens. We’ve determined if it is for a short-term, medium-term, or long-term goal. We know where we are going to park it and how we are going to distribute it. So that way, you're not having to reinvent the wheel while you're taking in larger deposits all at once this time of year.”